Taxable Munis Key to Diversifying, Report Says

Investors who counted on diversification to shield them from market swings learned during the financial crisis they were not as diversified as they thought.

In a white paper published earlier this week, Community Capital ­Management argued taxable municipal bonds can offer asset diversification superior to corporate bonds.

While taxable municipal bonds tend to move in the opposite direction from stocks, companies’ debt can at times unexpectedly move in tandem with stocks.

Taxable municipal bonds exhibit lower correlation to stocks than do corporate bonds, CCM argued, and can therefore better cushion a portfolio against market declines than corporate bonds can.

Under modern portfolio theory, ­pioneered by Nobel Prize winner ­Harry Markowitz in the 1950s and 1960s, an ­investor can achieve equal or greater ­returns with less risk through ­diversification.

This works by blending a portfolio of investments with a mix of securities that do not move in sync. Markowitz’s proposition was that the overall expected return of a portfolio would not go down with a more diverse mix of securities, but the volatility would.

Vital to the diversification benefits of portfolio theory is low — ideally, negative — correlation between securities.

If an investor populated a portfolio with safe bonds that do well in bad times and risky stocks that do well in good times, the portfolio would ensure a steady return in both good times and bad, the theory goes.

Investors have long over-relied on corporate bonds for the fixed-income portion of their portfolios, Community Capital said.

The 25 biggest core fixed-income products hold nearly a third of their assets in corporate bonds, according to CCM, whereas the Barclays Capital U.S. aggregate bond index has an 18.5% allocation to corporate bonds.

The strategy has not worked, CCM’s paper argued.

For the past five years, Morningstar’s intermediate-term bond category exhibited a 0.55 correlation with the Standard & Poor’s 500 index.

That means investors are not really diversifying: when stocks go up, the bonds go up too. More important, the reverse is true.

During the months when stocks ­declined over the past five years, the ­intermediate-term bond group displayed a correlation of 0.64 with stocks.

Far from recouping losses on stocks, corporate bonds compounded them.

“Balanced portfolio strategy theorizes that fixed-income allocations should insulate investors’ portfolios against erratic swings up or down in the equity markets,” Community Capital Management analysts wrote.

“However, this positive correlation for both actively and passively managed bond portfolios limited the anticipated diversification benefits of investors’ allocation to bonds,” they said.

The flimsy diversification advantage of corporate bonds was even more pronounced in 2008 — a time of unprecedented volatility when investors most needed their bonds to cushion against equity losses.

The intermediate-term bond category fell 4.9% that year, with a high correlation to stocks.

“An increased weighting in corporate bonds can lead to heightened volatility when investors need to rely more heavily on their fixed-income allocation to hedge against downturns in the equity markets,” CCM wrote. “This can decrease the effectiveness of an investor’s fixed-income allocation and in turn hinder a balanced portfolio’s returns over the longer term.”

A traditionally overlooked corner of the fixed-income universe offers less volatility, lower correlation to stocks, and ­comparable returns to corporate bonds, the white paper said.

The firm said taxable state and local government debt is an “ideal substitute” for corporate debt.

During the last four years, taxable municipals have exhibited a slightly negative correlation to stocks, compared with corporate bonds’ correlation of 0.5.

Municipals have achieved this negative correlation with less volatility.

The standard deviation of returns on municipals during that period was 4.7%, compared with 6.5% for corporate bonds.

Add in lower historical default rates, and taxable municipal securities offer similar returns, higher credit quality, lower volatility, and greater diversification, the ­report said.

Taxable bonds would have enhanced diversification relative to corporate bonds during the financial crisis by exhibiting lower correlations to stocks both during and after the meltdown, according to the report.

“As part of a balanced portfolio, the taxable municipal bond market can offer investors an ideal surrogate to corporate bonds,” the paper said.

Based in Fort Lauderdale, Fla., Community Capital Management manages $1.1 billion of assets.

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