More Is More: Combining Corporates and Munis in Laddered Bond Strategies

Fixed income investors often think of changes in US Treasury rates as the tide that lifts or lowers all other domestic bond yields. This principle has been especially true during the last year, with most segments of the fixed income market seeing increased volatility. But Treasury rates aren’t the only variable at play. We’ve also seen periods over the past 15 years where valuations in the municipal and corporate markets have deviated significantly due to unique sector factors.  

Volatility can create opportunity, especially when correlations are imperfect. Blending municipal and corporate bonds can enhance after-tax returns, reduce volatility and improve long-term portfolio durability when market waters are choppy.  Let’s get into the benefits and challenges.  

What drives returns in the bond markets? 

The credit components of the municipal and corporate bond markets don't always move evenly over time. The risk premium of corporate bonds and municipal bonds can deviate greatly under market stress, depending on how credit fundamentals and supply–demand technicals develop in each market. 

The macroeconomic outlook does impact municipal valuations, but this sector’s credit metrics tend to be much more stable than in the corporate bond market, because they’re usually a function of tax receipts and therefore tend to be more predictable. Revenue bonds can be a more volatile segment of the municipal market, but even they have relatively stable revenue sources like tolls, airport taxes, and water and sewer fees. This contrasts with corporate bonds, where BBB-rated issuers now make up more than 45% of the ICE BofA US Corporate Index. Whether someone should invest in a corporate bond depends not just on the overall state of the economy, but also on the issuer’s industry fundamentals, competitive positioning, profitability and interest coverage. 

Changes in tax codes can have a material impact on the demand for municipal bonds and, to a much lesser extent, corporate securities. Constant demand from pension plans and retirement accounts can dampen volatility in the corporate market, while the municipal market, which is largely owned by retail investors, lacks that source of stability. Both municipalities and corporations will use the proceeds from newly issued bonds to fund new projects, but acquisition activity and special dividends—both of which decline during weak economic periods—will also drive corporate bond issuance. Lastly, seasonal factors affect supply and demand much more in the municipal market than in the corporate bond market. 

The Fed has been worried about the inflationary impact of tariffs, and governors are split on the number of cuts in 2025. Despite volatile markets though, economic growth, labor and consumers have remained resilient in 2025. Yields in most fixed income sectors remain higher than when the Fed first began cutting rates in September 2024.  

Volatility may continue, along with policy uncertainty and geopolitical risks, but most fixed income sectors have posted positive performance year to date. We believe slower growth and ongoing disinflation could drive yields lower in the near term.  

We believe investors benefit most when managers optimize their fixed income allocations to both tax-exempt municipal and taxable corporate bonds. This should be based on the client's tax rate and the relative yield of bonds across the two sectors. This optimization may provide predictable income—the central objective of a laddered bond portfolio—while selecting the most attractive after-tax choice available at the time of investment. Our analysis indicates that when either munis or corporate bonds are more expensive on a relative basis, the ability to access the other sector can offer significant investor benefits.   

Rules-based asset allocation also allows managers to integrate technology that speeds up the implementation process. A bond ladder evenly weights bonds by their maturity year and reinvests the proceeds from maturing bonds in the longest maturity rung of the ladder. But in a universe of more than 1.5 million munis, identifying and transacting bonds at attractive levels from credit-worthy issuers isn't so simple. Expanding the screening process to include the investor's federal and state tax rates, plus the more than 6,000 outstanding intermediate-maturity corporate bonds, would be almost impossible without advanced technology.    

Systematically combining municipal and corporate bonds in one portfolio permits the manager to allocate cash to the sector with the highest after-tax yields. Starting yields are one of the most important factors driving the performance of fixed income investments. Higher starting yields typically correlate to higher forward returns. Over the past five years, most fixed income sectors have underperformed their longer-term averages. With yields well over their 10-year highs, we’re optimistic that return profiles going forward could prove to be more attractive.