Rising Rates: What All Muni Investors Should Know - Context

What shouldn’t you do as the Federal Reserve tightens policy? You shouldn’t be passive. Passive muni investors suffer from the painful phenomenon of clipped wings. That’s when passive strategies can’t rapidly reinvest in higher-yielding securities as rates climb, unlike their more nimble, actively investing cousins.

We’ve shown the vicious effects of passive investment on investor returns.

And now we know when passive investing hurts most: Always. Because in every kind of yield-curve environment, from steep to inverted, as rates fall and as they rise, passive investors are leaving significant money on the table. So while it matters that rates may rise today, it doesn’t change the answer to the question investors keep asking us: passive, or active?

If you care about your bottom line, active simply steals the show.

Here’s another bonus for the active muni investor. As we explained last week, rising rates eventually lead to slower growth. This causes long-term Treasury and AAA municipal yields to fall faster than short-term yields rise, resulting in flatter yield curves. As curves flatten, Treasuries and high-quality municipals start to beat lower-quality credits. One of the most prudent steps muni bond investors can take during this time is to lean into Treasuries and higher-quality munis.

An actively managed tax-aware municipal bond strategy, which will make the shift and adjust the balance according to an investor’s tax rate and the relative after-tax yields of Treasuries and municipals, can be an effective way to do that.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams