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Frank Holmes

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5 Reasons Why Short-Term Municipal Bonds Make Sense Now

Last week Federal Reserve Chairwoman Janet Yellen insisted that record-low interest rates will stay as they are for a "considerable time." So what does that mean for bond investors? Many people realize that rising interest rates affect yields and prices, but what others might not know is that if you stick closely to short-term, investment-grade debt securities--the very kind our Near-Term Tax Free Fund (NEARX) invests in--the impact of such a rate hike is not as dramatic as some investors might think.

As you can see in the chart below, NEARX has been a steady grower over the years, in times of rising and falling interest rates as well as extreme market downturns. In fact, it's taken nearly a decade and a half for the S&P 500 Index to surpass NEARX using a hypothetical $100,000 investment back in June 2000.

Think of NEARX, then, as the emotionally-stable, no-drama fund.

Near-Term Tax Free Fund vs S&P 500 Index
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Take a look at the latest performance of the fund here.

Although short-term bonds might not be as sexy as common stocks in fashionable brands like Apple and Tesla, they play an important role in any serious investor's portfolio. Below are five reasons why investing in municipal bonds makes sense now more than ever.


1. Short-term, investment-grade municipal bonds are less volatile in a climate of rising interest rates.

Interest vs Bond Prices

Interest rates are currently at 50-year lows, but as I wrote about previously, they can't stay near zero forever. And when rates do rise, bond prices will fall. At first glance, this inverse relationship might seem illogical, but it makes sense. If newly issued bonds carry a higher yield, the value of existing bonds with lower rates fall.

Let's imagine the Fed raised rates tomorrow. What potential implications would that have on the yield curve and bond prices? As you can see in this hypothetical example using a two-year, 10-year and 30-year Treasury, the farther out the maturity date and higher the rate hike, the more your security would be affected. Remember, these are Treasuries, not municipal bonds, but munis could be similarly affected.

The Longer the Maturity, the Greater the Price Volatility
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As you might guess, what this indicates is that investors should take advantage of short-term bonds, which are less sensitive to rate increases than longer-term bonds that are locked into rates for greater periods of time.

I want to reassure investors that when the Fed raises rates next year, as many economists and analysts speculate, it will most likely be done incrementally over the course of several months rather than in one fell swoop. Just as deep sea divers risk getting the bends when they surface too fast, there's economic risk in allowing rates to rise too much too quickly. The Fed is well aware of this.

Below is one research firm's projection of what rates might look like at different time periods in the future. As you can see, the probability of higher rates rises gradually over time. Some readers might perceive this forecast as too dovish, but it makes the point that an unexpectedly huge rate hike that some investors fear is unlikely.

Probability of an Interest Rate Hike
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What the chart also shows is that there's still time to gain exposure to short-term securities, which are less sensitive to interest rate hikes. NEARX not only invests in such securities but is actively managed by professionals who closely monitor the bond market and interest rate environment.

John Derrick, Director of Research at U.S. Global Investors and portfolio manager of the Near-Term Tax Free Fund, stated during his recent interview with Oxford Club Radio that rising interest rates can actually work in the fund's favor: "When interest rates rise, we'll try to step in and use that volatility to our advantage. You just try to be prudent about how you position duration and maturity structure."


2. Investment-grade munis have a low default risk.

In 2013, your chances of investing in a reliable, secure municipal bond from an issuer that wouldn't default were roughly 99.9 percent. That's according to the number of bond issues in the S&P Municipal Bond Index that defaulted last year. Out of more than 21,000 bonds in the index, only 23 failed to meet their payment obligations.

In the table below, you can see there's a greater likelihood that an issuer won't default the higher its rating and the shorter its maturity. Bottom line: these securities are relatively safe.

Muni Bond Inssuers' Cumulative Default Rates by Initial Moody's Rating
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In a July Frank Talk, John held that:

"On a tax-adjusted basis, municipal bonds have a very compelling risk-reward profile, which means the risk-adjusted returns are high. To take advantage of this, I would encourage investors to add exposure to their portfolio by investing in a product that holds high-quality, traditional municipal bonds."

John reiterated this point during his interview with Oxford Club Radio: "At the end of the day, we stick to the high-quality munis. We really don't play in the higher yield front, where there's more of a risk of a correction."


3. Municipal bonds are tax-free at the federal level.

As you might already know, munis are typically exempt from federal income taxes and often from state and local income taxation as well. This fact is especially appealing to high net worth individuals who want to minimize the tax impact on their investments.

That means more money stays in your pocket and can be reinvested.


4. Munis help diversify your portfolio.

It's prudent to have a diversified portfolio of both equity and debt securities, not to mention cash and commodities such as gold. Stocks can offer you growth and capital gains while bonds provide income and can help protect your assets during more volatile times.

Even within the bond portion of your portfolio, it's important to diversify the types of debt securities you're investing in. NEARX, for instance, holds a wide range of municipal bonds, from school districts to transportation to utilities.

"We're buying high-quality municipals, GOs [general obligations] and essential service revenue," John says.

He likes to describe NEARX as a "classic municipal bond fund."

"We operate in a very conservative manner, probably much more so than most of our peers. It's not the kind of fund where you're going to wake up one day and find that some high-yield security has blown up."


5. Municipal bonds help make America strong.

Speaking of schools, transportation, utilities and other projects, bonds help state and local governments build, repair and maintain much-needed services. This is one of the most compelling reasons to invest in short-term, investment-grade munis. Not only do they have an attractive risk-reward profile and offer tax-free income, they also ensure that municipalities have the funding to provide their citizens with essential needs like education, roads and energy and help build their communities.

Below you can see what some of the largest bond issuances are earmarked for. Without exception, the revenue that bonds generate goes toward services that make America's states, counties and cities attractive places to live.

Municipal Bond Issuances for the 21 Largest Infrastructure Purposes
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Also, there's reason to believe that issuing bonds is the most effective way for governments to generate the funding necessary for specific undertakings. In a recent POLITICO Magazine article entitled "Are Conservative Cities Better?", columnist Ethan Epstein shows that whereas some cities and municipalities rely on and raise taxes indefinitely to fund projects and programs, others prefer instead to issue bonds because they're intended for only one sole purpose:

"[B]ond issues go to specific projects, and cover only a specific amount of money. That's different from funding a social program, or simply forking over higher taxes and hoping that the extra funds go where the government says they're going." "People are OK with investing in their communities," says former Mesa, Arizona, mayor Scott Smith, adding, "People don't trust programs. They trust...tangible results."

However one feels about social programs, Mayor Smith's point is clear: bonds do precisely what they're designed to do, namely, fund projects such as hospitals and roads that benefit all citizens, young and old, rich and poor.

 


Take a Look at NEARX.

The Near-Term Tax Free Fund recently received the coveted five-star rating from Morningstar for the three-year performance period in the Municipal National Short-Term category, and it's been rated four stars overall for many years. The turnover of NEARX is very low, and it has performed well against its peers. Additionally, the fund seeks preservation of capital and has a floating $2 net asset value (NAV) that has demonstrated minimal fluctuation in its share price.

For those investors who wish to seek tax-free income and portfolio diversity and who want to take an active role in strengthening America's infrastructure, I encourage you to request an information packet.

Remember to sign up for our October 2 webcast, "One World Market, Many Central Banks: How Will Your Investments Be Impacted?" Participants can receive a continuing education (CE) credit. Also, be sure to download my latest whitepaper, "Managing Expectations: Anticipate Before You Participate in the Market."

Stay curious!

 

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