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, in the form of reinvestment risk, will exist if prevailing rates are lower than the bond’s coupon when the bond matures or is called.
Another way to counter interest rate risk is to build large portfolios with a diversity of securities. While individuals may lack the capital and stomach for investing across the credit spectrum, in unpopular sectors, or in bonds with unconventional structures, our team uses its carefully honed expertise to explore the full array of muni opportunities. Funds can also combat interest rate risk when the AAA munis are “cheap to Treasuries,” meaning that the muni security is delivering more after-tax income than a Treasury with a comparable maturity. In some markets, our funds have also been able to counter interest rate risk by taking advantage of the spread between long-term AAA munis and long-term BBB munis.
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.
It’s the rare muni investor who hasn’t read about the defaults that put Detroit, Puerto Rico, and Stockton, Vallejo, and Orange County, California in the headlines. These events were certainly concerning, especially as they were first unfolding, for the municipalities involved and their bondholders. However, while “breaking news” leads the mainstream media to jump in, often with alarmist tones, the coverage of outcomes is practically buried. (When all was said and done, Orange County bondholders received 100% of the principal and interest owed, plus penalties, but the news media had moved on and that story wasn’t front page news.)
The $3.8 trillion muni market has been actively traded and liquid throughout these and other defaults, and nearly all issuers remain current in their principal and interest payments.
According to Moody’s Investors Service’s July 2018 report “US Municipal Bond Defaults and Recoveries, 1970-2017,” the 5-year cumulative default rate for muni securities since 2008 stands at 0.18%; the comparable default rate for global corporate bonds is 6.57%. The 10-year cumulative default rates for bonds rated by Moody’s in 1970 to 2017 were 0.17% for munis and 10.24% for the corporates.
Additionally, the lowest-rated muni bonds have had much lower cumulative default rates than investment-grade corporate bonds, according to Moody’s. Investors, we believe, should also be comforted by the following insight from the most recent Moody’s report: “Municipal ratings successfully differentiate defaulters from non-defaulters. Municipal defaulters in 2017 were on average rated below 99.3% of the rated municipal universe as of January 1, 2017.”
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 were 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 call– 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.
Fixed income investing can entail credit and interest rate risks; as interest rates rise, bond prices generally fall and a fund’s share price can fall, too. A portion of a municipal bond fund’s distributions may be subject to tax and may increase taxes for investors subject to federal alternative minimum tax. Capital gains distributions are taxable as capital gains.