Morgan Stanley
  • Wealth Management
  • Jul 29, 2016

The Cost of Waiting for Higher Rates

Is it time for fixed-income investors to take a more active approach to managing their municipal bond portfolios?

For years, experts have warned of the day when interest rates would suddenly shift higher, raising yields and driving down the prices of existing bonds.

That day hasn’t seemed to come.

Numerous professional forecasters have failed to correctly call the year-ahead 10-year Treasury yield every year since 2001, and few predicted that key interest rates in some countries would dip below zero.

Investors, meanwhile, have generally heeded warnings that “rates can only go higher from here." Rather than risk the unthinkable—losing money in bonds—investors flocked to short-term bonds; the logic being that bonds with shorter duration would be less vulnerable to rate hikes. Between 2008 and 2015, short-term municipal mutual fund holdings increased four-fold.

Professional Forecasters Have Persistently Overestimated Future Treasury Yields

Source: Federal Reserve Bank of Philadelphia Professional Forecasters, Morgan Stanley Research. Note: Forecast is year-ahead for 10Y Treasury and forecast error is based on average annual 10Y Treasury yield

Yet, according to a Research report from Morgan Stanley’s Michael Zezas, by investing in short-term, low-yield bonds, investors have exposed themselves to what is arguably a bigger risk over time: earning very low yields. “There is an opportunity cost of sitting at zero and waiting for higher rates," says Christopher O'Dea, managing director for Morgan Stanley Wealth Management's Capital Markets business.

Bonds still play a role in investors' portfolios, to be sure. Nevertheless, sustained periods of low rates call for more precision in managing individual bond holdings, including municipal bonds. The days of fix it and forget it have long been over. “The approach shouldn't be buy and hold, it should be buy and manage," says O'Dea, whose team works behind the scenes to help Morgan Stanley financial advisors buy and sell fixed-income securities for their clients.

Why Higher Rates Aren't a Given

No doubt, the last decade has been marked with no shortage of surprises, from the financial crisis to Brexit. In talking about rates, it could be pointed out that the 10-year Treasury topped 15% in 1981 and has since fallen, resulting in a 35-year bull market in bonds.

However, today's low rates are not the anomaly. In fact, it may be the opposite. Since 1857, in fact, the long-term average municipal yield has averaged 4%.1

It's also important to consider the forces at work going forward. The aging of the world's population combined with less capital-intensive innovation—both of which can lead to slow growth and low inflation—may also keep interest rates in check for the foreseeable future.

In the wake of Britain's vote to exit the European Union, monetary tightening by the Fed or other central banks seems even less likely than it did earlier this year. Even so, investors should keep in mind that there is not always a one-to-one correlation between long-term rates and monetary policy. Between 2003 and 2005, for example, the Fed raised its federal funds rate 425 basis points. During that time the 10-year Treasury rate rose just 50 basis points.

What This Means for Investors

Investors should not assume that rates can only go higher, but nor should they be lulled into thinking low rates are here to stay. “We're currently not advocating that investors buy 30-year bonds," says O'Dea. “The point is that the conventional wisdom about bonds does not always play out."

For many investors, a prudent strategy is to remain duration neutral—not take big bets on the direction of rates. Duration may vary slightly depending on yield targets and risk tolerance, but there is little to be gained by going to one extreme or the other. The same is true for credit quality. Most investors should focus on finding high-quality municipal securities with above-market yields. Recently, spreads between high-quality and lower quality munis have narrowed to the point where the premium for most lower quality securities does not justify the increased credit risk.

Some investors who have traditionally used bonds for diversification are shifting assets into alternatives, but for income-oriented investors, bonds are still one of the best sources of stable income. During the first half of 2016, munis delivered 4.3% total return. This comes on the heels of a 3.3% total return in 2015, according to Barclays.

"Even as low rates persist, investors can still find high-quality munis with taxable equivalent yields of 5%2." The tax savings that characterize most municipal bonds adds an extra buffer for investors, O'Dea adds.

While mutual funds and exchange-traded funds offer diversification and low-cost professional management, they carry additional market risk for investors who typically hold to maturity; fund managers typically don't own bonds to maturity.

“The danger of buying an exchange-traded fund or mutual fund in this environment is you are subject to market risk every day," O'Dea says. “Investors who own individual bonds have an easier time stomaching the value of their bonds going down because they know that, barring default, they will get their money and likely earn predictable income."

Investors who have sufficient assets in their bond portfolios should build a ladder of individual bonds with different maturities that suit their yield objectives and risk tolerance. “The beauty of a ladder is that if rates go higher, you can reinvest maturing bonds to take advantage of higher rates, if and when they come," he says.

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