The outlook for the muni market is favorable for 2020, but investors should be prepared for twists and turns. Active and flexible strategies that effectively balance risk and reward as conditions evolve can help keep investors on track.

Last year’s municipal returns were the highest in five years, with the Bloomberg Barclays Municipal Bond Index up 7.5%. As yields fell, income-hungry investors helped drive credit spreads lower. As a result, long-maturity and lower-quality bonds performed especially well.

The seemingly insatiable appetite for municipal bonds easily absorbed an uptick in gross new issuance in 2019. In fact, demand for munis was so strong that municipal bond mutual flows reached a record $94 billion.

With yields likely to remain low, we expect continued robust demand for income to readily absorb new issuance in 2020. We think four tactics will serve municipal investors well in this environment:

1) Consider medium-grade municipal credits. As we saw last year, high demand for income translates into a favorable environment for municipal credits rated A or BBB. But technical conditions aren’t the only reason investors should consider allocating a portion of their portfolio to medium-grade municipal bonds in 2020.

Today’s economic expansion is the longest on record, and municipal governments have used the extended period of economic growth and rising employment levels to shore up their fundamentals. State and local government tax receipts have skyrocketed. The Urban Institute recently reported that, for the five months ending November 2019, total state tax revenues rose 5%. Of the 46 states reporting, 41 saw an increase in tax revenue.

State and local officials have been prudent managers of their growing revenues, as evidenced by strong growth in rainy-day reserve funds. Such funds climbed from less than 2% as a percentage of general fund spending in 2010 to more than 7% in 2019. Reserves are now at their highest levels in 20 years. Rainy-day reserve funds provide a cushion in the event of an economic downturn or a recession.

Rating agencies have rewarded this fiscal discipline; for the past several years, upgrades have outpaced downgrades across the municipal market by as much as two to one.

Lastly, A- and BBB-rated bonds provide an extra yield buffer in the event interest rates do move higher. And for investors whose mandates permit investment in non-investment-grade debt, select credits rated below BBB are also attractive, in our view. That said, investors in municipal bonds of any rating tier should focus on careful security selection that maximizes opportunity and minimizes risk.

2) Add US Treasuries. Long-maturity municipal bonds look relatively expensive by historical measures. Until long municipals are more attractively priced, a modest position in long-term US Treasuries can provide protection against the risks of recession, on the one hand, or a reversal in muni yields, on the other.

In addition, the yields on one-year US Treasuries are currently higher after taxes than the yields on AAA-rated municipals. Investors making an allocation to short-maturity Treasuries today will not only pick up extra income but may reduce their overall volatility when muni yields rise. Once municipal yields have risen and are again attractive relative to Treasuries, investors can easily exit the highly liquid Treasury position in favor of munis.

Because relative after-tax yields fluctuate, investors should keep an eye on the relationship between high-grade municipals and US Treasuries—and be able to lean into Treasuries when the opportunity arises.

3) Flex your maturity structure. History shows that no one—including professional money managers—can predict exactly when or how much yields will rise. In fact, expert forecasters are more likely to be wrong than right. But active investors can adjust their maturity structure, or yield-curve positioning, depending on the slope and curvature of the yield curve.

This kind of strategy takes into consideration not only current yield levels along the yield curve, but also the likelihood that the shape and slope of that curve will normalize over time, generating changes in price.

Different maturity structures can have the same average duration, or sensitivity to changes in interest rates. Most passive buy-and-hold strategies, for example, employ a laddered structure, with holdings distributed evenly along the yield curve. An active manager might have the same portfolio duration but distribute the holdings in a barbell (short plus long maturities only), a concentration in a single “sweet spot” of maturities, or some variation of any these.

In today’s environment, investors should consider leaning into more of a barbell structure, given the lack of curvature in the yield curve. Today, a barbell will provide greater yield plus roll compared to a concentrated maturity structure.

4) Secure protection against inflation. At 2.2%, core consumer price inflation (CPI) remains within its range of the last two years. That doesn’t rock any boats. But we believe that inflation will gradually rise in 2020.

Meanwhile, inflation protection is extremely cheap, as measured by the current sizable gap between the CPI rate and the five-year break-even inflation rate. Investors can take advantage of this cheap pricing on inflation protection through either CPI swaps or Treasury Inflation-Protected Securities (TIPS).

Finally, because of the high correlation between rising inflation expectations and rising interest rates, inflation protection can help reduce a portfolio’s interest-rate risk.

Awake Behind the Wheel

Approaches such as adding medium-grade credits, US Treasuries and inflation protection to a municipal portfolio, or changing the portfolio’s maturity structure, require an active, flexible mandate. Investors who stay awake behind the wheel and employ flexible strategies are better positioned to navigate the twist and turns of dynamic markets.

Daryl Clements is Portfolio Manager—Municipal Bonds at AllianceBernstein.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of all AB portfolio-management teams, and are subject to revision over time.

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