Five ways Muni investors can navigate a rising interest rate environment

Investors evaluating the value of their municipal bond portfolios are getting bad news.

With the Federal Reserve raising interest rates earlier this month and expectations of more hikes, municipal bond prices have become increasingly volatile, and the Bloomberg Municipal Bond Index has fallen 46 of 57 trading days so far this year. Prior to 2022, that hadn’t happened since the index’s inception in 2001.

That’s not a problem if you hold bonds to maturity and collect interest along the way. But US households are increasingly investing in Munis by buying shares in mutual funds and exchange-traded funds, which are more easily traded and can rise and fall in value based on market movements.

Concerned investors have bought $12.9 billion of inflation-linked government bonds since the beginning of the year, according to Refinitiv Lipper, financial advisors said. (Some of the withdrawn money is also likely to be used to pay tax bills.)

But even in a world of rising interest rates, investors, advisers, managers and brokers said there are plenty of ways to move in the $4 trillion state and local government bond market.

1. Buy very short-term bonds

Bonds maturing soon, say within the next three years, will not fall in price as much as, say, 10-year bonds in response to the Fed’s moves. (Yields go up when prices go down.) That’s because it won’t be long before those bonds mature and the money can be reinvested in newly issued, potentially higher-yielding monies.

The gap between short-term and longer-term yields has narrowed recently, meaning that investors are less likely to forego buying shorter-dated bonds. “You really don’t get an earnings benefit by going out longer,” Ted Halpern, president of Halpern Financial, based in Ashburn, Va., said in an email. “So why take the risk?”

Investors have put $11 million into the Van Eck Short Muni ETF while withdrawing $65 million from the Van Eck Intermediate Muni ETF so far this year, according to Morningstar Direct.

2. Buy very long-dated bonds

Buying bonds with distant maturities, say 20 years or more, could also pay off for patient investors. These bonds are likely to depreciate more than short-term debt over the next few years, but could recover more sharply if the Fed keeps inflation and interest rates in check.

“It’s kind of an offensive strategy,” said Justin Hoogendoorn, head of fixed income strategy and analysis at broker-dealer HilltopSecurities. “Even though it looks like it might be underwater for a while, eventually you’re going to come out on top.” There’s also steady demand for long-dated bonds from certain asset managers, like insurance companies, which is helping push prices into the to drive up.

Michael Zezas, head of municipal strategy at Morgan Stanley Research, recently suggested buying equal amounts of muni bonds with maturities under four years and muni bonds with maturities longer than 20 years.

3. Buy junkie bonds

A stimulus-driven economic boom and waves of federal Covid-19 aid to state and local governments have boosted the finances of municipal borrowers. This means that worries about repayment difficulties should not drive the prices of most bonds down, at least in the short term. Buying lower-rated, higher-yielding government bonds could be a potentially attractive way for investors to hedge against the effects of rising interest rates.

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That’s because any change in interest rates will erode the value of a higher-coupon bond less than a lower-yield bond with the same maturity date. According to Refinitiv Lipper, high-yield funds saw inflows in the week ended Wednesday after more than a month of outflows.

Still, bondholders venturing into the high-yield market should be aware that it’s more volatile than high-quality municipal bonds, and many advisors warn against chasing junk bond yields.

“The ride could get rougher, maybe a lot rougher,” said Matt Fabian, a partner at Municipal Market Analytics.

4. Sell and lower next year’s tax bill

Reducing tax costs is usually why investors turn to the munis in the first place, since the bonds typically pay interest that’s exempt from federal and often state taxes. Falling muni prices in 2022 present an opportunity for another way to reduce tax burdens known as “tax-loss harvesting,” something that has been difficult to accomplish in recent years as muni prices have risen.

That means selling an asset that has fallen in value to book the loss and offset it against any gains booked in 2022, with the ultimate goal of reducing the tax bill next April. (Investors typically buy a similar bond to the one being sold to keep their portfolio largely intact.)

“It’s a way of making lemonade out of lemons!” Brian Cohen, an investment advisor at Landmark Wealth Management, based in Melville, NY, said in an email.

5. Stop trying to time the market

Yes, any municipal bonds bought today could easily lose value as interest rates rise and expectations for further hikes shift. But these bonds will still have higher coupons than almost any debt issued in recent years. Sitting apart for a few weeks or months can be useful. But investors looking for the best bargain could end up missing out.

“At the end of the day nobody knows how to pick rock bottom,” said Mikhail Foux, head of community strategy at Barclays PLC.

Write to Heather Gillers at heather.gillers@wsj.com

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