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Wednesday, November 23, 2022

Municipal US bond yields better than bank deposits

تم إعداد هذا المنشور من قبل سنشري للاستشارات

Municipal US bond yields better than bank deposits
Municipal US bond yieldsbetter than bank deposits

*Trading in financial market carries risk and can result in loss of capital.
*This performance is only observed with historical backtests and not traded by the company.

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The product and investment ideas do not consider the risk profile and financial position of the recipient and may not be suitable for everyone. Trading in financial markets and use of margin involves a significant risk of loss, which can exceed deposits. Please read the complete disclaimer carefully.

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

HI: 0.3306

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

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Blackrock Taxable Municipal Bond ETFs are held for a period of 2-3 years.
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Feds Fund Rate peaks near 6% and the Fed pivots some time in 2023/2024.
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All other parameters remain constant.

Disclaimer

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Majority of the Municipal ETFs have decent exposure to bonds that are in the investment-grade level and only some to corporate high yield bonds; hence the chances of default are considerably lower. However, investors need to note that these bonds offer a higher return than the treasury securities and signify that there is some inherent risk involved and one should consider their risk tolerance before adding these ETFs to their portfolio.
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Fluctuations in interest rate and economic conditions can trigger price changes in the income securities also.
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Higher leverage can return in higher yields, but they also increase the risk Investments in financial markets are considered risky and there is always a risk of loss of capital.
Risks and Assumptions for Back-tested trading strategies
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The risks and assumptions listed here are not intended to be an exhaustive summary of all the risks and assumptions involved.
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The strategy might suffer from look-ahead bias which occurs due to the use of information or data in a study or simulation that would not have been known or available during the period being analyzed. This can lead to inaccurate results in the study or simulation.
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Future price movements may not be exactly the same as the historical price movements and this could lead to variation in performance.
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Testing can sometimes lead to over-optimization. This is a condition where performance results are tuned so high to the past they are no longer as accurate in the future.
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The model assumes no slippages in trading. Slippage refers to the difference between the expected price of a trade and the price at which the trade is actually executed.
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Drawdowns in actual trading can be higher than the tested system and losses could be significant in the event of leverage.
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Unforeseen events can lead to variation in performance from the tested trading strategy.
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The tested result has been computed with price feeds available from Bloomberg.
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The testing environment has not considered transaction or any other costs.
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Trading indicators used for the purpose of testing has been provided by Bloomberg.
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The strategy might suffer from data mining fallacy, selection bias and backfill bias.

Data Source: Bloomberg
Data: 18/11/2022

Arun Leslie John
Chief Market Analyst

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