Municipal bond investors like their muni portfolios to play the role of Old Faithful in their overall asset allocation, providing safety and income. But that doesn't mean that the investment environment is reliably the same. How can muni investors stay on track in 2019? They can adhere to these three strategies.
1) Stay invested. The outlook for muni bonds in 2019 is favorable. This is partly because the supply/demand picture for municipal bonds is exceptionally supportive of prices, with net supply likely to be negative in 2019. Investors who stay on the sidelines during supportive supply conditions will miss out on a potential rally.
Also, we expect the pace of rising rates to slow, as the Fed has become more dovish. Since late 2015, the Fed has hiked the federal funds rate nine times, to a range of 2.25% to 2.50% today. That puts the level of rates now into nearly neutral territory relative to the healthy growth of the US economy. In response, Fed Chair Jerome Powell recently indicated that there will likely be just two rate hikes this year. He also characterized the current Fed mindset as "patient and flexible," reflecting a more data-dependent approach as we near a rate that neither boosts nor slows the economy.
The upshot is that yields will probably rise modestly this year.
Municipal bond portfolios can defend against the associated price decline by slightly reducing their average portfolio duration, or interest-rate sensitivity. And bear in mind: with yields already higher than at this time in 2018, the income generated by muni bonds creates an ample cushion for further modest increases in yield. Concentrating high-grade bond holdings more heavily in short and intermediate maturities while underweighting more vulnerable long-maturity bonds should also help.
In other words, investors are unlikely to be rewarded for shortening their maturity targets in 2019. And if the economy does soften more than we expect, municipal bond holders will be happy to have stayed invested.
2) Own credit. To bolster portfolio income, investors can look to municipal credit. Historically, when the Fed has raised the Fed funds rate, muni credit has held its value better, outperforming both US Treasuries and high-quality municipal bonds. That's a pattern that held true in 2018 and continues to hold true today.
This makes sense because the Fed hikes rates during times of strong growth. And today's growing economy has helped to bolster state and local tax revenues and, in turn, improved municipal creditworthiness.
State and local officials have been prudent financial managers of their growing revenues, as evidenced both by the conservative revenue assumptions used for budgeting and by strong growth in rainy-day reserve funds. State budget directors reported that revenue has exceeded 2019 budget forecasts in 40 of the 50 states. And reserves are now at their highest levels in 20 years.
These healthier financial conditions bode well for both mid-grade and high-yield issuers. Demand for income - another key objective for muni investors - also bodes well. In addition, from a valuation perspective, spreads have remained stable, despite improvement in overall credit quality. As a result, the extra yield available for A-rated and BBB-rated debt remains at attractive levels, near their long-term averages. For example, investors can pick up an extra 0.85% in yield on average by investing in BBB-rated municipals. These factors make it a good time to earn extra income from a diversified position in mid-grade - and some high-yield-municipal bonds.
Nonetheless, caution is key when choosing which credits to invest in. Muni investors should avoid reaching for yield and instead focus on careful selection that maximizes opportunity and reduces risk.
3) Be active. Some investors try to protect their portfolios from rising rates by building a ladder of passive muni strategies. But ladders are static. Market conditions change. Today's volatility and uncertainty make active management essential. Furthermore, active managers outperform passive ladders 97% of the time and by a significant margin.
And don't forget: Active muni managers with flexible approaches have even bigger advantages. Flexible mandates have more tools and strategies at hand for navigating the challenges and the opportunities that dynamic markets present. They're also the best way for investors to keep their muni portfolios on track in 2019.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.