A New Paradigm
- Wednesday, 06/13/2012
With investor sentiment now shaded by the daily changes in market direction for both equities and fixed income, I suggest that we are faced with a changed investment paradigm, at least in the near term. While Europe tries to extricate itself from economic doom and gloom, many major equity indices struggle to post positive year-to-date returns1. In my opinion, as shown in the table below, inflows into fixed income may be an indication that it is currently the preferred asset class over equities. More specifically, I believe municipal bonds have generally offered investors some sense of stability. The Barclays Municipal Bond Index2 returned 3.43% year-to-date, with an average coupon of 4.90%3. This generated enough return to help investors weather momentary downturns in market value.
Managing investor expectations means a modification to the risk/return equation. If risk, in the form of price volatility, continues to take a hit on total return, then perhaps investors will consider fixed income as the predominate return generator in their asset allocation, since coupons generally are a steady source and component of total return.
If you couple the average coupon of the Barclays Municipal Bond Index with the current spread of 216 bps3 between the Barclays BAA Municipal Bond Index with the Barclays AAA Municipal Bond Index, an investor may have reason to believe that any economic improvement would result in the narrowing of this spread to its long-term mean of 121 bps3. This would potentially generate 95 bps of excess return. However, without any improvement, the coupon alone generated nearly 5.00% to returns year-to-date. With today's uncertain markets, I think investors might find this appealing.
Source: Morningstar, May 31, 2012. Note: Balanced funds invest both in equity shares and fixed-income-bearing instruments (debt) in some proportion.
Broad Asset Class Flows YTD ($Mil)
Estimated Net Flow
1All year-to-date references are as of June 8, 2012.
2The Barclays Municipal Bond Index is considered representative of the broad market for investment grade, tax-exempt bonds with a maturity of at least one year. The Barclays Municipal AAA, BAA Indices are subsets of the broader index.
3Source: Barclays Municipal Credit Research, May 2012.