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Market View

The muni market has been marked by significant changes in ownership patterns and credit ratings. Here’s how professional management may prove useful for investors.

 

In Brief

  • Investors contemplating adding municipal bonds to their portfolios should be aware of two significant changes in the asset class in recent years.
  • First, muni ownership patterns have altered, with individuals owning individual bonds in their brokerage accounts now holding less than half the market while larger investors and individuals investing through mutual funds have increased their shares.
  • Second, overall credit ratings of the asset class have changed, as far fewer bonds are rated 'AAA,' not owing to deterioration in the credit quality of municipal issuers but instead reflecting the diminished presence of municipal-bond insurers.
  • The key takeaway: The markedly different nature of the muni market may argue in favor of active managers, who have access to sophisticated security valuation and credit research capabilities.

 

The municipal bond market staged an impressive recovery in 2014 after a difficult 2013. While the market experienced some selling pressure in February, the muni sector, as represented by the Barclays Municipal Bond Index, remains in positive territory for the year-to-date through March 13, 2015. Munis’ strong performance in recent periods may have attracted some investors who had previously not considered the asset class.

But those contemplating muni investments should realize that, to borrow a phrase from an old car commercial, “this is not your father’s muni market.” Here, we’ll highlight two significant changes in the tax-free fixed-income category in recent years—and how they have heightened the potential importance of active management in municipal bond portfolios.

First, let’s examine how muni ownership has changed over the past 10 years. (See Chart 1.) Munis have long been considered the redoubt of the individual investor. But individual muni holdings (also categorized as “household” holdings) have come to make up less of the market over the past several years, having shrunk from 55% in 2004 to 43% in 2014. Insurers and banks now account for larger shares of the muni market. Meanwhile, a shift to individuals using active management of muni portfolios rather than owning individual bonds is evident in the increasing portion held by mutual funds, which have grown from 13% to over 20%.

 

Chart 1. How Has Municipal Bond Ownership Shifted in the Last 10 Years?
Percentage ownership by investor type in the indicated periods

Source: Federal Reserve Flow of Funds Z.1 Statistical Release for Dec 11, 2014. Data are most recent available.
For illustrative purposes only and does not represent any specific Lord Abbett mutual fund or any particular investment.

 

This statistic may actually understate the shift to “active,” according to a recent article from the mutual fund industry news service Ignites, as the household segment includes separately managed accounts (SMAs), which are actively managed. This is due to bonds in SMAs being held in brokerage accounts under individual names even though a professional money manager has discretion to trade the holdings. The article noted that muni SMA assets grew to $84 billion at year-end 2014 from $33 billion at the end of 2007.

What’s behind the shifting ownership patterns? As Lord Abbett Partner & Director Daniel Solender noted, in prior years, advisors were more comfortable recommending individual bonds to their clients due to the support from bond insurance but are now less comfortable with many municipal bond issuers because they don’t have the resources to do the research on each one. Also, today there are many more buyers for municipal bonds, including so-called “crossover buyers” who typically focused on other asset classes but have become more comfortable with many of the large issuers of munis in recent years and have increased their holdings. Finally, with municipal bond yields remaining at similar levels compared to Treasury bonds despite having the tax exemption, many institutional buyers are seeing the relative value and are increasing their weightings to municipals. 

Even as bigger buyers have entered the muni market, the net supply of outstanding munis continues to fall. The U.S. municipal-bond market shrank in 2014 for the fourth straight year, to $3.65 trillion at year-end, according to Federal Reserve data. The overall muni market has shrunk by $140 billion from its 2010 peak, reflecting reduced issuance as municipal governments have become less aggressive borrowers, not willing to raise taxes or reduce funding for existing services to finance new projects.

The second significant shift in the muni market has to do with credit quality, specifically in the highest tier, as shown in Chart 2. Ten years ago, some 70% of issued municipal bonds in the Barclays Municipal Bond Index carried the highest credit rating of 'AAA.' The majority of 'AAA'-rated bonds carried that designation because they were insured by muni bond insurers. Insured municipal bonds were viewed as 'AAA'-rated quality with “essentially no need to even measure their underlying credit profiles,” according to a Wells Fargo report, because the insurers themselves were 'AAA'-rated companies and none had ever failed to make a payment. (Solender noted that Lord Abbett never viewed insured ratings in this way and conducted research on all insured investments.)

 

Chart 2. Where Have All the 'AAA'-Rated Munis Gone?
Percentage of 'AAA'-rated issues in the Barclays Municipal Bond Index for the indicated periods

Source: Barclays Municipal Research. Credit ratings are derived from the major U.S. credit rating agencies.  Bonds included in the index must be rated by at least two of the following ratings agencies: Moody’s, Standard & Poor’s, or Fitch.  The lowest rating is used to determine credit quality eligibility.
Income from municipal bonds may be subject to the alternative minimum tax. Federal, state, and local taxes may apply.
For illustrative purposes only and does not represent any specific Lord Abbett mutual fund or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.

 

But when major muni bond insurers began to lose their 'AAA' ratings in the wake of the 2008-09 credit crisis, the entire muni category underwent a seismic shift in terms of perceived credit quality even though the high underlying quality of municipal issuers was not materially changing; it was the credit ratings of bond insurers that were getting worse. As of September 2014, only 13% of issued municipal debt carried the 'AAA' designation from the major credit rating agencies and fewer than 5% of new bond issuers in recent years have come to the market with insurance. As Solender noted, investors have had to adjust to the environment of having minimal participation from bond insurers.

What should current—and prospective—muni investors take away from all these changes? The markedly different nature of the muni market may argue in favor of active management. With professional investors holding greater shares of a smaller pie through institutional accounts or the growing assets in mutual funds, valuing individual muni securities has become more difficult without the bond insurers. Also, a professional manager with sophisticated research capabilities may be better able to identify attractively valued securities—and avoid overpriced issues by doing in-depth research of the wide range of large and small bond issuers. Further, an active manager, with greater size and trading capabilities, may have better access to inventories of municipal securities. Meanwhile, the reduced role of municipal-bond insurers means that the type of rigorous credit research that professional managers have at their disposal becomes more important.

How do Solender and his investment team approach the muni market? He noted that the research process “is focused on security-specific credit fundamentals, relative value assessments of the yield curve along with credit spreads, sector outlooks, and general economic activity.” As for 2015, Solender reiterates his view from early in the year: “Munis remain a good place for long-term investors to allocate a portion of their assets.”

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

MUNIS ON YOUR MIND?
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