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.
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 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.
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.
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.
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.
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.
- Major market indices finished lower this week. The Dow Jones Industrial Average fell 0.96 percent. The S&P 500 Stock Index dropped 1.37 percent, while the Nasdaq Composite declined 1.48 percent. The Russell 2000 small capitalization index fell 2.41 percent this week.
- The Hang Seng Composite fell 2.26 percent; Taiwan declined 2.71 percent and the KOSPI lost 1.08 percent.
- The 10-year Treasury bond yield fell five basis points to 2.53 percent.
Domestic Equity Market
The S&P 500 Index pulled back this week, likely due to normal volatility. The market fell 1.37 percent this week, but currently stands about 2 percent from the all-time intraday high set a week ago. Global growth concerns and Federal Reserve policy shifts were the biggest concerns in the market, although nothing has changed much from a week ago.
- The materials sector outperformed this week as Sigma-Aldrich rose 33.6 percent after being acquired by German pharmaceutical and chemical company Merck in an all-cash deal. CF Industries also rose by more than 7 percent as the company said it is in preliminary discussions to merge with Norway’s Yara International, creating the largest nitrogen fertilizer company in the world.
- The health care sector also outperformed as biotechnology stocks such as Gilead, Biogen Idec and Celgene continued recent outperformance.
- Sigma-Aldrich was the best performer in the S&P 500 as mentioned above, but other well-known names such as Nike, Micron Technology and Bed Bath & Beyond all traded higher in a down week on good earnings results.
- The industrial sector was the worst performer this week. Broad-based weakness was seen across most industry groups. Concerns over the global growth outlook and a stronger U.S. dollar were the biggest contributors to the weaker performance.
- The energy sector was also under pressure as the sentiment around weaker oil prices did not improve.
- CarMax was the worst performer in the S&P 500 this week, falling by 11.33 percent. The company reported disappointing earnings, citing customer purchasing preference for new cars versus used cars.
- The Federal Reserve remains accommodative and other global central banks even more so. This should prove as a strong tailwind for equities.
- The U.S. economy is currently a bright spot in the developed world, potentially allowing money to funnel back into the U.S. equity market.
- The path of least resistance for the market appears higher as this “classic” bull market phase of grinding higher with lower volatility remains intact for now.
- Volatility has been remarkably low and this bull market has been an abnormally smooth ride. This calmness won’t last forever and late summer/early fall has traditionally been more volatile.
- With central banks and earnings off the agenda for next week, the focus will likely be on geopolitical risks.
- Geopolitical tensions remain high, and while the market has been able to shrug off these events so far, an escalation could be the catalyst for a long-awaited correction.
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Treasury yields were lower this week, but the two-year portion of the curve continues to inch higher. As seen in the chart below, short-term Treasury yields have moved consistently higher for the past six weeks or so and reflect growing speculation that the Federal Reserve is getting closer to actually raising interest rates. The market is anticipating a move from the Fed by June 2015 and this is being gradually factored into prices. On the other hand, the long end of the yield curve rallied this week, sending yields lower as equities sold off mid-week while the market had a risk-off tone.
- Markit’s manufacturing purchasing managers’ index (PMI) in the U.S. held steady for September at a 52-month high, continuing to bode well for both the U.S. manufacturing sector and the economy overall.
- New home sales rose 18 percent in August, hitting a six-year high and keeping the idea alive that housing could be a positive economic catalyst in the months ahead.
- Truck tonnage hit a new high in August, up 4.5 percent year-over -year. This should be a good read on the health of the economy as well as activity levels.
- While new home sales were solid, existing home sales were weak, falling 1.8 percent in August.
- German business confidence hit a 17-month low in September, now falling for five straight months. This weakness from Germany is a bad sign for Europe, as this country is the heart of manufacturing on the continent.
- Two-year Treasury yields continue to creep higher, implying that the market is bracing itself for tighter Federal Reserve policy.
- Bond yields in Europe remain low, with some short-term European bond yields trading in negative territory. U.S. fixed income yields look attractive and will likely bring money flows from overseas.
- European Central Bank (ECB) president Mario Draghi continued to reiterate his pledge that monetary policy will be easy “for a long time.”
- With key global central banks back into easy policy mode and inflation trending lower in many parts of the world, the path of least resistance for bond yields likely remains down.
- The U.S. economy has some positive momentum and appears poised to continue to build on that as we move into the fall. If the economy gains strength it could force the Fed’s hand.
- The geopolitical situation remains unsettled and a flare up could occur at any time.
- The two big economic indicators to watch next week are the ISM Manufacturing Index along with nonfarm payrolls. If either positively surprises the market, the bond market will likely sell off and fears of Fed tightening could get pushed forward.
