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Add Muni Bonds to Help Stabilize Your Fixed-Income Portfolio

This article was originally published on ETFTrends.com.

Investors looking to inject stability into their fixed-income portfolios, particularly as Treasury yields continue to rise and depress prices, may want to consider adding municipal bonds especially when volatility has been racking both the stock and bond markets as of late.

Moody's Investors Service's released an annual report, US Municipal Bond Defaults and Recoveries, 1970-2017, highlighting the municipal bond market through 2017. One notable to extrapolate from the 100-page report was that stability is prevalent in the municipal bond market since the propensity for these debt issues to default is rare.

Based on the report's findings, the five-year all-rated cumulative default rate (CDR) on municipal bonds from 1970 to 2017 was a scant 0.09%. Compare this to a CDR of 6.7% for global corporate bonds within the same timeframe and it shows just how stable municipal bonds can be.

Furthermore, defaults on municipal bonds were rare even during time periods of dire financial straits. The reason is state and local governments have delinked revenues and expenditures, which allow municipalities to defer debt and delay a crisis.

In some instances, municipal bond debtors can even obtain additional financing whereas corporate bond debtors must foot the bill when the debt is due.

Related: J.P. Morgan Launches First Ultra-Short Muni Bond ETF

$3.8 Trillion Muni Bond Market Pie

The U.S. municipal bond market represents a $3.8 trillion pie and smart beta exchange-traded fund (ETF) strategies are looking for a slice, such as Columbia Threadneedle Investments' Multi-Sector Municipal Income ETF (MUST) . Columbia already boasts an ETF roster that utilizes smart beta strategies for emerging markets, equity income and fixed income. However, as shown in the pie chart below, the municipal bond market has been relatively untouched.

Smart Beta ETFs Eyeing Slice of Municipal Bond Market Pie 1

“Today’s municipal market is comprised of nearly $4 trillion in assets spread out among more than one million debt offerings from 80,000 issuers,” Catherine Stienstra, head of municipal bond investments at Columbia Threadneedle Investments and serves as Lead Portfolio Manager of MUST, said in a note. “In the muni space, buying individual bonds or purchasing a debt-weighted benchmarked product doesn’t give investors the diversification they need, nor the ability to manage credit risk transparently and efficiently. We created MUST with the goal of simplifying investors’ municipal bond exposure without compromising their investment objectives.”

Columbia's use of smart beta with MUST includes multi-factor investments that help combine uncorrelated investment styles to smooth out volatility. Since there are multiple uncorrelated factors at play, it helps guarantee that at least one factor will help support the portfolio during times of distress.

Moreover, a multi-factor ETF removes the need for investors to babysit a portfolio and switch between factors in an attempt to time market moves.

“Even though most investors’ current exposure to municipals is through actively managed portfolios or individual bonds, we’ve seen a growing interest in passive products in the municipal space,” said Marc Zeitoun, CFA, head of strategic beta at Columbia Threadneedle Investments. “Given the limitations of existing municipal bond benchmarks, we opted to draw upon our expertise in managing active municipal bond portfolios to build an innovative, strategic beta fund that leverages our best thinking, but in a cost-effective, risk-managed way.”

Treasury Yields Higher Across the Board

Treasury note yields got much of the blame for last week’s stock sell-off as benchmark notes went on a weeklong ascent in the week prior, pushing to new highs that caused investors to fret. Today, yields continued to climb, but didn’t affect the markets negatively as the Dow Jones Industrial Average was up over 100 points as of 1:45 p.m. ET.

The benchmark 10-year note went to 3.192, while the 30-year note was at 3.344. Short-duration yields were up as well with the 2-year note rising to 2.895 and the 5-year note heading up to 3.043.

As rates rise and bond prices fall, investors can use fixed-income ETFs like the  Xtrackers Hi Yld Cor Bd Intst Rt Hdg ETF (HYIH) or the  WisdomTree Interest Rt Hdg Hi Yld Bd ETF (HYZD) .

HYIH seeks investment results that correspond generally to the performance of the Solactive High Yield Corporate Bond-Interest Rate Hedged Index–more high yield to appease Axelrod’s appetite for risk. HYIH will invest at least 80% of its total assets in instruments that comprise the underlying index, such as long positions in U.S. dollar-denominated high yield corporate bonds and shorts in U.S. Treasury notes or bonds of approximate equivalent duration to the high yield bonds.

HYZD seeks to track the price and yield performance of the BofA Merrill Lynch 0-5 Year U.S. High Yield Constrained, Zero Duration Index, which provides long exposure to the BofA Merrill Lynch 0-5 Year U.S. High Yield Constrained Index while seeking to manage interest rate risk through the use of short positions in U.S. Treasury securities. The majority of the fund’s total assets will be invested in the component securities of the index and investments that have economic characteristics that are similar in nature.

For more trends in fixed income, visit the Fixed Income Channel.