February 17, 2009
“None of the volatility in these two examples was related to the underlying credit of these bonds or the respective issuers,” says Doe. “Once you take default off the table and understand this volatility, there are great opportunities to buy when the market weakens.”
While default, headline, and ratings risk explain most of the volatility in the municipal market, long term investors face a fourth risk common to all fixed income markets – rising interest rates and inflation. No inflation-protected securities exist in the municipal markets comparable to TIPS in the Treasury markets.
Funds versus ETFs versus SMAs
Doe cautions advisors to avoid mutual funds that are merely managed indices lacking aggressive management of their portfolios. Some fund companies have reduced staff and analysts, he says, making it more difficult for them to conduct comprehensive credit surveillance for the 65,000 issuers in the muni market. “Make sure you are getting the credit surveillance you are paying for,” Doe says.
Separately managed accounts (SMAs) have grown aggressively relative to traditional muni mutual funds, according to Doe. “SMAs offer customization for the individual investor and are not necessarily managed to an index unless an investor prefers such a strategy,” says Doe. These accounts can offer more diversification relative to coupon rates and strategic execution that takes advantage of specific credits, trends and value in the yield curve - managers pay more attention to individual securities. Lower minimums have made SMAs accessible for more accounts. “At the end of the day it may simply be that the managers are more accountable to the individual investor,” observed Doe.
“Given the low default rate, you may not need the broad diversification offered by mutual funds,” says Doe.
About 20 municipal bond Electronically Traded Funds (ETFs) are now available, and they are gathering assets, according to Doe. Some are focused on sections of the yield curve, on specific credit ratings, or on characteristics such as pre-refunded bonds. Doe cautions that liquidity issues can create large bid-ask spreads for these ETFs, but most are “hanging on” while other ETFs are closing down as their asset bases shrink. Municipal ETF’s are evolving. That they have managed to grow through the tumultuous events of the past 18 months is encouraging. They certainly pose a significant challenge to mutual funds that are also managing to an index, as the strategy is the comparable and fees can be lower and managed with greater tax-efficiency.
Pricing accuracy is a problem that plagues all muni products. Lack of liquidity means virtually all muni bonds are matrix-priced - the evaluation vendor calculates prices using theoretical spreads relative to similar-maturity municipal credits and Treasury issues. Most of the time, matrix evaluation works pretty well, but, occasionally, it fails completely. Such was the case in 2001, when Heartland Advisors saw one of its muni funds lose 70% of its value virtually overnight.
Matrix pricing is particularly problematic for ETFs, which must be priced on an intra-day basis.
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