This is an unusual environment for the bond market. The Federal Reserve Board is tightening credit at the same time domestic fiscal policy is highly stimulative. The US is in the tightening phase of its monetary cycle, while Europe and Japan each still run easing programs; US rates are significantly higher than those of many developed countries. Finally, the US$ is strengthening in the face of increasing global trade protectionism. Equity markets have been quite volatile over the last month and are in some phase of correction. As has been evident over the last 40 years, equity markets behave poorly when market psychology finally recognizes potential future effects of interest rate policy. How long equity market volatility is pure speculation.

A clear benefit for investors in this interest rate environment is that bonds once again offer reasonable rates of return. In high tax states like California, New York and New Jersey, tax equivalent yields are easily in the 4%-6%. Even short US Treasury securities (which are not taxed at the state and local level) have some attraction.

Municipal bonds aren’t as cheap as they were versus US Treasurys.  The much watched MOB ratio (Municipals over US Treasury Bonds) is well below 1 and CA municipal nominal yields are actually lower than 5 years ago. The 2017 Tax Cuts and Jobs Act reduction in corporate tax rates certainly weakened the incentive for banks and corporations to buy municipal bonds. However, the $10,000 cap on SALT (State and Local Taxes) itemized deductions on Federal tax returns reduced options for investors to shelter income, greatly enhancing individuals’ demand for tax-exempt municipal bonds. Increased retail demand combined with reduced supply from municipalities are combining to keep nominal yields at historically dear levels.

 

Real Yields are at 5-year highs.  Market implied inflationary expectations can be read by the level and direction breakeven rates. A breakeven rate is the yield during the life of the security in which investors are indifferent between owning US Treasury nominal bonds and Treasury Inflation Protected Securities (TIPS). For example, if you believe inflation will exceed 2.06% per year (the current 10-yr breakeven rate) over the next 10 years , then you would be better off buying 10-year TIPS instead of like term nominal bonds. TIPS pay nominal coupons while accruing an inflation factor that gets paid at maturity, compensating the investor for recorded inflation during the life of the security. The yield of a TIPS bond without the inflation factor accrual is referred to as the real yield. With inflation reasonably in check, real yields are at their highs for the last 5 years.

Short term Credit is relatively unattractive. Corporate bonds are fully taxable and, as such, need to offer enough nominal spread to remain attractive versus Municipals and US Treasurys. Spreads aren’t that wide. Consistent with traditional late cycle environments, the market currently does not offer appropriate underwriting protections at lower credit ratings; only longer term, high quality corporate credit is modestly viable.

Table legend: Yields are annualized. Taxable Equivalent Yield (TEY) assumes 37% Federal tax rate, 13.3% CA tax rate. CA Municipals are exempt from both Federal and State taxation, Corporate Bonds are fully taxable, US Treasury securities are Federally taxable but exempt from State taxation. Breakeven yields are the inflation rates over the term period in which investors are indifferent between owning US Treasurys and Treasury Inflation Protected Securities (TIPS).