Despite recent favorable inflation trends, yields across the bond market remain elevated, hovering around 10-year highs. Increased bond yields and lower prices are often related to an increase in perceived market risk. This backdrop begs the question: how should fixed-income investors position their portfolios in today’s market environment?
With a late cycle economy and sticky inflation, investing in higher credit quality fixed income bonds, while locking in yields for durable income, may be rewarding in the longer term.
While most investors are familiar with tax-exempt municipal bonds, their taxable counterparts are often overlooked. Based on market size according to Bloomberg, 20% of the $4 trillion municipal bond market are taxable issues, often the same entities that issue in the tax-exempt space. Over the past several years, taxable municipals have gained traction among US institutional investors, particularly insurers. The attraction is fueled by the potential benefits they offer.
Strong Credit Quality:
77% of of taxable municipal bonds are rated AA or higher, contrasting with 9% of global investment grade corporates1
Figure 1: An Opportunity to Increase Credit Quality
Source: Bloomberg as of July 31, 2023. Taxable Municipals represented by ICE BofA Broad US Taxable Municipal Securities Index (TXMB). Global Corporates represented by Bloomberg Global Aggregate Corporates Index.
It is not possible to invest directly in an index. Please see disclosures and index descriptions at the end of this document.
Soaring US Federal budget deficits (nearing $2 Trillion) and significant increases in overall debt to GDP (35% in 1980s versus nearly 125% today) have put US Treasury debt at risk for a possible downgrade by Moody’s Investor Service. In contrast, most US states have a constitutional requirement to balance their budgets and have maintained steady leverage metrics over the past decade.
Lower Ratings Volatility
Historically, municipals have experienced lower ratings volatility when compared to corporate bonds.2 These higher credit quality borrowers with monopolistic characteristics have dedicated cash flows which help drive repayment consistency on debt service. This contrasts with corporate bonds, where most cash flows are unsecured, creating less payment certainty.
Figure 2: Opportunity to Lock in Durable Income
Attractive Curve Positioning
In eight of the last ten years, taxable municipals have outperformed the Bloomberg US Aggregate Index (Aggregate). As of September 2023, municipals outperformed the Aggregate year-to-date by 209 basis points (bps).3
In contrast to investment grade corporates, an allocation to taxable municipals can offer higher yields and achieve positive roll-down effects. This allocation may also boost total return and provide a cushion in the event rates continue to rise.
For insurers with longer-term investment horizons, tapping into attractive value opportunities at the longer-end of the curve may be beneficial. Expanding into taxable municipal bonds provides enhanced diversification via high quality bonds with the potential for appealing long-term returns.
1. As measured by the ICE BofA Broad US Taxable Municipal Securities Index and the Bloomberg Global Aggregate Corporates Index.
2. Moody’s Trends in Global Corporates Rating Transitions, Moody’s US Municipal Bond Defaults and Recoveries as of October 18, 2023
3. Source: Bloomberg
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Past performance is not indicative of future results.
COMPARISONS TO AN INDEX
Comparisons to a financial index are provided for illustrative purposes only. Comparisons to an index are subject to limitations because portfolio holdings, volatility and other portfolio characteristics may differ materially from the index. Unlike an index, portfolios are actively managed and may also include derivatives. There is no guarantee that any of the securities in an index are contained in any managed portfolio. The performance of an index may assume reinvestment of dividends and income, or follow other index-specific methodologies and criteria, but does not reflect the impact of fees, applicable taxes or trading costs which, unlike an index, may reduce the returns of a managed portfolio. Investors cannot invest in an index. Because of these differences, the performance of an index should not be relied upon as an accurate measure of comparison.
Source: ICE Data Indices, LLC (“ICE Data”), is used with permission. ICE® is a registered trademark of ICE Data or its affiliates, and BofA® is a registered trademark of Bank of America Corporation licensed by Bank of America Corporation and its affiliates (“BofA”) and may not be used without BofA’s prior written approval. ICE Data, its affiliates and their respective third party suppliers disclaim any and all warranties and representations, express and/or implied, including any warranties of merchantability or fitness for a particular purpose or use, including the indices, index data and any data included in, related to, or derived therefrom. Neither ICE Data, its affiliates nor their respective third party suppliers shall be subject to any damages or liability with respect to the adequacy, accuracy, timeliness or completeness of the indices or the index data or any component thereof, and the indices and index data and all components thereof are provided on an “as is” basis and your use is at your own risk. Ice data, its affiliates and their respective third party suppliers do not sponsor, endorse, or recommend MacKay shields LLC, or any of its products or services.
“Bloomberg®”, “Bloomberg Indices®”, Bloomberg Fixed Income Indices, Bloomberg Equity Indices and all other Bloomberg indices referenced herein are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indices (collectively, “Bloomberg”) and have been licensed for use for certain purposes by MacKay Shields LLC (“MacKay Shields”). Bloomberg is not affiliated with MacKay Shields, and Bloomberg does not approve, endorse, review, or recommend MacKay Shields or any products, funds or services described herein. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to MacKay Shields or any products, funds or services described herein.
The following indices may be referred to in this document:
Bloomberg U.S. Aggregate Bond Index
The Bloomberg U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. Must have at least one year to final maturity regardless of call features. Must have at least $300 million par amount outstanding. Must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody's, S&P, Fitch. Must be dollar-denominated and non-convertible.
Bloomberg Global Aggregate Corporate Index
Bloomberg Global Aggregate Corporate Index is a flagship measure of global investment grade, fixed-rate corporate debt. This multi-currency benchmark includes bonds from developed and emerging markets issuers within the industrial, utility and financial sectors. You cannot invest directly in an index.
ICE BofA Broad U.S. Taxable Municipal Securities Index
ICE BofA Broad U.S. Taxable Municipal Securities Index tracks the performance of U.S. dollar denominated debt publicly issued by U.S. states and territories, and their political subdivisions, in the U.S. domestic market. Qualifying securities must be subject to U.S. federal taxes and must have at least 18 months to maturity at point of issuance, at least one year remaining term to final maturity to enter the index and one month remaining term to final maturity to remain in the index, a fixed coupon schedule (including zero coupon bonds) and an investment grade rating (based on an average of Moody’s, S&P and Fitch). The call date on which a pre-refunded bond will be redeemed is used for purposes of determining qualification with respect to final maturity requirements. Minimum size requirements vary based on the initial term to final maturity at time of issuance. Securities with an initial term to final maturity greater than or equal to one year and less than five years must have a current amount outstanding of at least $10 million. Securities with an initial term to final maturity greater than or equal to five years and less than ten years must have a current amount outstanding of at least $15 million. Securities with an initial term to final maturity of ten years or more must have a current amount outstanding of at least $25 million. “Direct pay” Build America Bonds (i.e., a direct federal subsidy is paid to the issuer) qualify for inclusion in the index, but “tax-credit” Build America Bonds (i.e., where the investor receives a tax credit on the interest payments) do not. Local bonds issued by U.S. territories within their jurisdictions that are tax exempt within the U.S. territory but not elsewhere are excluded from the Index. All 144a securities, both with and without registration rights, and securities in legal default are excluded from the Index. Index constituents are market capitalization weighted. Accrued interest is calculated assuming next-day settlement. Cash flows from bond payments that are received during the month are retained in the index until the end of the month and then are removed as part of the rebalancing. Cash does not earn any reinvestment income while it is held in the index.
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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. Bonds subject to interest rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner.
Diversification cannot assure a profit or protect against loss in a declining market.
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