Navigating the global fixed income waters when interest rates are rising

The environment is turning for municipal bonds, where opportunities are emerging

Apr 29, 2014 @ 12:01 am

By Andrew B.J. Chorlton

With the Federal Reserve gradually tapering its quantitative-easing program, interest rates will eventually rise from the historic lows fixed-income investors have become accustomed to in recent years. As advisers look to restructure their investors' fixed-income portfolios in light of this changing environment, they should consider the municipal bond sector, which currently offers one of the most compelling value-investing opportunities in the fixed-income markets.

On the surface, municipal bonds might not appear to be the most promising fixed-income asset class and have often been outside the comfort zone of many fund managers. Many municipal bonds have long durations, in some cases taking 30 to 50 years to mature, and can incorporate call features. The dominance of retail investors can also deter non-dedicated managers, and municipal bond mutual funds experienced a record $58.1 billion in outflows in 2013, according to Morningstar Inc. This investor exodus was marked by concerns over rising interest rates, the bankruptcies of Detroit and other municipalities around the country, and the downgrading of Puerto Rico's credit rating to “junk” status.

(Don't miss: Finra examining trading in new Puerto Rico bonds)

However, despite the negative headlines, investors' mass exit of municipal bond funds last year actually created an opportunity. The municipal bond investor base is composed of mostly domestic retail investors — U.S. taxpayers. When retail investors sold off their muni bond holdings they created a vacuum that has made municipal bonds much more compelling from a valuation standpoint than comparable long-term credit instruments such as U.S. Treasuries.

Valuation metrics suggest opportunities in the municipal market. The municipal bond ratio to Treasuries in 30-year maturities, at 102%, looks attractive compared with the 91% longer-term average, and even simply comparing tax-equivalent yields between munis and other fixed-income assets shows why investors are beginning to pay attention. With taxes rising, investors can utilize municipal bonds to obtain tax-free income as part of a total-return investment strategy.

Some pension plans and other institutional investors are beginning to recognize the role municipals can play as part of their fixed-income allocation. As of March 31, the S&P Municipal Bond Index was up 3.54% for the year, outperforming the S&P/BGCantor U.S. Treasury Bond Index (1.01%) and the Bloomberg Global Investment Grade Corporate Bond Index (3.48%). Indeed, longer-term municipal bonds are so attractive at this time that even some European investors — who, like pension plans, cannot reap the tax-free income benefits from municipal bonds issued in the U.S. — are purchasing them for potential performance and diversification.

(See also: Muni bond fund rebound appears to have legs)


In addition to their more favorable valuations compared with U.S. Treasury and corporate bonds, municipal bonds are also buoyed by strong fundamental and technical indicators. Many municipalities are recovering financially due to higher taxes and while Detroit and Puerto Rico have captured much of the media attention related to municipal finance over the past year, they are not the core of the municipal bond market. In a sign that municipalities are becoming fiscally healthier, state and local government revenues have improved for the last 17 consecutive quarters. The supply of municipals is falling as well. Net new issuance has been negative for the last six years and we expect 2014 to follow suit.

Municipal bonds, whether purchased individually or as part of an investment in a mutual fund, also provide investors with additional diversification during a still-uncertain market. Investors who allocate assets to municipal bonds from corporate bonds may mitigate credit risk because municipal bond defaults have historically been very low (municipalities have the power to simultaneously cut services and raise taxes to shore up their coffers, which helps decrease the likelihood of defaults). In 2013, the overall municipal bond default rate was 0.107%, falling from 0.144% in 2012, according to S&P Ratings Global Fixed Income Research, while the U.S. speculative-grade corporate bond default rate for 2013 was 2.1%.

Furthermore, in spite of negative publicity surrounding its downgrade, Puerto Rico issued $3.5 billion in high-yield, tax-exempt general obligation bonds this past March — the commonwealth's largest-ever bond issuance. The bonds were priced to generate yield of 8.73%, a very high yield for municipal debt instruments, and the majority of the bonds' initial buyers were hedge funds, which do not usually invest in municipal debt.

If and when investors choose to take advantage of the benefits of municipal bond exposure, they are better off obtaining this exposure through a mutual fund rather than purchasing individual bonds. Like much of the financial services sector, municipal bond investing has changed since the crisis of 2008. The days when a few big-name monoline insurance companies could wrap bonds together so municipal issuers could improve their credit ratings are behind us and since the introduction of Build America Bonds in 2009, the broader investment universe is much more familiar with municipal finance than it was 10 years ago.

Despite the retail investor exodus and negative headlines during the past year, municipal bonds offer one of the best opportunities for U.S. taxpayers to receive high income over the long term when interest rates increase. By educating investors about the potential benefits of municipal bond exposure, advisers can help cushion their clients' portfolios ahead of the normalization of interest rates.

Andrew B.J. Chorlton is a portfolio manager at Schroder Investment Management North America Inc.


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