INSIGHTS

On November 26, 2018

AAM Viewpoints – The Darling of Late Cycle Safe Havens

With two equity market corrections of close to 10%, 2018 has reminded investors of the need for balanced diversified portfolios that include allocations to assets that can act as a ballast to turbulent equity markets. Unfortunately, most higher-grade fixed income markets – which have traditionally operated as the safe haven of choice – have not provided much reprieve against a backdrop of higher rates and an aggressive Federal Reserve. With healthy economic fundamentals and likely another Federal Open Market Committee (FOMC) rate hike before year end, there does not look to be any relief on the horizon for investors seeking capital preservation via traditional fixed income. One asset class investors seeking a late-cycle haven might consider is U.S. tax-exempt municipal debt. Municipals have exhibited resilience in the face of higher rates, are the best performing high grade fixed income asset class year to date and carry fundamentals that point to the potential of continued outperformance relative to other traditional safe haven asset classes.

Short to intermediate interest rates now sit squarely within the higher end of their range for this economic cycle. There are several factors at play that have coalesced to drive up rates across the year. First and foremost, the U.S. economy, on balance, continues to exhibit healthy underlying economic fundamentals. Corporate earnings are robust, contributing further strength to an already strong labor market. Tax cuts have provided fiscal tailwinds and the vigorous U.S. economy has, in turn, allowed the Federal Reserve to pursue a slow but aggressive tightening stance. The slow methodical pace at which rates have moved up over the last several years, along with the relative stability of longer-duration assets, has overshadowed the fact that we are seeing a bond market selloff that could be called historic by just about any measure. The Bloomberg Barclays Aggregate Index – the bellwether for the high-grade bond market – is likely to post only the fourth down year since 1976, when recordkeeping for the index began. The -2.23% year-to-date (as of 11/15/2018) performance would mark the second worst year in the history of the index trailing only the -2.92% in 1994. The Bloomberg Barclays Investment Grade Corporate index is down -3.95% year-to-date (as of 11/15/2018) which would represent the third worst year for the index since 1976 and the BBG Barclays U.S. Treasury Index is down -1.82% year-to-date (as of 11/15/2018) which would be only the fifth down year since 1976. While these might not seem like large down years, these negative returns represent significant moves in the context of an asset class traditionally used for safety and capital preservation. The one notable exception has been tax-exempt municipals. The Bloomberg Barclays Municipal Index is off a meager -0.67% year-to-date, less than half of Treasuries, which are the closest comparable fixed income asset class on a relative performance basis.

We are cautiously optimistic that municipals will remain the preferred late cycle safe haven for individuals seeking to “batten down the hatches.” Many factors point to continued outperformance relative to Treasuries and corporate bonds. U.S. Treasuries represent the “safest” market in the world from the standpoint of credit risk. Notwithstanding credit risk, however, they are the most interest rate sensitive asset class available in fixed income markets. Years of low interest rates with new issuance carrying correspondingly low coupons has left the BBG Barclays U.S. Treasury Index with the longest duration and smallest weighted average coupon in the history of the index. With smaller cashflows and more interest rate sensitivity, U.S. Treasuries, as evidenced this year, could struggle to stay above water during periods of rising interest rates. While municipals do entail more credit risk than Treasuries and are not immune to higher rates, the broader municipal market still resides in A to AA territory along with significantly higher yields, coupons and cashflows than Treasuries could make them a better ballast to equity market volatility, especially where said volatility is due to interest rate increases.

Investment Grade U.S. Corporates have also, historically, provided an option for investors seeking non-correlation to the equity markets. Investors, however, should consider whether investment grade corporate debt will provide the traditionally non-correlated asset class exposure it has in the past should we see broader weakening economic metrics. Municipals have provided significant outperformance this year relative to investment grade debt which is down almost 4% on the year. Low interest rates and, in turn, low cost of capital have allowed issuers to increase leverage leading to higher levels of debt leaving corporate markets with a preponderance of lower grade BBB credits. The BBB segment of the U.S. Investment Grade market now constitutes 50% of all outstanding U.S. investment grade debt. While aggregate credit qualities have weakened, strong corporate earnings have and could continue to support corporate balance sheets. To date, increases in free cash flow levels due to strong economic fundamentals have outpaced increasing corporate debt levels and corporate default levels continue to be benign. However, because of the multitude of lower grade issuers the corporate bond market is likely much more sensitive to underlying economic fundamentals than in cycles past. With higher relative credit qualities than the investment grade corporate market, municipals might provide a more attractive alternative to corporate bonds during periods of financial distress.

Recent municipal market performance can be attributed to many factors that remain intact and, moving forward, municipals could continue their relative outperformance versus other traditional safe haven asset classes. For investors who carry a high tax liability, risk-adjusted municipal yields continue to outpace comparable credit quality Corporates even after the municipal outperformance in 2018. The yield-to-worst of the BBG Barclays Municipal Bond Index is currently at 3%. For an investor with a 35% federal tax liability that equates to approximately a 4.6% (3%/0.65 = 4.60%) taxable equivalent yield-to-worst versus the BBG Barclays U.S. Corporate Investment Grade Index which has a yield-to-worst of 4.30%. This disparity comes into focus when one considers the aggregate credit quality of the BBG Barclays U.S. Investment Grade Corporate index stands at A3/Baa1 versus the BBG Barclays Municipal Bond Index which currently resides in AA territory (AA-/Aa3). In addition to more attractive risk-adjusted yields, the municipal market tells a story of improving economic fundamentals. The strong U.S. economy, coupled with strong fiscal oversight post 2008, has left states and local municipalities with improving balance sheets that include growing tax revenues and improving pension funding levels. Finally, approaching the one-year anniversary of recent tax reform, supply-and-demand fundamentals continue to look favorable for municipals with robust demand and supply continuing to lag long run averages, down 12% in 2018.

While the current economic backdrop does portend an end to the current expansion, equity market corrections in the last year should be a reminder to investors that high grade safe-haven assets remain an important part of a diversified portfolio. In searching out ballast don’t overlook tax exempt municipals, as they have been, and could continue to be the darling of late cycle safe havens.

CRN: 2018-1105-7010R

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.