Three reasons, beyond just tax reform, to consider munis Three reasons, beyond just tax reform, to consider munis

Three reasons, beyond just tax reform, to consider munis

Fundamental and long-term forces are shining a positive light on municipal bonds.

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.

TAGS Fixed Income Income
Email icon

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Past performance is no guarantee of future results.

Bloomberg Barclays Municipal Bond Index: A market-value-weighted index for the long-term tax-exempt bond market. To be included in the index, bonds must have a minimum credit rating of Baa. They must have an outstanding par value of at least $7 million and be issues as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least one year from their maturity date. Indexes are unmanaged and investments cannot be made in an index.

Bloomberg Barclays U.S. Aggregate Bond Index: An unmanaged index composed of securities from the Bloomberg Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index and the Asset-Backed Securities Index. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indices are rebalanced monthly by market capitalization. Indexes are unmanaged and investments cannot be made in an index.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Correlation expresses the strength of relationship between distribution of returns of one data series and its benchmark. The coefficient correlation is always between +1 (perfect positive correlation) and -1 (perfect negative correlation).

Credit ratings of A or better are considered to be high credit quality; credit ratings of BBB are good credit quality and the lowest category of investment grade; credit ratings BB and below are lower-rated securities ("junk bonds"); and credit ratings of CCC or below have high default risk.

Diversification does not assure a profit nor protect against loss.

High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risks and may be more volatile than investment-grade securities.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

Standard deviation is the measurement of the spread or variability of a probability distribution; the square root of variance. It is a simple, symmetrical distribution where 66% of all outcomes fall within +/-1 standard deviation of the mean, 95% of all outcomes fall within +/-2 standard deviations, and 99% of all outcomes fall within 2.5 standard deviations. Standard deviation is widely used as a measure of risk for the portfolio investments.

Federated Investment Management Company