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Market View

Employing a team of dedicated investment professionals who perform in-depth credit research on each security is now more important than ever.

When it comes to investing in tax-free fixed-income securities, individual efforts to locate and purchase the right bonds may face some challenges. That’s where the expertise of professional money managers may help. In this Market View, we identify four compelling reasons to consider an actively managed municipal-bond strategy.

1. There Are Fewer ‘AAA’ Rated Municipal Bonds Available

In the past, municipal bond issuers were able to reap the benefits of lower borrowing costs by paying for insurance on their debt, thereby guaranteeing principal and interest payments owed to investors. Not only did the insurance wrapper lower the interest rates of the obligor by assigning a ‘AAA’ rating to the bond but also it enhanced the liquidity of the bonds, a benefit to the investor.

Throughout the 1990s, several bond insurers began venturing into unchartered, but seemingly more profitable, territory by expanding their insurance coverage to structured products, particularly residential mortgage-backed securities (RMBS), resulting in a boost to their top-line revenue via insurance fees. The percentage of the insurers’ business that was comprised of insuring structured debt increased—right up until the housing market imploded in 2008, crippling the RMBS market and, ultimately, leading to the loss of the insurers’ ‘AAA’ ratings.

 

Chart 1. The Percentage of ‘AAA’ Rated Bonds Fell Sharply after 2007
Municipal bonds (as represented by the Bloomberg Barclays Municipal Bond Index) by credit ratings; breakdowns as of December 31, 2007–December 31, 2016, respectively

Source: Barclays Municipal Research. Total may not add to 100% due to rounding. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Naturally, the loss of ‘AAA’ status of the insurance companies trickled down to the bonds they insured. The result was that the percentage of 'AAA’ rated municipal bonds fell, from roughly 70% in 2007 to only 14% by the end of 2016, according to Barclays Municipal Research, and currently less than 10% of new issuance comes with insurance. Investors must now assess the credit risks of municipal bonds more diligently. With this in mind, employing a team of dedicated investment professionals who perform in-depth credit research on each security is today more important than ever, as the fundamentals of the underlying issuer can no longer hide behind an insurance guarantee.

Lord Abbett has been researching municipal credits since the early 1980s, and does not rely on credit rating agencies when determining an issuer’s ability to pay interest and principal on its debt.

2. Investors Can Take Advantage of Institutional Pricing

Portfolios managed by institutions stand to benefit from the pricing advantage associated with purchasing large blocks of bonds as opposed to smaller-sized trades. According to a report, for example, 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.

 

Chart 2. Buying Bonds in Bulk Gives Institutional Investors a Distinct Cost Benefit and May Boost Yields 

Source: Municipal Securities Rule Making Board, 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 strategy.

 

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 $5,000,000 came with a spread of only 13 bps. Other studies have shown that the average spread paid by retail investors in the secondary market was 2% of a bond’s yield, more than double that of an institutional investor’s spread.1 What is more, institutions have the advantage of potentially buying new issues much closer to the price offered by the underwriting syndicate.2  

As an institutional buyer, Lord Abbett’s purchasing power may ultimately benefit its investors.

3. Accessing Sufficient Inventory Is More Difficult for Individual Investors.

Trades in the municipal securities market occur in the over-the-counter dealer market, rather than on a centralized exchange. This means investors who wish to buy or sell bonds must go through dealers. In order for an individual to shop around for more competitive prices, they must do so through multiple dealers, which would require multiple brokerage accounts. This may be cumbersome to individuals, and may limit the bonds available to the inventory of just one or two dealers.

 

Chart 3. Dealer Inventories Have Been Shrinking
Dealer municipal bond inventory



Source: Federal Reserve Flow of Funds and the National Securities Association. Data are the most recent available.

