Passive investing has come back into vogue in the financial markets, but there are still assets where active management can generate superior risk-adjusted returns. The municipal bond market is a prime example with its often-inefficient pricing and the high impact that personal circumstances – such as an individual’s tax bracket or risk tolerance – have on investment decisions. Investors can use actively managed muni funds to reduce costs, improve income generation and avoid potential risks in the market.
In this article, we will look at why passive investing falls short and how investors can spot relevant opportunities in the municipal bond market by relying on active strategies.
Passive Strategies Fall Short
There is strong evidence that suggests most investors can’t beat market averages over the long term, but municipal bonds may be an exception to the rule. According to Morningstar data, most investors still prefer actively managed muni bond funds, which had about $26.3 billion dollars of capital inflows in 2016 compared to just $6.8 billion for passively managed funds. Passive funds may outperform active funds in total returns, but individual investors could outperform both types of funds by purchasing individual bonds that are best suited for their individual tax situation.
The attractiveness of muni bonds certainly depends on the issuer’s credit rating and macroeconomic factors like interest rates. But unlike most typical bonds and equities, a muni bond’s value also depends on the individual investor’s location, tax bracket and yearly losses. Individual investors that bypass passive funds can build tailored muni bond portfolios with specific durations and securities. Investors can also take advantage of tax loss harvesting strategies that involve selling investments for a capital loss to offset gains on income taxes and replenishing them with other assets.
- Political and regulatory uncertainty make passive strategies less relevant: President Donald Trump’s election may prompt individual muni bond investors to avoid specific problem sectors – a feat not possible with indexed funds. For instance, lower federal healthcare subsidies could put pressure on nonprofit hospitals that issue muni bonds, while infrastructure spending could provide public-private opportunities. With this in mind, actively managed funds may choose to avoid healthcare bonds and buy infrastructure bonds.
- Passive strategies cannot be applied uniformly across all asset classes: Passively investing in muni bonds doesn’t inherently make sense in the same way that it does for equities. Passively managed bond funds are often overweight in the most indebted rather than the most creditworthy issuers and may be concentrated in certain states like California, whereas actively managed funds use criteria like credit ratings or duration when weighing a portfolio – a strategy that could help generate higher risk-adjusted returns over time.
Finding Opportunities Amid Muni Pricing Discrepancies
Choosing the right municipal bond funds or individual munis (click here to check recent muni bond trades) depends on an investor’s investment objectives. For example, an investor in a low tax bracket who is seeking exposure to safe-haven bonds may be interested in passively managed funds, while a high net worth individual looking to maximize after-tax returns or pursue other goals (e.g., green investing) may build their own fund. In short, there’s no single muni bond fund that’s right for every investor.
Investors should instead consider several factors (click here to read in more detail) when choosing the right fund or bond:
- Taxes: The interest earned on muni bonds is often exempt from federal income tax, but investors may also be able to avoid state and local taxes by buying bonds in their home states. It’s also important to keep in mind that some bonds are taxable or subject to the Alternative Minimum Tax (AMT).
- Yields: Many investors rely on bonds to provide a steady income stream during retirement, which means paying close attention to dividend yields, tax equivalent dividend yields, yields to maturity and tax-equivalent yields.
- Credit risks: A bond’s duration measures its sensitivity to changes in interest rates, while credit ratings provide clues into potential political or financial risk factors. Investors should also consider the impact of broader reforms that may not be reflected in ratings.
There may also be opportunities for investors to pick up mispriced bonds. BNY Mellon Wealth Management CIO Leo Grohowski recently mentioned that the expected fall in muni demand from reduced tax rates is likely overblown. Second-tier muni bonds could be a buying opportunity in this case, since higher-risk bonds have been more substantially mispriced. It can also be argued that shorter-duration bonds could gain prominence in 2017, when the US Fed is expected to raise rates faster.
The Bottom Line
Most investors stick to passively managed funds when it comes to equities, but municipal bonds play by different rules in many cases. Investors should consider actively managed muni bond funds as a way to capitalize on mispricing – including mispricing resulting from President Trump’s actions – and as a way to build the portfolio best suited to their individual circumstances.
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