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.