In light of the major shift in the governing ideology on taxes, regulation and other issues ushered in by the new presidential administration, and in consideration of the muni market’s higher volatility and lower liquidity since the 2008 crisis, municipal bonds deserve a fresh look.
The market for municipal securities is illiquid: their average daily trading volume is a mere 2% of Treasuries’ and just over a third of corporate bonds’. Those who would transact in munis are challenged further by the lack of a centralized exchange, as munis are traded exclusively through registered dealers. More than ever, muni bond trading is a relationship business, giving those who know the issuers and the dealers a significant pricing advantage.
The muni market is also inefficient, since the supply and demand of bonds is highly fragmented. On the supply side, there are 30,000 individual issuers and 1 million distinct securities. On the demand side, retail investors account for 70% of muni ownership. Retail investors often make investment decisions without the benefit of the market-level and security-specific information that professional investors possess. As a result, individual muni issues are often mispriced relative to other securities of similar credit quality, coupon and maturity.
This unique combination of illiquidity and fragmentation presents investors with a wide range of potential outcomes depending on the vehicle through which they choose to access the asset class. The typical avenues of access – buying individual bonds, participating in passive ETFs, and purchasing mutual fund shares or SMAs — are fraught with limitations.
Mutual fund managers, for example, are hampered by the very factors designed to protect retail investors from risk: investment restrictions, mandated liquidity provisions and taxes levied at the investment company level. Though protective, these measures can make it difficult for a manager to conviction-weight trades in times of extreme dislocation.
Further, high liquidity can lead to “cash drag” and fire sales. As mutual funds are required to stand ready to accept daily redemptions at net asset value, the manager can hold more cash than her convictions might dictate, diluting returns. Worse yet for investor outcomes, mutual fund managers are often forced to liquidate securities at unfavorable prices during a liquidity crunch.
Mutual funds are also structurally inefficient from a tax standpoint in that tax implications hit the investment company before flowing to the end investor. There are two negative consequences worth noting: first, mutual fund investors can incur a net loss of principal in a given tax year but still owe income and capital gains tax on individual transactions made at the fund level. Second — and conversely— mutual fund investors cannot avail themselves of benefits from tax-loss selling.
Given these limitations, investors may be wise to consider investment vehicles that provide the advantages of active management without losing the control and customization afforded by direct investment in the underlying bonds.
Enter a lesser-known option to access munis: private funds.
Offered under an exemption from Regulation D, private funds offer Qualified Purchasers unique benefits. Chief among these is the opportunity to extract alpha from a structurally inefficient market by utilizing a research-intensive relative value approach.
Private municipal funds can accumulate large positions in specific municipal issues or economic sectors, as long as they stay within self-imposed portfolio parameters. Provided that investors understand and are comfortable with these limits at the outset of investing, the increased flexibility can benefit investors.
During periods of dislocation, an issue may trade well below what the manager perceives to be its intrinsic value. Unlike their counterparts at mutual funds, private fund managers can focus exclusively on reward and risk in sizing a position in this issue, acquiring enough bonds so that the attainment of the price target will produce a substantial positive impact on overall portfolio return.
The private fund structure also provides the patient capital needed for opportunistic trades. If there is a pullback in municipal markets, mutual funds will likely be forced by redemptions to reprise their role as net sellers. Meanwhile, private funds will be in a position to step in as a provider of liquidity.
With regard to taxes, limited partnerships’ structure is significantly more efficient than that of mutual funds. Gains are allocated to each LP, rather than first passing through a corporate entity, making the tax implications of private fund participation much like those of investing directly in individual bonds. Specifically, each LP can use the losses incurred from tax loss swaps to offset personal gains in other parts of their portfolio.
For qualifying investors who do not need daily liquidity, limited partnerships may be worth considering. They may offer diversification and active management while preserving the tax benefits of investing in individual bonds and potentially profiting from the short-term orientation of other investors.