Confucius wrote, “The green reed which bends in the wind is stronger than the mighty oak which breaks in a storm.” We believe that, similarly, municipal investors who choose flexible mandates will be well equipped for any type of weather.

Interest-rate increases, rising inflation expectations, major shifts to tax policy as well as other proposed policy changes—any and all of these introduce uncertainty and volatility to the investment environment, as well as potential opportunities to increase income and return.

The Flexible Municipal Mandate: Be Like Bamboo
Source: Flickr
Flexible Municipal Mandate

Why does this matter so much to muni investors? Because these three principles—safety, income and after-tax return—are the bedrock of municipal investing.

Flexibility, Four Ways

Flexible municipal managers know that being nimble helps keep a portfolio on track with those objectives. Here are four ways we advocate being flexible today:

Shift into some taxable bonds to keep volatility at bay. Small opportunistic positions in US Treasuries and other taxable bonds in municipal portfolios can buffer portfolios during volatile periods.

For investors subject to high tax rates, municipal bonds have made sense over the years, and they still do. But relative after-tax yields aren’t static, and municipals’ after-tax yield advantage may be eroded by proposed changes to tax codes—specifically, lowering the highest individual and interest income rates.

That’s not to say investors should lose any sleep just yet over tax rates. Tax code is complex, and it may be a long road from proposal to legislation. While tax rates were cut in Reagan’s first term, it took six years to pass major tax reform during the Reagan administration.

Increase income with credit. One way to boost the income of a muni portfolio today is by adding mid-grade and high-yield municipal bonds. (In fact, this is preferable to boosting income by lengthening maturity, which exposes investors to both more rising-rate risk and more tax-reform risk.)

Mid-grade and high-yield municipal credits look attractive today. The yield advantage these credits are offering over high-grade municipals is higher now than a year ago. It’s likely that a growing economy will improve revenues and creditworthiness for lower-quality issuers, causing this yield advantage to contract over time. That “spread” contraction, coupled with higher income at purchase, would result in relative outperformance versus their high-grade counterparts.

In fact, that’s exactly what occurred in the last five Fed tightening cycles, when municipal credit outperformed municipal high-grade securities.

Be dynamic as policies unfold. As executive orders and Congressional bills are drafted or even rumored, the market rises and falls at possible short-term outcomes. But most policies take a long time to come to fruition. For municipal portfolios, that means paying attention to the details and being prepared for long-term consequences. For example, although we think sanctuary cities will continue to receive federal funding, investors should be paid for the risk. Also, we’re underweight hospital bonds in the likely event that the Affordable Care Act is changed dramatically or repealed.

Shield yourself against inflation. Is inflation on the horizon in the Trump era? It’s looking more likely, given the probability of falling federal revenues and rising federal spending, particularly on infrastructure. Mix in decreased regulation, and it’s a recipe for faster inflation. Investors should be careful to choose the right tool for the job, and to do so before inflation protection becomes too costly.

Above All, Don’t Be Passive

Passive municipal bond ladders may seem enticing, but they have hidden risks.

Passive ladders lock in low yields that have little chance of beating even a modest rate of inflation. And while they’ll eventually begin to capture rising yields, it takes them a long time to get there. Lastly, some strategies can have significantly more interest-rate risk than investors expect, and that can translate into painful volatility.

In contrast, an actively managed portfolio provides access to multiple sources of after-tax income and return potential, while also providing greater liquidity, diversification and risk control.

While it’s impossible to predict exactly how interest rates, inflation or policies will play out and the ultimate effect they’ll have on the market, a flexible municipal portfolio will be well positioned for uncertain conditions—whether it’s a typhoon or a little dust in the wind.

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.

Article by Guy Davidson – Alliance Bernstein