Viewpoints

Capitalizing on Illiquidity in the Muni Market

David Hammer, head of Municipal Bond Portfolio Management, and Rachel Betton, municipal bond portfolio manager, discuss how an interval fund structure may help investors earn higher after-tax income by exploiting structural illiquidity in the municipal market.

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Rachel Betton, Portfolio Manager, Municipal Bonds: In a world of low rates and tight credit spreads, we’re constantly looking for innovative ways to deliver higher after-tax yields to our investors. 

David Hammer, Head of Municipal Bond Portfolio Management: Liquidity has been a source of investor frustration in recent years. Since the financial crisis, available liquidity in the muni market,

Chart: A bar chart shows broker/dealer inventory (LHS) in billions from 2005 to 2019 increasing before 2008 and then decreasing afterward. Overlays a mountain chart that shows municipal fund assets steadily increasing during the same period.

so these are market makers that provide bids and offers every day, that liquidity has declined. Over the same time period, funds with daily liquidity offered to investors like open-ended mutual funds have increased in size, so there’s a growing mismatch between the available liquidity and investors that might demand that liquidity. 

As a result, during outflow cycles in the muni market, what we’ve experienced are overshoots where valuations’ prices really overshoot fundamentals.

Rachel: During the past decade, every three to four years, we’ve seen large outflow cycles.

Chart: A mountain chart shows peaks and troughs of muni market flow cycles from 2010 to 2019. Overlaying that are two line graphs, rising and falling yield to maturities for investment grade municipal bonds and high yield municipal bonds for the same time period.

David: Back in 2010 and ’11 following Meredith Whitney’s proclamation on 60 Minutes that there would be billions of municipal defaults caused an outflow cycle. In 2013 after the fed-induced taper tantrum, that coincided in the muni market with a down grade of Puerto Rico and also Detroit filing for bankruptcy, so we saw a prolonged outflow cycle. 

Rachel: Most recently in 2016 following the presidential election, fears of lower taxes and higher interest rates led to an outflow cycle and a resultant spike in yields. In these selloffs, most muni funds have to raise cash to meet redemptions.

Shots of PIMCO employees working.

We don’t see outflow cycles going away. In fact we think they are probably becoming more common and potentially more severe.

David: We do see an opportunity here, but it really needs to be an investment vehicle that’s not subject to the same daily liquidity demands.

Rachel: We think a product that has less liquidity, like an interval fund, can be particularly compelling for long-term investors because it can stay invested and actually deploy capital during market sell-offs as yields rise.

David: That puts us as portfolio managers in a better position to take advantage of these outflow cycles, make opportunistic purchases, and create long-term value for investors that expect to be allocated to the muni market for a prolonged period of time.

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Disclosure


Past performance is not a guarantee or a reliable indicator of future results.

References, either general or specific, to securities and/or issuers in the Material are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Investors should consult their investment professional prior to making an investment decision.

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, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice. PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and concerns.

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. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax; a strategy concentrating in a single or limited number of states is subject to greater risk of adverse economic conditions and regulatory changes. 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. 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. Diversification does not ensure against loss.

An investment in an interval fund is not suitable 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 an interval 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. There is also no secondary market for interval fund shares and none is expected to develop. There is no guarantee that an investor will be able to tender all or any of their requested shares in a periodic repurchase or tender offer.

This material contains the 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. Except for the historical information and discussions contained herein, statements contained in this material may constitute forward-looking statements. These statements may involve a number of risks, uncertainties and other factors that could cause actual results to differ materially, including the performance of financial markets, the investment performance of PIMCO’s sponsored investment products, general economic conditions, competitive conditions and government regulations, including changes in tax laws. Investors should carefully consider such factors. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material 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. ©2019, PIMCO.

Pacific Investment Management Company LLC (650 Newport Center Drive, Newport Beach, CA 92660) is regulated by the United States Securities and Exchange Commission. | PIMCO Investments LLC (“PI”), a U.S. broker-dealer registered with the U.S. Securities and Exchange Commission, serves as the principal underwriter for the U.S. registered PIMCO Funds (“Funds”) and placement agent for the PIMCO-sponsored private funds (the “Private Funds”).

CMR2019-0625-403337

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