Strategy Overview
Municipal bonds are debt securities issued by or on behalf of state and local governments, their agencies and authorities, and other instrumentalities. The interest income of most municipal issues is exempt from Federal income taxes. Additionally, the interest income of municipal issues of a specific state will generally not be taxable for state income tax purposes for residents of that state.
The PIMCO Short Duration Municipal Bond strategy is designed to be appropriate for investors seeking tax-exempt income. The strategy consists of a diversified portfolio of primarily short duration, high credit quality municipal bonds that carry interest income that is exempt from federal tax and in some cases state tax.
In the municipal bond market, issuer-specific credit analysis is critical. Unlike passive strategies that typically rely solely on a rating agency for credit analysis, PIMCO applies extensive research on each municipal bond we purchase. We believe it is imperative to analyze each issuer, both at purchase and on an ongoing basis, to avoid what we feel are municipalities of deteriorating credit quality in our efforts to protect investors’ capital. Active management not only enables the strategy to invest in only the issuers and securities we endorse, but also allows us to change the portfolio structure should credit conditions change. In addition, active management allows for management of capital gains and losses, working to minimize the tax effect of gains, while harvesting losses when available.
| Applications for the Short Duration Municipal Bond Strategy |
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.
The Short Term Municipal Bond Strategy primarily utilizes bonds from the short end of the municipal yield curve. |
| Sources of Added Value |
Our strategic objectives are to consistently add value over benchmark total returns and to maintain return volatilities similar to those of the selected benchmark. We use the following portfolio strategies in attempting to achieve consistent above-benchmark returns:
- Duration
- Curve positioning
- Credit analysis / sector selection
- Issue selection / bond structure
- Quantitative analyses / portfolio structure
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. |