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Munis, Interest Rates, and The Fed

May 22, 2023

ARE MUNIS DIFFERENT?

A bond by any other name is still a bond. A bond is a debt and all debts are IOUs. Corporate bonds, municipal bonds and U.S. Treasuries all fit the same definition.

There are differences, of course. Nevertheless, municipal bonds have come in lately for their fair share of attention in the financial press. The subject matter and tone are negative, but should not be unexpected.

State and local governments borrow money to finance their local operations and spending plans. But, the specter of default risk for major municipalities (such as happened in the past with New York City, Detroit, and the states of Illinois and California) casts a long shadow.

Whereas, the past examples were somewhat unique to the specific municipalities involved, the situation currently is not so much about a specific municipality, insomuch as the rising interest rates which have darkened the operating environment for all participants.

Even then, the situation is not unique to municipal bonds. As we said earlier, “all bonds are debts and all debts are IOUs”; and, all bonds have been affected negatively by rising interest rates.

During the year 2022 municipal bonds lost 13%, corporate bonds lost 15%, and U.S. Treasury Bonds lost similar amounts.

BONDS, HISTORICALLY SPEAKING 

Bonds in general are considered a more conservative allocation for investors assets. Most of the time, they are considered a buffer to negative stock market activity. Investors who are more income oriented look to bonds for both income and safety.

Lack of volatility, regular income, and low default risk didn’t save bond investors in 2022, though. In fact, the returns were every bit as bad as stocks…

“…it was the worst-ever year on record for U.S. bond investors, according to an analysis by Edward McQuarrie, a professor emeritus at Santa Clara University who studies historical investment returns.”  (source)

The reason for the horrible returns on bonds is the ongoing increase in interest rates. As interest rates rise, the value of any existing bonds declines. That is how it works for munis, corporates, and U.S. Treasuries – i.e., all bonds.

MORE CARNAGE AHEAD? 

As long as interest rates continue to rise, the value of any existing bonds will continue to decline. If rates remain stable, then bond prices (in general) will remain stable as well.

If interest rates decline, then existing bond prices will go up. That would be a welcome relief to bond holders; but it may not be long-lasting, if indeed, it does happen.

Interest rates are at historically low levels still. A return to more normal, higher levels would inflict additional damage on bonds, stocks, and the economy.

It takes time to heal from the negative effects of artificially-induced low interest rates. After decades of cheap money/credit, the most vulnerable victims to the change in interest rate policy underway are bonds.

FACTS AND CONCLUSION 

Some have said that the Federal Reserve will be forced to reverse their current interest rate policy and pursue lower rates again. Possibly, but there are some problems with that expectation.

Regardless of the Fed’s desire and intention, interest rates are set in the bond market. The only interest rate controlled by the Federal Reserve is the discount rate. 

The discount rate is the rate that the Fed charges member banks to borrow funds directly from the Federal Reserve.

The Fed, as part of their current policy, suggests a range for the Fed funds rate. The Fed funds rate is the rate that member banks pay to borrow money from other banks on an overnight basis to meet their reserve requirements.

That particular rate, however, is a floating rate which changes daily and depends on member banks assessment of other banks and their need for additional reserve funds.

Other than that, all interest rates are set in the bond market by the buyers and sellers of bonds. Those buyers and sellers can, and do, make choices that are not exactly in accordance with Fed policy. The sum of all their trades determines the actual market rate of interest for various securities, and the actual interest rates on specific U.S. Treasury securities is a reference or benchmark for consumer loans, credit cards, home mortgages, etc.

Although Fed policy can influence interest rates, the Fed does not set or control the specific rates themselves.

The Fed can and does enter the bond market as a buyer and/or seller of U.S. Treasury securities and certain mortgage-backed securities. This has an impact on bond prices and rates of interest, but should not be construed as control.

We are at a point where bond market activity and the direction and level of interest rates may diverge in large measure from Fed policy and intention. Be prepared.

By Kelsey Williams for Neptune Global

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Neptune Global is a full service precious metals dealer serving individual investors, the wealth management industry, broker dealers and institutional investors. The firm’s platform of investment bullion includes all forms of traditional physical precious metals in conjunction with innovative physical precious metal investment assets which provide unparalleled diversification, transparency and liquidity. Their leadership in the market is documented with such official designations as being the recipient of a US Patent for the PMC Ounce (Precious Metals Composite). While dynamic offerings such as the PMC Ounce provide investors with many of the conveniences and benefits generally associated with mutual funds and ETFs, all of Neptune Global’s product offerings remain true to the firm’s core convictions related to the time tested value ascribed to physical precious metals ownership.


The periodic symbol for gold is AU which come from the Latin for gold aurum.
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