The idea of a great rotation arose last year, as record-low interest rates persisted and the Federal Reserve pledged to keep interest rates low until at least the end of 2014 or early 2015. Market participants worry that this could prompt investors to rotate out of bonds and into stocks, pushing bond yields higher.
In the muni market, in particular, the idea of a great rotation is more alarming for municipal investors, as munis are more exposed to rate changes, Barclays analysts wrote in a municipal research report released on Thursday.
“This is largely due to the lower-yielding nature of the muni asset class, along with its predominantly retail base, which could be more sensitive to Treasury rate movements and negative total returns,” according to the report, authored by municipal credit analysts Thomas Weyl, Sarah Xue and Ming Zhang.
Analysts noted that as an asset class, corporate bonds have a fairly diversified buyer base, while munis have a more concentrated set of buyers, with individuals and mutual funds holding more than 70% of the entire $3.7 trillion market.
“Thus, unlike the corporate market, the muni market is heavily dependent on the retail buyer, and by extension, mutual fund flows,” analysts wrote. They added that the lack of a steady base of buyers and a dependence on less sophisticated investors add an element of volatility to the muni market.
Munis, however, have something that other asset classes lack: tax-exemption. Barclays analysts said this factor could serve as a bulwark against muni sell-offs, mitigating unpredictable changes in retail behavior.
“Specifically, as rates rise, the value of the muni interest exemption from income increases, effectively increasing demand from new investors while mitigating selling pressure from existing investors experiencing negative total returns,” analysts said.
The report also looks at historical muni fund flows and performance during periods of meaningful Treasury sell-offs, finding that overall, muni ratios tend to compress, as muni yields rise less than Treasuries when Treasury rates back up.
“Generally, we believe that the inverse relationship between muni ratios and Treasuries is due to a muni-specific reason touched upon earlier – as general interest rates increase, munis become more attractive by comparison, as the absolute tax incentive from tax exempts is higher when rates are higher, given higher tax-equivalent yields,” analysts wrote.
The report concluded that Treasury moves alone will not likely bring any significant muni fund outflows, but it will depend on other drivers in the market at the time, such as the federal funds target rate and idiosyncratic events.