Market View
Municipal Bonds: Look Beyond the “Tax-Free” Label
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.
IMPORTANT INFORMATION
This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.
This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.
A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.
Correlation is a statistical measure that describes the strength of relationship between two variables. It can vary from 1.00 to -1.00.
Standard deviation measures the dispersion of data from the mean. Applied to a rate of return, standard deviation is an indication of an investment’s volatility.
The Bloomberg Barclays Municipal Bond Index a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. Bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two ratings agencies. They must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least one year from their maturity date.
The Bloomberg Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Total return comprises price appreciation/depreciation and income as a percentage of the original investment.
The Bloomberg Barclays U.S. Corporate Bond Index includes all publicly held issued, fixed-rate, nonconvertible investment-grade corporate debt. The index is composed of both U.S. and Brady bonds.
The Bloomberg Barclays U.S. Corporate High Yield Bond Index is a market value-weighted index which covers the U.S. non-investment grade fixed-rate debt market. The index is composed of U.S. dollar-denominated corporate debt in Industrial, Utility, and Finance sectors with a minimum $150 million par amount outstanding and a maturity greater than 1 year. The index includes reinvestment of income.
The Bloomberg Barclays U.S. Treasury Index is the U.S. Treasury component of the Bloomberg Barclays U.S. Government Index. The index includes public obligations of the U.S. Treasury with a remaining maturity of one year or more.
The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.
The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.
The credit quality of the securities in a portfolio are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from 'AAA' (highest) to 'D' (lowest). Bonds rated 'BBB' or above are considered investment grade. Credit ratings 'BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.
No investing strategy can overcome all market volatility or guarantee future results. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.
The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.
The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.