Navigating illiquidity in municipal bonds

Investors have been flocking to the $3.6 trillion U.S. municipal bond market and demand is expected to remain strong. But while the muni market has experienced growth over the last decade, dealer participation in the space has not. Inventories have shrunk over that same period, hitting historic lows.
That dynamic creates bouts of illiquidity when the retail investors who dominate the municipal market decide to sell instead of buy. As investors redeem shares from mutual funds or sell cash funds out of separately managed accounts, and there’s no natural buyer to support the market, munis become exceptionally cheap. The downward push on prices creates a significant vacuum of liquidity. This episodic “risk on, risk off” cycle has played out over the last few years, notably in 2013, when munis moved to their cheapest levels compared to taxable bonds in almost 25 years.
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The technical deterioration among munis has caused unusual moves not previously seen in the bond market. That means that understanding the impact of the supply-demand behavior is much more critical than in the past. Because impaired liquidity translates into risk, it’s important to take a more opportunistic view when managing portfolios, particularly as valuation gaps collapse or widen.
VOLATILITY CAN MEAN NEW POSSIBILITIES
Skilled value managers know that while violent movements cause negative price performance, they also open new possibilities in different sectors of the fixed income markets. Such managers have the ability to move in and out of different asset classes mdash; whether tax-exempt munis, taxable munis or corporate bonds — depending on where the relative value lies. With that interplay between the retail and institutional worlds, not only can they capture opportunities to generate attractive return potential, but they also can seek to create very well-diversified portfolios for investors.
Retail investors are sometimes reluctant to part with their tax-exempt munis — even when their after-tax return might be higher with a taxable fund. Portfolio managers with mandates that are not adverse to that, however, can take advantage of price discrepancies during times of illiquidity. Managers invested in tax-exempt bonds can ‘cross over’ to select taxable bonds when they believe they are undervalued. They can buy taxable bonds and still potentially benefit from the price performance on an after-tax basis for certain investors. By factoring in that the total return component may include not just the coupon, but also the price performance of the bond, such strategies can increase the likelihood of a high level of after-tax total return.

KNOWING WHEN TO IGNORE THE NOISE
Implementing this strategy requires more than just detecting tactical plays to drive performance. It requires knowing when to ignore the noise of the market. It’s easy to focus on fundamentals and overweight factors such as impending Federal Reserve interest rate hikes while overlooking the supply and demand shifts that have skewed the behavior of bond market participants. It’s critical to resist the collective fear of investors who envision munis falling into a bottomless pit with endlessly dropping prices. That doesn’t happen when managers step in with a base of non-taxpaying clients who buy munis when they are cheap and attractive on an absolute basis.
In addition to the skill of the value manager, the size of the asset management firm also plays a role in the success of strategies. Firms with the ability to excel in this area are generally large enough to invest in a sizeable global infrastructure of economists and risk analytics, but nimble enough to implement strategies without having an oversized impact on market pricing. It’s difficult for oversized firms to implement strategies using cash because getting out of a position under constrained liquidity can adversely impact the market and performance.
For investors looking to make wiser decisions about which municipal bond funds are best equipped to manage risk during bouts of illiquidity, the strategy is a core investment philosophy based on deep value. With a consistently applied investment approach based on a long-term horizon, managers can seek to maximize the after-tax return as investors in the U.S. and globally step in and buy cheap bonds at extraordinary value. The idea is to observe the risk appetite of the investor patiently and execute moves based on how the market is priced, independent of the noise. It means believing that a fundamental generic view is sometimes less rewarded, while a contrarian view may pay off by embracing risk when everyone is selling it.
It means combining the expertise of portfolio managers and research analysts each of whom are keenly focused on identifying value at exactly the right time by deciphering a market that is often much more complex than many investors realize.

Julio C. Bonilla is a portfolio manager for Schroder Investment Management North America Inc.