• Muni Nation

    The Good “D” Word: Diversification

    Jim Colby, Portfolio Manager
    March 20, 2012
    • What price, risk?
    • Credit "events" do occur in munis
    • ETFs may offer built-in diversification

    Markets go up and down, and money is made and lost as the ebbs and flows of opportunities coincide or diverge. Great fortunes can be made by placing risky bets. However, the probability of achieving such success is fairly small, which leads to an age-old question: How can prudent investors craft a risk-appropriate strategy?

    For the majority of us who are not possessed with the gifts of insight and inventiveness, one element of Modern Portfolio Theory has proven its value as a steadying hand: diversification. Acquiring a diverse array of assets in a particular category (as well as across many categories) potentially helps to hedge against any one or two investments going sour and irreparably damaging an entire portfolio. In municipal bond portfolio construction, diversification can be especially valuable. Municipal bond ETFs are naturally diversified in that they hold multiple bonds — many of them broadly — with the aim of tracking an index's returns for an especially difficult asset class to understand, let alone master, by buying and selling individual bonds.

    Although it is generally true that municipal bonds are of medium investment-grade quality, credit events do occur, and portfolios with only a small number of positions run the risk of having a singular event wreak havoc. ETFs that seek to replicate muni indices, with hundreds or even thousands of securities, are naturally diversified. Though it may be impossible to "replicate" a full index, an ETF's "representative sampling" techniques produce a diversified, index-tracking vehicle that has the potential to cushion investors against unexpected negative impacts.


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    Municipal bonds are subject to risks related to litigation, legislation, political change, conditions in underlying sectors or in local business communities and economies, bankruptcy or other changes in the issuer’s financial condition, and/or the discontinuance of taxes supporting the project or assets or the inability to collect revenues for the project or from the assets. Additional risks include credit, interest rate, call, reinvestment, tax, market and lease obligation risk. High-yield municipal bonds are subject to greater risk of loss of income and principal than higher-rated securities, and are likely to be more sensitive to adverse economic changes or individual municipal developments than those of higher-rated securities. Municipal bonds may be less liquid than taxable bonds.

    The income generated from some types of municipal bonds may be subject to state and local taxes as well as to federal taxes on capital gains and may also be subject to alternative minimum tax.

    Diversification does not assure a profit or protect against loss.

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