Munis' Risk-Adjusted Returns Beat Other Assets in Turbulent 2015

  • Tax-free debt tops Treasuries, stocks, commodities, corporates
  • Investors pour money into muni funds as city finances improve

In 2015, the boring market was best for the bottom line.

U.S. stocks plunged briefly into a correction, commodities hit new lows, Treasuries whipsawed at the whims of the Federal Reserve, corporate debt lost money and hedge funds barely made anything. Then there was the $3.7 trillion municipal-bond market, where defaults fell for a fifth-straight year, a tax-revenue influx allowed cities to save record amounts and cost-cutting left state and local governments with less debt than they had five years ago.

That bastion of buy-and-hold investors returned 2 percent last year after adjusting for the risk of price swings, according to data compiled by Bloomberg and Bank of America Merrill Lynch. The gains dominated other assets: The Standard & Poor’s 500 index of stocks eked out a 0.1 percent gain and Treasuries earned 0.2 percent on that basis, while company bonds dropped 0.1 percent and commodities sank 1 percent.

The top spot is a familiar one for state and local government debt. It’s been there for four of the past five years. High-yield tax exempt debt was the exception, with Puerto Rico’s fiscal crisis and defaults keeping the sector unchanged on a risk-adjusted basis last year.

“Munis have been a very attractive asset class for taxable investors when you look at the alternatives,” said Chris Alwine, head of munis at Vanguard Group Inc., which oversees $150 billion of the debt. “In particular when you look at the yield volatility. The returns don’t jump around as much. And then you have the tax advantage.”

The risk-adjusted gains are calculated by dividing total return by volatility, or the degree of daily price-swing variation, giving a measure of income for the amount of risk taken on. Higher volatility means an asset’s price can swing dramatically in a short period, increasing the odds of an unexpected loss.

Munis produced a 5.8 percent risk-adjusted return in 2014, more than double the other investments. They also outperformed in 2011 and 2012 as yields -- which move in the opposite direction as price -- fell to the lowest since the 1960s.

The winning streak may keep going as higher tax-free yields make the bonds an even greater draw, said Mark Sommer, a fund manager at Fidelity Investments.

“It’s not about absolute return of munis, but the relative return,” said Sommer, whose firm oversees $31 billion of munis. “The returns are pretty substantial on a tax-adjusted basis over a longer period of time, and you smooth out that slightly negative impact you might have over rising rates.”

Buy and Hold

Municipal-debt prices tend to remain steady because more than half of the market is owned by individuals, who are typically more interested in the tax-free interest payments than capital gains. As a result, they tend to hold the bonds until they mature. Trading volume last year fell to the lowest in at least a decade, a sign that bondholders weren’t fretting over the Fed’s first interest-rate increase since 2006.

The degree of daily price-swings on munis last year was half what it was for other fixed-income assets and minuscule compared with stocks and commodities, which boosted munis’ risk-adjusted returns, Bloomberg data show. State and local bonds posted gains in 2015 because their interest payments outweighed the price declines ahead of the Fed’s decision to lift rates on Dec. 16.

It helps the returns look better when other assets are struggling.

‘Loss of Confidence’

The S&P 500 was mostly flat for the year after recovering from a stock-price drop in August that pushed the index down by the most since 2011. Two-year Treasuries yields are at the highest level since 2010, reflecting the decline in price, and 30-year bonds ended the year with higher yields than at the end of 2014.

The S&P GSCI index of commodities touched the lowest since 2004 as China’s economy slows and oil prices plunge. That’s had a spillover into corporate bonds, leading to a rout that’s even affecting investment-grade bonds.

“You have to some degree a loss of confidence in some of those asset classes,” said Peter Hayes, head of munis at BlackRock Inc., which oversees $111 billion of the debt. “With the steady returns and the low volatility that munis offer, and with a focus on pure income, that’s where a lot of the demand has come from.”

Munis have also been propped up by the continuing recovery from the recession that ended six years ago.

Moody’s Investors Service upgraded the most states and cities in seven years during the first three months of 2015. Defaults dwindled, with just 54 missing payments for the first time through Dec. 18, according to Municipal Market Analytics.

The demand for tax-free debt has reflected the improving backdrop. Individuals poured more than $11 billion into muni mutual funds last year, Lipper US Fund Flows data show.

“Some of the reasons we’ve seen this relative stability is credits are generally stable to improving,” said Kevin Ramundo, a fund manager at Fidelity. “We’re expecting that to continue as long as the economy remains healthy and tax revenues continue to improve.”

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