Divide and Conquer!

If you are an investor in a high marginal tax rate, total returns from tax-free municipals have been fine this year, but certainly a laggard compared to the returns generated by investment grade corporate bonds, high yield bonds, and other fixed income sectors.

The iShares National Muni Bond ETF (MUB) has produced a total return YTD through August 31 of 7.22% with a most recent SEC yield of 1.48% (tax-free!).  Alternatively, the iShares High Yield Corporate Bond ETF (HYG) has produced a total return of 10.84% with a most recent SEC yield of 5.18% (taxable). On a pre-tax equivalent at a 30% marginal tax rate, HYG still has a yield advantage over MUB by a wide margin; 2.11% versus 5.18%.  So, you will pay more tax, but still end up with more incremental income; being careful not to jump into a higher tax bracket.

Additionally, a comparison of these two bond ETFs shows some interesting statistics.  First off, they are not too correlated with each other with a 10-year correlation of only 0.10; in other words, no correlation - a good thing from a portfolio construction perspective!  HYG is obviously a riskier proposition than MUB with a 10-year standard deviation of 7.03% versus 4.53% for MUB.  But, the Sharpe ratio of excess return per unit of risk is mildly advantageous to HYG over MUB by 0.91 versus 0.83, respectively.

The performance trend line for fixed income sectors with some duration or credit risk, including HYG, has done especially well this year.  Long-term strategic investors should already have a position in duration and credit in their portfolios this year and reaped the rewards of broad diversification.  This is in no way a market call given the aggressive rally this year in duration and credit risk instruments, but a well-timed entry given today’s market situation can complement income and portfolio diversification.