News Center

Muni Bonds Are Defying Rate Worries

by Community Manager

‎04-09-2014 12:35 PM

Market-Commentary.pngBy John Bonnell,

Assistant Vice President of Mutual Fund Portfolios

 

After a not-so-great 2013, municipal bonds bounced back big in the first quarter of 2014. The Barclays Municipal Bond Index gained 3.3% in the three-month period, which more than made up for last year’s loss. In fact, the January-to-March return was one of the best first-quarter showings for muni bonds in the past two decades.

 

There are a number of reasons why muni bonds have done unexpectedly well so far this year, and by “unexpectedly” I mean that they had strong performance even as the specter of rising interest rates grows larger. Rising rates are generally viewed as negative for bonds; when bond yields go up, their value goes down. The reliability of that inverse relationship was seen in the second half of 2013, after the Federal Reserve first hinted that it would soon start tapering its monthly bond-buying program. The response was a panicky interest rate spike that hammered bond prices.

 

The tapering began in January and has since accelerated on a percentage basis. And last month, new Fed Chair Janet Yellen suggested that the other policy shoe — keeping short-term interest rates near zero — might drop sooner than investors had expected. The muni bond market, so excitable just nine months earlier, responded to both the taper and the rate-hike news with a yawn.

 

What’s different this time around?

 

The key reason is a basic supply-and-demand imbalance. In the first quarter, the dollar value of newly issued bonds was more than 25% below the same three months of 2013 and had not even kept up with the value of maturing bonds. Refinancings of existing bonds also dropped considerably during the period. At the same time that supply has tightened, more investors have come into the market looking to buy muni bonds.

 

The strong demand is being driven by muni bond yields that are attractive compared to other sectors of the bond market. They have outperformed Treasuries, and their yields are comparable to similarly rated corporate bonds but with less risk. Interest income from muni bonds is exempt from federal taxation, which further enhances their appeal to investors. The tax exemption also applies to the new 3.8% investment income surtax for high-earning Americans, which could be an additional demand driver this year.

 

When the Fed starts raising short-term interest rates, muni bond prices will likely go down in the short term. Over the longer term, however, there will be a significant benefit for investors seeking current income, as principal returned from maturing bonds is reinvested at higher rates that generate higher returns.

 

It’s also not clear how an increase in rates at the short end of the yield curve may affect yields at the long end. Rising rates are a reflection of growing confidence in the U.S. economy and a demonstration of the Fed’s commitment to heading off potential inflation. If investors are comfortable with the idea that inflation will be subdued and that credit quality will improve along with the economy, yields at the long end may not rise much at all.

 

Another test will come when new issuance of muni bonds reverts back toward the long-term average. States and local governments are still licking their wounds from the financial crisis and thus have been wary about taking on new debt. But they can only overlook their infrastructure needs for so long; eventually, they will start borrowing again to finance new bridges, school buildings and the like. At least through 2014, however, we expect the muni bond supply to remain constrained, which could continue to support prices.

 

 

USAA Offers a Range of Municipal Bond Funds:

 

USAA offers several municipal bond funds, including USAA Tax Exempt Short-Term Fund (USSTX), USAA Tax Exempt Intermediate-Term Fund (USATX) and USAA Tax Exempt Long Term Fund (USTEX).

 

Additionally, state funds are available, including USAA California Bond Fund, USAA New York Bond Fund and USAA Virginia Bond Fund.

 

204300-0414

 

This material is for informational purposes and is not investment advice, an indicator of future performance, a solicitation, an offer to buy or sell, or a recommendation for any security. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing.

 

Consider the investment objectives, risks, charges and expenses of the USAA mutual funds carefully before investing. Contact us at 1-800-531-8910 for a prospectus containing this and other information about the funds from USAA Investment Management Company, Distributor. Read it carefully before investing.

 

Investing in securities products involves risk, including possible loss of principal.

 

Past performance is no guarantee of future results.

 

As interest rates rise, existing bond prices fall. 

Some income may be subject to state or local taxes or the federal alternative minimum tax.  

Foreign investing is subject to additional risks, such as currency fluctuations, market illiquidity, and political instability. Emerging market countries are most volatile. Emerging market countries are less diverse and mature than other countries and tend to be politically less stable.

  

The S&P 500 Index is a well-known stock market index that includes common stocks of 500 companies from several industrial sectors representing a significant portion of the market value of all stocks publicly traded in the United States. Most of these stocks are listed on the New York Stock Exchange.

 

Standard & Poor’s 500 Index and S&P are registered trademarks.  The S&P 500 Index is an unmanaged index of 500 stocks.  The S&P 500 focuses on the large cap segment of the market, covering 75% of the U.S. equities market.  S&P 500 is a trademark of the McGraw-Hill Companies, Inc.

 

The Russell 2000® Index is an unmanaged index which consists of the 2,000 smallest companies in the Russell 3,000 Index, and is a widely recognized small cap index.

 

USAA or its affiliates do not provide tax advice. Taxpayers should seek advice based upon their own particular circumstances from an independent tax advisor.

 

High double digit returns are attributable, in part, to unusually favorable market conditions and may not be repeated or consistently achieved in the future.

 

Financial planning services and financial advice provided by USAA Financial Planning Services Insurance Agency, Inc. (known as USAA Financial Insurance Agency in California, License #0E36312), a registered investment adviser and insurance agency and its wholly owned subsidiary, USAA Financial Advisors, Inc., a registered broker dealer.

 

Investments provided by USAA Investment Management Company and USAA Financial Advisors Inc., both registered broker dealers.

 

The Real Return Fund may be subject to stock market risk and is non-diversified which means that it may invest a greater percentage of its assets in a single issuer. Individual stocks will fluctuate in response to the activities of individual companies, general market, and economic conditions domestically and abroad. When redeemed or sold, may be worth more or less than the original cost.

 

Managed Accounts is a service of USAA Investment Management Company (USAA), a registered investment adviser and broker dealer.

 

Diversification does not guarantee a profit or prevent a loss.

Community Managers

Briana Hartzell

Briana Hartzell

Briana knows all about moving. This Navy wife has helped her husband relocate to four different naval air stations in the last three years. A former USAA employee, Briana is co-founder of The Triple Dish, a blog focused on food, fitness and military life.

View Briana's Profile
Wendy Poling

Wendy Poling

Wendy is a social media strategist and founder of MyMilitaryLife.com, featuring a popular military spouse blog and the hit podcast Navy Wife Radio and now Military Life Radio. She is the wife of a submariner who has also served in Afghanistan.

View Wendy's Profile
Charles Pratt

Charles "Chazz" Pratt

Charles "Chazz" Pratt III is a former U.S. Army Captain who made the Military-to-Civilian career transition in 1994. In his book, The Fort Living Room Transition Course, he shares valuable tips & tricks to help you succeed. Since his transition from the military, he's worked for several Fortune 500 companies, including Pfizer, Genentech, and St. Jude Medical, among others.

View Chazz's Profile
Scott Halliwell

Scott Halliwell

Scott Halliwell is a CERTIFIED FINANCIAL PLANNER™ practitioner.

View Scott Halliwell's Profile
Joseph Montanaro

Joseph "J.J." Montanaro

Joseph "J.J." Montanaro is a CERTIFIED FINANCIAL PLANNER™ practitioner.

View Joseph "J.J." Montanaro's Profile