Research summary
Actively managing negative convexity in muni bonds
September 06, 2023
New research from Vanguard’s investment strategy and fixed income teams examines how the proliferation of a diverse coupon stack in the municipal bond market and, later, the Federal Reserve’s aggressive rate hikes put negative convexity front and center in active muni investing.
Key takeaways
- A prolonged low interest rate environment in the 2010s led to the creation of a diverse coupon stack in the municipal bond market. This included 2%, 3%, and 4% coupon bonds—a new phenomenon for a market that for years had issued predominantly 5% coupon bonds.
- In 2022—a year in which the Fed aggressively raised rates to combat inflation—many of these lower-coupon callable municipal bonds experienced price declines as the impact of negative convexity emerged.
- Active managers who are navigating this higher rate environment benefit from understanding how to prudently manage negative convexity risk. The diversity of the current coupon stack provides a historically unique lever for actively managing convexity risk.
Read the research paper in its entirety here.
Related links:
- Munis, Fed policy, and negative convexity (article, issued July 2023)
- Active Fixed Income Perspectives Q3 2023: Cruising altitude (article, issued July 2023)
- What the rapid rise in rates could mean for investors (article, issued June 2023)
Notes:
All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss.
Investments in bonds are subject to interest rate, credit, and inflation risk.
Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
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