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How SMAs and Interval Funds Can Help Meet Municipal Investor Needs

Potential for higher yields, greater control are among the many features of municipal SMAs, interval funds

There are many potential advantages to investing in tax-exempt municipal bonds, but not all advisors are aware of additional strategies and investment vehicles that can help them meet muni-focused client needs. In this Q&A, we outline the potential benefits of pairing municipal bonds with separately managed accounts (“SMAs”) and interval funds.

Q: Many fixed income investors prefer to have immediate access to their holdings in the form of highly liquid funds. Are there drawbacks to that strategy?

A: There can be. In general, there are positives and negatives to accessing fixed income markets through mutual funds or individual bonds via SMAs. Neither vehicle is better than the other, but they may be better suited for certain clients or situations based on specific needs and objectives.

We’ve found that fixed income investors tend to overestimate their need for liquidity, and municipal investors are no exception. In fact, many municipal investors hold almost all of their assets in daily-liquid vehicles. That runs contrary to their generally long-term investment horizon and may dampen yield and total return potential. That’s because managers of highly liquid funds have to be prepared for potential redemptions, which can prevent them from investing in less-liquid but potentially higher-yielding securities.

Q: What are interval funds and how can they help municipal investors who don’t require as much liquidity?

A: An interval fund is a type of non-listed closed-end fund that isn’t subject to daily redemptions. The interval structure gives municipal fund managers the flexibility to invest in assets or execute investment strategies that may be less liquid and better suited to longer holding periods.

It also may help to prevent investors from making behavioral investment mistakes, such as selling when prices are depressed. This allows interval fund managers to maintain lower levels of liquidity because they don’t have to worry about unexpected redemptions, which avails them greater capacity to go on offense when the rest of the market may be selling. Managers can harness the features of the interval fund structure and capitalize on the outflow cycle, which can be volatile and destructive, by buying bonds at dislocated prices.

The interval fund structure allows the manager to pull a few different levers both offensively and defensively. On the offense, they can create dry powder with leverage when opportunities are plentiful, and defensively, they’re not forced to sell into an illiquid market.

Lastly, the interval structure gives fund managers the option to make use of term leverage rather than relying on short-term leverage, such as tender option bonds, which can be called away at the worst possible time. Fund managers can dial up leverage or adjust risk up or down depending on market conditions, and with fewer restrictions and a longer holding period, interval funds can potentially generate higher yields and higher risk-adjusted returns, which is especially important in a low-yield environment.

Q: What kinds of securities can municipal interval funds hold?

A: An interval fund structure with a flexible mandate enables access to less-liquid, more complex, and privately issued muni bonds, which may have higher return potential. This structure also provides access to a wide range of investments and investment strategies, including listed, non-listed, public, and private investments. There’s a fairly broad investment set from which to choose.

For example, interval funds may have the option to invest in closed-end funds when they offer attractive value. Traditional closed-end funds listed on an exchange, trade in the open market and can have prices that vary widely or trade at a discount from their net asset values (NAVs). This can offer attractive opportunities, particularly during market sell-offs, but they tend to be thinly traded and may be one of the last things an investor would want to be forced to sell to obtain liquidity.

Q: How about separately managed accounts (SMAs)? How can they help advisors address municipal client needs?

A: Separately managed accounts offer a high degree of flexibility to tailor portfolios to clients’ specific objectives – primarily because the investor owns the underlying securities, rather than shares in a fund. So while the investment manager invests the funds at the direction of the client, the client never relinquishes ownership.

For advisors, SMAs also have distinct advantages. SMAs allow for aggregating client accounts and can provide added transparency into client portfolios. SMAs also often come with fees that are competitive relative to traditional mutual funds. Here we’d caution, though, that advisors should understand the tradeoffs that come with transparency and liquidity.

Q: Can investors combine an interval fund with allocations in SMAs?

A: Absolutely. We believe the two can be a natural complement to each other. Municipal investors concerned about liquidity issues can pair SMAs with interval funds to help address concerns about interval fund liquidity. Conversely, interval funds may help clients overcome SMA objections, which might include lower after-fee SMA yields in a low-yield environment.

In our experience, municipal SMA holders rarely tap their portfolios for liquidity and tend to have a “buy and hold to maturity” mindset. However, SMA investors may be sacrificing some return for lower volatility, and, given the current rate backdrop, may find their current portfolios lacking in income distributions.

Q: Can you provide an example of combining the two?

A: One example that seems to be resonating with SMA investors is to carve out a portion of their individual holdings, say 20% or 30%, and move that into something more opportunistic. This allows them to increase income and return potential without materially changing the risk metrics of their portfolio on the whole. In particular, we think interval funds are appropriate to be this complementary, opportunistic asset for investors who can afford to give up daily liquidity on a portion of the portfolio they were unlikely to tap it in the first place.

