Ever since the official end of the Great Recession in 2009, the constant fear of rising interest rates has haunted the bond markets. Yet, year after year, the prediction of higher rates has been unfulfilled.
Maybe, just maybe, 2014 finally will be the year rates head higher.
The announcement last week from the Federal Reserve that it will begin tapering — reducing its massive bond buying campaign from $85 billion a month to $75 billion — is considered the first step in removing stimulus and, potentially, could lead to higher interest rates to fight inflation.
While the possibility of rising rates exists, the Fed statement after its two-day meeting set some clear parameters as to when it might begin bumping up short-term rates, saying, “It likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6.5 percent, especially if projected inflation continues to run below the 2 percent longer run goal.”
Recent readings on the economy suggest those targets remain elusive. The latest report by the Department of Commerce last week showed the consumer price index has increased just 1.3 percent in the past 12 months. And, earlier this month, the Department of Labor showed the nation’s jobless rate at 7.0 percent.
While the Fed likely will keep the lid on short-term rates well into 2015, the bond market has already begun to push longer term rates higher. For the first time in a long time, the market values of bonds are declining. All of a sudden, investors are seeing their bond portfolios declining.
Municipal bond markets, especially in California, have become very sensitive to market condition. Not only are rising rates a concern — as rates go up, market values decline — but the uncertainty of defaults and bankruptcies also continue to linger.
“As 2014 approaches, along with the call for continued higher interest rates, we would remind investors of the importance of proper perspective,” said Sean Carney, municipal strategist at BlackRock. “Investments Rates, while important, are not the be all, end all. The income-oriented nature of the municipal asset class should continue to draw investor interest and prove beneficial for tax-exempts in the months ahead.”
In a high-tax state such as California, the tax-exempt return on municipal bonds can be very important. A muni bond with a yield of 4.00 percent, tax-free, is equal to a taxable yield of 7.38 percent, difficult to achieve in today’s market without assuming a high degree of risk.
But another factor lingers over the municipal market. The pending bankruptcy of Detroit and uncertainty about the safety of debt issues in Puerto Rico have investors once again questioning the viability of municipal bonds as investments.
While there have been several recent bankruptcies, including Vallejo, Stockton and San Bernardino in California, such drastic steps are rare, as are defaults on bond payments and return of principal.
However, defaults are still very rare, affecting less than a half-percent of all bond issues on a year-to-year basis.
Bottom line, municipal bonds are still an appropriate consideration for some income-oriented investors. However, it is wise to consider the quality and maturity of the bonds — either as individual bonds or through a mutual fund — before making an investment decision.