Municipal bonds are supposed to be boring, but the rising rate environment we’ve been in for the past year has made this asset class tricky to say the least.

While we haven’t found a magic trick to avoid bond market losses when rates rise, there are ways to adjust your muni portfolio to help reduce volatility, lower risk, and take advantage of changes in the economy.

A muni bond adjustment starts with analysis. Exactly which bonds do you own? What are your other income sources? Do you need income from the bonds? How do you feel about bond volatility, etc? After a discussion about your needs, we move on to looking at each of the specific bonds in your portfolio.

If your muni bond investments are in mutual funds, they’re worth reviewing to take advantage of possible losses and to consider owning bonds directly. In a mutual fund, you’re beholden to the bonds that are chosen by the fund manager and their team. Often, clients miss out on some tax benefits in a mutual fund portfolio. Owning your own bonds gives you better control over exactly what you own, bond maturity and duration levels and credit ratings. In addition, owning your own bonds can allow for trading on bond mispricing and the harvest of gains and losses against the rest of your portfolio.

When created correctly, a muni bond portfolio could be triple tax free (no federal, state, or local income tax), done easily when you own the bonds directly with an active bond manager, as we have the ability to customize the bond portfolio. Morgan Stanley has access to a large network of boutique bond managers.

Our analysis work on client bond portfolios is ongoing, and as the economy changes, so does the structure of our bond portfolios. For example, in 2022, lowering the duration of your bond portfolio by investing in shorter maturity bonds made sense, as the most sensitive bonds to rising rates are bonds with the longest maturities.

Think about the logic: I own a 30-year bond paying 3%. But after the Fed’s rate hikes, I can buy a 6-month bond paying 4%. The only way someone would be interested in buying your 30-year bond is if you sold it at a deep discount to its issue price. Early in 2022, we began swapping our long-term bonds out for short-term, and this helped our clients avoid some bond losses—again no magic trick, but the adjustment helps.

Looking to the end of 2023 and beyond, it’s likely the Federal Reserve is near the end of its rate hiking campaign, and if the economy continues to decline as expected, the Federal Reserve is likely to cut interest rates. Therefore, while 2023 has been a time of increasing credit quality of client bond portfolios and buying shorter-maturity bonds, when the inverse is true, long-term bonds typically appreciate in value the most. We believe there is a good opportunity to lock in relatively high rates on muni bonds and potentially make some money on price appreciation. Even if the Fed doesn’t cut rates, our clients have locked in decent interest rates.

I hope this article helped you understand how we analyze outside muni bond portfolios. If you’re interested in having us take a look at your portfolio related to holdings, tax efficiency, and minimizing cost, please reach out.

Senior Vice President, Financial Advisor Corporate Retirement Director
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