As we all know, the outbreak of COVID-19 in the United States created unprecedented municipal bond market volatility during March and April of 2020. Beginning in May, we saw a remarkable u-turn in the market where both the investment grade and high yield municipal bond indices rallied and generated 14 straight weeks of positive total returns before taking a slight pause in mid-August. Meanwhile, mutual fund net flows swung from -$21.8 billion to +$20 billion.
With the November 2020 presidential election quickly approaching, many investors are bracing for more potential muni market volatility. It’s times like these when investors tend to second-guess entering into, or even remaining invested in, the municipal bond market. It can be tempting to stray from long-term financial goals by attempting to time market fluctuations with short-term investment decisions. We don’t view an allocation to municipal bonds as a tactical trade, but rather as a dedicated part of a complete asset allocation strategy meant to be held for the long-term, regardless of periodic, but often short lived, bouts of volatility. Let’s consider key reasons why.
Short-term performance is unpredictable
Focusing on the past five elections, municipal bond performance for the full month of November dating back to November 2000 is mixed. There’s been no clear pattern or trend in the investment grade and below investment grade muni markets (Figure 1) except to say that the median total return for the former is slightly positive +0.32%, and for the latter, slightly negative (-0.28%). Moreover, other heavily influential factors occurred concurrently during these election cycles and likely had meaningful impacts on total return. For example, the 2008 election period occurred right in the middle of the financial crisis, which took a toll on below investment grade securities (e.g. those rated Ba1 and lower).
Figure 1: No clear patterns of performance in past Novembers of presidential election years
November monthly total returns over the past five presidential elections.
Source: Morningstar. Investment grade municipal bonds represented by Bloomberg Barclays Municipal Index. Below investment grade municipal bonds represented by Bloomberg Barclays High Yield Municipal Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Holding Period Matters
History demonstrates that, over time, municipal bonds have proven to be highly resilient. It’s this resiliency that underscores the importance of investors not getting caught up in trying to time the muni market. Attempting to tactically buy or sell municipal bonds doesn’t necessarily protect investors from losses and could potentially limit total returns over time.
To confirm this, we looked at rolling performance over the 10-year period between August 31, 2010 and August 31, 2020, measuring the historical total returns for a hypothetical portfolio consisting of 75% investment grade municipal bonds and 25% below investment grade municipal bonds (Figure 2).
Figure 2: Holding period matters — median total returns increased incrementally, with each increase in holding period
Rolling ten-year total returns for a hypothetical portfolio consisting of 75% investment grade municipal bonds and 25% below investment grade municipal bonds (8/31/2010 – 8/31/2020)
Source: Morningstar. Measures the performance of a hypothetical portfolio consisting of 75% investment grade municipal bonds (represented by Bloomberg Barclays Municipal Index) and 25% below investment grade municipal bonds (represented by Bloomberg Barclays High Yield Municipal Index) during rolling periods from 8/31/2010 – 8/31/2020. Total returns are not annualized. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. For illustrative and discussion purposes only. Hypothetical portfolio does not represent actual Client accounts or actual trades and may not reflect the effect of material economic and market factors. The actual transaction costs and other data in Client accounts may be different and performance will vary. This illustration is not a prediction of future performance and should not be relied on to make investment decisions.
What we found is that when the hypothetical municipal bond portfolio was held for 18 months or more, total returns were positive across all rolling periods. In fact, holding period mattered, as indicated by the median return and worst-case return columns in figure 2. Total return potential increased incrementally with each step up in holding time. These results are evidence of the benefits of holding municipal bonds for the long-term and demonstrate how attempting to time a tactical allocation in this asset class can lead to poorer outcomes for investors.
Active Management Matters
Regardless of presidential elections or any other pockets of temporary volatility, municipal bonds should continue to be an important part of a diversified, long-term asset allocation. Our perspective remains that a strategic allocation to municipal bonds can also be enhanced via the benefits of active management. As uncertainty in the fixed income markets persists, we believe that active managers who are able to take advantage of price weaknesses and market dislocations are well-positioned to more likely add significant outperformance over passive approaches.
Active management is the use of a human element, such as a single manager, co-managers or a team of managers, to actively manage a fund’s portfolio. Active management strategies typically have higher fees than passive management.
This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective. This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
Municipal bond risks include the ability of the issuer to repay the obligation, the relative lack of information about certain issuers, and the possibility of future tax and legislative changes, which could affect the market for and value of municipal securities. A portion of a fund’s income may be subject to state and local taxes or the alternative minimum tax. Income from municipal bonds held by a fund could be declared taxable because of unfavorable changes in tax law, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. High-yield municipal bonds may be subject to increased liquidity risk as compared to other high-yield debt securities. Bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner.
Bloomberg Barclays Municipal Bond Index is considered representative of the broad market for investment-grade tax-exempt bonds with a maturity of at least one year. Bonds subject to the alternative minimum tax or with floating or zero coupons are excluded.
Bloomberg Barclays Municipal High Yield Index is an unmanaged index of municipal bonds with the following characteristics: fixed coupon rate, credit rating of Ba1 or lower or non-rated using the middle rating of Moody’s, S&P, and Fitch, outstanding par value of at least $3 million, and issued as part of a transaction of at least $20 million. In addition, the bonds must have a dated-date after December 31, 1990 and must be at least one year from their maturity date.
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