08-13-2014 11:03 AM
By John Bonnell, assistant vice president of mutual fund portfolios
Tucked away in a quiet corner of the capital markets, municipal bonds are enjoying a stealthy but stellar 2014.
This year wasn’t supposed to be a good one for munis (or any bonds, according to market pundits), but a convergence of several factors has produced strong performance. State and local governments are keeping a tight grip on their spending, and the path of interest rates continues to confound the experts. Even the current worries about global instability are contributing to the muni rally.
As of August 11, the Barclays Municipal Bond index was up 6.7 percent year to date, nearly a percentage point higher than equities as measured by the total return of the Standard & Poor’s 500 index. The year-to-date performance for long-dated munis is even better, with the Barclays Municipal Long Bond index up approximately 11 percent.
The biggest factor propelling munis is a significant imbalance between supply and demand, and this doesn’t seem likely to change in the near future.
On the supply side, new issuance has been muted and through midyear is well below historical norms. State and local governments are in better shape fiscally than they were a few years ago, but most of them are still not ready to raise the money for big, new capital projects. Issuance by some states is down 40 percent or more compared to last year.
Meanwhile, demand is robust. Part of the clamor for munis is the same flight to quality that has boosted Treasuries as geopolitical tensions increase in Ukraine and several hot spots in the Middle East. Fixed-income investors are also seeking higher yield in a low interest rate environment, and the strong credit quality of munis (Detroit and Puerto Rico being among the exceptions) make them attractive. The tax-exempt status of most munis also has appeal. According to Reuters, new money flowing into muni bond mutual funds has been positive for 25 out of the 32 weeks this year.
It was universally expected that interest rates would rise in 2014 as the Federal Reserve pulled back on its monetary stimulus, but the rate on the 10-year Treasury has actually dropped from around 3 percent in January to 2.4 percent this week.
We don’t try to forecast interest rates because, as this year has proved, there are too many variables that can throw you off. We believe rates will likely be higher in five years than they are today, but we also think the increase may be slower than many expect as we recover from the debt hangover of the Great Recession.
Rising rates would likely have a negative impact on bond prices in the short term. Over a longer span, however, that impact would be softened by the interest income generated by the bond. Investors would also stand to gain as the principal from maturing munis is reinvested in new bonds with higher coupon payments.
The income component of a bond or bond fund is often forgotten when investors get nervous about how interest rate hikes may affect bond prices. Over time, a greater share of a fixed-income investment’s total return comes from income. For that reason, we manage our muni bond portfolios with a primary focus on income generation over the long term.
USAA Investments Managed Portfolio Outlook
Our view of caution toward U.S. equities remains unchanged — we are underweight U.S. large caps and small caps. While signs point to continued recovery of the U.S. economy, valuations are no longer cheap, and profit margins are near record highs.
We are tactically underweight fixed income, primarily to fund a deployable cash position. Within fixed income, we prefer areas of the market that are more credit-sensitive and less sensitive to changes in interest rates, such as investment-grade corporate bonds and high-yield bonds. The USAA Intermediate-Term Bond Fund and the USAA High Income Fund fit this profile.
We are overweight to assets that are positively correlated to inflation expectations. The USAA Real Return Fund provides potential protection against the risks of long-term inflation.
We are overweight non-U.S. developed markets and emerging markets based on relative valuations. Though they have been hit especially hard recently, we believe that emerging markets remain attractive. Along with compelling valuations, they offer an interesting long-term prospect for growth. The USAA Emerging Markets Fund offers exposure to stocks in less-developed countries.
As always, we encourage investors to speak with one of our financial advisors, who can help determine which investment vehicles are best suited for your individual goals, objectives, risk tolerance and time horizon.
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. Download 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.
Foreign investing is subject to additional risks, such as currency fluctuations, market illiquidity, and political instability.
As interest rates rise, existing bond prices fall.
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.
A widely recognized index of investment grade tax-exempt bonds. The eight subsets of the Index are market weighted. The Index includes general obligations, revenue bonds, insured bonds, and pre-refunded bonds.