Treasury yields (30 year) fell to just 2.22% on July 12 (and even lower a day before), reaching their lowest yields since January of 2015. Although the S&P 500 has rallied more than 5% this year, many analysts believe that equities may be overvalued given their earnings potential. Add to that the Brexit and European banking issues and it’s clear why investors have turned toward municipal bonds as a safe-haven asset that provides a bit more yield than comparable bonds.
In this article, we will explore why low-yielding muni bonds may actually be attractive in today’s market and how investors can build exposure to the asset class.
It’s All Relative
Municipal bonds may seem troubled on the surface with their all-time low yields, Puerto Rico’s default, and Illinois’s budget crisis. But these risk factors are relatively mild compared to the year’s swings in stocks and other riskier asset classes. The Brexit sent the Dow Jones reeling more than 500 points lower only to recover to 52-week highs. And now, analysts are worried that equity valuations may be too lofty given the weakness in the domestic economy.
The biggest case to avoid muni bonds is the potential for higher interest rates, which lead to higher yields and lower prices for the bond market. However, the Brexit and Europe’s slowdown will likely pause any potential interest rate hike. The pause could turn into lower rates or more stimulus if the U.S. economy shows any further signs of weakness. A significant slowdown in overseas markets could cause the same outcomes if the global economy is affected.
Muni bonds have benefited from these trends since they provide higher yields than comparable Treasury yields or many corporate bonds. At the same time, most of them are backed by the full faith and credit of state and local governments and are widely held by individuals until maturity. These factors translate to a higher level of safety relative to many other assets. Muni bonds are even less sensitive to interest rate movements given their tax-advantaged nature.
Investing in Munis
Investors purchasing individual municipal bonds should ensure proper diversification. In general, it’s a good idea to ensure that no single muni bond accounts for more than 10% of an overall portfolio. Diversification also means investing in muni bonds across different states and potentially of different varieties — such as revenue bonds versus general obligation bonds. This makes sure that no individual state’s problems will meaningfully harm an entire portfolio.
To mitigate interest rate risk, those purchasing individual muni bonds may also want to utilize bond ladders to spread out duration. Short-term bonds that have lesser interest rate risks will help offset long-term bonds that are more exposed. This is due to lower sensitivity to interest rate changes for shorter duration bonds. If interest rates continue to fall, the opposite will be true as long-term bonds will stand to benefit more. Laddering also helps even out cash flow to ensure consistent income over time.
A final option is to leverage muni exchange-traded funds to invest in a broad range of bonds via a single security. Often times, this is the cheapest way for investors to gain exposure to the muni space without purchasing tens of thousands of dollars worth of individual bonds needed to ensure the right level of diversification. The only drawback is the added expense ratio associated with ETFs, but investors don’t have to pay any bond-specific costs.
The Bottom Line
Municipal bonds have become an attractive asset class, despite their low yields and Puerto Rico’s default. Although they may seem risky on the surface, they face a lot less risk than many other asset classes in today’s market. Risk-averse investors are happy to take an above-market yield that’s backed by state and local governments. But these investors should be sure to maintain diversified exposure to avoid any potential pitfalls.