There are many ways to shield a portfolio from inflation, but investors that rely on a fixed income cannot always avoid bonds. Fortunately, municipal bonds may provide an attractive safe haven from inflation, particularly for high net worth investors maximizing their tax advantages. The challenge is finding the right opportunities in a highly competitive market.
Let’s look at the current state of inflation and how muni bonds may help protect your portfolio.
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The recent surge in inflation is stronger and more durable than policymakers initially anticipated, although it remains tame outside of pandemic-related areas like used car prices, airfares, and transportation. For example, used car and truck prices rose 10.5% in May, accounting for one-third of all the month’s consumer price index gains.
Still, even when confined to these areas, rising inflation could negatively impact the cost of living, particularly for retirees on a fixed income. While food inflation should slow next year, the ever-rising cost of housing suggests that some inflation could stick around in some areas for the long term. These dynamics could put pressure on bond yields over time.
Investors that don’t require income from their portfolio may decide to reinvest maturing bonds into stocks to fight inflation. However, those that do may need to look for unique opportunities to hedge against inflation—such as muni bonds. These bonds may offer attractive yields to combat inflation while generating a consistent source of income.
Over the past year, these dynamics helped muni bonds outperform many other government and corporate bonds, including high-yield categories. General obligation (GO) bonds, in particular, have seen their yields fall sharply lower amid a surge in demand. As a result, it can be challenging for any investor—especially retail —to find opportunities in these areas.
That said, many revenue bonds continue to offer an attractive yield along with the tax advantages of owning a muni bond. Investors seeking these opportunities must look beyond passively-managed funds that are obligated to hold GO bonds and toward actively managed funds that have the flexibility to seek out better opportunities.
Muni bond ladders also enable investors to lock in higher yields with longer-term bonds while using shorter-term bonds to capture higher yields if rates rise without liquidating long-term holdings at a loss. When looking for bonds, investors should be mindful of credit quality (especially with high-yield bonds) and ensure call protection is in place.
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