The following was written by the Litman Gregory research team and was excerpted from the firm's latest "No-Load Fund Analyst".
We have written at length about our strategy on the bond side in many of our recent commentaries, and our focus has been almost exclusively on taxable bonds, addressing investors for whom taxes are not an issue, either due to tax bracket or account type (retirement assets for example). The fiscal cliff negotiations have brought taxes to the forefront of people's minds, and we want to update readers on our thinking about the municipal bond asset class. Regarding munis specifically, though, our take may well be different than what you'd expect based on the headlines.
At a high level, our objectives for the bond portion of our tax-sensitive portfolios are the same as for our tax-exempt portfolios. We are trying to improve returns while not entirely trading off the modest risk-management benefit we get from high-quality core bonds. Muni bonds carry generally the same challenges and problems as their taxable counterparts. Yields are dismally low, but in a fear-driven market they would likely rally to some extent along with Treasurys, so their role in providing ballast to a port¬folio is similar to that of high-quality, core taxable bonds. But at the same time, with taxable equivalent yields very low, our analysis convinces us that it is unlikely, across almost all scenarios, muni returns will match those of some of their taxable counterparts, such as those we use in place of core bonds in our tax-exempt portfolios. (In other words, at current price levels, potential muni returns set a fairly low bar that at least a few of our taxable bond funds should be able to exceed even on an after-tax basis.) Osterweis Strategic Income and PIMCO Unconstrained serve as good examples. The annualized returns for these funds over the next five years will likely range from 3%–6%, depending on the economic scenario, and for munis to achieve those returns from current price levels, it would require 10-year Treasury rates to drop from current levels of approximately 1.6% to approximately 1%. That's a pretty dire scenario. This has been the situation for a while, and as a result, we have been using some of our preferred flexible and absolute-return-oriented bond funds — alongside muni funds — in our tax-sensitive portfolios.
Although we have added some credit risk by shifting part of our fixed-income exposure away from high-quality core munis, we have reduced our exposure to the threat of higher interest rates. This is consistent with the fixed-income allocations in our taxable models. We are willing to accept greater credit risk and less short-term downside protection in exchange for protecting against what could be a more painful, rising interest-rate scenario. In other words, there appears to be an asymmetric risk/reward scenario among most fixed-income asset classes. The upside is limited because of the absolute low level of rates, while there could be significant downside should rates rise. We also include floating-rate loan funds in our bond-heavy conservative models to further reduce interest-rate risk. In both taxable and tax-sensitive strategies we are very cognizant of downside loss thresholds and take these into account in our overall portfolio allocations, including our exposure to credit and interest-rate risk.
One other option for managing muni bonds' interest-rate risk is to shift from intermediate-term munis to short-term munis. However, short-term muni yields are paltry. For example, the one- to three-year segment of the muni market is yielding 0.5%, compared to 1.6% for an average 10-year muni bond. Meanwhile, going farther out the muni yield curve and investing in longer-maturity bonds does get us higher yields, but doing so further increases risk from rising rates. We believe the intermediate part of the muni curve, where we are currently positioned, currently offers the best risk-reward tradeoff.
Stronger Demand from Expected Tax Increases May Be Overblown
Supply and demand forces also play a role in determining muni returns. Since the muni market collapse in late 2008, due to concerns over substantial defaults, strong investor demand has pushed muni returns higher by more than 25%. We suspect much of the potential demand tailwind that contributed to this rally has already played out. Individual investors typically account for roughly two-thirds of the muni market, and we expect that most high-tax-bracket investors already hold munis. Therefore, an increase from 35% to 39.6% in the top bracket isn't likely to result in a significant swing to munis and increase demand for tax-exempt bonds. So where has the recent demand come from?
One source has been taxable investors making a tactical play by crossing into the muni market as yields in certain parts of the taxable fixed-income markets (such as high-quality corporate bonds) have been less attractive than munis even on a pretax basis. Some of that is from taxable mutual funds, including PIMCO and others. Some of these “crossover” investors are investing in the longer-dated, higher-duration maturities, and in the riskier high-yield segment of the muni market, which has rallied strongly, but seems quite vulnerable to a pullback that could be made more painful if and when this shorter-term money rushes for the exits.
On the supply side of the supply-demand equation, net new municipal bond issuance has been minimal, with the majority being municipalities refinancing at lower rates. With a lack of new bonds in the muni market, existing demand also contributed to bond prices rising and yields dropping to record lows.
State and Local Government Fiscal Problems Have Improved
We are likely to continue to read about fiscal problems at the state and local level, including threats of defaults, union strife, pension abuse and reform, etc. This headline risk could contribute to periodic weakness in the muni market, and, as noted above, could contribute to “hot money” heading for the exits. But this isn't a driver of our thinking, as there have also been encouraging signs relating to generally improving fundamentals.
While municipalities are not clear of their fiscal challenges, they have made progress in improving their fiscal credibility. We have seen many examples of higher taxes, pension reforms, public sector layoffs, and significant spending cuts (several hundred billion in expenses have been cut at the state level over the past three years) that are to varying degrees helping municipalities correct gaps between what they take in and what they spend.
Where Does That Leave Us in Terms of Owning Munis?
We make investment decisions at the asset-class level based on a five-year analysis of risk and return across multiple broad, macroeconomic scenarios in concert with each portfolio's 12-month downside risk threshold. Based on that analysis, we view munis as marginally unfavorable relative to other selective options in the taxable bond universe, even for investors in the highest tax bracket. Our rationale is not driven by concerns about state and municipal finances, but rather is comparable to our rationale on the taxable side in that Vanguard's Intermediate-Term National and California funds (for example) each have yields comparable to Treasurys and we are confident they will trail, even on an after-tax basis, other taxable vehicles we can own. As with core taxable bonds, what little yield you get with munis comes with risk of price declines if and when we see rates moves higher. But also like core taxable bonds, if we see fear drive stocks lower, munis are likely to follow Treasurys higher in a flight to quality.
Our preliminary analysis leaves us seriously considering a small reduction in munis. We don't feel urgency to move aggressively or quickly, but it's possible that we could start to incrementally decrease our muni exposure over time, provided we identify more compelling options that can be substituted appropriately (including potentially higher allocations to funds already in our portfolios). These could include vehicles such as flexible municipal strategies; higher-yielding, shorter-duration funds such as Osterweis Strategic Income; floating-rate loans (which would benefit from higher interest rates); and other options on the taxable side. Importantly, we will be assessing how any potential changes impact the risk profile of our portfolios, and any changes will take our downside loss thresholds into account just as we do on the taxable side. This analysis is among our higher research priorities, and we expect to complete our work in the near future.