Download Municipal bonds: Three reasons to invest

Municipal bonds:
Three reasons to invest
1. Income
Municipal bonds continue to represent an attractive source of income, despite
much-talked-about tax reform and its potential implications. Our view: Lower
individual tax rates and/or a potential cap on tax-exemption may lower the value
of munis’ tax benefit, but neither change erases it. As shown below, munis still
offer an after-tax yield advantage relative to other fixed income assets − even at a
lower tax rate.
Peter Hayes,
Head of the BlackRock
Municipal Bonds Group
Attractive after-tax income, even at lower tax rates
Yields across fixed income assets
5.0%
Municipal bonds hit a postelection speed bump, but are
regaining traction as investors
acknowledge some of the
features that continue to make
tax-exempts attractive.
Peter Hayes, Head of the
BlackRock Municipal Bonds
Group, points to three timely
and perhaps not-so-obvious
reasons to consider
the asset class today.
4.56
4.0
3.39
3.0
2.58
2.68
Munis
Aggregate
3.58
1.98
2.0
1.0
0.0
Treasuries
Invest.-grade
Muni TEY
@ 28%
Muni TEY
@ 43.4%
Sources: BlackRock and Bloomberg; as of March 21, 2017. Yields shown are yield to worst. Treasuries represented by the
Bloomberg Barclays Treasury Index, munis by the Bloomberg Barclays Municipal Bond Index, aggregate by the Bloomberg
Barclays U.S. Aggregate Bond Index and investment-grade by the Bloomberg Barclays U.S. Aggregate Corporate Index. It
is not possible to invest directly in an index. TEY (tax equivalent yield) figures show the tax-adjusted yield offered at current
top tax rate of 43.4% and assuming a 28% cap on the benefit of tax-exemption.
Positioning your muni allocation
While munis may come with more uncertainty and volatility than in recent years prior, that does not make them any
less valuable as a core component of a broadly diversified portfolio, in our view. Munis provide the unique advantage
of tax-free income (alterable, but not dispensable), high credit quality among fixed income options, and an important
ballast to equity and equity-like risk. We’d offer four key ideas for managing your municipal bond allocation in 2017:
Favor short to intermediate maturities (7-10 years) for liquidity, flexibility and insulation from interest rate and policy uncertainty.
Consider flexible strategies that allow you to be nimble and manage around interest rate and policy risks.
Look to the A-rated space, which has outperformed the broader market since 2009.
Be choosy and diversify. Not all credits are created equal. We see an advantage in owning a diversified, professionally managed portfolio of munis over single bonds.
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20170510-154097-421027
2. Quality and diversification
3. Value
With an average rating of AA, the municipal market
remains of high quality, particularly relative to the
corporate bond market. In addition, municipals have
tended to have very low default rates, a dynamic that is
unlikely to change. The reason: Municipalities, unlike
corporations, have a social and political obligation to
continually provide services to tax-paying citizens, making
defaults difficult and rare. S&P’s most recent data puts
10-year cumulative default rates at 0.15% for investmentgrade municipals vs. 2.72% for investment-grade
corporate bonds. Municipal bonds also have tended to
exhibit low volatility. We expect that to tick up this year as
the market anticipates Fed rate moves and clarity around
tax reform, but it is unlikely to rise to the level of traditional
risk assets. In fact, munis show a negative correlation to
equities, making them effective portfolio diversifiers.
Muni prices fell sharply immediately post-election.
The drop reflected interest rate and liquidity concerns,
as well as policy uncertainty under a new administration.
The policy fears centered on tax reform diluting the
benefit of the tax-exemption (and hurting demand) and
infrastructure spending inciting a spike in supply. The
market has since come to realize that the actual
manifestation of these early policy promises isn’t
so clear cut.
Munis can help offset equity risk
One-year correlation to various assets
Is the market overpricing tax reform?
1.00
0.80
0.63
0.60
Muni pricing puts tax rate at 25%
0.58
0.40
0.09
0.20
Equities
0.00
-0.20
Treasuries
Tax reform could take many forms, extending pros and
cons across asset classes, and infrastructure spending
could prove a positive depending on how it’s funded. By
some measures, the market is priced for tax rates in the
area of 25%. This would be an overshoot if you assume a
top marginal tax rate at 33% and the benefit of the muni
tax deduction capped at 28%. Ultimately, the market has
not adjusted back to its pre-election level, and the “price
gap” between Election Day and today is where the
opportunity may reside.
Invest.-grade
High yield
-0.40
-0.19
Source: Morningstar, as of Feb. 28, 2017. Correlations based on one-year daily total
return. Treasuries represented by the Bloomberg Barclays Treasury Index, investmentgrade by the Bloomberg Barclays Investment Grade Corporate Index, high yield by the
Bloomberg Barclays U.S. High Yield 2% Issuer-Capped Index, equities by the S&P 500
Index, and munis by the Bloomberg Barclays Municipal Index.
Want to know more? 50%
45
40
35
30
25
20
15
Implied tax rate
3/15/16
6/15/16
9/15/16
12/15/16
3/15/17
Sources: BlackRock and Bloomberg Barclays indexes, as of March 15, 2017. Chart
shows the market-implied tax benefit by calculating the complement of the ratio of the
Bloomberg Barclays Municipal Bond Index to the Bloomberg Barclays U.S. Aggregate
Corporate Index.
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Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when
interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the
issuer of the bond will not be able to make principal and interest payments. There may be less information available on the
financial condition of issuers of municipal securities than for public corporations. The market for municipal bonds may be less
liquid than for taxable bonds. A portion of the income may be taxable. Some investors may be subject to Alternative Minimum
Tax (AMT). Capital gains distributions, if any, are taxable. Index performance is shown for illustrative purposes only. You cannot
invest directly in an index. Past performance is no guarantee of future results.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt
any investment strategy. The opinions expressed are as of March 2017, and may change as subsequent conditions vary. The information and opinions contained in this material are
derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. There is no guarantee
that any forecasts made will come to pass. Any investments named within this material may not necessarily be held in any accounts managed by BlackRock. Reliance upon information
in this material is at the sole discretion of the reader.
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are those of their respective owners.
Prepared by BlackRock Investments, LLC, member FINRA.
Not FDIC Insured • May Lose Value • No Bank Guarantee
Lit. No. 3REASONS-0317R
008512A-0317
20170510-154097-421027