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On a tax-adjusted basis, municipal bonds may offer greater returns than taxable debt sectors, such as Treasuries and corporate bonds, having similar credit ratings and maturities. In addition to providing the potential for attractive tax-adjusted yields, municipal debt generally has high credit quality. During credit-sensitive time periods, such as a recession, municipal debt default frequencies tend to be lower than corporate debt. The potential for higher tax-adjusted yields than corporate bonds and low credit default risk make municipal bonds an attractive asset class.
We manage municipal bond portfolios with the same core investment process used for all of our strategies:
We avoid undue reliance on a limited set of strategies, which could lead to greater return volatilities and large tracking errors relative to the stated benchmark. We have customized our analytics for municipal-specific factors, such as municipal yield volatility, call option costs, and tax exposures. Because we concentrate on relative value opportunities across most global debt sectors, we can use our extensive experience in relative value comparisons to help select the most fairly valued securities to meet portfolio objectives. Above all, we seek to hold well-structured municipal bonds, being compensated appropriately for risks relating to calls, credit quality, liquidity, tax liabilities, and market supply-demand conditions.
Most municipal bonds have call options. Callability introduces duration uncertainty as duration can be extended or shortened dramatically, depending upon changes in interest rates. For example, as yields drop, the likelihood of a bond getting called away well before its stated maturity date may increase substantially. Under such a circumstance, the bond’s duration could be dramatically shortened, thereby limiting the potential price appreciation resulting from falling yields. We carefully measure the added yield from accepting call risks and will structure our portfolios to provide for appropriate call protection. Similarly, we use our extensive internal analytics to gauge the potential price effects of yield curve movements and sector yield premium shifts.
We closely track potential tax liabilities of market discount bonds, which may be trading near their safe harbor limits , or the price at which any further price increases to par are not taxable. Such market discount bonds will experience price volatilities differently than their stated duration calculations. For discount bonds near or below the safe harbor limits, market discounts would be taxed at ordinary income tax rates upon disposal, call, or maturity. Due to this potential tax liability, a market discount bond can sustain adverse price movements as the de minimis safe harbor limit is approached.
As one of the largest bond managers in the U.S., we have available trading economies of scale, permitting us to manage trading costs to as low a level as possible. Trading costs are reflected in bid-ask spreads, which can be substantial in the municipal market due to the absence of sufficient trading liquidity, the very large number of different issues, and the relatively small average issue amount. Our trading volumes provide us with continuous access to all of the major market makers, allowing us to assess broker inventories and current market conditions. Trading costs, including tax effects, are factored into all of our analyses to help ensure that the relative value benefits of a trade outweigh the transaction costs.
We are unique among municipal managers in that we integrate our municipal bond managers with our other sector specialist and generalist portfolio managers. Through this integration, our municipal managers acquire a relative value perspective among all debt sectors, enabling them to assess how relative sector and issue valuations may shift under changing circumstances and how relative portfolio performance may be affected.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. PIMCO strategies utilize derivatives which may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. There is no guarantee that this investment strategy will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. Diversification does not ensure against loss. Please consult your tax and/or legal counsel for specific tax questions and concerns.
This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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