Konoplytska
By Randy L. Gross
Monetary policy is likely to tighten until the job is done, but investment opportunities are emerging.
Markets viewed the Federal Reserve’s September meeting as its most hawkish year-to-date, and the reaction was swift: U.S. Treasury yields moved higher across the curve, pricing in further rate hikes for November and December.
The central bank also ramped up its scheduled balance sheet reduction to $95 billion per month. As the Fed steps away from being the largest buyer of longer-maturity Treasuries, new buyers will have to step in to fill this void, which may lead to continued volatility in longer-term U.S. Treasury rates. Overall, the direction of interest rates is likely to remain foggy as the Fed continues fighting inflation by cooling the economy.
At this point, the Fed is seemingly focusing on a singular mandate of price stability at the expense of maximum employment—a break from its traditional dual mandate. In our view, the housing slowdown seen as mortgage rates soared could portend further moderation of inflation in other sectors as tightening is fully absorbed. When the Fed eventually shifts its focus to the economy and deems inflation contained, bonds purchased today would likely experience price appreciation, while any unrealized losses on current holdings could be reversed.
Indeed, even with a pullback from recent extremes, yields on investment grade municipals are hovering close to multiyear highs, which is a major benefit to savers, who can lock in those higher yields and increase their valuable tax-free income.
Looking to Premium Coupons
Amid the recent spike in rates, the volatility of lower-coupon bonds increased as some bonds became subject to de minimis tax implications—a negative tax consequence as their prices fell below 100 rapidly. This makes lower-coupon bonds (below 3%) less desirable and can cause more price erosion than for premium bonds with like maturities. Since premium coupons are coveted for their above-market income and defensive qualities, they tend to be more liquid and less volatile than par bonds of similar maturities in a rising-rate environment. We currently favor premium-coupon bonds in light of these defensive characteristics. These coupon structures have, in general, comfortably outperformed lower coupons as yields have risen this year.
Focus on Selection, Research
We appreciate that most investors share our regard for municipals’ preservation of capital and tax-advantaged benefits. As events unfold in the coming months, security selection and proactive credit research, independent of ratings agencies, are likely to remain essential. In our opinion, active professional management should continue to add meaningful value and outperformance versus passive strategies.
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