This Diversification Tool Adds Resilience to Your Portfolio

Think your portfolio is diversified? If it's just stocks and bonds, you might be missing a crucial layer: Including government balance sheets.

Municipal bonds — issued primarily by states and cities — bring something different to the table. They're secured by independent government revenue streams and local financial strength, offering investors steady income and a way to help maintain stability when conditions shift at the federal level.

In today's uncertain environment, adding munis to your mix isn't just an effective tax-management strategy — it's also a way to build resilience into your portfolio.

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Why governmental diversification matters

The U.S. federal government carries enormous fiscal responsibilities, but municipal issuers — states, cities, counties and local authorities — operate under separate and distinct financial frameworks. They rely on local revenue sources, not federal borrowing, and manage their finances independently, as established under the U.S. Constitution.

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This independence creates a powerful diversification benefit. When markets react to fiscal headlines or economic uncertainty, municipal credit quality doesn't automatically follow. Most muni issuers maintain strong balance sheets and conservative debt practices, making municipal bonds a steadying force.

For investors, that means a diversified pool of municipal bonds can help smooth out idiosyncratic government-specific fluctuations, providing steady income and resilience even when federal finances are in the headlines.

Layers of support: The cascade effect

Many crucial segments of the tax-exempt bond market can be supported by their local communities or even states. Consider the New York Metropolitan Transportation Authority (MTA). It's a large, complex issuer with multiple revenue streams including fares, tolls and dedicated taxes.

The MTA's resilience goes deeper: It benefits from overlapping layers of support, including state backing, regional cooperation and, in some cases, federal grants. This "cascade effect" of intergovernmental support helps keep the system running, even in times of stress.

These relationships can be structural, designed to ensure essential services continue. For investors, municipal bonds aren't just another government security. They're a distinct ecosystem, often with various levels of safeguards.

Geographic and economic diversification: Tapping into local strengths

Municipal bonds offer exposure to the diverse strengths of America's local economies.

State and local governments operate in environments shaped by regional industries and demographic trends. Investing in a range of municipal bonds taps into different regional economies, from tech-driven cities to agricultural heartlands, helping your portfolio remain resilient as conditions shift across the country.

This diversification means your investments aren't tied to any single region. When one area faces challenges, others might thrive, providing balance for long-term investors.

Credit quality

Municipal bonds stand out as one of the highest-quality segments of the fixed-income market. Most carry investment-grade ratings, with more than two-thirds of the Bloomberg Municipal Bond Index in the AA category or higher as of December 31, 2025. Defaults are rare and typically isolated.

This credit strength reflects prudent fiscal management at the state and local levels. Balanced budget requirements, rainy-day funds and conservative borrowing practices all contribute to soundness.

These practices make municipal bonds a compelling choice for investors seeking predictable income and some diversification from federal fiscal volatility.

One of the most persistent misconceptions in the market is that federal deficits somehow translate into municipal credit risk. They don't. State and local governments aren't responsible for federal obligations, and their ability to meet debt service depends on local economic conditions.

Dispelling misconceptions

Another common misconception is that municipal bonds depend on federal aid. While federal funds sent to states and cities can occasionally be delayed or reduced, legal safeguards help ensure most commitments are honored. Even if adjustments occur, the impact is typically limited.

To our knowledge, no state or local governments are dependent on federal transfers. In rare cases in which funding changes lead to short-term challenges, issuers generally stabilize by relying on their own diverse revenue sources or managing expenses.

A strategic pillar for resilient portfolios

Governmental diversification isn't just theory. It's a practical strategy for resilience. Allocating to municipal bonds reduces concentration risk tied to federal fiscal policy and provides exposure to a broad, decentralized network of issuers.

For long-term investors, that diversification can be invaluable. It complements other portfolio strategies, helping to smooth returns through economic and political cycles.

Key takeaways for investors

In a world where headlines spark volatility, municipal bonds may offer a steadier path to resilience. They're not immune to risk, but their independence and strong credit fundamentals make them a powerful tool for diversification.

As you look ahead, remember: Government risk isn't one-size-fits-all. Think in layers and variety of independent issuer balance sheets. Municipal bonds can help you build a portfolio that's ready for changing economic landscapes.

If you're considering investing in munis, you should be aware that although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal alternative minimum tax.

Also, bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.

All investments are subject to risk, including the possible loss of the money you invest.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Paul Malloy is head of municipal investment at Vanguard. Previously, he was head of Vanguard Fixed Income Group, Europe. In that role, Paul managed portfolios that invested in global fixed income assets. He also oversaw Vanguard’s European Credit Research team. Mr. Malloy joined Vanguard in 2005, the Fixed Income Group in 2007 and has held various portfolio management positions in Vanguard’s offices in the United Kingdom and the United States.