Markets around the world are reacting to COVID-19 as investors sort through the potential economic impact across asset classes — and that includes the municipal (aka “muni”) bond market. But despite that volatility, and although the road ahead may continue to be bumpy, we believe Ellevest’s strategy for investing private wealth clients’ assets in the bond markets is fundamentally strong.
What happened, and what does it mean?
Muni bonds are those issued by a local government, like a city, state, or county, to help them raise money for public projects like building schools, fixing bridges, etc.
The type of fast and dramatic pullback the muni market saw over the last few weeks — before reversing course last Wednesday ahead of the passage of the CARES Act — is especially rare for assets that tend to exhibit very low volatility. Much of the initial decline in muni bond prices was driven by muni mutual funds, which posted their first week of fund outflows (more investors pulling money out of the fund than putting money in) after more than 50 weeks of inflows (more investors putting money in than taking it out). Since then, prices seem to have started to settle, although they’re still down from their most recent highs.
In normal markets, mutual funds experience inflows and outflows every day. A fund’s portfolio manager can choose to sell bonds and other assets in order to turn them into cash so that investors can make withdrawals (while minimizing the impact on the remaining investors in the fund). But when there’s a spike in the number of people selling their shares of the fund, the managers are forced to sell bonds at less-than-ideal prices so that everyone can make their withdrawals, driving prices down even further. This is often called “liquidity-driven” selling — selling for the purposes of raising cash.
This economic crisis still has so many unknowns, including how this will all shake out. This type of global flight to safety, where investors are selling anything that isn’t cash or Treasurys, seems to be evidence of a “sell now, ask questions later” mentality, which — in conjunction with the fact that prices already seem to be normalizing — suggests that the recent selloff may have been an overreaction.
The significant drop in economic activity driven by this pandemic is bound to impact local governments’ finances, as many states limit where people can travel, work, and shop. That being said, it doesn’t seem like people are selling muni bonds because they’re nervous about the municipalities defaulting (failing to pay back the principal) — muni bonds have sold off across the board regardless of credit quality. Instead, the recent selloff appears to be more about investors just wanting cash.
Widespread defaults aren’t as likely as scary headlines make them out to be; many bond-funded projects and issuers have plenty of measures in place to help them make repayments. We believe that policymakers are aware of how important things like central transportation centers are to the cities’ ability to function, not to mention the economy’s eventual recovery. The muni sectors most likely to be adversely impacted are those exposed to discretionary economic activity, like convention centers and stadiums — none of which are sectors that we actively invest in. We seek to buy higher-quality munis that have a greater capacity to withstand disruption (more on this below).
How Ellevest uses muni bonds in clients’ portfolios
For clients who use Ellevest’s digital investing platform, we invest in municipal bond exchange-traded funds (ETFs). These are baskets of many different muni bonds put together, which makes it possible to build a diversified portfolio of bonds even if you don’t have a lot of money to invest.
For our private wealth clients who have more to invest, it’s possible to purchase enough individual bonds to build a diversified portfolio. In that case, we often place muni bonds in taxable investment accounts, because the income they generate is usually exempt from federal income taxes. If you live in the state that issued the bond, that income might also be exempt from state and local income taxes.
We have clients across many states, all of whom have different income tax situations and cash flow needs. In some states, like California and New York, the muni market is large and has many issuers; other states, like Vermont, have fewer issuers. Each state also has unique political, geographical, and economic risks. We take all of these considerations into account in order to build customized municipal bond ladders for our private wealth clients.
What’s a bond ladder?
A bond ladder is a portfolio of individual bonds, each set to mature (aka reach the end of its life) or redeem (meaning the issuer buys the bond back early) at regular intervals over a set time period. Each year, as a portion (“rung”) of the ladder matures, that money can be reinvested to extend the time period.
The strategy is intended to be “buy and hold,” meaning you would hold on to your individual bonds until they mature. The bond’s redemption value — the amount the issuer will pay when the bond matures or redeems — is known when you buy it (assuming the bond doesn’t default, which is rare). Here’s why: The prices of individual bonds fluctuate over time the same way that the prices of funds containing individual bonds fluctuate. This means there would be price uncertainty (and risk) if you were planning to sell the bond before its maturity date. But if you buy and hold all the bonds in the ladder, reinvesting them as mature, all the price fluctuations that happen in the meantime won’t affect your expected returns (except, again, in the rare case of default).
Muni bond ladders at Ellevest
At Ellevest, we focus on building bond ladders using high-credit-quality municipal bonds, taking into consideration which state you pay income taxes in. We look for bonds with ratings of AA or better, issued by one of the major credit rating agencies, that have been reaffirmed within the last few years. Historical default rates for municipal bonds with good credit ratings are very low.
To help mitigate credit risk further, we focus on general obligation bonds and essential service revenue bonds. General obligation bonds (GOs) tend to be backed by the “full faith and credit” of the issuing state or local government — and its ability to raise money via taxes. (For that reason, default rates on GOs are very low.) Essential service revenue bonds, on the other hand, tend to be backed by the revenue generated from the local government’s critical services, like water and sewer systems. These revenue streams also tend to be reliable and resilient during times of market stress.
At the end of the day, the type of bond issuers Ellevest seeks out tend to have characteristics that can make their credit ratings more stable through economic cycles. That might include ample financial resources, strong management, conservative fiscal practices, and / or regular revenue streams. While we know there might be downgrades and ongoing pressure on local governments while the world works its way through the fallout from the coronavirus, we believe that the long-term fundamentals of our investment strategy should remain stable, and we’ll continue to build muni bond ladders for our clients.
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