Volatility made a big return during the first quarter, as escalating trade risks, geopolitical turmoil and signs of overvaluation in the stock market weighed on investors. As a result, the CBOE VIX Volatility Index spiked 81%, including the biggest one-time gain on record.
Municipal bonds offer investors an asset class where they can protect themselves from large price fluctuations while the stock market goes through its most volatile period in recent times. Although muni bonds are commonly referred to as ‘sleepy’ or ‘boring,’ these adjectives come in handy when seeking to build a diversified portfolio.
Check out this article to see whether munis serve a good equity hedge during volatile markets.
Why Volatility Is Rising
Wall Street just completed one of its most turbulent periods in recent memory. The event that triggered the correction was a seemingly innocent nonfarm payrolls report released in early February. In that report, Labor economists showed an unexpected surge in wage growth – the highest in eight years – which caused investors to reevaluate their outlook on inflation and monetary policy. Lo and behold, the Federal Reserve raised interest rates in March and gave strong signals that it would continue to do so at a steady pace over the next two years.
But the return of inflation was only one piece of the puzzle. The other piece was the Trump administration’s protectionist agenda and its potential to disrupt free trade and economic growth. Last month, President Trump announced hefty import tariffs on steel and aluminum products. A few weeks later, the president made China’s trade surplus with the United States top priority. In doing so, he imposed fresh tariffs on Beijing worth up to $60 billion. Although China responded with reciprocal tariffs, it would later offer to buy more semiconductors from the world’s largest economy.
Combined, these market concerns have caused investors to be unsure about the continued growth in company valuations and stock prices, which have led to a spike in volatility and a recent decline in market indices.
Be sure to read our previous article where we showed investors how higher interest rates affect muni bonds.
How Municipal Bonds Have Performed
Amid the latest market downturn, longer duration municipal bonds have largely weathered the storm and have outperformed comparable assets such as corporate debt. What’s more, the volatility of 10-year AAA-rated munis is near its lowest level on record at 8.598%. Meanwhile, the VIX closed right around 20 at the end of March, which is in line with its long-term historical average. (The VIX briefly spiked above 50 in early February and spent multiple stints at or above 30.)
One of the primary reasons why muni bonds have been able to outperform the market is lack of correlation. Muni bonds are far less correlated to the broader market than most major asset classes, as demonstrated by the following chart:
Another important feature that works in favor of muni bonds is their historically low default rates. This not only provides long-term stability, but helps investors increase (or at least retain) their portfolio’s valuation during times of uncertainty. This is captured in the following chart, which compares municipal default rates to their corporate counterparts:
Be sure to check this article to remain aware of the due diligence process for evaluating municipal bonds.
Check out the different ways to invest in muni bonds to stay up to date with current investment strategies.
Opportunities and Risks With Municipal Bonds
In today’s investment climate, longer duration municipal bonds might offer more opportunity to those seeking capital preservation. In particular, 10- to 30-year maturities are best suited to fill this need as they are less impacted by movements in the federal funds rate. This is critical because the Fed is expected to raise interest rates at least two more times this year. Goldman Sachs is pricing in three more rate hikes this year, followed by another four in 2019. Although 1- to 5-year maturities might also protect investors, they are more susceptible to changes in the Fed’s interest rate policy.
An environment of rising interest rates also magnifies the importance of muni bond ladders. This type of portfolio can mitigate the impact of rising interest rates by holding bonds to maturity and let them mature at par. By adopting such a strategy, investors can ensure that price volatility does not impact the original yield at purchase. In fact, it could bring the portfolio’s average yield higher over time. Higher interest rates also boost the tax-exempt yield for bond ladder portfolios because they allow investors to reinvest proceeds from maturing bonds. From these it is evident that the value of tax-equivalent muni yields are more likely to be higher than their taxable counterparts when rates begin to rise.
In terms of risks, it’s equally important to bear in mind that large fluctuations in the market could have a major impact on correlation. Large market drops, for example, usually result in an increase in correlation among major asset classes, including muni bonds. This means volatile spikes leave all asset classes exposed. Additionally, any change in the yield curve structure might cause longer duration bonds to be more directly influenced by Fed policy.
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The Bottom Line
As volatility makes its presence felt, longer duration municipal bonds are a logical choice for investors in search of steady growth. However, investors should also be cognizant of the risk of increased correlation as well as unpredictable changes in the yield curve structure. Both factors would influence municipal holdings negatively.
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