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Fixed-Income Insights

How might active managers construct a portfolio of muni bonds with different credit characteristics to help limit risk—and share in potential upside of outperforming sectors?

(This article is from the forthcoming third-quarter 2019 edition of The Muni Quarterly.)

Constructing accounts for our clients in separately managed accounts (SMAs) focused on municipal bonds is a complex process that involves a full team of portfolio managers, research analysts, and portfolio analysts. Building a diverse portfolio of specific investments and maturities requires a thorough understanding of bonds’ structures and call features. It also involves broader considerations such as yield curve positioning; pricing as influenced by state, sector, credit quality, and overall supply; and other internally-determined strategic benchmarks.

However, since The Muni Quarterly is a publication about credit analysis, this piece will focus solely on issuer creditworthiness, and how we create diversification within SMA accounts across different sectors and subsectors. Credit diversification is important because it serves the dual purpose of seeking to protect clients from sudden downside in a specific sector, while also aiming to provide sufficient breadth to benefit from the potential outperformance of any given sector. Therefore, we construct SMA portfolios intended to generate returns while avoiding risk associated with an overly-correlated portfolio of investments.

How might that work in practice? The infographic below provides an example of how we would maintain diversity in a hypothetical national SMA account. We can also create state-focused SMA accounts that preserve credit diversity in a similar way, by investing in bonds across numerous sectors and backed by disparate revenue bases.

In this case, the sample portfolio is only an example and does not reflect the account of an actual client. Instead, we’ve constructed it to show the broad range of sectors represented in the muni SMA space; in this instance, we’ve included the tax-backed, hospital, airport, higher education, transportation, electric utility, and water/sewer sectors.

A key focus of the sample portfolio is diversification of revenue streams—even within similar sectors and sub-sectors, the revenue bases securing the included bonds can differ substan­tially. For example, within the tax-backed sector, California’s General Obligation bonds consist largely of personal income taxes on residents within the state, while Corpus Christi Independent School District’s bonds are largely backed by property taxes in a completely different part of the country. Metropolitan Atlanta Regional Transit Authority has bonds primarily supported by a sales tax on residents in the Atlanta area.

We believe that the differing revenue bases here create diversity for bondholders because of their exposure to distinct taxpayers, tax structures, and economies. A similar analysis in other subsectors present in our sample portfolio reveals similar results—bonds held in our SMA accounts are supported by revenues that can span the entirety of the municipal market. Some revenues, such as rates paid to utility systems, are broad and compulsory. Others, such as tuition revenues, tolls, purchases at airports, and medical fees are demand-driven, and generated largely from users of a specific service. When constructing an SMA account, we endeavor to create balance between revenue coming from essential services with less yield and lower credit risk and revenue from more demand-driven sectors that provide compensation with incremental yield.

Overall, we believe that the potential benefit of a diversified muni SMA portfolio is that clients are able to invest in many of these opportuni­ties, offering the potential for consistent performance over time.

 

 

Tap Into Our SMA Expertise

 

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Learn more about Lord Abbett’s capabilities in municipal bond separately managed accounts.

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