Five Reasons to Hire a Professional Municipal Bond Manager

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Many investors are taking a fresh look at municipal bonds, especially given the attractive level of income available in the current environment. Yields on AAA-rated general obligation bonds have risen roughly 150-250 basis points (bps) across the maturities on the muni-bond curve since the start of the year. As of December 22, a 15-year AAA GO bond was yielding 3.06%, which equates to a 5.17% tax-equivalent yield.¹ Looking at issues of lesser credit quality, a 15-year A-rated GO bond yielded 3.57%, representing 6.03% on a tax-equivalent basis.

In this Market View, we offer five reasons why individual investors may want to consider the guidance of a professional muni bond manager—in particular, one with deep experience in actively managing the unique attributes of the muni market.

1.      Access to Inventory

Municipal bonds trade over the counter, rather than on a centralized exchange, meaning investors looking to buy or sell bonds must go through dealers. Over the past 15 years, dealer inventory levels have shrunk dramatically (see Figure 1). 

Since the global financial crisis of 2008–09 (GFC), dealers faced new legislation restricting some of their trading, and the dollar amount of muni bonds on their books has declined by approximately 80%. Why does this matter? Most retail investors have access to one or two dealers—at most a handful—which significantly restricts access and their opportunity set.

Professional managers have a broad network of dealers, allowing for access to bonds from a wide array of sectors, states, maturities, and ratings. In some cases, professional managers are able to purchase entire maturities of competitive new issues that smaller-scale investors would never have the opportunity to buy.

2.     Institutional Pricing Advantage

Professionally managed portfolios also stand to benefit from wholesale pricing available to active managers. According to a report from the Municipal Securities Rule Making Board (MSRB), buying bonds in bulk may reduce bid-ask spreads, lower transaction costs, and ultimately boost yields for investors. 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 million came with a spread of only 13 bps. (See Figure 2.)

Some retail investors may be wary of paying a management fee and instead opt to purchase bonds on their own. However, since professional managers can collapse spreads and achieve “wholesale” pricing compared to a smaller-scale investor, they can cover part of their management fee simply through their institutional pricing advantage.

3.      Deep Credit Research Expertise

Active managers bring additional benefits to muni-bond management through their comprehensive credit research capabilities.

First, a bit of historical perspective. Before the GFC, almost 70% of municipal bonds were within the AAA-rated credit tier, and bond insurance was very common. According to Bloomberg, post-crisis and after the fall of most bond insurers, the percentage of ‘AAA’- rated municipal bonds fell to approximately 16% by the fourth quarter of 2022, and bond insurance has become much less common. (See Figure 3.)

With this significant structural change in the market, credit research has become increasingly necessary. Professional managers employ a team of dedicated investment professionals who perform in-depth credit research into all bonds under consideration and monitor each security that is purchased. The infor­mation necessary to conduct detailed credit research and monitoring is typically unavailable in mainstream financial publications, and thus professional managers have access to resources (and time) that most individ­ual investors do not.

Additionally, many investors consider municipal bonds to be primarily issued by “state and local governments”, but in reality, roughly two-thirds of the market is comprised of revenue bond, not general obliga­tion, issuers. With over 50,000 different municipal issuers² that span well beyond just city and state governments, significant resources are required to evaluate and fully take advantage of the available opportunities.

4.     Identifying Relative Value

The benefits of hiring a team of investment professionals extend far beyond the need for credit research. In a roughly $4 trillion market made up of tens of thousands of issuers (according to Reuters), there are many factors at play in uncovering relative value. For example, within a portfolio of municipal bonds, which sectors should be underweight, and which should be overweight, relative to the market? Within each sector, which issuers should be focused on? Unlike the equity market, the fixed-income market offers several options per issuer. For example, while a company has one common stock, it may have a number of different bond issues trading in the secondary market that will vary based on maturity, coupon, duration, and other characteristics.

In terms of credit quality, public ratings sometimes do not communicate the full credit picture and often lag real-time fundamentals. Are credit rating agencies late to upgrade a specific issuer? If so, is the upgrade priced in, or does an opportunity exist? Some professional managers place more weight on internally generated research and often have internal ratings that differ from public ratings.

Another crucial decision is that of yield-curve positioning, which involves an evaluation of the current shape of the muni yield curve and the potential for yield-curve shifts. Some portfolio managers seeking to optimize total return look to purchase bonds on the steepest portions of the curve that, although they may not offer the highest yield relative to similar bonds, may offer the highest expected return based on price changes as time passes, and the bonds “roll” down the curve.

This strategy is only as simple as it sounds if the yield curve remains unchanged, but the relative steepness frequently fluctuates. Professional managers regularly monitor the overall shape of the yield curve in an effort to enhance this total return. Below is an example of one such total-return calculation broken up by maturity across the yield curve. 

5.      Comprehensive Risk Management

As an active manager, we believe risk management is essential in all investment processes, and municipals are no differ­ent. While return and yield on an absolute level are often the focal point of retail investors, investment professionals view return and yield on a risk-adjusted basis, considering reward in the context of risks taken. Additionally, while risks may be taken to achieve rewards, professional managers seek to mitigate risks in several ways.

Much of what we have discussed so far is associated with risk management, including in-depth credit research and monitoring to lower credit risk, relative-value assessments to reduce valuation risks, and a wider access to bonds to mitigate opportunity risk. Additionally, relative sector/position limits and diversification offer the potential to decrease portfolio volatility that stems from being overly concentrated in any one sector or issuer. Risk management systems may be used to analyze municipal bond portfolios based on a large number of attributes, including yield-curve position­ing, duration characteristics, credit-quality weightings, sector weightings, coupon weightings, liquidity premiums, and call protection, and to quantify relative exposures by sector, subsector, and issuer, as well as interest-rate sensitiv­ity and volatility. 

Individual investors needn’t be intimidated by the complexity of the municipal bond market. But the clear advantages of active management should not be overlooked. A pro­fessional municipal bond manager that can provide broad access to the marketplace, institutional pricing power, credit expertise capable of evaluating the full range of sectors and bond types, relative-value perspectives, and risk management capabilities falls within a small group of investors that can take full advantage of the opportunities available in the municipal market.

While 2022 has been a difficult year for municipal bonds (along with fixed-income markets in general), muni yields were recently sitting near the highs of recent history, making for an attractive entry point. With the market starting to show signs of turning over in the last month or so and the growing performance dispersion among various sectors, credit tiers, and positions along the curve, why not choose an active manager focused on a relative-value approach with decades in the market? Further, why not consider an active manager that focuses on capitalizing on the idiosyncratic characteristics of the municipal market to deliver a more attractive balance of tax-free income and capital appreciation than a ‘buy-and-hold” orientation? We think investors seeking to position their municipal bond investments for long-term performance may discover considerable merit in the active approach.