Investors looking for stability and income in this rocky market may want to consider municipal bonds. Concerns about the U.S.-Iran conflict have rattled the stock market this week, with the S & P 500 on track to lose 2% and the Dow Jones Industrial Average down about 3% week to date. In the Treasury market, bond yields rose this week alongside surging oil prices. Bond yields move inversely to prices. Municipal bond yields followed the Treasury moves. Munis, the majority of which are investment grade, have income that is free of federal income taxes and state taxes, if the holder lives in the issuing state. MUB YTD mountain iShares National Muni Bond ETF year to date For Tom Kozlik, head of public policy and municipal strategy at HilltopSecurities, the latest moves mean an opportunity to lock in attractive yields, as well as peace of mind. In fact, even before the move higher in yields this past week, he has been telling investors to use munis as a way to stabilize their portfolios. "I don't think that the geopolitical risk is a negative towards overall credit quality in municipals," Kozlik said. "It's just an opportunity for investors to gain investments at yields that, even just a week or two ago, I didn't think that we would have again for some time." Vanguard municipal portfolio manager Stephen McFee also sees the recent rate volatility as an opportunity. "These are obviously very domestic focused, more than most other asset classes investors get to choose from," he said. "So there is a level of insulation from the things that are breaking out in the Middle East, even though there is a correlation to what's happening in Treasury rates." VTEB YTD mountain Vanguard Tax-Exempt Bond Index Fund ETF year to date In fact, while municipals underperformed other fixed-income investments last year, that has turned around. The Bloomberg Municipal Bond Index has gained about 1.5% year to date, versus a less than 1% return on the Bloomberg U.S. Aggregate Bond Index, which tracks the investment-grade bond market. "It's been a very good year so far," said Cooper Howard, director of fixed income research and strategy at the Schwab Center for Financial Research. "A lot of that has been driven by a lower amount of supply and a stronger amount of demand." In fact, Dan Close, head of municipals at Nuveen, believes the muni bond rally could be in early stages. Over the past 25 years, when the performance spread for municipals versus the U.S. aggregate has fallen below -400 basis points, municipals have recovered to a 375 basis point spread, he said. Munis underperformed by more than 400 basis points last April, and have been slowly climbing back, Close said. "We've recovered, as of [Thursday] night, about 220 basis points of this, but if history's any guide, we'll get back to even, and not only will we get back to even, we'll get back to this point where we're actually meaningfully exceeding that plus-400 mark," he said. That said, investors should be prepared for the possibility of further rockiness ahead, said Howard. "There might be some volatility in the near term due to the situation with Iran, concerns about inflation, concerns about a slowdown in economic growth, concerns about the path forward for the Fed, but overall credit quality continues to remain relatively favorable in the muni market," he said. "We're not showing major signs of weakness, major signs of stress." Their yields relative to Treasurys have moved lower to a ratio that is below the three-year average. That could signal underperformance relative to Treasurys in the next 12 weeks, Howard said. That said, "on an absolute yield basis, they do continue to look fairly attractive, especially for those investors who are in higher tax brackets," he said. For investors in the top tax bracket, a 3.4% yield translates to a 5.8% tax-equivalent yield, Howard said. Bonds vs. ETFs Investors can get muni exposure through either buying the bonds directly or through exchange-traded or mutual funds. "If you are an individual who has maybe less money to invest, it tends to lend itself better towards mutual funds and ETFs, because they receive broad diversification," Howard said. "However, the downside of those is that the price can fluctuate, and the price does fluctuate." Individual bonds are good for those looking for a stable source of income, but investors will need a larger amount of money to achieve adequate diversification, he said. Those looking to build a bond strategy are increasingly doing so in separately managed accounts through their advisors, noted Howard. He suggests an overall duration of around six years, which can be split between some short term and longer-term bonds. While investors can build ladders of varying maturities, Howard thinks a barbell strategy — with short duration on one end and long duration on the other — is attractive right now. "You're getting the flexibility of the shorter-term bonds, because when they come due, you have the money that redeploy into whatever you want or potentially spend that now," Howard said. "The benefit of longer-term bonds is that valuations are more attractive on the longer part of the yield curve."
