The often misunderstood municipal bond market is not considered a ‘core’ asset class by many investors and institutions offering financial products to investors. Certainly investment grade municipal bonds have some qualifications to be ‘core’ and the proposed Qualified Public Infrastructure Bond (QPIB) might help change the way we think about this important asset class.
Some things for us to consider:
- High quality. The average rating (Moody’s, S&P and or Fitch) of bonds in the S&P National AMT-Free Municipal Bond Index is higher than the average rating of bonds in the S&P U.S. Issued Investment Grade Corporate Bond Index.
- Low default rate. According to our research (Rieger & Cling: 2015), the 2014 12 month trailing default rate for municipal bonds was 0.17% (by number of defaults vs. # of bond deals outstanding). I would be hard pressed to find another U.S. bond asset class beyond U.S. Treasuries that had a lower a default rate.
- Duration. It is a common assumption that municipal bonds are longer in duration than corporate bonds. Currently the duration of the S&P National AMT-Free Municipal Bond Index (tracking only investment grade bonds) is 2 years shorter in duration than the duration of the S&P U.S. Issued Investment Grade Corporate Bond Index. All else being equal, shorter duration means lower price movement up and down when rates rise and fall.
- Yield. The nominal yield of tax-exempt municipal bonds is indeed lower than corporate bonds. However, when looked at from the perspective of how much return an investor actually keeps after taxes the story is different. The taxable equivalent yield of municipal bonds is very competitive to taxable bonds.
- Not only for the wealthy. In the current high tax environment we are in tax-exempt municipal bonds can be considered an option for many investors and not just the wealthy or the top 1%.
- Liquidity. U.S. municipal bonds are indeed less liquid than their corporate bond counterparts. Most municipal bonds are smaller in par amount than corporate bonds and their are many more municipal bonds brought to market. However, investment grade municipal bonds are far from illiquid. During the 12 month period ending November 2014 an average of 68% of the over 9,500 bonds in the S&P National AMT-Free Municipal Bond Index traded each month! The average trade size during that period of time: over $265,000.
- Public good. U.S. municipal bonds serve as an important infrastructure funding source. Roads, highways, bridges, tunnels, airports, ports, schools and so much more are built and maintained because they are funded by bonds.
- QPIB. The recent proposal by President Obama to create a new type of bond called a Qualified Public Infrastructure Bond (QPIB) is intended to bolster the issuance of bonds to help maintain U.S. infrastructure. This proposal must pass a republican congress and it is not the administrations first attempt at funding infrastructure development. However, we all can see the degradation of our infrastructure. Considering investment grade municipal bonds as a ‘core’ asset class might help this program and the use of other municipal bond issues make a difference.
References cited:
Rieger, James & Cling T. January 2015 Fixed Income Update: The U.S. Municipal Bond Default Rate Hits 3-Year High in 2014: 0.17%
This article was written by J.R. Rieger, global head of fixed income, S&P Dow Jones Indices.
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