Don’t overlook short term municipals in a volatile environment
Today’s environment of equity volatility and rising interest rates has some wondering: how should I position my investment portfolio? There are quite a few asset classes to help investors diversify their portfolios by allocating away from equities and traditional fixed income, including one that taxable investors often look to – municipal bonds.
Municipal bond returns historically have low correlations to traditional asset classes (as seen in Figure 1), and their tax-exempt nature can make them an attractive option for investors seeking income. Additionally, municipals have historically been less sensitive to interest rate movements than Treasuries.
The advantages described above apply broadly to municipal bonds across the maturity and credit spectrums. However, in the current environment, investment grade short-term municipal bonds, in particular, may offer a favorable solution for investors looking to manage risk by diversifying their portfolios while seeking tax-exempt income.
Diversification is key for better risk-adjusted performance
Investing 101 says that diversification can lead to better risk-adjusted performance over time, but why is that? The first reason is that when you invest in many different asset classes, you have a better chance to reap the rewards of each, without taking on the concentration risk of betting on only one or too few asset classes. The second is slightly more complicated: when you combine different asset classes, the total risk of the combined portfolio is dependent on the correlation between the asset class returns. The less correlated they are (or, the less likely they are to move in tandem), the lower the risk of the combined portfolio. Therefore, investors may want to consider diversifying their assets.
Figure 1: 10 Year Asset Class Return Correlations
|Asset Class||Short-Term Muni||Investment-Grade Muni||High-Yield Muni||U.S. Aggregate Bonds||U.S. Corporates||High Yield Corporates||U.S. Treasuries||Equities|
|U.S. Aggregate Bonds||0.61||0.62||0.19||1.00|
|High Yield Corporates||0.16||0.25||0.28||0.14||0.51||1.00|
Source: Morningstar, 11/08 – 10/18. Past performance is not indicative of future results. It is not possible to invest in an index. Short Term Munis represented by BBgBarc Muni 3 Yr 2-4 TR USD Index; Investment Grade Muni represented by BBgBarc Muni TR USD Index; High Yield Muni represented by BBgBarc HY Muni TR USD Index; US Aggregate Bonds represented by BBgBarc US Agg Bond TR USD Index; US Corporates represented by BBgBarc US Corp Bond TR USD Index; HY Corporates represented by ICE BofAML US High Yield TR USD Index; US Treasuries represented by BBgBarc US Treasury TR USD Index; Equities represented by S&P 500 TR USD Index. Index definitions can be found at the end of this post.
As the table above shows, municipals tend to have either no correlation or a negative correlation to equities. In fact, short term municipal returns have a lower correlation to equities than the broad taxable bond universe at -0.12. This means that short term municipals have provided the most diversification benefit to equities out of the asset classes above, except for Treasuries, but we’ll get to that later.
Even investors that have already hedged away their equity exposure may benefit from adding short-term municipals to their portfolio – the relatively low risk nature of the asset class is a great diversifier especially when combined with high yield municipals or high yield corporate bonds, which have a correlation of 0.30 and 0.16, respectively.
Don’t forget the potential tax benefit when comparing performance
While municipals are lauded for their tax benefits, it’s important to note that many times this benefit is not factored into stated returns for the asset class. This means that when comparing returns for municipals vs. other asset classes, we are usually assuming that the income received is treated the same across the board, when that simply isn’t the case for many U.S. investors. Over time, this can amount to significant differences between the stated return and the return (capital appreciation plus tax exempt income) that investors may have actually experienced.
Once the coupon is adjusted to account for the tax benefit, we have seen that over time, the risk-adjusted return (as measured by the Sharpe ratio) of municipals has exceeded that of many asset classes, as shown below. This is especially true on the short end of the curve – the lower risk nature of short-term municipals combined with after tax-income has led to very favorable results over time.
Figure 2: Standard Deviation (Risk) of Various Asset Classes
Source: Morningstar, 11/08 – 10/18. Past performance is not indicative of future results. It is not possible to invest in an index. Short Term Munis represented by BBgBarc Muni 3 Yr 2-4 TR USD Index; Short-Term Corporates represented by BBgBarc US Corp 1-3 Yr TR USD; Investment Grade Municipals represented by BBgBarc Municipal Index; US Treasuries represented by BBgBarc US Treasury TR USD Index; US Corporates represented by BBgBarc US Corp Bond TR USD Index; Global Bonds represented by BBgBarc Global Aggregate TR USD; High Yield Municipals represented by BBgBarc HY Municipal TR USD Index; HY Corporates represented by BBgBarc High Yield Corporate TR USD Index; U.S. Equities represented by S&P 500 TR USD Index; International Equities represented by MSCI EAFE NR USD; Emerging Markets Equities represented by MSCI EM NR USD. Index definitions found at the end of this post.