Q: Do you see similarities in investment philosophy between SMA investors and interval fund investors?

A: There are definitely some overlaps. In general, investors in both SMAs and interval funds – and municipal investors as a whole, for that matter – have a long-term investment horizon and are generally not quick to sell when prices fall. That comes with some degree of risk, but it also has important implications for performance, since municipal securities with less liquidity can carry added return potential.

Q: How can PIMCO help advisors address muni-focused client needs?

A: PIMCO offers municipal investors a wide range of thoughtful strategies, including mutual funds, exchange-traded funds (ETFs), interval funds, and SMAs. Our municipal interval fund, PIMCO Flexible Municipal Income Fund (“MuniFlex”), is one of the first interval funds to focus on federal tax-exempt income. It allows us the opportunity to exploit the inherent structural illiquidity in the municipal market. Couple this with separately managed accounts that can be customized for geography, tax-loss harvesting, and special-impact areas like ESG, and advisors have access to a broad suite of municipal product offerings that can help them pursue municipal client investment objectives.

Learn more about PIMCO Separately Managed Accounts.

The Author

Mark Thomas

Account Manager, Global Wealth Management

Tracy Wills-Zapata

Alternatives Sales, U.S. Global Wealth Management

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Disclosures

Investors should consider the investment objectives, risks, charges and expenses of the PIMCO Flexible Municipal Income Fund carefully before investing. This and other information are contained in the fund’s prospectus, which may be obtained by contacting your investment professional or PIMCO representative or by visiting www.pimco.com. Please read the prospectus carefully before you invest or send money.

The fund is an unlisted closed-end “interval fund.” Limited liquidity is provided to shareholders only through the fund’s quarterly offers to repurchase between 5% to 25% of its outstanding shares at net asset value (subject to applicable law and approval of the Board of Trustees, the Fund currently expects to offer to repurchase 10% of outstanding shares per quarter). Although interval funds provide limited liquidity to investors by offering to repurchase a limited amount of shares on a periodic basis, investors should consider shares of the Fund to be an illiquid investment.

The managed account strategies described in this material are offered by Pacific Investment Management Company LLC, and are available exclusively through financial professionals. Managed accounts have a minimum asset level and may not be appropriate for all investors.

There can be no assurance that the investment approach outlined above will produce the desired results or achieve any particular level of returns. This material has been prepared without taking into account the objectives, financial situation or needs of any specific investors. This material does not constitute any tax, legal, financial planning, or investment advice to you as part of information contained herein and no recommendation of any particular security, investment, tax strategy or product is being made.

Past performance is not a guarantee or a reliable indicator of future results. It is important to note that all investments are subject to risks that affect their performance in different market cycles.

A word about risk: Investing in municipal bonds involves the risks of investing in debt securities generally and certain other risks. Income from municipal bonds is exempt from federal income tax and may be subject to state and local taxes and at times the alternative minimum tax. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. 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. Concentration of assets in one or a few states, territories (or a particular area) and projects will subject a portfolio to greater risk than if the assets were not concentrated. Private credit involves an investment in non-publically traded securities which are subject to numerous risks including, but not limited to, illiquidity risk and real estate-related risks, which include prepayment, delinquency, foreclosure, non-performing loans, and adverse regulatory developments. Derivatives 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 use of leverage may cause a portfolio to liquidate positions when it may not be advantageous to do so to satisfy its obligations or to meet segregation requirements. Leverage, including borrowing, may cause a portfolio to be more volatile than if the portfolio had not been leveraged.

An investment in an interval fund is not appropriate for all investors. Unlike typical closed-end funds an interval fund’s shares are not typically listed on a stock exchange. Although interval funds provide limited liquidity to investors by offering to repurchase a limited amount of shares on a periodic basis, investors should consider shares of the Fund to be an illiquid investment. Investments in interval funds are therefore subject to liquidity risk as an investor may not be able to sell the shares at an advantageous time or price. The Fund anticipates that no secondary market will develop for its shares. There is no guarantee that an investor will be able to tender all of their requested Fund shares in a periodic repurchase offer. An investment in an interval fund is speculative involving a high degree of risk, including the risk of a substantial loss of investment. Investors should consult their investment professional prior to making an investment decision.

ESG and socially responsible investing is qualitative and subjective by nature, and there is no guarantee that the criteria utilized, or judgment exercised, by PIMCO will reflect the beliefs or values of any one particular investor. Information regarding responsible practices is obtained through voluntary or third-party reporting, which may not be accurate or complete, and PIMCO is dependent on such information to evaluate a company’s commitment to, or implementation of, responsible practices. Socially responsible norms differ by region. There is no assurance that the socially responsible investing strategy and techniques employed will be successful.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. 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. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2021, PIMCO.

PIMCO Investments LLC, distributor, 1633 Broadway, New York, NY, 10019 is a company of PIMCO.

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