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Vanguard Favors High-Quality Munis Over High-Yield Ones

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While municipal bonds with lower credit quality have been outperforming so far this year, with the spread between Aaa and Baa rated bonds tight and with valuations on the higher end of the spectrum, investors may want to shy away from lower-quality munis over the longer haul.

That’s according to Vanguard, one of the nation’s largest fund companies, which said in a recent report that its investment managers prefer high-quality municipal bonds over the higher-yield, more risky ones. “There is not much more room for spreads to compress, but there is room for them to widen,” wrote Vanguard. “Although it could take a recession to force investors to demand a higher premium for lower-credit-quality bonds.” While investing in higher-yielding bonds has resulted in better returns, with the current market environment, the risk could outweigh the rewards, making higher-quality bonds more attractive.

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On top of the spread remaining tight, Vanguard noted that the yield curve has flattened over the past year and will likely remain flat throughout 2018. Over the next six months, Vanguard expects the 10-year U.S. Treasury note to trade above 2.6% and possibly hit 3%. With expectations that there will be a modest increase in inflation, this should result in the Federal Reserve raising short-term interest rates further. “It is typical to see a bear flattening at the late stages of the cycle,” said Vanguard, noting that, with the current yield curve flatter than normal, there is little room for more compression.

Based on the fund company’s internal metrics, Vanguard said its municipal portfolio holds around half the risk it would have if it were operating in a full bull market. That’s not because it thinks a recession is imminent but because an economic slowdown could happen in the next two years. Vanguard said that it expects to hold the current level of risk or reduce it further until a recession does arrive. “We are not typically fast-lane speedsters anyway, but at this point, we feel the best route is the slower, and we think safer lanes of investment-grade credit,” wrote the fund company.

Vanguard said that it is content to favor investment-grade bonds from issuers it thinks will be able to pay back their debts. Bonds backed by predictable and stable revenue sources fit that bill, noted the fund company. “Given the current municipal market dynamics, some defensive driving will serve our investors best over the long term.”

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