On an appreciation-only basis, in Q1 muni bonds underperformed the broad fixed income market by 175 bps and lagged Treasuries by 210 bps–using the iShares National Muni Bond ETF ($MUB), the iShares Core US Aggregate Bond ETF ($AGG) and the iShares Core U.S. Treasury Bond ETF ($GOVT) to proxy index performance. However, tax-exempts recaptured 56 bps of relative performance versus $AGG and beat $GOVT by 76 bps through the first 20 days of April.
Our momentum work regards the recent turnaround for municipal bonds versus Treasuries and taxable fixed income as the opening act in a multi-month relative advance. In fact, we expect this burgeoning trend to persist into the summer, and to forge new all-time (relative) highs in the process. The chart below illustrates graphically our forecast path for medium-term momentum for munis vs. taxables.
Consistent with our call for munis to best Treasuries and bonds in general in weeks and months ahead, per our second exhibit, interest rates look to be in the early phases of a medium-term (i.e. 2-3 month) move higher; the iShares Core U.S. Aggregate Bond ETF contains about 38% Treasuries as of the time of this writing.
(While rising rates pose a headwind for bonds of all stripes, Treasuries tend to be exhibit greater sensitivity to changes in rates than other classes of fixed income, as government bonds have no spread component that might tighten to offset yield-driven price declines.)
$MUB’s effective duration of 4.71 versus 5.87 for $GOVT supports our premise that munis are likely to demonstrate some insulation from the impact of rising rates evident in Treasuries ($AGG’s effective duration of 5.22 is likewise higher than $MUB’s).
As a final note, we dismiss conventional thinking that suggests it inappropriate to consider munis for qualified accounts or for accounts subject to low tax rates. We concede that in so doing, investors do not take maximum advantage of the benefit of the federally tax-free nature of municipal bond interest income, however, we counter by noting that $MUB’s distribution yield is 54 bps greater than $GOVT’s, so investors gain income (before and after taxes) as well as appreciation potential (we believe) by swapping out of $GOVT into $MUB. $AGG’s distribution yield trumps $MUB’s by 43 bps, however, we expect the 4 bps/month drop-off in interest to be more than offset by cap gains over the expected horizon for this trade.