Market Memo: 3 reasons, beyond just tax reform, to consider munis

08-02-2018

As we’ve noted earlier in this forum, the supply and demand dynamics of the municipal bond market benefitted from, more than they were harmed by, tax reform. Specifically, the new tax law that kicked in with the new year severely limited the ability of municipal issuers to refinance their tax-exempt debt prior to call dates, causing gross issuance to drop off significantly. At the same time, the law helped feed demand among many individual investors looking for protection from the tax man now that the federal deduction for state and local taxes has been capped at $10,000.

These favorable characteristics help explain why, during a period of generally rising rates, municipal bonds have outperformed most other fixed-income asset classes this year, with the Bloomberg Barclays Muni Bond Index essentially flat year-to-date through end of July, versus a loss of 1.59% for the Bloomberg Barclays U.S. Aggregate Bond index. But there are other reasons a long-term diversified investor should still consider munis in their portfolios:

  • The potential to reduce risk: Done properly, diversification can help reduce risk by pairing low correlated asset classes. Municipal bonds relative to equities fit that bill. From 1992 through June 2018, the correlation on returns for the Bank of America Merrill Lynch Muni Bond Master Index relative to the S&P 500 was just 0.06! By comparison, the correlation of equities to high-yield bonds as measured by Bloomberg Barclays was 0.61.
  • Robust credit history: With the demise of the AAA-rated muni bond insurers, the muni market has drastically changed since 2008, arguably taking on traits of the corporate credit market. But that said, it is a much safer credit market relative to comparably rated corporate bonds. Default rates for munis are much lower at every tier of the credit quality ratings spectrum. For example, the 10-year cumulative average default rate for munis rated BBB at issuance was just 0.81%, while the default rate for BBB-rated corporate bonds was 4.35% over a comparable multi decade time horizon, based on S&P U.S. corporate and public finance default and ratings data that covers many decades.
  • Attractive tax-adjusted returns on a risk-adjusted basis: When using top federal and state tax rates, muni investment-grade bonds produced taxable equivalent annualized returns of 7.9% over the past 10 years, according to Bloomberg Barclays. That high return is almost equivalent to U.S. high yield corporate bond’s annualized returns of 8.2%, but with significantly less volatility—the standard deviation of returns for munis for that period was only 4.2%, versus 10.4% for U.S. high yield.

There are other shorter-term reasons to consider munis, as well: The expanding U.S. economy has improved state and local tax finances, supporting credit quality in many muni sectors, and the Fed seems inclined to move slowly, which should keep yields on a manageable upward path.

Ann Ferentino
Ann Ferentino, CFA
Senior Investment Analyst/Portfolio Manager

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