The Flip Side of the Muni Market Selloff

 

January 17, 2017 [Market volatility, inflation, rising rates]
John Burnham, CFA


A painful selloff in the muni bond market represents a partial correction from overvalued levels, paving the way for more attractively priced bonds. A laddered bond strategy can also go a long way to mitigate the pain.

Recent municipal bond market movements mark a transition from a period of significant overvaluation to fair or even undervaluation. This can be a painful process for muni market investors. The standard deviation of the generic 10-year AAA general obligation muni real yield1recently moved from more than -1.5 to around -1. So the overvaluation has lessened, but is still considerable, notwithstanding the sharp recent selloff. A less pricy muni market, of course, is cold comfort to muni investors.

One of the best methods for managing these transitions, though, is to reassess the diversification of one’s portfolio against long-term goals. Is the allocation to cash, stocks and bonds correct? If the bond portion of the portfolio has decreased and the stock portion has increased, then rather than selling muni bonds, the time to buy them may be approaching particularly if they continue to decrease in price. The purchases could be financed with the assets that have increased in value, namely U.S. equities, given not just their recent rally of late, but also their long runs since the financial crisis.

As it appears that we may be entering a period of increased market volatility given rising growth, inflation and interest rate expectations, maintaining appropriate portfolio diversification is important.

For muni and fixed income investors generally, it is in volatile markets that a laddered portfolio structure excels. Typically, laddered bond portfolios organically generate cash of approximately 1% to 1.5% of assets under management each month. For muni portfolio managers, this fresh cash can be used to meet shareholder redemptions or invest along the ladder at higher interest rates, providing increased tax-exempt income for clients of muni strategies.

For long-term investors, these periods of transition can provide great opportunities to increase tax- exempt cash flow and harvest tax losses that can be used to offset taxable gains generated in other portions of their portfolios. And for investors who want to reduce the duration risk of their tax-exempt portfolios, low duration municipal bond portfolios fit the bill. If they are also laddered in the zero to five-year range, then as benchmark interest rates rise income will increase at the most rapid pace among the portfolios by maturity. The opposite is true, however, if interest rates decrease.

Low duration portfolios will tend to recover any initial price decline faster than the low-, limited-, intermediate- and long-term portfolios.

1 Using the core personal consumption expenditure index and going back to 1994.
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The views expressed are subject to change and do not necessarily reflect the views of Thornburg Investment Management, Inc. This information should not be relied upon as a recommendation or investment advice and is not intended to predict the performance of any investment or market.

Investments carry risks, including possible loss of principal.

Investments carry risks, including possible loss of principal. Portfolios investing in bonds have the same interest rate, inflation, and credit risks that are associated with the underlying bonds. The value of bonds will fluctuate relative to changes in interest rates, decreasing when interest rates rise. Unlike bonds, bond funds have ongoing fees and expenses. Investments in the Funds are not FDIC insured, nor are they bank deposits or guaranteed by a bank or any other entity.

The laddering strategy does not assure or guarantee better performance than a non-laddered portfolio and cannot eliminate the risk of investment losses.

Diversification does not assure or guarantee better performance and cannot eliminate the risk of investment losses.

The information given should not be considered tax advice. Please consult your tax advisor for personal tax questions and concerns.

Income earned from municipal bonds is exempt from regular federal and in some cases, state and local income tax. Income may be subject to the alternative minimum tax (AMT).

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