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More Is More: Combining Corporates and Munis in Laddered Bond Strategies

Bernie Scozzafava photo

Bernie Scozzafava, CFA

Director, Quantitative Research and Portfolio Management

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Evan Rourke photo

Evan Rourke, CFA

Director, Portfolio Management

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Treasury rates aren’t the only reason domestic fixed income yields move up or down. Learn how to take advantage of unique sector factors with a multisector bond strategy.



Fixed income investors often think of changes in US Treasury rates as the tide that lifts or lowers all other domestic bond yields. This principle has been especially true in 2022, with most segments of the fixed income market off to a poor start due primarily to the move higher in the US Treasury curve. But Treasury rates aren’t the only variable at play. We’ve also seen periods over the past 10 years where valuations in the municipal and corporate markets have deviated significantly due to unique sector factors.  


These developments create opportunities for municipal ladder investors to enhance returns by purchasing corporate bonds when they offer higher after-tax yields. A rules-based multisector asset-allocation strategy can help investors do this efficiently. However, there are both benefits and challenges to consider when implementing such a strategy.  



What drives returns in the municipal and corporate bond markets?


Under typical market conditions, it makes sense for investors in the highest federal tax brackets to purchase municipal bonds over corporate bonds due to a more favorable tax treatment. However, there are credit components of the municipal and corporate bond markets that don’t always move proportionally over time. When economic growth is strong, companies and municipalities alike generate ample cash flow to meet their debt liabilities, and yields in both markets trade at historically low levels relative to Treasury rates. On the other hand, during periods of market stress, the risk premium of corporate bond and municipal bonds can deviate greatly, depending on how credit fundamentals and supply–demand technicals develop in each market.


The risk premium that investors require to own a corporate bond depends on the overall state of the economy, as well as the issuer’s industry fundamentals, competitive positioning, profitability, and interest coverage. The macroeconomic outlook impacts municipal valuations as well, but this sector’s credit metrics tend to be much more stable than in the corporate bond market, since they’re usually a function of tax receipts and therefore tend to be more predictable. Even revenue bonds, which can be a more volatile segment of the municipal market, are largely composed of A- and AA-rated issuers with relatively stable revenue sources like tolls, airport taxes, and water and sewer fees. This is in contrast to corporate bonds, where BBB-rated issuers now make up more than 50% of the market and economically sensitive sectors like commodities and retail currently account for 13%, as measured by the ICE BofA US Corporate Index.


Changes in tax codes can have a material impact on the demand for municipal bonds and, to a much lesser extent, corporate securities. Constant demand from pension plans and retirement accounts can dampen volatility in the corporate market, while the municipal market, which is largely owned by retail investors, lacks that source of stability. Both municipalities and corporations will use the proceeds from newly issued bonds to fund new projects, but acquisition activity and special dividends—both of which decline during weak economic periods—will also drive corporate bond issuance. In contrast, federal programs designed to stimulate economic growth will often promote the issuance of municipal bonds during these weak periods. Last, seasonal factors affect supply and demand much more in the municipal market than in the corporate bond market. 

 

We offer tax-advantaged core bond market exposure

How does a multisector fixed income strategy benefit investors?

We believe investors benefit most when managers optimize their fixed income allocations to both tax-exempt municipal and taxable corporate bonds based on the client’s tax rate and the relative yield of bonds across these two sectors. This optimization can provide predictable income—the central objective of a laddered bond portfolio—while selecting the most attractive after-tax choice available at the time of investment.  


Rules-based asset allocation also allows managers to integrate technology that speeds up the implementation process. Constructing a bond ladder is a simple concept that entails evenly weighting a portfolio by maturity year and reinvesting the proceeds from maturing bonds in the longest maturity rung of the ladder. But identifying and transacting bonds at attractive levels from credit-worthy issuers in a universe of over 1.5 million municipal bonds isn’t easy. Expanding the screening process to include the investor’s federal and state tax rates, as well as the more than 6,000 outstanding intermediate-maturity corporate bonds, would be impossible without advanced technology.


Our analysis indicates that when either muni bonds or corporate bonds are expensive on a relative basis, the ability to access the other sector can offer significant investor benefits. For example, muni ratios relative to Treasuries in some parts of the curve were at or near historic lows in 2021. Building a multisector one- to 10-year ladder that buys either corporate or municipal bonds in a maturity rung would have produced a yield pickup of 26 basis points (bps) on an after-tax basis for a top federal bracket payer. Historic after-tax yields were calculated using the same curves and methodology developed to power Parametric’s Laddered Interest Rate Scenario Tool


The past 15 years were rich with opportunities to add incremental return by investing in the optimal fixed income sector. Most investors in the highest federal tax bracket of 40.8% assume that munis are always the optimal sector. However, an investor would have maximized after-tax yield over this period by investing in some amount of corporates 73% of the time. Those who did invest in corporates had an average 38% starting allocation in the sector. Their multisector ladders out-yielded all-municipal ladders by an average 20 bps, with a yield pickup of up to 1.6% in some markets.


Yield advantage of multisector vs. all-municipal
one- to 10-year bond ladders

Best Sector Yield Muni

Source: Parametric, 6/1/2022. Simulated data is hypothetical and is for illustrative purposes only. It does not reflect the experience of any investor and should not be relied upon to make investment decisions. Not a recommendation to buy or sell any security. Past performance is not indicative of future results. Not intended to reflect any strategy offered by Parametric.


It’s also important to consider the role of interest rates in the success of multisector strategies. A laddered bond portfolio benefits from a rising rate environment as the proceeds from maturing positions are reinvested in bonds in the longest maturity range. Since municipal and corporate curves have never experienced meaningful inversions, distributions increase over time, especially when rates rise.



The bottom line
Municipal and corporate yields can respond quite differently to market stress. A laddered bond investor can benefit from stressful moments in both sectors by building a multisector allocation. For optimal results, managers require teams with expertise in both asset classes who can collaborate well in the development of a rules-based investment process and trading capabilities. A properly implemented rules-based multisector process that considers tax rates, interest rates, and sharp-eyed credit selection is likely to deliver superior returns.

Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to such factors as interest rate sensitivity, market perception of the creditworthiness of the issuer, and general market liquidity. When interest rates rise, the value of corporate debt securities can be expected to decline. Debt securities with longer maturities tend to be more sensitive to interest rate movements than those with shorter maturities. Company defaults can impact the level of returns generated by corporate debt securities. An unexpected default can reduce income and the capital value of a corporate debt security. Furthermore, market expectations regarding economic conditions and the likely number of corporate defaults may impact the value of corporate debt securities.

An imbalance in supply and demand in the municipal market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads, and a lack of price transparency in the market. There generally is limited public information about municipal issuers. As interest rates rise, the value of certain income investments is likely to decline. Longer-term bonds typically are more sensitive to interest rate changes than shorter-term bonds. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer’s ability to make principal and interest payments.

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.