The Case for Systematic Investing in Municipal Bonds

Systematic investing can offer investors a chance to pursue better outcomes by focusing on systematic premiums that drive higher expected returns.  from Dimensional suggests that there are three reliable drivers of cross-sectional differences in municipal bond returns: credit spreads, term spreads, and clientele effects.

“The Cross-Section of Municipal Bond Returns” (Wang, 2022) extends findings from previous research demonstrating that variable credit and variable term approaches can improve the expected returns of municipal bond strategies. Exhibit A shows that lower-credit municipal bonds (those rated A to BBB) on average outperformed higher-rated counterparts from November 2006 to December 2021. Moreover, when the difference in yields between lower- and higher-rated municipal bonds was larger, investors in lower-rated bonds were typically rewarded with a larger credit premium.

Similarly, Dimensional’s research demonstrates reliable term premiums in municipal bonds, meaning that investors in longer-duration bonds earned higher average returns than investors in shorter-duration bonds. As Exhibit B shows, longer-duration municipal bonds on average outperformed shorter-duration municipal bonds from November 2006 through December 2021, and the outperformance was larger in months starting with a larger term spread.

In summary, Dimensional’s research indicates that term and credit premiums vary over time. In periods when term or credit spreads are wider, the realized credit and term premiums are typically larger. In periods when term or credit spreads are narrower, the realized credit and term premiums are typically smaller. Municipal bonds with lower credit ratings and those with longer terms can present additional risks to investors. Therefore, in periods of smaller expected term and credit premiums, reduced exposure to term and credit can protect investors from taking on additional risks that are unlikely to be rewarded with significant premiums.

Given the dynamic nature of the term and credit premiums in municipal bonds, investors can systematically target higher expected returns by emphasizing lower-credit and higher-duration bonds in periods with higher expected credit and term premiums, and reducing exposure to those bonds in favor of higher-rated or shorter-duration bonds when premiums are unlikely to be large. Systematically shifting term and credit exposures through variable credit and term approaches allows combining the pursuit of higher expected returns with robust risk management. 

Academic research has previously documented a link between municipal bond yields and state income tax regimes. Municipal bond yields are lower on average on bonds issued by states with high state income tax where in-state municipal bonds are exempted from state income taxes. Known as the clientele effect, this link is theoretically sensible since investors in higher income tax states are likely to have high demand for their state’s municipal bonds to avoid both state and federal taxation on interest income. The high demand for municipal bonds issued in states with strong tax clientele effects may increase prices and decrease yields. Dimensional’s research provides empirical support for this phenomenon, as shown in Exhibit C. On average, bonds issued in states with weak clientele effects provided higher returns than those issued in states with strong clientele effects.

Given the clientele effect, a municipal bond strategy that focuses on bonds issued in states with weak clientele effects may offer higher expected returns relative to a strategy with significant exposure to states with high state income taxes, such as California and New York. 

Dimensional’s research suggests that a systematic approach to municipal bond investing should focus on the credit, term, and clientele effects to target higher expected returns.