The yield curve continued to flatten in the second quarter of 2018; as of 06/29/2018, the thirty-year treasury only yielded 13 basis points more than the ten-year treasury.
Review
Duration underperformed in the first half of the year, while some shorter fixed income indices ended the second quarter in positive territory. The following table shows the returns of some popular Merrill Lynch fixed income indices.
Municipals: Technicals Are Favorable
MSRB transparency requirements have reduced the profitability of trading Munis, which has in turn reduced the amount of Muni bonds held in broker-dealer inventories for sale to investors. These inventories have fallen by about 65% during the last 10 years. The supply of new issues is also down due to changes in the tax laws which eliminate the use of tax-free bonds for the purpose of refunding outstanding issues. This has reduced the new issue supply of Munis by about 20% this year. This is making it more difficult for retail investors to find Munis at attractive levels. Access to bonds has become increasingly important. The best way to buy Munis is to purchase cheap, negotiated new issues from the dealer who is bringing the deal to market. Retail investors do not have access to new issues from other dealers. The scarcity of tax-free bonds and the strong demand from investors puts the muni market in a strong technical position. We expect Munis to outperform taxable bonds during the rest of the year.
Tax-Free ETF
The concept of indexing has gained traction in the Muni market. The scarcity of Munis and the change in markup disclosures for brokers selling to retail clients has been good for the market for tax-free ETF’s. The iShares National Muni ETF whose symbol is MUB has grown rapidly during the last 5 years to $9.8 billion. Despite the market euphoria surrounding Muni indexing, it is important to know there are reasons to question the wisdom of this strategy. These securities are not without drawbacks.
Interest Rate Risk
We find it interesting that investors are ignoring interest rate risk to invest in ETF’s since “everyone knows rates are going higher” and MUB has an effective duration of about 5.92 and only pays out a yield of 2.45%. This fund will not perform well in a rising rate environment. We believe it makes more sense to invest in an intermediate strategy with a duration of 4.0-4.5. This strategy will capture more than 80% of the yield of the longer strategy, but only has about two thirds of the risk of the longer strategy. This is a better risk/reward strategy for the client.
Not Tax-Efficient
MUB is not very tax-efficient for investors in high tax states and is not a customized solution for investors. It is most appropriate for smaller investors who have limited options due to the size of their account. Larger accounts can benefit from customized portfolios managed by fixed income professionals, which are tax-efficient and have better risk/reward characteristics.
Diversification Issues
Since the fund is market cap weighted it has heavy investments in states and cities that issue large amounts of debt (the minimum issue size is $100 million.) For example, 40% of the fund is invested in California and New York. This is a high concentration for the fund, and leaves the fund less diversified than it should be. This would have led to fund underperformance during the financial crisis since California’s budget was under severe stress during that time. The fund also has holdings in Illinois, Connecticut, and New Jersey. These states are all struggling with large unfunded pension obligations.
Vanguard’s creation of indexed equity funds is well known and has worked well for investors in the equity markets. An equity index that is cap weighted has a heavy concentration in the companies that have done well. A cap weighted muni index has a heavy concentration in states and cities that have big borrowing needs. This is a significant difference. We don’t think it makes as much sense to apply an indexed strategy to the Muni market where taxes and safety of principal are the main drivers for the investor. A customized portfolio designed to meet the unique investment objectives and tax situation for the client is a more suitable strategy.
“Liquidity Mismatch”
Muni ETFs have been growing at a rapid annual growth rate of over 35% since 2008. These ETFs are designed to closely track an index. However, there is some concern about the “liquidity mismatch” between the ETF which is very liquid and their underlying securities which don’t trade very often. In normal markets this does not present a problem. During periods of stress in the Muni market it can be more difficult for the ETF to meet redemptions. The chart below shows the discount or premium of MUB since inception. The largest discount to NAV came in the Fall of 2008 and was -3.54%. There have been other times such as in late 2010 and the middle of 2013 when the fund traded at a significant discount. Investors should be aware Muni ETFs may need to trade at discounts to NAV to meet redemptions when the market is weak. It is possible these discounts could wipe out a year’s worth of the income the portfolio generates.
We have concerns about the rapid growth of Muni ETFs and the liquidity mismatch that exists. Investors may suffer performance drag caused by this mismatch during periods of stress in the Muni market due to negative fund flows caused by investor redemptions.
“Socially Responsible Investing”
The Muni market is a good place for investors to have a positive social impact with their investment holdings. During the last few years there has been a proliferation of asset managers who are offering sustainable investment strategies which target investments that allow investors to have an impact on helping to make our communities a better place to live. These strategies are called ESG investing because investments are only made in projects which improve our Environment, help address Social or community problems, and ensure there is good Governance involved. Some areas of focus may be:
Environment
Clean water and sewer
Renewable/clean energy
Pollution control
Public transportation
Social
K-12 education
Higher education
Affordable housing
Programs to improve the social fabric of the community
Healthcare
Governance
Municipalities have sound finances and budgets
Plans are in place to fund Pensions and OPEB
Some projects or issuers do not qualify as suitable for ESG investing. These might include the following:
Sports stadiums
Pollution or carbon emission generating power plants such as coal
Projects that mostly benefit the private sector
Prisons or Jails
Issuers with large unfunded pension liabilities
Issuers that have not been responsible with budgeting
Issuers with a history of late disclosure filings
Templeton Financial Services Muni Strategy
We begin our investment process by examining the “public purpose” of the bonds. Bonds for education and essential services will always have good public support. Bonds which benefit the private sector do not have good public support from taxpayers if anything goes wrong. This has led us to place a strong emphasis on bonds for local school districts, healthcare, affordable housing, and essential services. We have avoided bonds with a weak public purpose such as stadiums and hotels. TFS has also avoided issuers that don’t demonstrate good governance. These issuers may have large unfunded pension liabilities, are over indebted, or do not have sound budget practices.