The fiscal cliff negotiations have brought taxes to the forefront of people’s minds, and we want to update advisors on our thinking about the municipal bond asset class. Our take may well be different than what you’d expect based on the headlines.
At a high level, our current objectives for the bond portion of our tax-sensitive portfolios are the same as for our tax-exempt portfolios. We are trying to improve returns while not entirely trading off the modest risk-management benefit we get from high-quality core bonds. Muni bonds carry generally the same challenges and problems as their taxable counterparts. Yields are dismally low, but in a fear-driven market they would likely rally further to some extent along with Treasurys, so their role in providing ballast to a portfolio is similar to that of high-quality, core taxable bonds. But at the same time, with taxable equivalent yields very low, our analysis across almost all scenarios suggests it is unlikely muni returns will match those of some of their taxable counterparts, such as those we use in place of core bonds in our tax-exempt portfolios. (In other words, at current price levels, potential muni returns set a low enough bar that at least a few of our taxable bond funds should be able to exceed even on an after-tax basis.) Osterweis Strategic Income and PIMCO Unconstrained serve as examples. The annualized return for these funds over the next five years will likely range from 3%–6%, assuming a base-case muddle-through scenario, and for munis to achieve those returns from current price levels, it would require 10-year Treasury rates to drop from current levels of approximately 1.6% to approximately 1%, an outcome we view as unlikely. This has been the case for a while, and as a result, we have been using some flexible and absolute-return-oriented bond funds — alongside muni funds — in our tax-sensitive portfolios.
Although we have added some credit risk by shifting part of our fixed-income exposure away from high-quality core munis, we have reduced our exposure to the threat of higher interest rates. This is consistent with the fixed-income allocations in our taxable models. We are willing to accept greater credit risk and less short-term downside protection in exchange for protecting against what could be a more painful, rising interest-rate scenario. In other words, there appears to be an asymmetric risk/reward scenario among most fixed-income asset classes. The upside is limited because of the absolute low level of yields, while there could be significant downside should rates rise sharply. We also include floating-rate loan funds in our bond-heavy conservative models to further reduce interest-rate risk, while remaining cognizant of our overall portfolio risk exposure.
One other option for managing muni bonds’ interest-rate risk is to shift from intermediate-term munis to short-term munis. However, short-term muni yields are paltry. For example, the one- to three-year segment of the muni market was recently yielding 0.5%, compared to 1.6% for an average 10-year muni bond. Meanwhile, going farther out the muni yield curve and investing in longer-maturity bonds does get us somewhat higher yields, but doing so further increases risk from rising rates. We believe the intermediate part of the muni curve, where we are currently positioned, currently offers the best risk-reward tradeoff.
Stronger Demand From Expected Tax Increases May Be Overblown
Supply and demand forces also play a role in determining muni returns. Since the muni market collapse in late 2008, due to concerns over substantial defaults, strong investor demand has pushed muni returns higher by more than 25%. We suspect much of the potential demand tailwind that contributed to this rally has already played out. Individual investors typically account for roughly two-thirds of the muni market, and we expect that most high-tax-bracket investors already hold munis. Therefore, we suspect that an increase from 35% to 39.6% in the top tax bracket is not likely to spur significant demand for tax-exempt bonds. So where has the recent demand come from?
One recent source has been taxable investors making a tactical play by crossing into the muni market as yields in certain parts of the taxable fixed-income markets (such as high-quality corporate bonds) have been less attractive than munis even on a pretax basis. Some of that is from taxable mutual funds, including PIMCO and others. Some of these “crossover” investors are investing in the longer-dated, higher-duration maturities, and in the riskier high-yield segment of the muni market, which has rallied strongly, but seems quite vulnerable to a pullback that could be made more painful if and when this shorter-term money rushes for the exits.
On the supply side of the supply-demand equation, net new municipal bond issuance has been minimal, with the majority being municipalities refinancing at lower rates. With a lack of new bonds in the muni market, existing demand also contributed to bond prices rising and yields dropping to generational lows.
State and Local Government Fiscal Problems Have Improved
We are likely to continue to read about fiscal problems at the state and local level, including threats of defaults, union strife, pension abuse and reform, etc. This headline risk could contribute to periodic weakness in the muni market, and, as noted above, could contribute to “hot money” heading for the exits. But this isn’t a driver of our thinking, as there have also been encouraging signs relating to generally improving fundamentals.
While municipalities are not clear of their fiscal challenges, they have made progress in improving their fiscal credibility. We have seen many examples of higher taxes, pension reforms, public sector layoffs, and significant spending cuts (several hundred billion in expenses have been cut at the state level over the past three years) that are to varying degrees helping municipalities correct budget gaps between what they take in and what they spend.
Where Does That Leave Us in Terms of Owning Munis?
We make investment decisions for our client portfolios at the asset-class level based on a five-year analysis of risk and return across multiple broad, macroeconomic scenarios in concert with each portfolio’s 12-month downside risk threshold. Based on that analysis, we view munis as marginally unfavorable relative to other selective options in the taxable bond universe, even for investors in the highest tax bracket. While we don’t feel urgency to move aggressively or quickly, we are seriously considering a further incremental reduction in munis in favor of such taxable fixed-income options in the months ahead.
Jack Chee is a partner and senior research analyst at Litman Gregory.