Stay Flexible as Rates Rise

The prospect of rising interest rates understandably has many municipal bond investors concerned. But rising rates aren’t necessarily bad for munis. In fact, higher yields should be welcome news, since they mean more income. The key is to stay flexible.

When rates are rising, investors need portfolio protection. But it’s no time to sit idly in cash and wait things out. Every day spent on the sidelines means income and opportunities lost. A passive, set-it-and-forget-it investing approach isn’t ideal either. Buy-and-hold laddered portfolios tend to lock in low yields that disappoint if the market begins to offer more.

In contrast, active muni portfolio returns have beat their passive cohorts 94% of the time, with an average outperformance of 1.9% over rolling two-year periods from 2009 to 2021. That’s because active muni investors can respond quickly as conditions shift.

Municipal Action Plan: Prepare to Flex

Truly active managers shine in challenging investment environments, especially when they are given a flexible mandate. Here’s the plan we believe investors should expect from their active managers today:

1. Shorten your portfolio duration target. As a rule, a portfolio with a shorter average duration will be less sensitive to rising interest rates than a portfolio with a longer duration. Just don’t shorten too much, or you’ll lose out on income.

2. Vary your maturity structure. There’s no single path to achieving your portfolio’s duration target. A ladder may make sense in some environments, while concentrating in a narrow range of maturities or “barbelling” holdings of short and long bonds may make sense in others. In today’s environment, a barbell structure will likely lead to better outcomes for investors.

3. Consider municipal credit. Not only do mid-grade and high-yield credits offer more income, but they tend to be less sensitive to rate increases. In fact, historically, municipal credit has outperformed when rates rise. And credit risk isn’t a prevailing concern today, given the health of municipal finances.