 

To make it worse, inventory levels across dealers have shrunk. Banking regulations instituted after the financial crisis of 2008–09 have led to fewer municipal bonds held in bank-affiliated dealer inventories. Since 2006, the amount of muni bonds held on dealers’ books has decreased roughly 60%, making it more difficult for financial advisors to find attractive bonds for their clients.

Lord Abbett has secured a broad market presence, accessing more than 100 dealers and, thus, access to a wide range of municipal securities.

4. A Professional Manager Will Avoid the Pitfalls of Market Timing

Although we cannot guarantee future performance, generally, historically speaking, municipal bonds have been a relatively safe investment over time. However, as with any asset class, there have been bouts of volatility, which many times have been induced by negative headlines in the media, which in turn can lead investors to sell a bond at inappropriate times. For example of such, the false and highly criticized predictions of hundreds of municipal defaults by financial analyst Meredith Whitney in 2010; the “taper tantrum” in 2013 followed by the Detroit bankruptcy filing, the largest municipal bankruptcy in U.S. history; and, more recently, concerns about what a new administration might mean for tax rates and infrastructure spending—each of these reflect periods of heavy selling pressure when prices were down.

 

Chart 4. History Shows Heavy Selling Pressure Following Negative Headlines
Data as of March 31, 2017 

Source: Municipal bond flows from Morningstar. Index returns from Bloomberg Barclays Municipal Bond Index. *As of March 31, 2017. Index returns include reinvestment of income and do not reflect the deduction of fees or expenses that would reduce performance of an actual investors account. Index is not available for direct investment. Past performance is not a guarantee or a reliable indicator of future results.
This chart is a hypothetical example shown for illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

However, despite these periods of market stress, municipal bonds have delivered attractive total returns over time. Although an investment in any index is not possible, a hypothetical $100,000 investment in the representative Bloomberg Barclays Municipal Bond Index at the start of 2008 would leave an investor with $149,205 by the end of March 2017, despite transitory periods of volatility and outflow over that time frame. In fact, selling with the crowd would have caused investors to miss out on attractive returns on the recovery. Over the 12 months following the peak month of outflows in 2010 and 2013, the Bloomberg Barclays Municipal Bond Index returned 10.7% and 6.1%, respectively.3

The main intent of professional managers like Lord Abbett is to remain fully invested over time. We avoid the pitfalls of trying to time the market by consistently applying the results of rigorous credit research and market analysis to our investment decisions at all times.

Conclusion

As we’ve discussed, the data support several key advantages to hiring a professional municipal bond manager. An institutional manager may be able to gain an investment edge and, ultimately, augment alpha in four ways. First, with a dedicated team of investment professionals carefully selecting and monitoring the bonds in a portfolio, managers may mitigate the price erosion that often is the result of overlooked credit risk. Second, by purchasing large blocks of bonds and claiming smaller bid/ask spreads, managers may be able to capture higher yields. Third, by analyzing the income and total return potential of bonds held by more than 100 dealers, rather than only one or two, managers may select bonds with a more attractive valuation profile. And, finally, by keeping a portfolio invested throughout periods of stress that otherwise might have caused investors to sell after prices have fallen and reenter the market after their recovery, managers may be able to prevent missed upside opportunity. 

 

1Lawrence E. Harris and Michael S. Piwowar, “Municipal Bond Liquidity,” AFA 2005 Philadelphia Meetings, 1 (February 13, 2004). GAO Report to Congressional Committees, “Municipal Securities: Overview of Market Structure, Pricing, and Regulation,” 11 (January 2012) (noting that the average spread on a trade of $20,000 was 2%, while the average spread on a trade of $5 million was only 0.01%); see also BlackRock, “The Benefits of Scale in Municipal Bond Execution.”

2Andrew Ang and Richard C. Green, “Lowering Borrowing Costs for States and Municipalities Through Common Muni,” The Hamilton Project Discussion Paper 2011-01, 8 (February 2011).

3 12/31/2010 – 12/31/2011 and 06/30/2013 – 06/30/2014.

 

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