I used to think that if there was reincarnation, I wanted
come back as president or pope or as .400
baseball hitter. But now I would like to come back as
bond market. You can intimidate everyone.
James Carville, February 1993
James Carville was already well known as a presidential campaign strategist when he was quoted in the Wall Street Journal on interest rates. He mocked the influence of investors who despised budget deficits and loose monetary policies. These “bond vigilantes,” as they will soon be called, demand fiscal discipline and insist on higher yields to offset the risk that misguided public policy will fuel inflation and reduce their rate of return. These sentiments have become somewhat outdated following the Great Financial Crisis and the introduction of quantitative easing by the Federal Reserve.
But times have changed. A global pandemic, rusty supply chains and geopolitical strife have reignited inflation and undermined confidence in the Fed’s ability to orchestrate a soft landing for the economy. A belated effort is now underway to raise short-term rates very quickly. The sudden shift in sentiment has resulted in a “nowhere to hide” environment. The vigilantes are apparently back.
Municipal bond investors reacted by exiting mutual funds and selling closed-end funds. Tax-exempt paper is poised to post losses for a fourth straight month after 12 straight weeks of mutual fund outflows. Closed-end funds, whose discounts have widened as price declines outpace declines in net asset value, are trading at levels not seen since the onset of the pandemic in 2020. In this type of trading environment tough market, it’s important to remember bond credit quality remains strong. Moreover, it is not at all unusual to see mutual fund flows turn negative for a period of time in rising rate environments.
The trend tends to be self-reinforcing until the relative value of tax-exempt paper becomes evident. This type of recognition may come a little earlier for leveraged closed-end funds, where the price correction has been significant. We expect market technicals, including seasonal redemptions and lower valuations relative to taxable paper, to increase investor appetite by the start of the summer and thus restore some balance to the market.
Main contributors: Thomas McLoughlin, Kathleen McNamara, Jeannine Lennon, Sudip Mukherjee, David Perlman and Sunil Vedangi.
For more information, please see the full report: Public Power in an age of geopolitical unrest, published April 14, 2022. Also ask your financial advisor for a copy of the Bond Strategist: Hawks at the Helm: 2Q Outlookpublished on April 7, 2022.
This content is a product of the Chief Investment Office of UBS.