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

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 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. We calculated the after-tax yields in this analysis for investors in the highest federal tax bracket, using historical ICE curves. 

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.

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.