INSIGHTS

On June 04, 2013

Municipal Bonds: Don’t Leave Home Without Them

As we head into the summer months, stock prices are soaring and bond yields have risen to their highest levels of the year. Consumers and market participants have recovered from their previous focus on the political back and forth in Washington and appeared to have moved on with their economic lives. Housing, the labor market, and consumer confidence have all demonstrated healthy improvement in recent months. Federal Reserve monetary policy remains accommodative but we are already well into the guessing game of how soon and by how much the Fed will begin to taper off its purchases of government securities.

Against this backdrop, investors may find themselves re-assessing the role municipal bonds (muni’s) can play in their total investment picture. One way to sort this out is to compare the prospects for total return between muni’s and other asset classes given current market conditions. This focus on total return is understandable as investors periodically analyze possible tactical changes to their asset allocations. In doing this analysis, however, we believe it is important to focus not solely on total return but to keep in mind all of the investment tasks any particular asset class is able to perform. When assessing municipal bonds as an asset class, we urge investors to recognize the full list of benefits muni’s have to offer.

We list below a number of points to consider when thinking about municipal bonds during this time of dynamic market movements and possible re-assessment of asset classes:

• Don’t be too quick to assume the total return prospects for muni’s will be dreadful going forward. A rising rate environment is a reasonable view to embrace given current conditions, but the key questions to consider are how soon that rate rise will come, how large of a rise will we have, and how much time it will take to play itself out. Talk of Fed tapering does not mean actual tapering now and actual tapering does not likely mean an abrupt, full-fledged, straight-line reversal of monetary accommodation. We believe high income tax rates, strong muni bond demand, and restrained new issue supply are likely to help municipal bonds (particularly intermediate maturities) deal reasonably well with rising rates compared to other bond sectors.

• The right amount of muni bonds can help give you the peace of mind to stay with your equity exposure. Many investors tell us they prefer to take their risks in equities, real estate, or in their own businesses and therefore wish their muni bond allocation to pay proper homage to the capital preservation/modest volatility objective. Properly constructed and managed, a muni bond portfolio can help dampen the volatility of an investor’s overall investment picture. That safety net can potentially give you the staying power to enjoy the full benefit of a strong equity run.

• Municipal bonds continue to provide attractive after-tax yields among conservative investment choices. Rates are relatively low but we implore investors to do the math. Investment grade municipal bonds are available with tax-exempt yields comfortably over 100% of U.S. Treasury bond yields. A modest-sounding 2.50% yield on an intermediate municipal bond portfolio sounds more than reasonable when top tax bracket investors equate it to a taxable yield of 4.14%. These yields must be considered in a world of nearly zero percent return on cash and a 2.10% before-tax yield on 10-year Treasury bond yields.

• Even with the increased budgetary challenges of recent years, municipal bonds have maintained a resiliency and safety record (from issuer default) second only to U.S. Treasury securities. Tax collections have recovered from previous low levels and tough budgetary decisions have improved financial cushions. According to a recent Moody’s report, investment grade municipal bonds experienced a default rate of 0.07% from 1970 through the end of 2012. That’s less than 1/10 of 1% (even including the very challenging environment of the past five years).

• The municipal bond asset class is large, diverse, and easily customizable. The municipal bond market has roughly $3.7 trillion in bonds outstanding, over 55,000 separate issuers of bonds, and a dozen broad sectors and security types. Municipal bonds offer a wide variety of maturity dates, coupons, call features and degrees of credit quality. This size and diversity allows investors to uncover overlooked value and be fairly precise when customizing their specific investment journey.

• A professionally managed muni bond portfolio can take advantage of rising rates. Staying in the muni bond market or starting a new portfolio now does not mean that yields are “locked in” or that portfolios are “etched in stone.” Bond portfolio management is a fluid exercise. A professional muni bond manager can structure a portfolio with reinvestment opportunities and execute appropriate bond swapping to take advantage of rising rates. Simply put, rising rate environments can present opportunities for skilled bond portfolio managers to make portfolios work harder.

The list we have provided above clearly reveals our opinions about the useful role municipal bonds can play for many investors. Our reference to municipal bonds in this piece refers primarily to investment grade, intermediate maturity municipal bonds. Non-investment grade and longer maturity muni’s may exhibit characteristics that differ from the benefits we have outlined above. We have always cautioned investors to “know what you own” in the muni bond market and we recognize the usefulness of FINRA’s basic reminder on the municipal bond market:

While municipal bonds have historically been considered relatively conservative investments, they do, like all bond investments, carry risk: Defaults, while quite rare, do occur. Information about financial problems that affect the bond's issuer has not always been readily available to investors. The current market value of a municipal bond may be hard to determine because many municipal bonds trade infrequently. A bond's market value may change for reasons having nothing to do with the financial condition of the issuer, such as a change in interest rates. In cases where an issuer has purchased bond insurance or some other protection feature, the higher overall credit rating of a bond may be more reflective of that protection than of the financial condition of the issuer. Investors considering an investment in municipal bonds should bear in mind that no two municipal bonds are created equal—and they should carefully evaluate each investment, being sure to obtain up-to-date information about both the bond and its issuer.

Market conditions constantly change and we recognize the need to periodically take a fresh look at each asset class and the role it plays in an investor’s total picture. We believe the points listed above present a useful reminder of all that municipal bonds can do for investors in the current market environment. We suggest muni’s can be one of those constant, basic tools that high net worth investors should include in their investment kit. We like to think of them as an old reliable – something that accomplishes a number of investment tasks and helps get investors through a variety of dynamic markets. For high net worth investors as they embark on their investment journeys, we say: don’t leave home without your muni’s.

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 ~/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com