For the week, spot gold closed at $1,218.07 up $2.37 per ounce, or 0.19 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, fell 2.74 percent. The U.S. Trade-Weighted Dollar Index rose 1.04 percent for the week.
|Sept 22||HSBC China Manufacturing PMI||50.0%||50.5||50.2|
|Sept 24||US New Home Sales||430K||504K||427K|
|Sept 25||US Initial Jobless Claims||296K||293K||281K|
|Sept 25||US Durable Goods Orders||-18.0%||-18.2||22.5%|
|Sept 26||GDP Annualized QoQ||4.6%||4.6%||4.2%|
|Sept 29||Germany CPI YoY||0.8%||--||0.8%|
|Sept 30||Eurozone Core CPI YoY||0.9%||--||0.9%|
|Oct 01||US ISM Manufacturing||58.3||--||59.0|
|Oct 02||ECB Main Refinancing Rate||0.5||--||0.5|
|Oct 03||US Change in Nonfarm Payrolls||215K||--||142K|
- Gold mint sales are on the rise. This week, the United Kingdom’s Royal Mint launched an online bullion trading website for the first time. The move is aimed at accessing unsatisfied gold demand in the UK. The Mint’s gold coin sales have increased after being granted value-added-tax-free status in the UK. In the United States, gold coin sales are on the rise as well. Thus far in September, sales of American Eagle bullion gold coins have increased 84 percent from August.
- Central banks remain attracted to gold. Russia announced that its central bank has added another 9.3 tonnes of gold to its reserves. Russia has almost doubled its gold reserves since the financial crisis, being a net buyer every month since. Furthermore, European central banks have retained much more gold than they expected, unloading just 1.7 percent of the gold allowed in their agreement to limit sales.
- Roughly 50 tonnes of gold have been smuggled into India over the past ten days according to the Hindustan Times. The substantial inflows into the country stem from the seasonal demand for gold and highlight the resilient demand for the precious metal in India. Premiums for gold in India are anticipated to double to $20 per ounce over the London cash price going into October.
- South African platinum mining stocks fell to their lowest level since 2013 as metal prices continue to be depressed. The three largest platinum producers have also been unable to fully recover their production from the previous five-month strike.
- Down 12 percent this quarter, commodities are poised for the biggest decline since the financial crisis. Weak global growth data from Europe and China as well as a strong dollar have created severe headwinds for the asset class.
- The ETF that tracks the Market Vectors Junior Gold Miners Index, the GDXJ, is reportedly too large to match the benchmark. Most of the fund’s holdings have exceeded 10 percent of the outstanding shares, causing the need for the ETF to rebalance to an asset mix that departs from its benchmark.
- The World Gold Council says that gold will rebound by the end of 2014. The confidence in gold expressed by the council is due to the strong demand from India during the current wedding season. The council is forecasting demand figures in the range of 850 to 950 tonnes.
- A recent report issued by McKinsey and Company argued that the diamond industry will likely continue to be a strong and profitable one. In the near future, demand growth will outstrip supply.
- Desjardins Capital Markets issued a report on Mandalay Resources, identifying the company as a ‘top pick.” Desjardins expects production to grow over 50 percent by 2015. Mandalay sports a P/E of just 11 relative to the S&P 500 at 18. In addition, Mandalay has a dividend yield of 3.5 percent.
- According to Goldman Sachs Group’s Jeffrey Currie, gold is set to continue its decline. He argues that gold has been supported recently by geopolitical tensions in Ukraine, which are now fading. Investors are also shying away from gold as the dollar continues to appreciate and commodities as a whole suffer. Despite gold being unable to find many buyers during its recent slump, Mohamed El-Erian, Chief Economic Adviser at Allianz, noted today in an editorial that “only brave investors would omit it from their investment portfolio given the fluid world we live in.”
- Norilsk Nickel is looking at buying palladium from the Russian Central Bank. Uncertainty surrounding the deal, which is expected to amount to 2.4 million oz., may push palladium prices lower. Furthermore, whereas it was uncertain to what degree the Russian Central bank was holding palladium, this deal now reveals that the bank holds a substantial position in the metal.
- The Central Bank of Japan (BOJ) has reportedly purchased a record amount of Japanese equities. Holding 1.5 percent of the entire Japanese equity market, the BOJ’s aggressive purchasing leads one to speculate as to whether or not the U.S. Federal Reserve is doing the same. Since higher equity prices would directly enhance the wealth effect, thus raising consumer confidence, it is not beyond reason to consider.
- A coalition among the U.S. and five Arab states (Saudi Arabia, United Arab Emirates, Qatar, Bahrain and Jordan) launched coordinated strikes this week on two terrorist organizations, Islamic State and the Khorasan Group. Despite concerns from global leaders about a protracted struggle, concrete action has been taken. The United Kingdom voted late in the week to participate in the strikes as well. The solidarity of the international community over the growing threat in the Middle East is a reassuring sign.
- Wunderlich Securities raised Hi-Crush Partners, a domestic frac sand producer, from “hold” to “buy” this week. Equity analyst Abhishek Sinha set a twelve-month price target of $66.
- WTI crude oil rose for the second-straight week as stronger data out of the U.S. boosted prospects for higher oil demand. The recent increase in WTI comes as a relief to the energy market, which has languished recently.
