Know How You Can Use Municipal Bonds to Stay Flexible in 2020
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Municipal bonds or munis are inarguably the safest long-term investments and highly popular among investors. In 2019, municipal bonds recorded their highest returns in five years. In fact, the Bloomberg Barclays Municipal Index rose 7.5 percent. These inherently safe investments are a type of loan made to the state or local governments to help them raise money for public projects such as the construction of schools, bridges, hospitals etc., in return for guaranteed interest payments. The greatest advantage of investing in municipal bonds apart from their safe nature is their tax-free earnings. Even though the interest rates on municipal bonds are low as compared to those of the U.S. Treasury Bills, the tax advantages provided by these secure bonds make them more attractive for investors. This fundamental benefit of municipal bonds tends to significantly profit those who fall in a higher tax bracket. While comparing the two, in terms of a balanced risk and reward scenario, municipal bonds can win the race against any other. However, given the dynamic market situation and current pandemic, the market is expected to witness some tough changes this year.
Here is how you can use municipal bonds to stay flexible in 2020.
Table of Contents
Take the mid-road
The typical Fitch rating standards of municipal bonds consist of AAA for best quality bonds, AA+ and AA AA- for high quality, A+ AA- for upper-medium grade and BBB+ BBB BBB- for medium quality bonds. High rated bonds garner lower interest rates since they are extremely secure investments. On the contrary, mid-to-low rate bonds have a higher rate of interest to offset their associated risk. As an investor, your risk appetite should determine the bonds that are best for investments. But given the current and expected market changes, it is advisable to take the mid-way and advance in bonds that have a mediocre risk and averagely high returns than higher rated bonds. Thus, you can opt for municipal bonds with ratings between AA- and BBB+. Any lower-rated municipal credits (than BBB+) are junk investments, which might carry high yields but have a significantly elevated risk, as well as more chances of defaulting.
Monitor your bonds
As part of financial prudence, it is important for an investor to consistently monitor the growth of their bonds, interest payments, as well as the general ratings of the bonds. Bond ratings change over time. Hence, you cannot be complacent thinking that once you have made the ideal investment, you have done your part. With shifting market conditions, the upgraded ratings can slimmer to a low and could thereby significantly increase the risk and chances of default. If you have purchased municipal bonds of a city whose crime rate rises along with surging political issues, its credibility can fall and so can its municipal bond ratings. In such a case, it is best to always keep a tab on these ratings and shell out your investments by selling the bonds to another investor when the time is fit.
Invest for a medium-term
2019 has been a solid year for fixed-income investments, with municipal bonds recording consistently strong performances. But it would be judicious not to make very flowery judgments of the long-term future. Investors should enter the horizon at this point but maintain their mid-term flexibility by choosing municipal bonds of an average tenure between five to eight years. This will help maintain an active balance of risk and reward.
Ditch the concentrated maturity structure
No future predictions are 100 percent accurate. Given the constantly varying market conditions, it would not be very practical to lay all eggs in one basket. Therefore, choosing munis with the same maturity period will probably do more harm than good. An investor should invest in different maturity structures and ensure the bonds are distributed fairly across the yield curve, typically like a laddered approach. Investors can also consider a barbell investment strategy, which focuses on a balance between long-term bonds (10 years or more) and short-term bonds (5 years or less) only. It is expected to provide greater yields as compared to a concentrated maturity method. Hence, to stay flexible, it is best to ditch one lengthy strategy, and instead, curve out the portfolio.
Opt for inflation-linked municipal securities
Even though not so popular, inflation-linked municipal bonds are liable to be more useful than their ordinary counterparts. Given the rising rate of inflation and future expectations, accommodating inflation in the long-run by making investments which are likely to offset the impact of rising prices later can be a good idea. While inflation-linked municipal securities are almost similar to general munis, the main difference is that the assumed principal amount in the former adjusts to the ongoing inflation rate, as administered by the Consumer Price Index (a standard measure of the actual inflation rate). On the contrary, general municipal bonds offer only one coupon rate for the entire duration until bond maturity. By investing in the former, you can increase your flexibility by ensuring that the payout from inflation-linked municipal bonds is above the then prevalent inflation rate.
Actively tap on U.S. treasuries
To stay flexible for the coming years, investors must constantly track the market and assess the changes in the municipal bonds, as well as other fixed-securities such as U.S. Treasuries. While comparing municipal securities and U.S. Treasuries, it would be safer to say that both are equally secure mediums of investments, yet the former is preferred due to its tax-free earning nature, even though the interest rate on treasuries is higher in comparison. However, given the modest risks of recession and the high chances of fallback on muni yields in the coming years (majorly because of lack of supply and increased demand), it is more sensible to lean towards U.S. Treasuries currently. Moreover, in terms of yield comparison, as of now, the after-tax return on one-year Treasuries is higher than those of AAA-rated municipal bonds. So, to be more flexible, investors can opt to actively tap on short-term maturity treasuries currently to earn some extra dollars and fall back on munis when they rise and become attractive again. Overall, given the fluctuating after-tax yields, it is always advisable to compare high-grade munis with treasuries to ensure that you lean on the greener side when the time is right.
To sum it up
With the U.S. economy at an inflexion point and multiple issues floating the scenario, it is important for a wise investor to balance the risk and reward of municipal bonds. It is also equally essential to be cognizant and wary of the risks. To smoothly sail through the up-roaring tides of uncertainty in the financial markets, it is best to adopt a flexible and active strategy to consistently balance its municipal investments, given the situation. As per the current scenario, opting for some medium-grade munis with mid-range tenure, ditching a concentrated maturity structure to spread the yields evenly, as well as cautiously selecting inflation-linked securities and actively tapping on U.S. Treasuries to increase short-term income, are some of the easy ways to keep you afloat and financially secured in the coming years.
For expert guidance on investing in municipal bonds, you can seek help from professional financial advisors.
