Interest rates are rising, cities are filing for bankruptcy, and the Federal Reserve is preparing to begin reducing its monetary-stimulus policies, a process known as tapering.
To some, these events might make it appear to be a bad time to invest in the municipal bond market. But considering the muni market within the context of an overall investment strategy may lead to a completely different conclusion: investment-grade munis actually can lower portfolio volatility while providing tax-advantaged income and limited correlation to other asset classes.
Although many articles about Detroit have been in the headlines following that city's recent bankruptcy filing, the broader picture across the muni landscape is one of improving rather than deteriorating credit fundamentals.
It is important to consider that the muni market comprises more than 44,000 issuers, each with its own credit fundamentals. It is easy to paint the muni market with a broad brush but woefully inaccurate when evaluating the creditworthiness of a potential investment.
It is critical that investors, when considering the risk/return profile of a particular investment or asset class, place it within the overall context of their total investment portfolio.
For bond investors, it isn't sufficient simply to base an investment decision on an opinion of whether rates are going up or down. The devil is in the details.
Which rates? Treasuries? Corporates? Municipals? Short rates? Long rates? Intermediate rates?
Over what time frame? The next year? Two years? Next month?
How does this correspond with the investment time frame?
What is the risk tolerance?
And importantly, what are the correlation characteristics of the asset mix in this portfolio?
Rates have risen quickly, and concerns about the Fed tapering have become a focal point of negative market sentiment. The economy, for its part, seems to possess a degree of underlying strength, but it is difficult to envision this correction evolving into a much larger bear market with inflation well-contained and only a modest global growth outlook.
The sell-off in the bond market has been painful, but higher yields have resulted in improved valuations and greater yield protection against further price declines, should they occur.
In addition, munis historically tend to outperform Treasuries when rates are rising, in part because re-funding new-issue supply diminishes as higher rates preclude the opportunity to refinance.
The U.S. economy is in the fifth year of recovery from the worst economic downturn since the Great Depression.
Total state and local tax revenues have increased for 14 consecutive quarters and now exceed pre- recession highs. Most state and local issuers have fared well and have shown remarkable flexibility in dealing with the downturn and the disruption that followed.
Certainly, there are municipalities that continue to face severe challenges. But these towns are largely those that entered the recession with already-strained finances and, as such, lacked the flexibility and wherewithal to deal with the resultant pressures.
Because the assessment of muni credit quality is unique and of critical importance, we think it is essential to rely upon solid fundamental credit research to evaluate investment exposure in the muni market.
UNCORRELATED RETURNS
In addition to strong after-tax income potential, one of the key added benefits of muni-market exposure is its lack of correlation to equity market returns. We recently looked at the monthly returns of the S&P 500 and the Barclays 3-15 Year Municipal Bond Index for the 10-year period through July 31, and found a correlation coefficient of 0.02.
This characteristic may afford investors the opportunity to dampen overall portfolio volatility with the addition of an investment allocation to the muni market. This lack of correlation can help investors tailor the risk/return exposure of the portfolio composition by adding a high- quality, lower-volatility asset class, with strong after-tax income potential and limited equity market correlation.
These characteristics can make munis a building block for high-net-worth and institutional investors seeking more-durable portfolios.
Jim Grabovac is managing director and senior portfolio manager, and Dawn Mangerson is vice president and senior portfolio manager, at McDonnell Investment Management.
