A long-term plan may help investors overcome unprecedented low yields in the corporate and muni bond markets.
We believe that high-quality municipal and investment-grade corporate bonds—particularly when purchased in a proportionally weighted or ladder structure—will continue to provide the same superior diversification and income-producing benefits they have in the past. This is despite yields on muni and corporate bonds being near historic lows due to the Fed programs addressing the recession that’s driving short-term interest rates toward zero.
For investors who are questioning their asset allocation—particularly younger ones with longer investment horizons—it’s good to remember why financial advisors continue to recommend bonds. Traditionally, a core allocation to muni and corporate bonds has served three primary purposes.
During a flight-to-quality occurrence, equities post sharp declines, while Treasury yields tend to fall when investors sell riskier assets to buy high-quality bonds that are safer. Since muni and corporate bonds trade relative to Treasury yields during such periods, they often follow Treasury prices higher. This diversification benefit provides less risk-tolerant individuals the ability to stay fully invested through a down cycle instead of selling stocks at an inopportune time and missing the subsequent market recovery. In particular, long munis have a negative correlation to equities.
According to Bloomberg, the 10-year Treasury rate is only slightly above 0.6%, and corporate bonds continue to provide 20 basis points of excess carry relative to the dividend yield on the S&P 500®. When examined on a taxable equivalent basis, muni yields further out on the curve offer even more excess carry.
The versatility of having liquid assets becomes important should an investor’s cash needs change or better investment opportunities in more speculative markets come along.
Some investors may be tempted to rotate out of bonds given the unprecedented low yields. Our advice now is the same as it was in our March blog post, when valuations were at the other end of the spectrum: Don’t let short-term market developments dictate financial decisions. Assess your financial situation and goals, and base any adjustment to your portfolio thoughtfully. In other words, we suggest being patient.
Driven by the substantial move lower in Treasury rates, muni and corporate bonds have outpaced equity returns this year. With spreads approaching start-of-year levels, muni and corporate bonds likely offer limited opportunity for significant price appreciation. Nevertheless, it appears that they will still provide principal protection in the event of an equity sell-off. Last month the S&P 500® was just shy of registering a 10% correction while muni and corporate bond returns remained in positive territory.
Fund flows suggest that investors continue to realize the benefits that bonds have to offer. According to JPMorgan, investment-grade bond funds have posted 24 weeks of consecutive inflows since April, pushing year-to-date (YTD) flows to $141 billion while muni funds marked their 19th consecutive weekly inflows that brought YTD inflows to $20 billion. In contrast, equity fund flows have been -$303 billion on a YTD basis.
Aside from the structural arguments, there are a number of fundamental factors that support allocating to bonds; the most important is the Fed acting decisively to ensure market stability and to support asset prices. In March, the Fed announced that it would directly purchase corporate bonds, including those that were subsequently downgraded to high yield. It also instituted a new facility that gives corporate borrowers direct access to the Fed balance sheet in the event the new-issue market closes again. It’s important to note that after these actions were taken, credit spreads became far less sensitive to changes in equity prices.
The Fed has been less aggressive in the muni market, but it provided a significant backstop when it established the Municipal Liquidity Fund. This fund, with $500 billion in lending capacity, is meant to ensure that even stressed issuers don’t see temporary COVID-19-related concerns develop into a more serious liquidity crisis.
In August, the Fed announced a major change to its inflation targeting methodology. Its new policy permits it the leeway to wait for significantly higher inflation before raising rates. With the year-over-year consumer price index only slightly off its 1.2% low, significant excess capacity in the economy, and fewer constraints, it’ll likely be years before the Fed moves policy rates higher.
Maximizing the income from the bond portion of a portfolio becomes more important on an incremental basis in a low rate environment. There are several ways to accomplish this, but it requires a trade-off. For instance, extending the maturity of a portfolio will increase its yield, but it will also increase the portfolio’s sensitivity to rate changes. A comprehensive interest rate scenario tool is a good way to assess this trade-off. For long municipals with embedded options, the trade-off is less about adding duration than it is about assuming extension risk—a trade that could make sense today.
Income can also be enhanced by investing in lower-quality bonds. A trusted team of experienced fundamental analysts can help advisors manage the trade-offs between higher yields and higher downgrade risks. Their principal protection ratings help guard against idiosyncratic risk by identifying issuers with a history of stable or improving ratings, avoiding the underperformance created by downgrades.
A proportionately weighted ladder structure maintained over time has a proven track record of increasing subsequent distribution yield and preserving principal. If rates rise sooner than expected, an investor could benefit from being in a well-structured ladder since maturing assets are systematically reinvested at higher rates. Additionally, in a rising rate environment, the ability to harvest tax losses can offset gains elsewhere in the portfolio. This provides investors with an additional benefit.
Bonds have a long history of providing important diversification benefits and incremental yield. Other than the historically low levels of yield, we see little to persuade us that those benefits won’t continue to accrue. Many of the same objections made against bonds today have been made in past. At the turn of the century, few investors thought that corporate bonds would outperform the S&P 500® over the next 20 years. From July 2000 to July 2020, corporates did exactly that—returning 6.31% versus 6.28% for the S&P 500® while suffering far less volatility. This shows that having a long-term plan and sticking to it are far more important than trying to time a major structural turn in market dynamics.