The cruelest month? Municipal investors would probably say November. But the sell-off that began when Donald Trump won the US election already appears to be running out of steam. Investors who sell now may soon regret it.
Why? Because the municipal market is built for recovery. Sure, a narrow investor base makes municipal bonds susceptible to sudden downturns like the one that shaved almost 4% off the market in November. But this is a market that, historically, has bounced back quickly—usually in less than a year. The rebound may already be underway.
History also shows that higher income eventually overcomes price declines and ultimately leads to positive returns. This is a key reason why bonds are a major building block of a safety-oriented portfolio.
Even so, there are adjustments that skilled portfolio managers can make to keep investors’ municipal portfolios safe as we wait for more detail about Trump’s plans to cut taxes and boost spending. Here are five things investors may want to consider:
1) Don’t be passive. Some investors try to protect their portfolios from rising rates by building a ladder of passive muni strategies. But ladders are static. Market conditions, on the other hand, change. Today’s elevated volatility and uncertainty make active management essential.
2) Stay flexible. Trump wants to cut federal tax rates, and with Republicans in control of Congress, he’ll probably get his way. Details are still hazy, though, and that will keep the market volatile. The ability to use taxable bonds opportunistically can help preserve capital.
3) Consider inflation protection. Lower taxes and Trump’s trillion-dollar infrastructure plan could lead to higher inflation. But for investors who pay US taxes, buying Treasury Inflation-Protected Securities isn’t an ideal way to shield a bond portfolio. A muni portfolio that gets inflation protection through consumer price index swaps may be more tax efficient.
4) Limit maturities. The municipal bond market appears to have priced in a hefty decline in tax rates already. But investors can play it safe by reducing their portfolios’ average maturity and their holdings of long-maturity bonds. This limits exposure to falling tax rates and rising interest rates.
5) Add some credit. If you believe Trump’s policies will stoke economic growth—and markets clearly do—consider adding mid-grade and high-yield municipals. The issuers of these bonds should thrive in an improving economy. Over the last five Federal Reserve tightening cycles, municipal credit has outperformed municipal high-grade securities.
Normally, municipals are less volatile than Treasuries and corporate bonds. And with a Trump tax cut already priced into municipal bonds, we’d expect the market to stabilize in the weeks ahead.
Here’s another thing to keep in mind: markets are assuming a tax cut is a done deal. But it took six years to pass the last major tax reform during the Reagan administration. It may not take that long this time, but that doesn’t mean it will happen immediately, either.
We understand that not every investor is comfortable committing capital in the current environment. But even for those who can’t bring themselves to buy into this market, these developments show that this is not the time to sell.
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