MUNICIPAL BONDS

Three reasons to invest

Mar 28, 2017

Municipal bonds hit a post-election speed bump, but are regaining traction as investors acknowledge some of the features that continue to make tax-exempts attractive. Peter Hayes, Head of the BlackRock Municipal Bonds Group, points to three timely and perhaps not-so-obvious reasons to consider the asset class today.

1. Income

Finding decent income (without indecent risk) remains a significant challenge today. Municipal bonds continue to represent an attractive source of income, despite much-talked-about tax reform and its potential implications. Our view: Lower individual tax rates and/or a potential cap on tax-exemption may lower the value of munis’ tax benefit, but neither change erases it. In fact, munis would still maintain an after-tax yield advantage to Treasuries, even if the top marginal tax rate drops to 33% (from 43.4%, including the ACA tax on investment income) or a 28% cap on the benefit of the tax-exemption -- potentially one of nearly 1% at the 10-year tenor in the latter instance.

2. Quality

With an average rating of AA, the municipal market as a whole remains of high quality, particularly relative to the corporate bond market. In addition, municipals have tended to have very low default rates, a dynamic that is unlikely to change. The reason: Municipalities, unlike corporations, have a social and political obligation to continually provide services to tax-paying citizens, making defaults difficult and rare. S&P’s most recent data puts 10-year cumulative default rates at 0.15% for investment-grade municipals vs. 2.72% for investment-grade corporate bonds. Municipal bonds also have tended to exhibit low volatility. We expect that to tick up this year as the market anticipates Fed rate moves and clarity around tax reform, but it is unlikely to rise to the level of traditional risk assets. In fact, munis show a negative correlation to equities and high yield corporate bonds, making them effective portfolio diversifiers.

3. Value

Muni prices fell sharply immediately post-election. The drop reflected interest rate and liquidity concerns, as well as policy uncertainty under a new administration. The policy fears centered on tax reform diluting the benefit of the tax-exemption (and hurting demand) and infrastructure spending inciting a spike in supply. The market has since come to realize that the actual manifestation of these early policy promises isn’t so clear cut.

Tax reform could take many forms, extending pros and cons across asset classes, and infrastructure spending could prove a positive depending on how it’s funded. Some analyses, indicate that the market is priced for tax rates in the area of 25%. This would be an overshoot if you subscribe to what we see as a worst-case scenario: that is, the top marginal tax rate at 33% and the benefit of the muni tax deduction capped at 28%. Ultimately, the market has not adjusted back to its pre-election level and the “price gap” between Election Day (Nov. 8) and today is where the opportunity may reside.

Positioning your muni allocation

While munis may come with more uncertainty and volatility than in recent years prior, that does not make them any less valuable as a core component of a broadly diversified portfolio, in our view. Munis provide the unique advantage of tax-free income (alterable, but not dispensable), high credit quality among fixed income options and an important ballast to equity and equity-like risk. We’d offer four key ideas for managing your municipal bond allocation in 2017:

  1. Favor short to intermediate maturities (7-10 years) for liquidity, flexibility and insulation from interest rate and policy uncertainty.
  2. Consider flexible strategies that allow you to be nimble and manage around interest rate and policy risks.
  3. Look to the A-rated space, which has outperformed the broader market since 2009.
  4. Be choosy and diversify. Not all credits are created equal. We see an advantage in owning a diversified, professionally managed portfolio of munis over single bonds.

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Peter Hayes
Head of Municipal Bonds Group
Peter Hayes, Managing Director, is Head of the Municipal Bonds Group within BlackRock Fundamental Fixed Income and a member of the Fixed Income Executive ...