The current rising interest rate environment, where the Federal Reserve has hinted toward multiple rate hikes per year in upcoming years, has fostered an environment of inflation growth. With an expected decline in purchasing power, fixed income investors are increasingly concerned about the negative impacts of rising rates on their existing, especially long-term, fixed income holdings.
Generally, investors are familiar with the inverse correlation between interest rates and bond values; however, investors with longer maturities are more vulnerable to the current interest rate environment and the forecast of steeper hikes in 2019 and 2020. The rate hikes and rise in inflation are indicative of growth and strengthening of the U.S. economy. Along the same lines, data from the U.S. Commerce Department indicate that the U.S. international trade gap has widened to $57.6 billion in February 2018, the largest since 2008, meaning that U.S. exports are growing, but imports are growing even more.
In this article, we will take a closer look at the current interest rate situation and how a laddered municipal debt portfolio can alleviate or help combat the risk of rate hikes on the values of your fixed income instruments.
Check out this article to determine whether muni bond ladders are right for you.
Current Interest Rate Environment & What Warrants Interest Rate Fluctuations
In the recent Federal Reserve meeting, Chairman Jerome Powell emphasized improving economic conditions and a stronger outlook, which are reflective of strong job growth, economic expansion and rising inflation. With that, he also hinted toward steeper interest rate hikes in upcoming years. The strong economic growth is evident in consumer markets where consumer sentiments are reaching high points and fostering an optimal environment for high inflation numbers. In addition, labor participation rates also remain high (low unemployment rates), putting additional limitations on wage growth. Now, let us explore why economic expansion warrants higher interest rates and vice versa.
One of the critical roles of the Federal Reserve is to gauge and maintain the strength of the economy and ensure the availability of credit to foster adequate growth. The Fed does that by adjusting the Federal Fund Rate to control interest rate movements.
During recessionary periods, the Fed tends to lower interest rates, which means more availability of credit at low cost. In bad economic times, consumers tend to be frugal with their spending and/or borrowing money from the bank; this creates a low demand environment for lending and creates a low interest rate environment, which also serves as a stimulant that encourages people to borrow funds and reinvigorates the economy.
On the other hand, the rise in interest rate happens when the economy is expanding and more people are borrowing funds to invest in business and consumer spending goes up. This stimulates the economy, but to control and maintain purchasing power (inflation) and prevent the economy from ‘overheating,’ the Fed tends to raise interest rates, which serves as a potential deterrent for people to borrow funds but makes it attractive for them to save money at high interest rates.
Be sure to check out our previous article depicting how rising interest rates might impact munis.
Laddering of Your Municipal Debt Portfolio
A laddered bond portfolio consists of bonds with various maturities ranging from short- and mid- to long-term. As short-term bonds mature, the principal is reinvested into the ladder at the longest maturity (long-term). This strategy share similar traits with the ‘dollar cost average’ strategy typically employed in equity investments, where an investor invests a set amount of capital at regular intervals to mitigate the market risk.
In the case of city, county or other local governments, almost all public funds are invested in such a manner. Laddering of fixed income portfolios mitigates the market risk and interest rate risk, and also helps to meets projected cash needs with the matured securities without having to unnecessarily sell holdings and potentially take a loss. Using laddering techniques, local governments invest their funds in such a way that spreads out their maturities from short to long; given the time horizon, local governments make sure that their average portfolio maturity remains below their investment policy threshold.
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Mitigation of Interest Rate Risk & Market Risk With Laddering
When analyzing interest rate risk for fixed income portfolios, it is common knowledge that longer maturities are often hit harder by interest rate hikes. In a well-constructed laddered portfolio, shorter securities mature as time passes. In a laddered portfolio, your maturities slide down on their duration every year. For example, a five-year bond instrument in May 2017 will have a remaining duration of four years in May 2018, and this concept applies to all the different maturities in the portfolio. Hence, with every year gone, your maturities are one year shorter, respectively, and less sensitive to interest rate risk. However, in a non-laddered portfolio, all your maturities have the same duration and same interest rate risk. For example, if interest rates rose by 0.50% every year for the next five years, after that five years a 10-year security will have only five years left to mature and thus will be less affected by the total 2.5% increase in interest rates. Also, under the laddering bond strategy, all debt instruments are typically held until maturity; thus, the interest rate risk becomes nonexistent.
As mentioned above, a laddered muni bond portfolio behaves like the Dollar Cost Average technique used by equity investors; instead of investing your money all at one time, he/she will place his/her trades at different times to potentially lower the cost basis of his/her investments. In the laddered portfolio, you are reinvesting your monies as the debt instruments mature, which can be a tremendous help in volatile markets.
Potential Risks That Never Go Away
Typically, one can build an optimal strategy with laddering techniques and potentially mitigate the interest rate risk or market risk to a certain extent. However, there are some risks that never go away even with laddering that every muni bond investor should consider:
- Credit Risk: This risk is associated with the municipality’s ability to meet its debt obligations or debt service payment for all of its debt issues. Like Detroit, MI or Stockton, CA, local governments can go through financial insolvency and be unable to meet their debt service payments to its bond holders. Investors must carefully analyze the credit rating reports on all of their potential debt investments and revenue sources before including such debt in their bond ladders.
- Income Tax or Change in Tax Codes: As seen in recent times, any small change to the U.S. tax code can have a huge impact on your bond’s coupon payments. For example, when the marginal tax rate is lowered, municipal debt is less attractive because the tax savings aren’t worth as much as they were with high marginal tax rates. Along the same lines, some debts that you might have originally assumed to be triple tax exempt might now be subject to tax. For instance, there have been numerous talks of removing the tax exemption for debt issued to fund sporting arenas.
- Market and Reinvestment Risk: Laddering doesn’t eliminate your market or reinvestment risk; however, it can help you manage that risk. Its crucial to actively look at your existing holdings and cautiously reinvest your matured securities so that you can optimally capitalize on the rising interest rate environment. However, it’s important to note that if interest rates begin to decline or stay flat, your portfolio will not be an optimal one. This is because you might lose out on the potential capital appreciation from long-term debt, since the short-term debt in your laddered portfolio would make less sense as interest rates start declining.
- Transaction Costs Associated With Bond Ladders: Above all, a laddered portfolio can be significantly more expensive than a non-laddered portfolio. In a laddered portfolio, you are investing in many different maturities, which might requires you to split your purchase orders for each group of maturities. In a non-laddered portfolio, you are generally purchasing similar maturities that might fall under one purchase order and reduce your transaction cost.
Be sure to check this article to remain aware of the due diligence process for evaluating municipal bonds.
The Bottom Line
Laddering can serve as a great risk-mitigation tool for investors in addition to providing predictable and consistent returns. For an actively managed strategy, the portfolio returns can be close to those of long-term bonds while being far less risky. Regardless of the interest rate movement, laddering is a smart way to structure your muni-debt investment portfolios.
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