Wednesday, November 23, 2022
Municipal US bond yields better than bank deposits
تم إعداد هذا المنشور من قبل سنشري للاستشارات
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Bonds look alluring!
So far, the Fed’s actions have put a stop to the bull market in bond prices that had been running since 1982. Investors have been dumping bonds based on their fear that higher interest rates will cause bond prices to fall. That fear has become widespread enough that bonds have been beaten down alongside stocks. A portfolio with 60% of its money invested in US stocks and 40% invested in the 10-year US Treasury note has lost 15% this year, its worst year since 1940.
However, this has created a long-awaited opportunity to buy relatively low-risk assets at bargain prices even as they pay higher yields than they have been in decades.
US macroeconomics
Inflation in the US retreated for the fourth consecutive month: It's hard to deny that the Fed's medicine is working -- although with lagged effects. The US CPI data came in at 7.7%, below market expectations of 7.9% and way below the September numbers of 8.2%.
Markets are now expecting the Federal Reserve to slow down the pace of rate hikes gradually and potentially halt hikes sooner than the market currently anticipates. According to the CME Fed watch tool, the probability of a 75 bps hike at Dec meeting dropped from 70% last month to 19%.
In fact, according to the CME Fed watch tool, 55% of market participants are now expecting the Fed Funds rate to peak at 5%. Until a week ago, 33% expected the rates to peak near 5.5%, while 40% expected it at 5.25%. So while the jury is still out on whether the inflation has topped out and whether the Fed will pivot, retail investors are pouring into debt markets, hoping to snap up the juicer bond yields not seen in over a decade.
However, the opportunity in bond markets could be short-lived.
Monetary policy acts with a lag. First, there’s a tightening in financial conditions. That’s followed by a slowdown in economic activity. Finally, inflation starts declining. This could mean that the Federal reserve could potentially halt hikes sooner and opt for rate cuts mid-2023.
With two-year U.S. Treasury yields already trading near 4.5% and the rates expected to peak near 5%, that could mean that the opportunity to add low-risk bond ladders to your income strategy may not be there if you wait too long. Yields generally top much ahead of a fed pivot and fall considerably lower following the pivot. This is due to the fact that bets are placed by traders and market participants months before a fundamental event (like Fed pivot) occurs. Therefore, by the time the Fed pivot really happens, the market has already moved, and the surge in yields is over (or nearing completion).
US municipal bonds like Guggenheim Taxable Municipal Bond & Investment Grade Debt Trust (GBAB) and BlackRock Taxable Municipal Bond Fund (BBN) currently offer 8-9% yield. Even after 30% tax rate, these bonds look pretty attractive as they offer over 6% yield, way above what one would earn keep their hard-earned money for negligible interest rates in the bank. For the ones who are still sceptical on what happen if rates increase further before the Fed pivot, the below calculation could calm your nerves. Let’s consider BlackRock Taxable Municipal Bond Fund (BBN) as an example.
When the Federal Funds rate increased from 0 to 4%, these bonds lost nearly 30% over than span of time (refer to the image below).
US 2-year yield versus BlackRock Taxable Municipal Bond Fund Chart
Data Source: Bloomberg
Data & Prices as of : 17/11/2022
With rates expected to peak near 5%, there appears to be only 50bps upside left to the yields, since the 2-year treasury yields are already trading near 4.5%. That would correspond to approximately 4% loss in bond price which would be well compensated by the gross dividend yield of 8.5% (after 30% tax- 6%).
Meanwhile, if the Fed pivots and opts for rate cuts in the latter half of 2023 or 2024, it would result in bond price appreciations along with net dividend yield of 6% annually. The table below explains the bond ETF payoff in different scenarios.
Assuming Fed doesn’t cut rates till end of 2024 | ||||||||||
2023 | 2024 | |||||||||
Worst case scenarios - Yield at end of 2024 |
Estimate U.S 2-year treasury yields |
Expected fall in BBN price |
Estimate Dividend to be received |
Estimate dividend to be received |
Net expected return at end of 2 years |
|||||
Interest rates peak at 5% and remain at 5% |
5% | -3.86% | 6.0% | 6.0% | 8.0% | |||||
Interest rates peak at 6% and remain at 6% |
6% | -11.50% | 6.0% | 6.0% | 0.4% |
Data Source: Bloomberg
Date: 21/11/2022, 3:00 PM UAE Time
Assuming Fed cut rates in 2023/2024 | ||||||||||
2023 | 2024 | |||||||||
Scenarios- Yield at end of 2024 |
Estimate U.S 2-year treasury yields |
Expected gain in BBN price |
Estimate Dividend to be received |
Estimate dividend to be received |
Net expected return at end of 2 years |
|||||
Interest rates peak at 5% and end 2024 at 4% |
4% | 3.86% | 6.0% | 6.0% | 15.8% | |||||
Interest rates peak at 6% and end 2024 at 3% |
6% | 11.50% | 6.0% | 6.0% | 23.4% |
Data Source: Bloomberg
Date: 21/11/2022, 3:00 PM UAE Time
It's probably time to stock up on bonds and let the equity market run its course now that the Fed's interest rate plateau has arrived. The bond trend appears to be far more durable/ long-lasting. To take advantage of the scenario, investors can opt for lump-sum investments or ladder investments in investment grade high yielding US bonds.
Assumptions to the above example
Disclaimer
Risks and Assumptions for Back-tested trading strategies
Data Source: Bloomberg
Data: 18/11/2022
Arun Leslie John
Chief Market Analyst
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