By Lena Katsnelson, senior manager, fixed income and multi-asset product management, and Michael Hampden-Turner, director, fixed income and multi-asset applied research
While it feels like the current interest rate correction might have further to go there is a quite a lot of bad news priced already and those who shortened their duration (See Chart 1) or stepped away and are lucky enough to have some dry powder to deploy are eyeing up the choices for when the time is right. Those looking might be attracted by some allocation towards the municipal market.
A combination of rising interest rates and a weakening economy are at the top of the current fixed income agenda, especially in the US, where the Fed is projected to raise rates by 25bps at each of its remaining meetings in 2022. The uncertainty seems to warrant some degree of caution. Munis offer better returns than treasuries, but still have defensive characteristics relative to credit where higher yields might prompt credit deterioration.
In the US, Tax-Exempt Investment Grade Municipal Securities Might Merit a Consideration From a Risk Perspective
In the US, investors also have the benefit of access to US tax-exempt municipal bond market which has ‘defensive’ or quality characteristics when compared to other assets. On average, tax-exempt investment grade municipal bonds have experienced low default when compared to their corporate peers. This characteristic, coupled with a tax-exempt feature that may be available to some investors, often offer an attractive risk return profile during time of turbulence. Consider performance of municipal bonds versus treasuries and corporate credit during periods of significant credit widening such as in 2018, during COVID crisis of 2019 and the start of 2022 (Graph 2: Treasury, US corporate and tax-exempt investment grade municipal return compared).
Despite having defensive characteristics, tax-exempt investment grade bonds delivered returns that were very similar to the investment grade corporate credit and well in excess of treasuries. Over the 10 year period from February 2012 – March 2022, municipal bonds, as measured by FTSE Tax-Exempt Investment Grade Municipal Index, returned 3.24% annually compared to 3.34% by the FTSE USBIG Corp Index and 1.8% FTSE US Treasury Index for the same period. The tax-exempt investment grade municipal component also had a better risk profile as shown by an annualized volatility of 19.21% compared to 24.42% for corporate investment grade during the decade in review.
Tax-Exempt Investment Grade Municipal Bonds Also Have a Preferred Duration Profile.
Tax-exempt investment grade municipal bonds can also offer some advantages when it comes to duration. A longer duration means an elevated sensitivity to moves interest rates. Compared to their investment grade corporate peers, 85% of municipal bonds have a callable feature and, when these feature is exercised, it may result in significant reduction in overall duration for the sector. Consider the average life and duration metric for US investment-grade corporate bond and tax-exempt investment-grade municipal bond securities as tracked by FTSE USBIG and FTSE Tax-Exempt Investment Grade Municipal Bond indices for May, 2022 profile (Table 1 Tax-exempt investment grade municipal average life, duration versus investment grade corporate bonds): the weighted average life for municipal bonds is 13.62 years compared to 12.17 for the corporate universe, while duration is only 6.06 years compared to 8.07 respectively. To learn more about FTSE municipal bond indices metrics and available sub-indexes please consult FTSE Tax-Exempt Investment Grade Municipal Bond Index 0+ Years’ factsheet
FTSE utilizes a modular construction in its index design which allows wrappers like ETFs and Mutual Funds to further reduce duration exposure in a municipal bond space by tracking term buckets instead of the entire index. The FTSE Tax-Exempt Investment Grade Municipal Bond index is available in variety of term combinations including 0-3 year, 0-5 year, or 0-7 year maturity buckets. This offers investors the choice of a more cautious and less interest rate sensitive index.
The evolution of indices and ETFs have given investors much more power to use these tools tactically in a way that ‘bond-only’ portfolio managers would be unable to achieve because of practical difficulties. In very uncertain times the shorter-dated sub-indices such as the The FTSE Tax-Exempt Investment Grade Municipal Bond index 0-3 Years can act like a low duration, low risk, investment with characteristics of a low volatility money market investment.
As increasing evidence about a recovery in the second half of 2022 gathers pace, this more cautious positioning can be flipped into the full index in a few hours using ETFs whereas it might take weeks to perform the same risk management exercise with a cash portfolio. The additional flexibility for retail investors managing their own portfolio is obvious but we believe it will become a standard tool for portfolio managers to manage risk too. Either using these tools outright to take a view or as a hedging tool making broad portfolio adjustments quickly and adjusting their cash portfolios subsequently.
To learn more about FTSE municipal bond product please read our new research.
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