Figure 3: Sharpe Ratios of Various Asset Classes
Source: Barclays, Morningstar, Federal Reserve Bank of St. Louis, as of 10/31/18. Past performance is no guarantee of future results. It is not possible to invest directly in an index. Investment Grade Munis represented by BBgBarc Municipal Index; Short-Term Investment Grade Munis represented by BBgBarc Municipal 3 Year (2-4) Index; Long-Term Investment Grade Munis represented by BBgBarc Municipal 20 Year (17-22) Index; High Yield Munis represented by BBgBarc High Yield Municipal Index; U.S. Equity represented by S&P 500 TR USD; International Equity represented by MSCI EAFE NR USD; Emerging Markets Equity represented by MSCI EM NR USD; U.S. Corporates represented by BBgBarc US Corp Bond TR USD; Short-Term Corporates represented by BBgBarc US Corp 1-3 Yr TR USD; High Yield Corporates represented by BBgBarc High Yield Corporate TR USD; Global Bonds represented by BBgBarc Global Aggregate TR USD. Index definitions found at the end of this post.
Why short-term municipals instead of Treasuries?
Short-term Treasuries are considered a safe haven investment for investors hoping to lower volatility in their portfolios while also collecting income. Considering the current interest rate environment, this may be the time to consider short term municipals as another option for taxable investors.
When considering the tax-equivalent yield of short-term municipals – the yield adjusted for the tax benefit when compared to Treasuries – we see that short-term municipals have historically provided better risk-adjusted income compared to short-term Treasuries. While municipals have a slightly higher standard deviation (a measure of risk), investors have been better compensated for their risk in municipals vs. Treasuries.
Figure 4: Risk-adjusted yield of short term municipals vs. short term Treasuries
Source: Morningstar, Barclays, 11/1/2013 – 10/31/2018. Past performance is not indicative of future results. It is not possible to invest in an index. Short-Term Municipals represented by an equally weighted portfolio of BBgBarc Municipal 1 Yr 1-2 TR USD Index and BBgBarc Municipal 3 Yr 2-4 TR USD Index; Short-Term Treasuries represented by BBgBarc US Treasury 1-3 Yr TR USD Index. Index definitions found at the end of this post.
Another point to note regarding municipal bonds is their sensitivity to interest rates vs. Treasuries. As mentioned earlier, municipals have historically been less sensitive to interest rate moves, which is important to keep in mind as we are in the midst of a rising rate period. As shown below, municipals have outperformed Treasuries since rates began their most recent climb in April 2013 and have typically outperformed during other periods of increasing rates as well.
Figure 5: Performance during rate increases
|Two-Year Treasury Rate Increase||+374 bps||+272 bps||+389 bps||+263 bps|
|Asset Class||9/1/93 – 11/30/94||10/1/98 – 4/30/00||6/1/03 – 5/31/06||4/1/13 – 9/30/18|
Source: Morningstar, Federal Reserve Bank of St. Louis. Past performance is not indicative of future results. It is not possible to invest in an index. Municipals represented by BBgBarc Municipal TR USD Index; U.S. Treasuries represented by BBgBarc US Treasury TR USD Index; Short-Term Municipals represented by BBgBarc Municipal 1-3 Yr TR USD Index; Short-Term Treasuries represented by BBgBarc US Treasury 1-3 Yr TR USD Index. Index definitions found at the end of this post.
Short-term municipals have historically been the low volatility municipal option, with all the advantages of municipal bonds, such as tax benefits and diversification, but with less risk (as seen in Figure 2). While short-term municipals can act as a temporary solution for investors looking to deploy idle cash or de-risk, they have also proven to compensate investors on a tax- and risk-adjusted basis over longer periods of time.
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.
This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
A portion of a municipal fund’s income may be subject to state and local taxes or the Alternative Minimum Tax. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner.
High-yield securities (commonly referred to as “junk bonds”) are generally considered speculative because they present a greater risk of loss than higher-quality debt securities and may be subject to greater price volatility. High-yield municipal bonds may be subject to increased liquidity risk, as compared to other high-yield debt securities.
Municipal securities risks include the ability of the issuer to repay the obligation, the relative lack of information about certain issuers, and the possibility of future tax and legislative changes, which could affect the market for and value of municipal securities.
Treasury Securities are backed by the full faith and credit of the United States government as to payment of principal and interest if held to maturity.
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The Bloomberg Barclays Municipal Bond Index is considered representative of the broad market for investment-grade tax-exempt bonds with a maturity of at least one year. Bonds subject to the alternative minimum tax or with floating or zero coupons are excluded.
The Bloomberg Barclays 1-Year Municipal Bond Index is considered representative of the broad market for investment-grade tax-exempt bonds with a maturity range of 1-2 years.
The Bloomberg Barclays 3-Year Municipal Bond Index is considered representative of the broad market for investment-grade tax-exempt bonds with a maturity range of 2-4 years.
The Bloomberg Barclays US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by US and non-US industrial, utility and financial issuers.
The Bloomberg High-Yield Corporate Bond Index is a rules-based, market-value-weighted index engineered to measure publicly issued non-investment grade USD fixed-rate, taxable and corporate bonds.
The Bloomberg Barclays High Yield Municipal Index covers the high yield portion of the USD-denominated long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, insured bonds, and pre-refunded bonds.
The Bloomberg Barclays Global Aggregate Bond Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes Treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.
The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities and commercial mortgage-backed securities (agency and non-agency).
Barclays US Treasury Index represents the US Treasury component of the US Government index.
The MSCI EAFE® Index consists of international stocks representing the developed world outside of North America.
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance in the global emerging markets.
The S&P 500® Index is widely regarded as the standard index for measuring large-cap U.S. stock market performance.
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