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Muni Bond Records Fall as Popularity Soars

 

Municipal bonds have jumped in popularity over the past year, with rising inflows prompting some in the financial media to dub the sector “2019’s hottest asset.”

Municipal bond funds raked in more money in the first four months of 2019 than they typically do in a “good“ year. And by mid-2019, inflows exceeded $45 billion, or more than 10 times the amount of cash gathered over the whole of 2018.

In recent months, muni bond yields have tumbled — setting records as trade tensions and faltering global growth bolstered the appeal of safe-haven assets.

Despite the rising popularity, question marks hover over the municipal market. Here are answers to some of today’s key questions.

1. Where do municipal bonds fit in a portfolio?

There’s no escaping it: The after-tax income offered by municipal bonds isn’t what it used to be; strong investor demand at a time of relatively modest issuance has caused yields to trend lower. And yet the asset class remains a relatively attractive option when pursuing income.

In addition to income, municipal bonds can provide another potential benefit for balanced portfolios: equity diversification. Indeed, investment-grade municipals have often shown modest correlation to U.S. equities, an attribute that is especially attractive in unsettled times.

Munis can help balanced portfolios in a couple of ways:

  • By moving cash off the sidelines. Cash gives investors liquidity and can also offer refuge amid volatility. But holding too much cash (or cash equivalents) can mean forgoing potential investment gains. As the Federal Reserve forges ahead with rate cuts, shorter-term higher-quality muni strategies, while bringing some investment risk, may be an attractive option for reallocating cash.
  • By upgrading core bond allocation. Higher quality munis can provide ballast in an equity-heavy portfolio, serving three of the four roles of fixed income — income, equity diversification and capital preservation.

2. Why pursue a state-specific or national municipal bond strategy?

The answer depends on your ZIP code and financial circumstances. That said, the decision really boils down to weighing the potential tradeoff between tax benefit and market opportunity.

In simple terms, residents of states with higher taxes stand to gain a greater tax advantage from strategies focused solely on in-state municipal bonds (because that investment income is typically exempt from state, as well as federal, income tax).

Assessing in-state muni opportunities is a little more involved. The market landscape varies from state to state as much as the actual terrain. California, for example, includes diverse issuers and thousands of municipal bonds. In contrast, the number of in-state bonds in less populous places may be several hundred or fewer. Yields also vary quite meaningfully from state to state.

3. With talk of recession growing louder, how safe are municipal bonds?

Recent market developments — including the inversion of the yield curve — have left some investors wondering if a recession is near. At times like these, it’s natural to revisit the level of risk in portfolios.

To the uninitiated, municipal bonds may seem risky given that they have often made headlines for the wrong reasons. Notable examples include Detroit’s 2013 bankruptcy and the 2015 debt crisis in Puerto Rico.

The facts, however, paint a different picture. In 2017, for example, Standard & Poor’s counted 64 defaults from U.S. companies and 20 from municipals. Recent history suggests that, over time, the percentage of rated municipal bonds that typically default is comparable to similarly rated U.S. corporates. Of course, default rates vary across market cycles. It’s also important to note that historical data may underestimate actual default rates due to unrated bonds being excluded from the analysis.

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4. What are the differences between general obligation and revenue bonds?

Often, when investors think about munis they have general obligation (GO) bonds in mind. By far, California and New York are the most frequent issuers of GOs, which are typically backed by the credit and taxing power of a state or local authority.

Some investors are surprised to learn that most munis are revenue bonds, which account for about 70% of investment-grade munis; hospitals, colleges and other providers of essential services issue these bonds. Each bond is backed by a dedicated revenue stream from a specific project and has very little connection to state and local government finances.

Fundamental research can provide a clear assessment of credit risk in revenue bonds, which have typically offered higher yields than GOs. In contrast, local government issuers face practical constraints on raising revenue. Politics and pensions are frequently significant factors. There can, therefore, be a lot more nuance and judgment involved in assessing whether GO bonds offer investors adequate compensation for the risks entailed.

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Final thoughts

Municipal bonds can play an important role in portfolios. Given current valuations, emphasizing higher-quality municipal bonds may make sense; waiting for market setbacks may offer more attractive entry points.

That said, the municipal bond market is vast. With nearly $4 trillion in bonds outstanding, there will continue to be areas that are not closely researched by investors.

“It’s a great time to be an active muni investor,” says Mark Marinella, a Capital Group Private Client Services portfolio manager. “From the shape of the municipal bond yield curve, to opportunities in healthcare and relative value in housing sector munis, research is helping us uncover truly varied opportunities.”

Posted September 27, 2019.

Bloomberg Barclays Municipal Bond Index is a market value-weighted index designed to represent the long-term investment-grade tax-exempt bond market.

Bloomberg Barclays U.S. Aggregate Index represents the U.S. investment-grade fixed-rate bond market.

Bloomberg Barclays High Yield Municipal Bond Index is a market value-weighted index composed of municipal bonds rated below BBB/Baa.

Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index covers the universe of fixed-rate, non-investment-grade debt. The index limits the maximum exposure of any one issuer to 2%.

Bloomberg Barclays Source: Bloomberg Index Services Ltd.

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The return of principal for bond funds and funds with significant underlying bond holdings is not guaranteed. Fund shares are subject to the same interest rate, inflation and credit risks associated with the underlying bond holdings. Lower rated bonds are subject to greater fluctuations in value and risk of loss of income and principal than higher rated bonds.

State-specific tax-exempt funds are more susceptible to factors adversely affecting issuers of their states' tax-exempt securities than more widely diversified municipal bond funds. Income from municipal bonds may be subject to state or local income taxes and/or the federal alternative minimum tax. Certain other income, as well as capital gain distributions, may be taxable.