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Market View

Investors have long embraced municipal bonds for their tax-advantaged status, but they may not be aware of other potential advantages the asset class offers.

 

In Brief

  • Investors may focus solely on the tax-free income provided by municipal bonds while overlooking other potentially positive attributes of the asset class.
  • First, municipal bonds have historically been a very high-quality asset class, with much lower default rates than corporate bonds, according to data from Moody’s.
  • Second, municipal bonds have the potential to provide effective portfolio diversification.  Given their negative correlation with equities, adding munis to an all-equity portfolio may reduce volatility and enhance risk-adjusted returns.

 

The tax-advantaged nature of municipal bonds is often the first attribute that comes to mind when investors consider the asset class. However, the potential appeal of muni bonds extends beyond their tax-free status. Here, we review two potential advantages of municipal bonds that investors may be overlooking.

1.  Credit Quality
Municipal bonds may be a viable option for investors looking to stay invested in the fixed income market but are wary of the possibility of default. Relative to corporate bonds, municipal bonds’ default rates historically have been much lower. As Table 1 shows, the average 10-year cumulative default rate for all rated municipal bonds through the end of 2018 was 0.16%, while the default rate for corporate bonds was 10.13%.

One other interesting insight from Table 1: default rates for all municipal bonds have historically been lower than the default rate for Aaa-rated corporate bonds.  In fact, during the 10-year period covered in Table 1, the default rate on single-A rated municipals was less than one-third the default rate for Aaa-rated corporate bonds.
 

Table 1. Municipal Bonds Have Had Lower Default Rates than Comparably Rated U.S. Corporates
Data for the period January 1, 1970–December 31, 2018 (latest available)

Source: Moody’s. Data are as of December 31, 2018, and show the average 10-year cumulative default rates of Moody’s rated corporate and municipal bonds for a study covering the period 1970-2018. Data are the most recent available. While municipal bonds are backed by municipalities, U.S. government securities, such as U.S. Treasury bills, are considered less risky since they are backed by the U.S. government. High-yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

2.  Diversification
Beyond low default rates, municipal bonds have the potential to increase portfolio diversification and reduce risk. As seen in Chart 1, the Bloomberg Barclays Municipal Bond Index (Municipal Index) has exhibited a negative correlation with the S&P 500 Index and the Russell 2000 Index, and a low correlation with key segments of the taxable fixed-income market. 

 

Chart 1. Correlation Data Underscore Muni Bonds’ Potential as a Portfolio Diversifier
Correlation of indicated indexes with the Bloomberg Barclays Municipal Bond Index, October 1, 2009–September 30, 2019

Source: Bloomberg. Data as of October 31, 2019.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect deduction of fees and expenses and are not available for direct investment.

 

Given their low volatility and negative correlation to the equity market, an allocation to municipal bonds may lower a portfolio’s volatility and enhance risk-adjusted returns versus an all-equity portfolio. For example, the trailing 10-year standard deviation (as of September 30, 2019) on a 60/40 blend of equities and municipals (in this case, 60% S&P 500® Index and 40% Municipal Index) has been 27% lower than the volatility of an all-equity portfolio during the same period. While substituting a 40% allocation to taxable bonds (using the Bloomberg Barclays U.S. Aggregate Bond Index) in place of munis would have similar volatility reduction benefits, the municipal bond index has generated higher returns than the taxable U.S. Aggregate index over the trailing three, five, and 10 years (through October 31, 2019)—and that’s before accounting for the tax advantage provided by munis.

Summing Up
As we noted last week regarding floating rate bank loans, sometimes investors need to look beyond the main “selling point” of a particular type of investment to appreciate the other potential advantages it may offer. We believe two key attributes of municipal bonds—historically strong credit quality and potential diversification benefits—serve to enhance their appeal beyond the tax-free income they have provided investors over the years.

 

MARKET VIEW PDF


  Market View

About The Author

RELATED FUND
The Lord Abbett Intermediate Tax Free mutual fund seeks to deliver a high level of income exempt from federal taxation. View portfolio and performance.
RELATED FUND
The National Tax Free Fund seeks to deliver a high level of income exempt from federal taxation by investing primarily in investment grade municipal bonds.
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