Many bond benchmarks have gotten riskier in recent years, but that isn’t the case in the muni market.
We how the credit quality of the key while their interest rate sensitivity has increased. This matters for investors who hold passive index-tracking investments, like exchange-traded funds (ETFs), that track those indices, because they may be taking on more risk than they originally intended.
These trends are different in the municipal bond market. Despite headline issues like Puerto Rico’s debt negotiations, Detroit’s bankruptcy, or Illinois’ struggles with their large unfunded pension liabilities, risks in the muni market remain low. As a result, municipal bond mutual funds and ETFs can be an appropriate investment option for investors looking to gain exposure to the muni market.
Two key risks in the bond market
Interest rate risk and credit risk are two of the important risks when investing in the bond market.
1. Interest rate risk is the risk that the price of a bond will fall if interest rates rise, as bond prices and yields move in opposite directions.
“Duration” is a measure of interest rate sensitivity. All else being equal, the higher a bond’s duration, the more sensitive the bond’s price is to a given change in interest rates. The same is true for bond funds, which have an average duration based on the fund’s underlying holdings.
What does a higher duration mean in terms of prices? A simple rule of thumb when it comes to duration is that a bond's (or bond fund's) price will generally rise or fall by a magnitude of its duration (in percentage terms) for each percentage point change in its yield. For example, assume a bond has a duration of five. If its yield were to rise by one percentage point (say, from 2% to 3%), its price would fall by roughly 5%.
2. Credit risk is the risk that a bond will default or will be downgraded, possibly resulting in a drop in its value. Bonds with low credit ratings tend to have higher credit risk, and their prices are usually more volatile than those with higher credit ratings—and that’s usually exacerbated during periods of broad market volatility or stock market sell-offs.
Interest rate risk has been stable in the muni market
The Bloomberg Barclays U.S. Aggregate Bond Index, commonly referred to as the “Agg,” and the Bloomberg Barclays Corporate Bond Index are two very popular indices that mutual funds or ETFs that invest in core bonds or the corporate bond market track. In fact, 415 funds track the Agg.1
Since late 2011, the durations of both the Agg and the corporate bond indices have increased, as illustrated in the chart below. This is unlike the Bloomberg Barclays Municipal Bond Index, a commonly tracked muni bond index, where duration has decreased.
Interest rate risk has been stable in the muni benchmark, unlike the Agg or corporate benchmarks
Source: Bloomberg, as of 1/31/2020
Not only have the durations for the Agg and corporate bond indices increased to record levels, but they are higher than the muni index’s duration. This is important to investors in ETFs or mutual funds because funds that track those two indices, compared to the muni index, are more sensitive to rising interest rates.
We expect the 10-year Treasury yield to over the rest of the year, and it may reach as high as 2%. Moderately rising rates are likely to have a greater impact on funds that track the corporate index or Agg. That isn’t to say that investors should avoid corporate or Treasury bonds in 2020, as those types of investments can offer diversification benefits.
Credit risk is lower in the muni bond market
The long and slow economic recovery has benefited state and local governments in that more municipal issuers have been upgraded than have been downgraded recently. In fact, the number of municipalities being upgraded has outpaced the number being downgraded for nine straight quarters.2
The generally stable and improving credit conditions for municipal issuers has translated into a stable number of highly rated investments in the broad muni index. As illustrated in the chart below, the number of Aaa and Aa-rated issuers in the broad muni index has been consistent since the 2008 credit crises. Aaa and Aa are the top two rungs of investment grade.
The muni market is made up of highly rated issuers
Source: Bloomberg Barclays Municipal Bond Index, as of 1/30/2020
Immediately following the 2008 credit crises the number of Aaa-rated munis declined, primarily as a result of the drop in the number of municipal bond insurers. A municipal bond insurer is a private company that agrees to make timely principal and interest payments on behalf of the issuer if they are unable to do so. Issuers insured their bonds because it commonly resulted in Aaa ratings and lowered their borrowing costs.
Following the 2008 credit crises a number of municipal bond insurance companies either declared bankruptcy or consolidated as a result of bad investments outside of the municipal bond market. This resulted in a smaller number of Aaa-rated munis. Although there was a decline in the number of Aaa-rated munis, there was a large increase in the number of Aa-rated munis—still a very high credit rating.
The corporate bond market exhibits higher credit risks
The credit stability in the muni market is unlike the corporate bond index, where there is a larger number of lower-rated issuers, and also an increase in the percentage of those lower-rated issuers.
To illustrate: Prior to the 2008 credit crisis, 85% of the muni index was made up of Aaa- and Aa-rated issuers.3 This compared with 24% for the corporate bond index. On the other end of the credit spectrum, only 5% of the municipal bond index was composed of bonds rated on the lowest rung of investment grade, Baa, compared with 35% for the corporate bond index. Today, nearly 8% of the muni index is made up of the lowest-rated investment-grade bonds, compared with 50% for the corporate bond index.
In other words, credit risks are higher and rising in the corporate bond market, but that’s unlike the muni market.
Credit risks are higher in the corporate bond market
Source: Bloomberg Barclays Indices, as of 1/30/2020
What to do now
We think index tracking funds can be an appropriate solution for investors looking to gain exposure to the municipal bond market. They generally have adequate diversification and can benefit from low transaction costs. However, the changes in the Agg and corporate bond index illustrate that muni investors shouldn’t get lulled into a false sense of security if they’re invested in a fund. Although the credit quality and duration of the muni index has been relatively constant, it could change.
Schwab clients can log in to average duration and breakdown of credit ratings under the “Research” tab. We suggest focusing on higher-rated issuers and targeting an average duration near the five-year range.
1 Source: Bloomberg, as of 2/3/2020
2 Moody’s Investors Services, as of 11/15/2019
3 As represented by the market weights of the Bloomberg Barclays Indices, as of 12/29/2006.
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