Thirsty for Yield? Municipal Bonds May Offer an Oasis in a Dry Market

08.12.2016 - Jeffrey S. MacDonald, CFA

The financial dramas that have unfolded in Puerto Rico and other high-profile municipalities over the past several years have generated sensational headlines about the municipal bond market, but they haven’t diminished our view of its value in client portfolios.

With a careful eye on credit quality, we continue to look to municipal bonds for tax-advantaged yield in today's challenging income environment, and we continue to see municipal bonds as a critical allocation in our clients' portfolios.

Against a backdrop of near-zero yields in the Treasury market and bouts of stock market volatility, we believe that munis offer the potential to help preserve capital and generate relatively attractive yields for our clients.

While muni yields are lower than their historical average, they are more attractive to us when viewed on a global scale and a relative basis. Munis not only compare favorably to the negative yields now being offered by almost a dozen developed markets, but also against most sovereign bonds in positive territory, especially when viewed on a tax-equivalent basis.

Munis Have Offered Higher Yields vs. Many Sovereign Bonds

(5-Year Maturities)

Source: Bloomberg/Thomson Reuters. All yields are for 5-year government bonds. Taxable-equivalent yield was calculated using Municipal Market Data from Thomson Reuters and an assumed federal tax rate of 39.6%. As of August 1, 2016.

Our focus on credit quality is key in this challenging market. Despite the anxiety created by Puerto Rico and other fiscally-challenged issuers, we are encouraged by today's historically low default rates in the muni market, and see plenty of opportunities to add high-quality sources of yield potential.

The Barclay's Municipal Bond Index offers a clear view of the market's diversity and credit quality, with almost 70% of the 48,000 individual bonds in the index rated AA or better. We have also seen municipal bond issuers generally behaving in a more fiscally-disciplined manner.

Almost 70% of Muni Bonds Are Rated AAA or AA

Source: Barclays Municipal Bond Index.
Revenue Bonds Offer Transparency
While we continue to find attractive opportunities across the muni market, we generally favor revenue bonds, which are backed by cash flows from a specific entity, service or levy (sales, gasoline tax, etc.).

If a municipality issues a revenue bond to construct a bridge, for example, its ability to pay bondholders periodic interest and principal at maturity would be backed by the municipality's ability to collect tolls from motorists who drive over that bridge. So the income generated by revenue bonds tends to be fairly predictable. Revenue bonds also offer the ability to evaluate not only the quality of the bond itself but also the cash flow that is dedicated to servicing the debt.

General obligation (GO) bonds, on the other hand, are backed by “the full faith and credit” of a municipality, which generally means its ability to raise taxes. But slow economic growth and other fiscal challenges have put significant pressure on some GO issuers. In some cases, a powerful combination of declining populations, unfunded pension liabilities and political gridlock have cast doubts about their creditworthiness.

When evaluating credit quality in the municipal bond market, whether we are analyzing a revenue bond or GO bond, we believe it makes sense to identify sources of stress. It is important to determine whether those headwinds are specific to an individual issuer or represent broader, structural themes influencing the market.

Balancing Risk and Reward
We continue to rely on the municipal bond market for yields that we find compelling on a relative basis. Although we are always on the lookout for opportunities, we are careful not to compromise our credit quality standards by stretching for incremental yield. The potential rewards are usually meager and the risks are high.

To be clear, at Fiduciary Trust our goal is not to eliminate risk from our clients' portfolios. Instead, our mandate is to establish which risks are appropriate for each client and ensure that clients are being adequately compensated for taking that risk.

Watch Video: Could Munis Be the Solution for Pricey Stocks, Negative Yields

This communication is intended solely to provide general information. The information and opinions stated are as of August 8, 2016, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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