Managing Investment Risk in Muni Bonds
Once upon a time, the only part of the risk/reward trade-off that seemed to matter was the reward. However, that investing fairy tale was fractured when new complications—increased market volatility and the recession, for example—felt inescapable.

In the new narrative, the focus has shifted to risk and, as in fairy tales, the plot has often been pushed to an extreme. Despite the marketplace noise about risk, we don’t see it as a “four-letter” word to avoid. Rather, it just may be time for yield-hungry investors to slay the fear-inducing giant that the media has made of risk and consider embracing risk/reward trade-offs.

Clearly, investors who seek tax-free income but are highly risk averse may prefer high-grade muni securities and bonds with shorter maturities. These types of holdings will reduce the level of risk but typically deliver low levels of tax-free income and ultimately diminish an investor’s purchasing power.

If protecting purchasing power is a priority, risk/reward trade-offs deserve consideration. Over time, these trade-offs can create advantages for muni investors. We’re not suggesting that investors ignore the possibility that an investment may not perform as expected. However, certain kinds of risk have demonstrated, over time, the potential to lead to higher levels of tax-free income. These include interest rate risk, credit (or default) risk and call/extension risk.

Interest rate risk refers to the risk that the value of a bond will go down because of changes in market interest rates.

Investing in shorter maturity bonds can reduce this risk as can investing in premium-coupon callable bonds, which will also be less sensitive to interest changes—as long as the coupon remains higher than market rates. Even so, interest rate risk will exist if prevailing rates are lower than the bond’s coupon when the bond matures or is called.

Another way to combat interest rate risk is to take advantage of the extraordinary spreads that have existed recently between long-term AAA munis and long-term BBB munis. AAA munis have been “cheap to Treasuries” – meaning that the nominal yields on the munis has been greater – and that, too, may represent an attractive investing opportunity.

Credit (or default) risk is the risk that the borrower will become less creditworthy, will run into financial difficulties or will fail to honor its schedule for debt service payments.

To our dismay, many investors seem to have heard the exaggerated claims that were made in late 2010 about risks in the muni market. Few, however, seem as aware of the chorus of muni experts who challenged these claims, often by citing the longitudinal study of municipal and corporate defaults among bonds rated by Moody’s Investors Service between 1970 and 2014.

The Moody’s study clearly shows that even the lowest-rated muni bonds have had a much lower cumulative default rate than investment-grade corporate bonds.

Several strategies exist for yield-seeking investors who have developed a more nuanced understanding of the muni sector’s real risk levels. In their pursuit of higher levels of tax-free income, they may invest judiciously in BBB-rated bonds (the lowest investment-grade classification), in below-investment-grade bonds and/or in unrated bonds. In our experience, three other factors may help investors take advantage of credit risk/default risk: building diversification into their portfolios, maintaining a long time horizon and conducting (or having an expert conduct) in-depth and security-specific credit research.

Call and extension risk are two types of risks represent opposite sides of the same coin. If a bond gets called at par before its final maturity, an investor is dealing with call risk. Typically, bonds are called when market yields have dropped. The investor ends up receiving less tax-free income than had been expected and may be hard pressed to find equally attractive opportunities to reinvest bond proceeds.

The opposite kind of risk is extension risk, which occurs when interest rates rise and the issuer sees that a par call will require future financing to be negotiated at higher rates. In this case, investors would be happier if the bond was called and they had more cash with which to buy higher-coupon bonds.

One strategy that we employ is to add premium-coupon callable bonds to some portfolios in an effort to mitigate call and extension risk. We see these bonds as strong credits – they are priced to a near-term maturity – with little potential for price volatility. Additionally, they often generate above-market yields long after their call dates. This is a case where the inefficiency of the market and its issuers works in the investor’s favor

Even small allocations into longer-term and/or lower-rated municipal holdings have the potential to produce an increase in tax-free income. Our experience has been that managing risk can produce portfolios with a reasonable likelihood of outperforming “risk-free” portfolios.