Investors who are looking to diversify in the current fixed-income market environment should consider exploring municipal bond ETF strategies bolster the foundation of a well-diversified, tax-efficient bond portfolio.
On the recent webcast, Muni Bond Strategies for a Low Interest Rate Environment, Samantha Azzarello, Vice President, Global Market Strategist, J.P. Morgan Asset Management; and Richard Taormina, Managing Director, Head of the Tax Aware Strategies Team, JP Morgan Asset Management, outlined the low-interest rate environment anticipated ahead and highlighted certain municipal bond strategies that are better positioned than others to benefit in this type of market cycle.
The strategists pointed out that the economy is still chugging along, with a 2.3% year-over-year real GDP growth as of the second quarter of 2019, which is more or less in line with the average rate of growth for the current expansion since the financial downturn.
Looking ahead, the FOMC and market expectations for the federal funds rate remain depressed without any significant increases. The markets anticipate rates to continue to dip in the years ahead while the FOMC has projected rates to remain steady through next year and slightly rise in 2021.
Additionally, headline CPI readings are still muted, registering a 1.8% reading in July 2019 or below the Federal Reserve’s 2% target and well below the 50-year average of 4.0%.
As it stands, fixed-income investors should not expect much headwinds from interest rate risk or high inflation cutting into real yields.
With investors considering ways to diversify a fixed-income portfolio, the strategists underscored the benefits of municipal bonds for their diversified and tax-exempt yields. Current nominal U.S. 10-year Treasury yields stood at around 1.5%, compared to municipal bond tax-equivalent yields of 2.5%.
Municipals provide portfolios with diversification benefits. Munis have exhibited a low 0.06 correlation to equities. The munis segment also comes with higher quality debt exposure than corporates. Specifically, the munis market is broken down into 6% Aaa-rated debt, 58% Aa-rated debt, 31% A-rated debt and 5% Baa-rated debt. From 1970 through 2018, default rates on investment-grade municipal bonds were a little over 1%, compared to the close to 7% default rate on investment-grade corporates. The disparity between defaults between munis and corporates only widens as we go down in credit quality.
In case of a recession, municipalities are better equipped to handle any downturn and are better equipped to resist defaults. Many cities and states are more accurately forecasting spending in their budgets and building up their rainy day funds. For instance, only seven states reported budget cuts due to revenue shortfalls in 2018 and none have reported budget cuts this year. Meanwhile, the median rainy-day-balance as a percentage of expenditures have steadily increased in recent years, providing states with a safe cash store.
To help investors better focus on opportunities in the municipal bonds market, J.P. Morgan Asset Management has come out with actively managed municipal bond ETFs, including the JPMorgan Municipal ETF (Cboe: JMUB) and JPMorgan Ultra-Short Municipal ETF (Cboe: JMST), which are backed by a highly experienced munis investment team.
For instance, JMUB has underallocated to areas that trade at yields below those of the national market, notably California and New York, which make up a combined 31% of the BB Barclays US 1-15 Year Blend Muni Index. Additionally, the muni managers have focused on potential areas of opportunity in sectors that have come under pressure, such as the healthcare sector that has come under greater scrutiny over costs, increased consumerism and calls to repeal the Affordable Care Act.
Active managers also provide the opportunity to add alpha through mispricings in the secondary market, gain access to the new issue market that can provide exposure to sought after paper and identify stable credits at attractive prices.
Financial advisors who are interested in learning more about the municipal bonds market can watch the webcast here on demand.