The active/passive debate frequently focuses on equities, where active approaches have historically underperformed passive strategies. The story is decidedly different in the world of fixed income, where active managers can more easily exploit mispricing and other inefficiencies. In this Q&A, product strategists Daniel Noonan, Avi Sharon, and Alan Trice discuss the advantages of active muni bond investing.
Q: In recent years, billions of dollars have flooded into low-cost, passive MUNICIPAL BOND exchange-traded funds (ETFs). Why should investors consider active fixed income strategies?
A: The active/passive debate typically centers on the underperformance of active equity managers relative to passive peers. But the narrative is decidedly different in the world of fixed income – including municipal bonds – where median active funds have outperformed their benchmarks and passive peers the majority of the time. According to Morningstar, over the past 10 years ended 30 June 2021 more than 70% of active bonds fund beat their benchmarks while less than 40% of active equity beat their benchmarks.Footnote1 We believe the potential to generate alpha in municipal bond funds is especially promising today for securities rated BBB or non-investment-grade – investments exchange-traded funds (ETFs) often overlook.
Q: What are the challenges of tracking fixed income benchmarks?
A: While many equity indices reflect market capitalization, most fixed income indices are debt-cap-weighted. The most indebted issuers – frequently in the largest and most indebted states – have the greatest index weights. That’s not a compelling investment strategy, in our view. Moreover, unlike equity indices, fixed income benchmarks include tens of thousands of individual CUSIPs (security identifiers), making replication far more difficult. In fact, passive fixed income strategies typically track a smaller subset of the largest and most liquid bonds, which may leave gaps that skilled active managers can exploit.
Q: But wouldn’t many muni investors want to invest in the largest bonds?
A: Not necessarily. California and New York account for about 33% of the Bloomberg Municipal Bond Index, and they have a similar weight in other national indices. But those states’ high tax rates make them more valuable for in-state investors and less attractive for national investors. All else equal, we would expect bonds issued in high-tax states to have lower yields, and for that reason we tend to underweight them in PIMCO portfolios. Of course, while securities in these states may still provide value, it doesn’t make sense to own them blindly. That’s where the expertise of an active manager can come into play.
Q: What inherent inefficiencies in muni markets make active management compelling?
A: Several factors make the municipal market inefficient:
The municipal market has a large diversity of issuers, including 50,000-plus issuers and more than a million CUSIPs, all traded over-the-counter, rather than on a centralized exchange.
The dominance of retail investors in muni markets generally leads to a relative lack of institutional research and high transaction costs. What’s more, municipalities are not subject to standardized accounting procedures, forward-looking guidance, or even timely, audited financial statements.
Many bonds have complex structures and unique tax treatment – which may include tax-exempt, double and triple tax-exempt, taxable, and AMT (alternative minimum tax) bonds.
All these factors make the case for professional active bond managers – at least those with significant resources and expertise.
Q: How could an active bond manager exploit these inefficiencies?
A: Active managers understand the nuances of the fixed income market and can seek to avoid the pitfalls of passive indices. Consider that bonds of small issuers tend to have less demand, leading them to trade with higher yields, whereas bonds from larger issuers often attract greater demand, leading to lower yields, even if risk characteristics are similar. Active managers can buy these higher-yielding bonds that passive strategies typically avoid because they’re not part of the indices they track.
Q: Should investors consider alternative minimum tax (AMT) bonds and taxable munis?
A: Private activity bonds, otherwise known as AMT bonds, are federally tax exempt, unless an investor is subject to the alternative minimum tax (AMT), in which case they are taxed at the full federal rate. Many mutual funds and ETFs are advertised as “AMT-free” to attract what had historically been a large universe of municipal investors subject to the AMT. The Tax Cuts and Jobs Act of 2017, however, all but eliminated the AMT, effectively making AMT bonds exempt from federal taxes for almost all municipal investors. However, given “AMT-free” funds are still unable to purchase AMT bonds, demand has not materially increased and investors can still pick up attractive yield frequently in AMT securities.
We sometimes see similar opportunities in taxable munis. Occasionally, yields on taxable munis are higher after tax than they are for the exact same issuance in the tax-exempt market. It may benefit portfolios to have flexibility to buy the bond with the higher after-tax yield. Similarly, even for residents of high-tax states like California and New York, we frequently find better after-tax yields by investing nationally, despite foregoing state tax exemptions.
Q: Why is liquidity important for municipal investors?
A: Liquidity mismatches arise when the daily liquidity offered by ETFs and mutual funds doesn’t match the underlying securities held in these funds. Since the global financial crisis in 2008–2009, the portion of the U.S. muni market held in daily liquidity vehicles has increased by nearly 300%, while inventories held by broker-dealers – the market’s liquidity providers – have fallen by about 85%, according to Federal Reserve data as of 31 March 2021. When the market experiences outflow cycles, this liquidity mismatch can cause sudden increases in yields, as nontraditional municipal investors need to be incentivized to provide liquidity.
We have seen passive high yield muni ETFs get battered during outflow cycles, so investors should be thoughtful about how they assume risk. These outflow cycles can present attractive opportunities to buyers, but be very painful to sellers. This mismatch has to be managed prudently, and we believe liquidity management is incredibly important for municipal investors.
Q: What is the typical credit risk profile for municipal bonds? Do they rarely default?
A: It’s true that munis historically enjoy very low default rates. That’s reflected in the makeup of municipal fixed income indices, which tend to be concentrated in bonds rated AA and AAA. While passive, index-tracking funds tend to have high credit quality, quality comes at the expense of yield. We believe well-resourced active managers can take advantage of opportunities down the credit spectrum in an effort to enhance returns.
Q: What is the overall strategy of PIMCO’s new muni ETF?
A: Put simply, we are trying to exploit inefficiencies in the municipal market by broadening our opportunity set beyond that of most ETF managers. PIMCO Municipal Income Opportunities ETF (MINO) seeks to generate current income and capital appreciation while prudently managing liquidity in an effort to avoid risks that we believe high yield ETF offerings currently pose. To do so, we deploy PIMCO’s time-tested active, approach, reorienting the portfolio into portions of the market where we see the most value. By investing up to 30% in sub-investment-grade credits, as well as above-benchmark allocations to bonds rated BBB, we believe the fund will offer a compelling and unique risk-reward profile in the municipal ETF landscape.