- The municipal bond market is dramatically different since 2008 due to structural changes, low interest rates and higher taxes.
- These changes have increased the volatility in the municipal bond market, requiring skillful navigation.
- We think municipal investors should consider a go-anywhere, flexible approach that embraces volatility to help generate total return.
Structural changes have increased volatility
The municipal market is vast: approximately 60,000 different issuers, over one million CUSIPs and about $3.7 trillion outstanding. Navigating this disparate universe is tremendously difficult for individual investors and their advisors. Key changes to the municipal market after the 2008 financial crisis have made this task profoundly more difficult, such as:
- Higher tax rates.
- The disappearance of AAA-rated monoline insurers.
- Increases in bank regulation.
- Declining broker-dealer inventories.
- An uptick in credit stresses, including Detroit, Chicago and Puerto Rico.
Looking first at municipal bond insurance, seven insurers carried AAA ratings in 2007; none of those insurers are AAA-rated today. As a result, the number of municipal bonds carrying AAA ratings has declined sharply (Exhibit A). Without the backing of a bond insurer, research and relative-value analysis have become top concerns for municipal bond investors.
Declining broker-dealer inventories have also increased the challenges for individual investors. Due to increased regulations, dealers are allocating less capital to municipal bond holdings (Exhibit A), leaving the market without a key stabilizing force during periods of stress and volatility.
Since the financial crisis, there has also been an uptick in credit stresses in the municipal market, with Puerto Rico, Chicago and Detroit among the most notable. The resulting volatility is due to ownership composition of the municipal bond market. According to the Investment Company Institute, individual (or retail) investors are the largest holders of municipal securities. These investors hold 35% of municipal bonds directly and another 36% indirectly through vehicles like mutual funds and exchange-traded funds (ETFs). As the market is heavily retail-driven, negative headlines about these credit stresses tend to have a greater influence on prices.
Shifting leadership requires active management
Due to increased volatility in this retail-driven market, we think that investors may want to maintain a greater amount of flexibility with municipal bonds. Municipal returns can come from a number of different areas. For example, Exhibit B shows that annual returns of municipal bonds by credit rating can shift remarkably from year to year.
Having the flexibility to move in and out of holdings based on credit rating is important in our estimation. Investors may need the ability to swap in and out of high grade and high yield based on spread changes across the entire credit spectrum.
Changes in the yield curve have also historically resulted in leadership changes in the municipal market (Exhibit C). Just as they should watch credit exposure closely, investors should continuously monitor a steepening or flattening of the yield curve and have the flexibility to react accordingly.
In other words, investors and their advisors need the ability to tactically shift positions as needed, whether that means across the credit spectrum or yield curve. We think that it depends on where an experienced municipal bond investor can find compelling value opportunities.
Take a total return approach to municipal bonds
The absolute low level in interest rates also deserves attention. Due to their federal tax-exempt income, municipal bonds have been favored as a source of stable income generation. As such, the municipal bond market has historically had a buy-and-hold mentality. But in this low rate environment, investors are looking to do more than just clip their coupon.
With interest rates as low as they have been over the past few years, a total return approach warrants some attention. Due to inefficiencies created by its retail investor-driven nature, the municipal bond market can be a sensible source of alpha. A lack of transparency and dearth of readily available information on the municipal bond market allows us to find what we believe are compelling opportunities.
As part of this total return strategy, we want to be buying bonds at the time they are not appropriately valued by retail investors. For example, this may include taxable municipal bonds, short-dated corporate-backed municipal bonds, and health care and transportation issues. We also look for opportunities when negative headlines arise and generate volatility, like those we experienced with Detroit, Chicago and Puerto Rico over the past two years.
Stay flexible and opportunistic in today’s municipal bond market
Going forward, the perfect storm of rising interest rates, higher taxes and negative credit headlines may increase volatility in the market. Most municipal bond investment strategies are prospectus-constrained into specific areas of the municipal market. These constraints may include credit quality (high grade or high yield) and duration (long, intermediate or short). Investors may want the latitude to seek municipal sectors, credit tiers and maturities.
In our view, a flexible, total return approach is an appropriate adaptation of a municipal bond strategy for what we think is a more volatile future. This type of approach can serve as a core position for investors looking for tax-advantaged investments. Due to the opportunistic nature, the strategy may be complementary to an existing core municipal bond strategy, allowing a portion of the portfolio to shift focus to where there may be opportunities.
http://www.eatonvance.com/
