By Justin Hoogendoorn, Senior Managing Director, Head of Strategy and Analytics, Fixed Income Capital Markets

January turned out to be the sixth worst month of performance for bonds over the past 30 years. Broad based bond indices lost 2.1% as investors braced for a series of Federal Reserve hikes to combat inflation. Municipals suffered as well, with outflows leading to widening percentages of Treasury levels and the eighth worst month of performance over the past 30 years and the worst January on record, down 2.7%. In fact, municipal yields rose nearly twice as much as Treasuries over the past month. However, a quick study of past cycles of both seasonal patterns, Fed rate hikes and fund outflows suggest that performance should improve dramatically.

From a short-term perspective, positive seasonal patterns should help municipal performance as $45 billion in reinvestment proceeds—coupon and principal payments—will be reinvested from cash flows in January and February. Funds should be flush with cash and therefore less likely to need to liquidate bonds to meet investor demands for cash. Finally, institutional accounts are stepping into the mutual fund and ETF demand gap. HilltopSecurities’ Head of Municipal Research and Analytics Tom Kozlik noted the likely improved demand on a recent CNBC interview.

Taking a longer-term perspective, municipals typically bounce back from these periods of underperformance with an extended period of outperformance. For example, municipals lost 3.7% in November 2016 following the election of President Donald Trump as expectations of a large tax cut diminished the benefits of this tax haven. However, the sector recovered from large outflows and provided investors with nearly 6.5% return over the coming 9-month period, despite passage of the tax bill with lower tax rates.

Additionally, municipals have outperformed Treasuries over each of the four significant hiking cycles over the past 30 years. To highlight one example, the Fed caught the market off-guard and moved rates higher very quickly during the 1994-1995 rate cycle. It hiked rates from 3% to 6% in seven unique rate hikes. Municipal percentages of Treasuries widened marginally; however, municipal yields only rose only a bit more than half of Treasuries from an absolute basis, providing investors with a softened impact from rising rates. As we have seen this move before from both rate hikes and fund flows performance perspectives, investors may want to begin to add tax-exempt bonds to portfolio purchases over the coming months.

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