Challenges in Today’s Municipal Market
Most fixed-income investments carry two key risks: interest-rate risk and credit risk. Both affect a bond’s value in the market. But before the 2008 financial crisis, interest-rate risk was the primary concern of many investors and investment managers—credit risk was much less of a consideration. My colleague Michael Brooks explains why.
The reason is that approximately 70% of municipal bonds prior to 2008 were rated AAA. Some of these bonds were legitimately of the highest quality, but with others, bond insurers appeared to eliminate one of the risk variables with a nice trick: they would guarantee lower-rated bonds and give them a AAA rating.
It worked—until the insurers themselves lost their AAA ratings, and the bond-insurance industry subsequently collapsed.
Prior to 2008, insured bonds represented more than 50% of issuance; today, they represent less than 4%. Investors can no longer rely on the crutch of bond insurance. All bonds today require in-depth credit analysis. And the truth is, they always did. We always looked to the underlying credit quality of a bond to make investment decisions.
The upside is that today there are far more lower-rated bonds available, and such bonds offer a substantial yield advantage. At the start of 2007, A-rated and BBB-rated securities comprised only 14% of the market; such bonds now represent more than 30% of the market, according to Barclays Capital. However, earning that extra yield requires significant fundamental research into the minutiae of an issuer’s financial management. Before purchasing a bond, it’s imperative to understand what short-term or long-term problems an issuer may face, and how they are being resolved.
Additionally, for an investment manager doing any kind of tactical overlay—especially managing for taxes—it’s crucial to capitalize on short windows of investment opportunity. But you can’t be nimble without the ability to very quickly do in-depth research on the bonds you’re interested in. There are too many pitfalls.
And today there’s another hurdle: increased regulation. As an offshoot of the Dodd-Frank Act, the SEC and FINRA have issued new rules on disclosures financial advisors must make when selling individual bonds to investors.
Because of the need for in-depth research, an actively managed municipal bond mutual fund may provide some investors with a more effective and flexible approach than a portfolio of individual bonds would. Investors in such actively managed funds gain the advantage of a full-time professional manager, one equipped to decode the risk and return potential behind the staggering array of variables that characterize the bond market. Financial advisors benefit, too—they’re freed from the need to conduct due diligence when selecting the appropriate bonds, so they can dedicate more time to servicing their clients.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio- management teams.
Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income, and Michael Brooks is Senior Portfolio Manager of Municipal Bonds, both at AllianceBernstein.