Attention Investors! Are Yields Set to Drop?

Recent U.S. economic data has been mixed. Manufacturing indices and housing numbers point to slower economic times ahead, while employment data indicate modest growth. The fact that we could discuss both the positive and negative implications of such reports reflects the murky picture of what lies ahead… but based on the views of most Federal Reserve governrnors, you’d almost think there’s not a problem in the U.S. today.

Several recent speeches by fed governrnors have included positive language on growth prospects for the U.S., along with concernrns that interest rates might not move up fast enough to stop inflation. I think they are mistaken on both counts, but that’s beside the point.

Given statements by fed governrnors as well as recent jobs and inflation data, the markets expect the Fed to start raising short-term interest rates in June. This has caused bonds to sell off over the past six weeks, bringing yields back up to where they were at year end, after dipping at the end of January.

In the months ahead, we could get a fabulous buying opportunity in bonds, particularly tax-free municipals, but the window to take advantage of these low prices probably won’t last long.

The Fed meets twice before their June session: next week (March 17–18) and in late April. If the Fed alters the language in its press release at these two meetings, implying it will act soon on interest rates, then yields on bonds across the spectrum should move higher, especially those with shorter maturities.

But the case is a little different for municipal bonds, which have a couple more factors at play that could serve to increase their returnrns.

As rates dropped over the past year, cities, states, and other municipal bond issuers pushed through authorizations approving bond deals so that they could take advantage of the low cost of capital. This doesn’t happen overnrnight. Some require approval by governrning boards or commissions, while others have to be approved by voters.

As the wheels of public finance finally get rolling, the bond deals are now starting to hit the market.  Through the first week in March, $68.5 billion in new munis have been issued this year, up 88% from the same period in 2014. For the entire year, analysts expect municipal bond issuance to surpass last year by just over 20%. With more bonds on the market and rates expected to rise, prices should drop and yields should move up.

And then there is the new regulatory environment.

After the financial meltdown, regulators went after banks with a vengeance. New capital requirements and limitations on trading were put in place, curtailing some of the risk that banks had been taking. Since almost every investment bank morphed into a regulated bank in order to receive bailout funds, these new limitations apply to all the major players in the industry.

This resulted in a severe decline in bond trading activity, which limits liquidity. According to the Securities Industry and Financial Markets Association (SIFMA), daily bond trading activity has declined dramatically since its heyday in the mid-2000s. Average daily municipal bond trading volume declined 60% from 2007 through 2014, while overall bond trading fell by 30%.

Corporate bonds are the one bright spot that showed an increase, reflecting higher issuance by corporations as they take advantage of the low rate environment

In the weeks ahead, municipal bonds will be fighting all of the factors above — higher yields in general, higher issuance, and lower trading volumes — at the same time, which could create an exceptional opportunity to lock in some yield for the next several years.

But if you’re in the market for bonds, don’t wait too long to pull the trigger. Even though the Fed appears set to push up overnrnight interest rates, the stage is set for the rest of the yield curve to drop, not move higher.

As I wrote in Boom & Bust in February, trends around the world are pushing yields down, not up. From deflationary forces in Europe to the baby bust in Japan, the pressure on global bonds is so great that yields are nose diving, with yields on many governrnment bonds falling below zero. U.S. bonds have positive yields, making ours seem like high yield offerings, while at the same time our currency is strengthening. This should attract capital from around the world, holding U.S. interest rates lower than expected.

And then there is the outlook for the U.S. economy.

Our growth has been modest, but we still compare favorably to other developed nations and the equity markets have been on fire. However, the baby boomers are still moving toward saving more as opposed to spending more, as evidenced by the latest tick higher in the savings rate. We’re not likely to see a dramatic increase in consumption until the end of the decade. As the economy fails yet again to reach escape velocity, yields should drop back near, or even through, their recent lows.

So if you’re in the market for tax-free income, pay special attention to yields on municipal bonds in the months ahead… but don’t wait too long to pull the trigger! The better deals probably won’t last long.

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