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AAM Viewpoints – Safety in Numbers

“Diversification is an established tenet of conservative investment”
- Benjamin Graham


Recent equity market volatility has served as a reminder that investors seeking balance and ballast in investment portfolios might benefit from an allocation to high grade municipals. After posting the worst quarter in 15 years to end Q1 (first quarter) 20181, municipals have rebounded quarter to date and look to finish out Q2 (second quarter) 2018 in positive territory2 as investors seek safe havens from equity market turbulence. Amidst the backup in rates and recent strength in fixed income markets, we remain very cognizant that the current macroeconomic backdrop portends the potential for renewed volatility.

We would suggest municipal investors review and adjust allocations as needed during these periods of strength in anticipation of future volatility. An important consideration in trying to reduce volatility is achieving an appropriate balance across factors such as number of issuers and sector allocations. While diversification amongst these factors is essential, an often-overlooked aspect to building municipal portfolios for capital preservation and income is achieving balance and diversification across additional factors such as credit quality, geography and maturities.

Credit Quality

Investors’ exposure to credit risk tends to be a moving target based on prevailing economic conditions, credit spreads, interest rates and investor risk tolerance. The weighted average credit quality of a given portfolio should always be appropriately positioned relative to client risk tolerance. While clients should understand the additional volatility entailed in lower rated bonds, we believe the need for a portfolio with a high weighted average credit quality should not preclude the use of lower rated bonds in meeting this objective. Investors looking for aggregate credit qualities in the high A to AA range should still consider the use of some lower A rated or possibly even higher rated BBB issues much like an investor looking for an average quality of BBB should likely still allocate some monies to higher A and AA rated bonds. There are times that performance across credit qualities, even within the higher rated areas of the bond market, can be significantly different. Year-to-date (YTD) returns in the municipal markets across investment grade quality ranges illustrate this point. The worst performing investment grade credit quality on a YTD basis happens to be AAA bonds down -0.63% YTD as of 6.20.18.1 Contrast this with AA rated bonds down -0.43% YTD2, A rated bonds down -0.32% YTD3 and BBB rated bonds up +0.15% YTD4. Investor appetite for yield and credit risk is a theme across bond markets this year and explains the outperformance of lower rated credits year to date, but this will also change over time. Too many times investors look at an average credit quality mandate at the portfolio level as precluding the use of any individual issues that might carry lower ratings. We would look to diversify across several credit qualities within the context of the weighted average quality the investor is trying to achieve. This will give the investor exposure across credit qualities and have the potential to help reduce overall portfolio volatility due to performance discrepancies amongst credit qualities.

Region/Geography

It may seem counterintuitive to recommend diversification across region, state or geography in the context of a municipal portfolio, but we would argue a state specific municipal portfolio might be an anachronistic way to look at your municipal allocation. Concentrated risk within a single state or region can lead to volatility and carries the potential for underperformance. In extreme cases, such as the sell-off in California municipal debt in 2008, state concentration can create significant volatility within portfolios structured for capital preservation. Over the last several years, cash strapped states with budgetary and pension concerns – such as Connecticut, New Jersey and Illinois – have experienced volatility as have states with a high reliance on oil revenues. Concentrated exposure in states that experience economic pressures can derail the objective of capital preservation and income. Without a specific client mandate to the contrary we would look to construct more nationally oriented portfolios with the potential for a state oriented bias for residents in high tax states such as California and New York. It is understandable that many municipal investors forgo geographical diversification for the state tax exemption that comes with a state specific allocation, however, in many cases these benefits could be overstated. The breakeven rate at which point in-state and out-of-state bonds provide equivalent yields after tax tends to be lower than most think especially outside of New York and California. Furthermore, when you expand the available universe of bond offerings from the state level to the national level you tend to move from looking at hundreds of available options to, in some cases, thousands. Even with the potential for some state taxation, we see the tradeoff in moving away from state specific portfolios to more geographically diversified national municipal portfolios as being minimal.

Maturity

Duration is a measure of interest rate sensitivity and is one of the more important metrics to consider when constructing fixed income portfolios. However, it is also important to consider the diversification across different maturities in addition to the overall duration. The changing shape and steepness of the yield curve over time can result in portfolios with the same duration behaving very differently depending upon the maturity structure of the portfolio. A portfolio with a duration of four years that is comprised of only long-term and short-term maturities (i.e. bond barbell) will behave much differently than a portfolio with a duration of four years across multiple maturities (i.e. bond ladders). Barbells tend to be more sensitive to moves in long-term or short-term rates, due to concentrated maturities, where bond ladders tend to be less sensitive to changes at any single point along the curve due to more diversified maturities. We have always been champions of bond ladders because of the reduction in overall interest rate risk and more specifically the reduction in sensitivity to any single point along the yield curve that comes with diversification of laddered maturities. Year to date returns in the municipal market by maturities reflect quite the divergence with 1-year maturities up +0.94%7, 5-year maturities up 0.23%8, 10-year maturities down -0.83%9, and 20-year maturities down -0.78%10. If the aim is capital preservation we would strongly consider diversifying duration exposures across multiple maturities to reduce for potential for volatility created by an over exposure to single point along the yield curve.

While diversifying across issuers and sectors is paramount the analysis should go further. We would advise investors consider credit quality, geographical and maturity diversification as well. Even the best laid plans can quickly go awry when and where overexposure to one or more of these factors leads to dispersion, tracking error and/or underperformance relative to the market or a specific benchmark. In our experience these unknown overexposures contribute to undue volatility that is generally not welcome in the context of fixed income for capital preservation.

  1. Bloomberg Barclay’s Municipal Bond Index (2018 Q1 -1.11%)
  2. Bloomberg Barclay’s Municipal Bond Index (QTD 2018 Q2 +0.75%)
  3. Bloomberg Barclay’s Municipal Bond Index (AAA credit quality as of 6.20.18)
  4. Bloomberg Barclay’s Municipal Bond Index (AA credit quality as of 6.20.18)
  5. Bloomberg Barclay’s Municipal Bond Index (A credit quality as of 6.20.18)
  6. Bloomberg Barclay’s Municipal Bond Index (BBB credit quality as of 6.20.18)
  7. Bloomberg Barclay’s Municipal Bond Index (1 Yr maturity as of 6.20.18)
  8. Bloomberg Barclay’s Municipal Bond Index (5 Yr maturity as of 6.20.18)
  9. Bloomberg Barclay’s Municipal Bond Index (10 Yr maturity as of 6.20.18)
  10. Bloomberg Barclay’s Municipal Bond Index (20 Yr maturity as of 6.20.18)

 

CRN: 2018-0604-6692R

An investment in Municipal Bonds is subject to numerous risks, including higher interest rates, economic recession, deterioration of the municipal bond market, possible downgrades, changes to the tax status of the bonds and defaults of interest and/or principal. A bond’s call price could be less than the price paid for the bond. Bonds typically fall in value when interest rates rise and rise in value when interest rates fall. Bond insurance covers interest and principal payments when due and does not insure or guarantee the value of any bond in any way.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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Effective, June 10, 2016, please note that Gene Peroni left Advisors Asset Management (AAM) to become President of Peroni Portfolio Advisors, Inc. Peroni Portfolio Advisors, Inc. ("PPA") is an investment advisor independent of AAM.