Quick Take on Fixed Income – Effects of Lowering Credit Quality in Municipal Bond Portfolio

Q: Can you capture higher returns on a municipal portfolio by lowering its credit quality?

A: Investors generally demand a higher yield when purchasing lower-credit-quality municipal bonds due to their greater risk. The assumption is the greater the risk, the greater the expected return. However, evidence has shown that investors have not realized higher risk-adjusted returns by denigrating credit quality. For investors seeking a higher return, we prefer to slightly tilt the portfolio allocation to a higher equity component rather than adding municipal credit risk.

History has shown A-rated municipals have not had significantly higher returns when compared with AA-rated munis. The below example shows the returns of two similar portfolios over a 20-year period (1994–2013). Portfolio 1 comprises 60 percent equity/40 percent A-rated municipals. Portfolio 2 slightly tilts to a 2 percent increase in equity allocation but holds only AA-rated municipals. The total return and compounded returns are almost identical, and the portfolio tilting toward stocks actually had a slightly lower volatility and performed better in the down year of 2008.

We examine the effect of lowering the credit quality even further to BBB-rated municipals in Portfolio 3, again using a 60/40 equity-to-fixed allocation over the same period. This portfolio has significantly higher credit risk, but the returns were almost identical to Portfolios 1 and 2 but with a significant increase in volatility. In addition, the 2008 performance was considerably worse, showing these lower-rated bonds behave like equities at the wrong time.

Rather than sacrificing credit quality, another option is to tilt to a higher equity allocation for a similar portfolio return. Portfolio 4 moves to a 66 percent equity/34 percent AA-rated municipal allocation. The returns were higher, and the volatility and correlation to equities were lower.

It’s important to remember that one of the primary purposes of fixed income securities is to provide stability to investors’ portfolio. It is this stability that allows them to take equity risk. 

Data supplied by Barclays. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Performance is historical and does not guarantee future results. 60/40 w/ A-rated muni: 67% S&P 500/33% MSCI EAFE; 62/38 w/ AA-rated munis: 41% S&P 500/21% MSCI EAFE/38% Barclays US AA-Muni Index; 60/40 w/ BBB-rated munis: 67%/ S&P 500/33% MSCI EAFE; 66/34 w/ AA-rated munis: 44% S&P 500/22% MSCI EAFE/34% Barclays US AA Muni Index.

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