- Copper fell to a three-month low this week on the London Metal Exchange. Lower Chinese growth prospects continue to weigh on the metal. Positive new home sales data out of the U.S. however, which is the second-largest copper consumer, could create some positive momentum for copper prices.
- The strong U.S. dollar continues to depress commodities across the board. Energy has been particularly weak, with the S&P 500 Energy Sector Index declining 2.36 percent for the week.
- Global growth concerns continue to weigh on industrial metals. The S&P/TSX Capped Diversified Metals and Mining Index declined for the fifth-straight week, down 2.16 percent.
- Rising ethylene prices may be positive for certain chemical companies such as LyondellBasell Industries. Ethylene margins in the U.S. have reached new highs as prices for raw materials have declined, such as ethane, which has declined roughly 18 percent from the second to third quarter. 11 percent of ethylene capacity remains offline, placing further upward pressure on ethylene prices.
- Suncor Energy is looking to move crude across the Atlantic Ocean in an effort to seek buyers outside of North America. The oil producer reportedly loaded its first eastward-bound tanker of heavy crude this week.
- This week the World Gold Council announced that it expects 2014 to end on a good note for gold. They argue that despite the challenging first half of the year for the precious metal, robust demand from India throughout wedding season may lift gold demand during the second half of the year.
- The top threat facing commodities right now continues to be a strong U.S. dollar, which has appreciated more than 7 percent since the start of July. Given the severity of the dollar’s almost-unchecked recent rise, the odds of a near-term pause or consolidation have likely increased.
- Despite positive economic data from the United States, markets remain worried about growth in Europe and China. Any real or perceived threat to global growth, regardless of a strengthening U.S. economy, remains a threat to commodities, especially to industrial metals.
- Chinese domestic A-shares were among the best performers in emerging markets this week, as new weekly account openings registered the largest gains in more than two years, ahead of the Shanghai-Hong Kong Stock Connect program. China’s flash manufacturing purchasing managers’ index (PMI) for September came in better than expected this week, and investors speculated that the country’s central bank governor may soon be replaced.
- Thailand continued to outperform the rest of Asia this week, as the junta prime minister reiterated plans to accelerate budget spending to boost the economy and job creation in rural areas over the next three months. The leader also plans to extend the price freeze on consumer goods by another two to three months. September foreign fund flows into Thai equities were the most since December 2012.
- The consumer staples sector was the best performer in emerging markets this week. Investors rotated to defensive sectors, curbing their risk appetite in anticipation of tighter global liquidity brought on by a stronger U.S. dollar.
- According to Bloomberg, Greek stocks suffered this week as lending to households and businesses fell 3.5 percent year-over-year in August. The Greek financial system remains under considerable pressure as investors await the results of the European Central Bank’s (ECB) most recent stress test to be released next month. Greece’s current account deficit widened 11 percent in the first seven months of the year from the same period a year ago. The Athens Stock Exchange General Index fell 5.41 percent this week.
- Colombian equities remain depressed after the government announced it’s seeking a higher wealth tax for top income earners. Reporting negative GDP growth in the second quarter, Colombia has seen its stock market decline substantially over the past weeks.
- South African equities suffered this week, led by a declining materials sector. A continually rising dollar has weighed substantially on the South African markets, which traditionally decline the most as the dollar rises. The FTSE/JSE Africa All Share Index declined 3.50 percent this week.
- Growth of China’s online education market is poised to accelerate in the next three years. The expected growth is led by rapid user adoption in an underpenetrated industry, where fewer than 11 percent of Internet users in the country participate in online education. Leading providers of Internet-based vocational training should be among the biggest beneficiaries of this trend, thanks to government policy support, a scalable business model and relevancy to the job market.
- Since 2005, two weeks before a large-scale initial public offering (IPO), Chinese equities have tended to underperform the Asian universe by approximately 1 percent. One month after such an event, the Asian universe outperformed by 2 percent on average, according to research from Goldman Sachs. If history is used as a guide, recent profit taking in Chinese ADRs associated with Alibaba's mega-IPO could be short lived.
- Vietnam may look attractive to global investors who are seeking exposure to secular-growth frontier markets for a number of reasons: (1) currency stability amid last year's Southeast Asian mini-crisis, (2) growth recovery led by an improving current account balance and domestic infrastructure spending, and (3) one of the lowest labor wages in developing Asia, adjusted for literacy and skill level.
- Colombia continues to face economic headwinds. Oil prices have declined substantially with the recent spike in the U.S. dollar, and there are mounting concerns that this decline could depress the country’s oil revenue in the coming months.
- Stronger economic data out of the United States continues to weigh on emerging markets. Strong second-quarter GDP growth and new home sales are viewed as evidence that the Federal Reserve will raise rates sooner than expected. Fear over higher rates in the U.S. is already causing a decline in emerging market equities and will likely continue to do so moving forward.
- Commodities and emerging markets have faced considerable headwinds from the stronger dollar, which shows no sign of slowing down. Countries that peg their currency to the dollar are now facing increased pressure to reduce domestic liquidity, primarily by raising rates in order to keep up with the appreciating U.S. currency.
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