How the Federal Reserve Has Affected the Fixed Income Market

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VanEck

The other features of the marketplace that you need to know about are controlled really by the Federal Reserve. The action the Federal Reserve has taken so far this year and what they propose to do with raising rates through the balance of this year—maybe two, three more times—has put pressure on investment grade and put pressure on the municipal yield curve. In fact, the curve has flattened, which has caused a little bit of concern by investors, preferring to mitigate their risk by moving further down the curve, reducing duration risk.

The other thing that has occurred was the passage of the Tax Act at the end of 2017, which in fact caused banks and insurance company portfolios to sell bonds and sell investment-grade bonds in the intermediate part of the curve, which has also contributed to underperformance.

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Effect of rate hikes on bonds

The March 2018 FOMC (or Federal Open Market Committee) meeting was closely watched, as it was Jerome Powell’s first meeting as chair of the committee. The market had expected a 25-basis-point rate hike, which the Fed delivered, thus bringing the Fed funds rate to a range of 1.5% to 1.8%. This rate hike marked the sixth hike since 2015. As the Fed increased interest rates, the yield on the ten-year Treasury rates also started rising. Even though the movements of the two were not in tandem, there is a positive correlation between the Fed funds rate and the ten-year Treasury rate. In the period between June 1998 and June 2018, the correlation between them stood at 0.84, which shows how a change in one affects the other.

How the Federal Reserve Has Affected the Fixed Income Market

At the June 2018 FOMC meeting, after approving a quarter-point increase, the Federal Reserve indicated two more rate hikes this year. Municipal bond performance is sensitive to interest rate movements, as the yield is inversely proportional to interest rate changes. So further rate hikes by the Federal Reserve could prove detrimental to muni yields.

While the decrease in the corporate tax rate caused banks and insurance companies to sell bonds, chances are that federal tax reform could boost the demand for tax-exempt municipal bonds (HYD) (XMPT) among individuals looking for high-quality tax-efficient income.

The BlackRock article titled “Muni Bonds on the Rebound,” which was published in May, reported that the muni bonds supply has started to pick up from early-2018 lows. Puerto Rico and tobacco sector bonds have proved to be the strongest-performing segments in the municipal bond (SMB) market this year.

Let’s take a look at how tobacco bonds have performed this year in the next article.