Thanks Mom and Pop: Finding Value in the Municipal Bond Market
The primary role of bonds in Aspiriant portfolios is to reduce volatility, but investors should also expect to receive fair compensation for the use of their capital. Bonds can achieve impressive returns, typically during periods of falling interest rates, but we have historically been reluctant to accept the significant interest rate or credit risk needed to generate strong bond returns over time. Instead, we have traditionally minimized risk in the bond component and allocated risk to asset classes such as equities which we expect to offer a higher long-term rate of return. In the last few months, however, we have identified an opportunity in the municipal bond space, which we find compelling enough to somewhat adjust our approach to fixed-income investing for clients who hold fixed-income in taxable accounts.
Telegraphing monetary policy
In August, the Federal Reserve committed to keeping the Fed Funds rate near zero for the next two years. This announcement, combined with weak global economic growth and concerns about the European financial system, caused the prices of US Treasury securities (USTs) to rise, with yields falling to new lows. This made USTs and other bonds which are priced relative to USTs (e.g., corporate bonds) even less attractive in our view. The extremely low current interest rate environment does not bode well for bond returns over the coming years as interest rates rise and put downward pressure on bond prices.
The municipal bond market, however, did not benefit from the UST rally; on the contrary, municipal yields rose slightly, particularly for long duration and high yield municipal bonds. We believe this disconnect, which has now persisted since the financial crisis in late 2008, creates an attractive opportunity for fixed income investors with a higher risk tolerance and capacity than the average mom- and-pop municipal bond investor.
The additional compensation earned for taking risk across the municipal spectrum (municipals vs. USTs, long vs. short duration, high quality vs. lower-quality securities) is very attractive relative to historical levels (more on this below) and relative to our assessment of the risk in the municipal bond sector. By most measures, municipal and state governments have continued to get their fiscal houses in order over the last couple of years, which reduces the risk of default; however, as we argue below, municipal bond prices do not yet appear to reflect the substantial improvement in financial condition.
Aspiriant has therefore changed our tax-exempt fixed income allocation to reflect the current conditions in the municipal bond market, increasing the allocation to longer duration and higher yielding bonds and comparatively stable very short term municipals (this is sometimes referred to as a “barbell” approach). The result is a fixed-income implementation that we believe has a similar risk profile to the current implementation, but with a somewhat higher expected return. These changes are, in part, opportunistic, with the expectation that we will reduce these exposures when valuations in the municipal bond market return to more normal relationships.
The role of high yield municipal bonds
The municipal bond market is very diverse and resists broad generalizations. Some reports put the number of municipal bond issuers at over 50,000, with millions of unique securities making up almost $3 trillion in value. Fewer than one-third of municipal bonds outstanding are the direct “general obligation” debt of state and local governments. Most of the remainder are “revenue” bonds, which use revenue from specific assets to repay bond holders. About half of these revenue bonds are issued by utilities with rate-setting powers which are therefore generally less impacted by recessions. Many universities, endowments, hospitals, and toll roads also issue tax-exempt revenue bonds.
While revenue bonds entail more credit risk because they are not backed by the full credit of a state or city, in some ways revenue bonds are more transparent than general obligation bonds. Like corporate bonds, revenue bonds have an identifiable source of cash flow and often have bondholder protections such as asset collateral which can be sold in the event of default.
We believe the current municipal bond market provides exactly the kind of opportunity which Aspiriant’s investment platform was designed to identify and achieve — tens of thousands of unique securities, little institutional following (particularly after the collapse of Lehman Brothers in 2008), and yields at historical highs relative to more “mainstream” bonds. However, the typical municipal investor does not have the capacity to evaluate (especially high yield) revenue bonds, creating an opportunity for institutional investors and sophisticated individual investors to earn strong risk- adjusted returns.
Implications for client portfolios
The fundamental truth of investing is that we must be willing to take risk to achieve a return. Of course, the primary purpose of the bond component in Aspiriant portfolios is to mitigate portfolio risk, with the secondary (but still important) objective of receiving a fair return on capital. It is our job to balance these (often competing) objectives, and in doing so we must ask ourselves whether all of the factors discussed above are reflected (albeit imperfectly) in market prices. That is, do the returns offered sufficiently compensate for the risks that are present?
Assuming a bond is held to maturity (i.e., putting aside any potential short-term trading opportunities) and the issuer pays in full, the total return of a bond is largely known at purchase. The pricing of the interest rate and credit risks of a bond (the “spread” between the municipal bond and similar duration Treasuries) therefore gives much more information about the likely total return of a bond than the pricing of equity risk (the price/earnings ratio, for example) gives information about the likely future return of a stock.
Are the spreads attractive enough to bear the risk of longer maturity and lower quality municipal bonds? Municipal bond spreads spiked to extreme levels in 2008 around the time of the financial crisis, which saw the implosion of the world’s largest muni bond dealer (Lehman) and several large hedge funds that had made unsuccessful stock bets and were forced to sell their muni bonds at fire sale prices. While the muni bond market has moderated from the extreme levels in 2008, by almost every measure municipal bonds are priced attractively relative to US Treasuries and US corporate bonds (see chart above).
With fear among retail investors dominating the current municipal bond environment, opportunity arises for a more sophisticated approach. At this point, the longer the maturity and lower the credit quality of a municipal bond, the more attractive its price relative to historical averages.
Our confidence in this approach to municipal bonds is further bolstered by the diversity of the municipal market and the absence of the kind of interdependence which drove the financial crisis in September 2008. In many cases, a single municipality will issue several series of bonds, each supported by a different source of revenue. For example, the same city might issue general obligation bonds, utility revenue bonds, and bonds supported by a first lien on a citywide sales tax. Although the credit quality of each of the bonds is largely affected by the local economy, unique factors will influence the specific repayment scenarios. As the chart below displays, less than 60% of the municipal bond market is backed by taxes, so an investment approach which focuses only on tax-backed and essential service bonds would leave out over 40% of the investment opportunity set.
Market value % by source and purpose for Barclays Capital High Grade Municipal, High Yield Municipal, and Municipal Taxable Indices.
Source: Bloomberg, Barclays Capital.
Aspiriant implements the fixed-income allocation with two partners – Vanguard and Nuveen. Vanguard, a longtime partner of Aspiriant clients, provides very low cost, broadly- diversified exposure to bond markets, which is ideal for the shorter end of the spectrum designed to mitigate volatility.
We have hired Nuveen Investments to help us sort through and capitalize on the opportunity in the large and misunderstood market for higher yield municipals. We believe that Nuveen, also a familiar name in Aspiriant portfolios, has the best municipal credit research department in the industry, with twice as many credit analysts than the next largest firm. Our confidence in them played an important role in our additional allocation to high yield.
Because Aspiriant clients are able to look beyond the headlines and the short-term volatility, we have taken a discerning and analytical approach to bonds. We have developed a structural allocation and implementation which we believe takes advantage of the current environment while standing up well to the cycle of interest rate increases which will eventually arrive.
Jason Thomas, Ph.D.,
CFA Chief Investment Officer
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