By James Welch, Portfolio Manager, Principal Global Fixed Income
A bunker is defined by Merriam Webster as a strong building that is mostly below ground designed to keep soldiers, weapons, and supplies safe from enemy attacks. And while the investment landscape is not a war zone, it's no secret that 2016 has been a battlefield for many investors. January greeted us with remarkable volatility, and we kicked off the summer with market chaos upon the unprecedented outcome of a Brexit referendum, in which the United Kingdom voted to leave the European Union. So now here we are in August, and investors are a little battered and the global economy is a little bruised. Surely, the potential for an investment bunker would be a welcome reprieve for many of us. This is where we believe municipal bonds (munis) come into play.
After the Brexit vote was announced, currency markets took a nose dive, equities entered a tailspin, and the global economy was briefly shell shocked. Yet, in the midst of the initial Brexit fallout, munis were rallying. But this isn't a 15 minutes of fame story. Munis have had a strong year, reporting 43 consecutive weeks of positive net fund flows as of Friday, July 29 - making this the fourth longest streak since 1992, both in terms of consecutive weeks and dollar amount. In fact, defying conventional wisdom, munis outperformed equities, investment-grade corporate bonds and even Treasurys in the days immediately following the Brexit vote, and have continued to provide investors with consistent performance. And while I don't buy into the hype surrounding the muni/Treasury ratio, it's becoming hard to ignore the sharp outperformance in munis - especially out long.
But it isn't just the performance of munis that is attractive. In a global economy, where many countries are facing very low, if not negative, yields, municipal bonds are appealing to foreign investors. Additionally, in times of market uncertainty, we often see flight to quality, or investors moving their capital from riskier investments to safer investments - a role well suited for fixed-income investments, notably munis, in an investment portfolio.
And while I want to be clear that municipal bonds are not without risk, in an environment where rates look to be on the path of "lower for longer," investing in munis becomes attractive, as they are designed to provide stable and superior tax-adjusted yields relative to taxable products. In fact, if we remain bogged down in this low interest rate environment, or if rates are reduced further, investors have the opportunity for their investment to appreciate through active management (buying and selling muni bonds as opportunities arise, rather than holding to maturity). And in the wake of Brexit, many believe rate hikes by the Federal Reserve are now off the table for the foreseeable future, which is good news for muni bond investors.
Now some may point to a reduced demand from direct retail, and it's true that direct ownership of muni bonds has fallen nearly 20% since 2008. However, ownership in muni mutual funds has risen by 37%. In fact, institutional interest in municipal bonds remains strong, healthy, and growing - serving as a nice reminder that bonds still matter. But the important thing to remember is that you should own bonds for more than just income. Meaning, the diversification benefit alone is a proven staple of a well-balanced portfolio. And balance is great - in fact, it is necessary - but as an investor, you should balance with bonds that can weather the storm. And when we look back on the year-to-date performance of munis through June, municipal bonds have surpassed the annual returns in seven of the last ten years. The takeaway? If you are looking for a Brexit bunker and believe in the benefits of diversification, consider fortifying your long-term investment strategy with municipal bonds.