Municipal Bond Investors Want Liquidity Plus Diversity by R. B. Davidson III, AllianceBernstein
The municipal market is no different than other markets when it comes to liquidity: they’re liquid until suddenly they aren’t. Investors must assess their need for liquidity to navigate such challenges.
Liquidity’s Almost the Same as It Ever Was
Liquidity is the grease that keeps the markets moving. When markets are liquid, investors can quickly buy and sell securities at minimal transaction costs. It’s a function of time and cost: if you need to sell a security right now, how much will it cost you?
By most standard measures, liquidity in the municipal market right now is about where it was before the global financial crisis. The volume of trades in fixed-coupon bonds has been stable—both in absolute terms and relative to the volume of outstanding bonds. And transaction costs are only modestly higher on average than they were just prior to the crisis. Banks and insurance companies have helped by increasing their muni holdings in recent years; this bolsters liquidity by broadening the investor base beyond individual investors.
But markets change in the blink of an eye, and we can see the seeds of potential illiquidity in today’s municipal market.
First of all, it’s very fragmented: more than 50,000 issuers, some big and some small, some strong and others just keeping their heads above water. Before the crisis, bond insurance masked this diversity—almost everyone got a AAA rating. But bond insurance now covers only 6% of new issuance (down from 57% in 2005), so this backstop has largely fallen away. Investors need to work that much harder to evaluate bonds.
There’s also less capital being committed to market-making today. Precrisis, bond dealers had inventories that totaled $50 billion. Today, they total only $19 billion, as dealers focus on matching buyers and sellers, not on trading bonds in the market themselves. Both a shortfall in market-making capital and less bond insurance could contribute to liquidity challenges in municipal bonds.
That’s liquidity on a big scale. But liquidity’s always more problematic for individual investors.
Transaction Costs Are Highest for Small Investors
As the name implies, liquidity isn’t static; it varies with changes in investor demand and the supply of municipal bonds. What remains true: Small investors pay higher transaction costs than big investors. Transaction costs, measured as a percentage of the transaction size, are four times higher for a trade under $100,000 than for a trade of $1,000,000 (Display 1).
This poses a difficult choice for individual investors. They can either get more liquid by holding larger and thus fewer positions in their portfolios or get safer by holding more and thus smaller positions. Mutual funds, exchange traded funds (ETFs) and separately managed accounts (SMAs) have all been created to address this challenge. Managers can buy bonds in large volumes and build diversified portfolios. They can also do the legwork to research issuers—no small feat in the fragmented municipal market.
Each investment structure has advantages and disadvantages, and liquidity is a prime consideration in determining which approach (or combination of approaches) is best for a particular investor.
How Much Liquidity Do You Need?
Mutual funds are commingled investment vehicles with daily liquidity. For long-term investors who might need some money back in a hurry, mutual funds may be a good solution. Investors buy and sell at the net asset value (NAV), or per-share market value, so they largely avoid transaction costs on their trades. The drawback: a fund’s investors share in transaction costs over time, although they’re typically extremely small, especially compared to the trading costs of individual bonds for the typical investor.
ETFs are commingled investment vehicles that can be bought and sold intraday—ideal for an investor who places a large value on liquidity. While ETFs potentially offer instant liquidity, their market price can deviate from the NAV. This represents a transaction cost relative to mutual funds. For example, over the last five years, when municipal mutual fund flows turned negative, the market price of an ETF fell below the NAV of the fund. We saw a discount of almost 3% during the “taper tantrum” in the summer of 2013 (Display 2).
SMAs are managed for individuals by professional portfolio managers and ideally benefit from the pricing and research advantage of institutional investors. They’re also the best vehicle for tax management and customization for an individual investor. However, liquidity isn’t as strong; if an investor instructs the manager to sell, and the manager has to sell without being able to group like sales from other accounts into a large order quantity, the investor will incur higher transaction costs.
Bridge over Troubled Water
Individual investors are moving away from the traditional “buy-and-hold” approach to municipal bond investing. A range of choices is enabling them to take advantage of scale in the municipal market and access greater liquidity. Mutual funds may be the best answer for investors who really need liquidity. For those who want customization and don’t expect to need liquidity, an SMA looks like the right approach. And for the opportunistic investor looking to take advantage of a short-term market dislocation, ETFs may be a great fit.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.