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Yield Curve Suggests Targeted Opportunity in Municipal Bonds

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Yield Curve Suggests Targeted Opportunity in Municipal Bonds PART 1 OF 2

Food for Thought: Consider Investing in Municipal Bonds

Many muni analysts and market participants maintain that the recent negative performance of muni bonds is unlikely to result in “taper tantrum-style” muni fund outflows, despite expectations of a Fed rate hike before year end.

We believe that markets have already priced in a rate hike, given that U.S. Treasury futures reflect a 70% probability of December Federal Reserve (the “Fed”) action. A more hawkish Fed is more likely about its low-bar for tightening rather than its confidence in the strength of U.S. growth and inflation. While recently we have seen the yield curve steepen, rate hikes are not necessarily a recipe for steeper curves. In the recent past they have actually resulted in curve flattening.

Market Realist – Before we consider the recent free fall in municipal bond prices and its implications, let’s look at why you should consider adding the asset class to your portfolio.

Food for Thought: Consider Investing in Municipal Bonds

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After-tax returns 

The biggest benefit of municipal bonds, or muni bonds (MUB) as they are more popularly known, is their extremely tax-efficient nature. Since the interest accrued on a muni bond is exempt from federal, state, and local taxes, the after-tax returns of a muni bond historically supersede those of a corporate bond (BND) or Treasury (TLT). Muni bonds (SHM) tend to outperform yields from Treasuries for all income brackets, as shown in the above graph. Tax-conscious investors can find better refuge in muni bonds than in Treasuries.

Food for Thought: Consider Investing in Municipal Bonds

Diversification potential and resistance to volatility

Bonds are often seen as a form of ballast in periods of high volatility when equities (VTI) underperform.

Food for Thought: Consider Investing in Municipal Bonds

As shown in the graph above, muni bonds tend to be a particularly good ballast against volatility. The graph shows average returns in the 11 months following 2010, when the S&P 500 (SPY) fell more than 2%. Volatility is on the rise, especially following the US presidential election and with imminent Fed rate hikes looming large.

Food for Thought: Consider Investing in Municipal Bonds

Muni bonds could provide a safety cushion for equity investors. Furthermore, muni bonds also tend to provide immense diversification potential since their historical correlation to other asset classes has been low, as shown in the graph above.

Food for Thought: Consider Investing in Municipal Bonds

Credit quality 

Muni bonds’ credit quality is undoubtedly robust. The graph above shows the ten-year average cumulative default rates for different classes of corporate bonds and muni bonds. Of Moody’s rated corporate bonds, 11.7% default, whereas only 0.13% of Moody’s rated muni bonds default. Moreover, the yields on muni bonds, particularly in today’s low-income environment, are stellar. Investors looking for both credit quality and decent fixed income could consider adding the asset class to their portfolio. In the next part of this series, we’ll discuss what good value opportunities muni bonds offer investors at the moment.

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