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Market View

Accessing the potential investment opportunity offered by the municipal bond market requires several levels of expertise that few individual investors have.

Read time: 4 minutes

We’ve noted in the past how professional managers may provide value in the municipal bond market, and this has only been underscored by the volatility resulting from the COVID-19 pandemic. In this Market View, we offer five reasons why individual investors may want to consider the guidance of a professional muni bond manager.  

REASON 1: ACCESS TO A BROADER POOL OF BONDS WIDENS THE OPPORTUNITY SET

 

Chart 1. Dealers’ Inventory Levels Have Shrunk 73% Since 2006

Dollar amount of muni bonds on dealers’ books, (2006-Q12020)

Source: Federal Reserve Flow of Funds. Broker and dealers, municipal debt outstanding, NSA. Data are the most recent available, released on 06/11/2020. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

In the muni market, trades occur “over the counter” rather than on a centralized exchange. This means investors looking to buy or sell bonds must go through dealers. For an indi­vidual retail investor to shop around for competitive prices, he or she would need to do so through multiple dealers, which would require multiple brokerage accounts.

Making this even more challenging, inventory levels across dealers have shrunk dramatically. Since 2006, the dollar amount of muni bonds on dealers’ books has declined by more than 70%, making it more difficult for financial professionals to find attractive bonds for their clients. Especially during a period of market turmoil, access to a wide range of bonds, both to manage the volatility and to potentially capitalize on it, is a critical advantage for professional managers.

REASON 2: INSTITUTIONAL PRICING BENEFITS MAY LEAD TO LOWER TRANSACTION COSTS

 

Chart 2. Buying in Bulk May Reduce Bid-Ask Spreads

Bid-ask spreads of municipal bond trades,* par value

Source: Report on Secondary Market Trading in the Municipal Securities Market, MSRB, July 2014. Data are the most recent available. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Professionally managed portfolios typically benefit from the pricing advantage that comes with size. According to a report by the Municipal Securities Rule Making Board (MSRB), buying bonds in bulk may reduce bid-ask spreads, lowering transaction costs, and ultimately boosting yields for investors. In fact, the MSRB report showed that, on average, trades less than or equal to $25,000 came with a bid-ask spread of 233 basis points (bps), while those greater than $5 million came with a spread of only 13 bps. During a period of market volatility, when bid-ask spreads may widen, the pricing advantage enjoyed by large, professionally managed portfolios may be particularly beneficial.

REASON 3: CREDIT RESEARCH MAY MITIGATE DOWNGRADE, DEFAULT, AND/OR PRICE RISK

Before the 2008 credit crisis, municipal bond issuers often paid for insurance on their debt, thereby guaranteeing principal and interest payments. But after the crisis, ‘AAA’- rated municipal bonds fell from roughly 70% of the market in 2007 to roughly 15% by the end of 2018, according to Bloomberg Barclays.1 What’s more, in today’s market the portion of newly issued municipal bonds that carry insurance is less than 10%.  

In light of this, we believe credit research is more necessary than ever, particularly as the coronavirus pandemic led to an increase in downgrades and defaults, albeit off of a low 2019 base. But individual investors lack the information to do the kind of in-depth analysis and monitoring typically carried out by a team of dedicated investment professionals.

In addition, the muni market is more varied and complex than individual investors may realize. While many may equate municipal bonds with “state and local governments,” the market is made up of more than general obligation bonds. Roughly two thirds of issuers issue revenue bonds in niches such as toll roads, airports, universities, hospitals, utilities, special tax, and industrial development.

The ability of professional managers to research credits in all these subsectors can be especially advantageous during periods of market turmoil, as opportunities may be more abundant in some subsectors than others.

REASON 4: MULTIPLE FORMS OF RELATIVE VALUE ASSESSMENTS MAY BE A TAILWIND TO RETURNS

In addition to credit research, a team of investment professionals provides relative value assessments. This involves decisions about sector weightings, security selection, and curve positioning.  

