Municipal Bonds: The Case for Active Management
We believe prudent financial advisors recognize the need today for professional, active management in the municipal bond market. In the past, many financial advisors had a high level of comfort buying individual municipal bonds, mostly insured, for their clients. However, those same advisors now recognize that the changes to the municipal market landscape have introduced investment risks and inefficiencies that require the skills of experienced, professional managers.
Following the 2008 credit crisis, the use of monoline bond insurance in the municipal market declined from 60% of new issuance to less than 10% in recent years. As a result, municipal investors are faced with a dizzying array of credit types and security features. In addition, over the last several years, a number of high-profile public finance crises have demonstrated that careful credit selection is essential. While we view the overall municipal market to be relatively lower risk, with respect to actual defaults, credit-related events impact pricing nearly every day. We believe credit expertise not only helps in avoiding the pitfalls but, more importantly, can be a direct contributor to generating excess return.
A number of factors contribute to the inefficient nature of the market:
- The market is highly fragmented. There are 87,000+ issuers and over 1 million distinct bonds in the $3.7 trillion municipal market. Each year, more than 10,000 new issues are priced and a large number of those issuers are infrequent participants in the market.
- Ownership in the municipal market also contributes to its inefficiency. Roughly 70% of municipal bonds are held by individual investors, some of whom represent direct holders of the bonds. Lacking sufficient investment expertise in a more complex municipal market, behavioral finance and emotion prevail, as headline news can lead to investors making poor investment decisions.
The following chart presents several technical sells-offs that have occurred since 2008 and shows how volatility can be a more significant component of the municipal market— supporting the case for an active municipal approach that seeks to navigate and harness these inefficiencies.
Figure 1: Dealer Inventories Have Declined; Volatility Has Increased
Sources: Barclays Capital and U.S. Federal Reserves, as of 3/31/17. Dealer inventories represents the inventory of muni securities. The Bloomberg Barclays Municipal Bond Index is an unmanaged index that includes approximately 15,000 municipal bonds, rated Baa or better by Moody’s, with a maturity of at least two years. The Barclays Municipal High Yield Index is an unmanaged index consisting of non-investment grade, unrated or below Ba1 bonds. Past performance is not indicative of future results. An investment cannot be made directly in an index.
This is where active, nimble managers can have a meaningful impact. Market access, based on long-term business relationships, allows experienced managers to search for investment opportunities across the spectrum of the 2,000+ municipal dealers. Prudent credit selection may be the difference between underperforming and outperforming the benchmark. Active managers appreciate supply and demand factors in the market and use that insight to identify specific opportunities, based on market trends. An actively managed portfolio can also provide credit and call risk diversity for investors.
The municipal bond market has changed dramatically over the past nine years and, we believe, has become increasingly complex and difficult to navigate for the individual investor. At one time, constructing a bond portfolio of high-quality general obligation bonds was a reasonable task for experienced financial advisors and individual investors. However, heightened volatility due to a lack of liquidity, the reduced new issue penetration rate of municipal bond insurers, combined with a growing municipal tax-exempt and taxable market, and increasing economic pressure on municipalities have made credit research in this space more crucial than ever. It would be highly unusual for most individual investors to have the time, experience, and resources to successfully perform the same analysis on their own. Experienced active managers are well positioned to capitalize on opportunities as well as navigate new risks in today’s municipal bond market.
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There can be no assurance investment objectives will be met.
Active management is an investment strategy involving ongoing buying and selling actions by the manager. Active managers purchase investments and continuously monitor their activity in order to exploit profitable conditions. Active management typically charges higher fees than passive management.
Availability of this document and products and services provided by MacKay Shields may be limited by applicable laws and regulations in certain jurisdictions and this document is provided only for persons to whom this document and the products and services of MacKay Shields may otherwise lawfully be issued or made available. None of the products and services provided by MacKay Shields are offered to any person in any jurisdiction where such offering would be contrary to local law or regulation. This document is provided for information purposes only. It does not constitute investment advice and should not be construed as an offer to buy securities. The contents of this document have not been reviewed by any regulatory authority in any jurisdiction This material contains the opinions of MacKay Municipal Managers™ but not necessarily those of MacKay Shields LLC. The opinions expressed herein are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and opinions contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Any forward looking statements speak only as of the date they are made, and MacKay Shields LLC assumes no duty and does not undertake to update forward looking statements. No part of this document may be reproduced in any form, or referred to in any other publication, without express written permission of MacKay Shields LLC. ©2017, MacKay Shields LLC.
Bond insurance (also known as “financial guaranty insurance”) is a type of insurance whereby an insurance company guarantees scheduled payments of interest and principal on a bond or other security in the event of a payment default by the issuer of the bond or security.
The Bloomberg Barclays Municipal Bond Index is an unmanaged index that includes approximately 15,000 municipal bonds, rated Baa or better by Moody’s, with a maturity of at least two years.
The Barclays Municipal High Yield Index is an unmanaged index consisting of non-investment grade, unrated or below Ba1 bonds.
Note to ERISA Entities Only: This presentation is a general communication that is educational in nature. This presentation is under no circumstances to be construed as a recommendation, including but not limited to a recommendation regarding any specific investment, investment product, strategy, or plan design. By providing this presentation, none of MacKay Shields LLC, its employees or affiliates has the responsibility or authority to provide or has provided investment advice in a fiduciary capacity.
Before you invest
Mutual funds are subject to market risk and will fluctuate in value.
Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner. High-yield securities (commonly referred to as “junk bonds”) are generally considered speculative because they present a greater risk of loss than higher-quality debt securities and may be subject to greater price volatility. High-yield municipal bonds may be subject to increased liquidity risk as compared to other high-yield debt securities.
Municipal securities risks include the ability of the issuer to repay the obligation, the relative lack of information about certain issuers, and the possibility of future tax and legislative changes which could affect the market for and value of municipal securities. Such uncertainties could cause increased volatility in the municipal securities.
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