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HomepageInsights & ResearchThe Fed geopolitics and the case for muni ultra short strategies

Today’s market backdrop is complex. The world started this year facing inflationary pressures and supply-chain disruptions as a result of the multi-year Covid-19 pandemic. Then, in February, new disaster struck — in terms of both humanitarian and financial market impacts — in the form of the Russia-Ukraine conflict.

The war in Ukraine is ongoing, inflationary pressures continue across the globe and financial markets continue to face volatility. 

The US Federal Reserve (Fed) has responded accordingly. The central bank introduced a 0.25% interest-rate hike in March, followed by a 0.50% hike in May. We're expecting five more increases throughout the year, two of which are likely to be 0.50%, as the Fed seeks to cool down the overheating economy and stabilize inflation. 

Investors seeking to hide from the market volatility while capturing yield could turn to the municipal (muni) ultra short arena. Here we outline the potential benefits of municipal ultra short strategies in this market environment.

Comparable total returns to longer maturity fixed-rate debt

While, as an asset class, municipal bonds underperformed during the first quarter, in our second-quarter outlook, we highlighted our reasons for optimism looking forward. We maintain that while rising interest rates and inflation present challenges to the muni market, they also present opportunities.

During the interest-rate hiking cycle from 2004-2006, muni ultra short strategies slightly outperformed fixed-rate paper (Chart 1). During the rate-hiking cycle from 2015-2018, on the other hand, muni ultra short slightly underperformed (Chart 2). But, as Chart 2 illustrates, while there was slight underperformance with municipal ultra short, there were fewer bumps along the way with than with fixed-rate, suggesting muni ultra short strategies could benefit investors seeking to dampen volatility more effectively.

Chart 1: Muni ultra short vs. fixed-rate performance, 2004 – 2006
This hiking cycle started with the first rate rise in June 2004 and ended with the last rise in June 2006

Source, abrdn, March 2022. Please refer to important information for key assumptions and blended index information for all charts.

Chart 2: Muni ultra short vs. fixed-rate performance, 2015 – 2018
This hiking cycle started with first rate rise in October 2015 and ended with last rise in December 2018

Source, abrdn, March 2022. Please refer to important information for key assumptions and blended index information for all charts.

Higher yields/income as Fed Funds move up

Muni ultra short yields tend to march higher as the Fed Funds rate increases. So, too, do their taxable equivalents (charts 3 and 4). In fact, on a taxable-equivalent basis, muni ultra short yields tend to trend higher in this situation than Fed Funds.

Chart 3: Municipal ultra short yields tend to increase with Fed rate hikes, 2004-2006
This hiking cycle started with the first rate rise in June 2004 and ended with last rise in June 2006

Source: abrdn, March 2022. Please refer to important information for key assumptions and index information for all charts. Taxable Equivalent Yield Calculated as Blend yield /(1-.37)

Chart 4: Municipal ultra short yields tend to increase with Fed rate hikes, 2015 - 2018
This hiking cycle started with the first rate rise in October 2015 and ended with last rise in December 2018

Source: abrdn, March 2022. Please refer to important information for key assumptions and index information for all charts. Taxable Equivalent Yield Calculated as Blend yield /(1-.37)

Relative NAV stability

Historically NAV stability has held up in ultra short strategies compared to fixed-rate strategies (charts 5 and 6). Investors can probably expect yields to tick up as the Fed tightens interest rates, which helps to make the case for ultra short strategies.

In addition, ultra short strategies can provide a compelling place to hide from NAV swings that tend to hit other asset classes harder. Given the geopolitical instability that the Russia-Ukraine conflict is causing and its global macroeconomic repercussions, NAV price swings are distinctly possible.

Chart 5: Price volatility – muni ultra short vs. fixed rate, 2004-2006
This hiking cycle started with the first rate rise in June 2004 and ended with the last rise in June 2006

Source: abrdn, March 2022. Please refer to important information for key assumptions and index information for all charts.

Chart 6: Price volatility – muni ultra short vs. fixed rate, 2015-2018
This hiking cycle started with the first rate rise in October 2015 and ended with last rise in December 2018

Source: abrdn, March 2022. Please refer to important information for key assumptions and index information for all charts.

Municipal vs. taxable ultra short

It’s worth noting that, while the two get lumped together sometimes, muni ultra short isn’t the same as taxable ultra short. In terms of yield, taxable ultra short has historically tracked well during Fed Funds rate changes, but it’s more susceptible to NAV fluctuations than muni ultra short. We can see an example of this from March 2020.

The reason that muni ultra short strategies may experience less volatility than their taxable counterparts during times of shifting Fed policy is a difference in their components. Muni ultra short strategies comprise more heavily of variable-rate demand notes (VRDNs) than taxable ultra short strategies, which use mainly short-dated fixed-rate securities and floating-rate notes.

This difference matters because VRDN yields fluctuate based on short-term interest rates, but their price always trades at par ($100). Taxable floating-rate notes, on the other hand, are more sensitive to both yield changes and price changes. So, the journey along the Fed path may be more volatile with taxable ultra short than muni ultra short strategies, even if both generate similar yields.

The case for muni ultra short

Times of rising interest rates can be stressful for investors. We believe that ultra short strategies offer a compelling opportunity for investors seeking to dampen volatility while receiving yield. Muni ultra shorts also offer appeal because of their tax advantages, giving added benefits to investors.

 

IMPORTANT INFORMATION

Charts 1-6: Blend = 50% SIFMA Municipal Swap Index Yield and 50% Bloomberg Municipal Bond 1 Year (1-2) Total Return Index Unhedged USD. Index = Bloomberg Municipal 1-3 Index. All securities priced at par from the SIFMA Index. Important information regarding SIFMA and MSRB.

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

Municipal securities can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities.

Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

US-190522-175228-2

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