Relative value assessment can be especially critical during periods of market turmoil. During the volatility resulting from the COVID-19 pandemic, professional managers generally sought to minimize the damage resulting from economic shutdowns by underweighting vulnerable sectors and overweighting defensive sectors.

In addition, during periods of market turbulence, investor demand for redemptions can force some institutions to sell holdings in order to raise cash. At these times, relative value assessments of particular securities enable professional managers to purchase those trading at a discount to their intrinsic value, potentially enhancing both income and price returns.

Professional managers can also potentially optimize returns via yield curve positioning. This requires an evaluation of the current shape of the muni yield curve and potential yield curve shifts. In this case, experience with how the curve has behaved historically, especially during market turbulence, can be critical.

In addition, some portfolio managers seeking the optimal total return profile look to purchase bonds on particularly steep portions of the curve. Although these bonds may not offer the highest yield relative to similar bonds, they may offer the highest expected price return over time as the bond “rolls” down the curve. When the market becomes unsettled, the curve may steepen, providing more potential opportunities for this return tactic. Again, this is a form of relative value assessment that individual investors may be ill-equipped to employ.

REASON 5: INVESTMENT PROFESSIONALS VIEW RETURNS ON A RISK-ADJUSTED BASIS

As with all investment processes, risk in the municipal bond market is a critical consideration. While individual investors may focus primarily on absolute returns and yields, investment professionals view them on a risk-adjusted basis, weighing rewards relative to the associated risks.  In addition, while taking on risk may lead to returns, professional managers use several means in seeking to mitigate this risk while maximizing return. For example, investing in a twenty year bond with a five year call versus a five year bullet maturity may offer higher cash flow with a similar duration to the five year bond as well as lower price erosion from amortization, which typically accelerates when bonds reach five years to maturity.

In fact, much of what we have discussed so far is related to efforts to mitigate risk, including credit analysis and monitoring to lower credit risk, relative value assessments to reduce valuation risks, and a wider access to bonds to mitigate opportunity risk. In addition, relative sector/position limits and diversification offer the potential to decrease portfolio volatility that stems from being overly concentrated in any one sector or issuer. Although professional managers typically implement processes designed to minimize the various risks involved in municipal bond investing, it is not possible to eliminate all investment risks.

Risk management systems may be used to evaluate municipal bond portfolios on a large number of attributes, including yield-curve position­ing, duration, issuer, credit-quality weightings, sector weightings and coupon weightings. Of course, during periods of market volatility, all of these risk management metrics become even more critical.

Summing Up: The Potential Benefits of Professional Management

The complexities of the municipal bond market need not deter individual investors. A professional municipal bond manager is likely well-equipped to navigate these complexities, especially during periods of volatility.  

 

[1] The statistics are using the credit quality breakdown of the Bloomberg Barclays Municipal Bond Index as of December 31, 2018. The Bloomberg Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. Bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two ratings agencies. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for investment.

 

Bloomberg Barclays Index Information:

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

IMPORTANT INFORMATION

This Market View may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The munic­ipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alter­native minimum tax. Federal, state and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

GLOSSARY OF TERMS

The bid-ask spread is essentially the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept.

A bullet bond is a debt instrument whose total principal value is paid all at once on the maturity date (versus amortizing the bond over its lifetime).

Duration is an approximate measure of a bond’s price sensitivity to changes in interest rates.

A general obligation (GO) bond is a municipal bond backed by the credit and taxing power of the issuing jurisdiction rather than the revenue from a given project.

A revenue bond is a municipal bond supported by the revenue from a specific project, such as a toll bridge, highway or local stadium.

A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates.

The credit quality of the securities in a portfolio are assigned by a nationally recognized statis­tical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

No investing strategy can overcome all market volatility or guarantee future results. State­ments concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar condi­tions in the future.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein. If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in Market View are as of the date of publication, are subject to change based on sub­sequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the perfor­mance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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