Confucius wrote, “The green reed which bends in the wind is stronger than the mighty oak which breaks in a storm.” We believe that, similarly, municipal investors who choose flexible mandates will be well equipped for any type of weather.
Interest-rate increases, rising inflation expectations, major shifts to tax policy as well as other proposed policy changes—any and all of these introduce uncertainty and volatility to the investment environment, as well as potential opportunities to increase income and return.
Why does this matter so much to muni investors? Because these three principles—safety, income and after-tax return—are the bedrock of municipal investing.
FLEXIBILITY, FOUR WAYS
Flexible municipal managers know that being nimble helps keep a portfolio on track with those objectives. Here are four ways we advocate being flexible today:
SHIFT INTO SOME TAXABLE BONDS TO KEEP VOLATILITY AT BAY. Small opportunistic positions in US Treasuries and other taxable bonds in municipal portfolios can buffer portfolios during volatile periods.
For investors subject to high tax rates, municipal bonds have made sense over the years, and they still do. But relative after-tax yields aren’t static, and municipals’ after-tax yield advantage may be eroded by proposed changes to tax codes—specifically, lowering the highest individual and interest income rates.
That’s not to say investors should lose any sleep just yet over tax rates. Tax code is complex, and it may be a long road from proposal to legislation. While tax rates were cut in Reagan’s first term, it took six years to pass major tax reform during the Reagan administration.
INCREASE INCOME WITH CREDIT. One way to boost the income of a muni portfolio today is by adding mid-grade and high-yield municipal bonds. (In fact, this is preferable to boosting income by lengthening maturity, which exposes investors to both more rising-rate risk and more tax-reform risk.)
Mid-grade and high-yield municipal credits look attractive today. The yield advantage these credits are offering over high-grade municipals is higher now than a year ago. It’s likely that a growing economy will improve revenues and creditworthiness for lower-quality issuers, causing this yield advantage to contract over time. That “spread” contraction, coupled with higher income at purchase, would result in relative outperformance versus their high-grade counterparts.
In fact, that’s exactly what occurred in the last five Fed tightening cycles, when municipal credit outperformed municipal high-grade securities.