With over 30,000 individual issuers and one million distinct securities, the supply of municipal bonds is highly fragmented.
Despite the advantages for larger, better-networked investors, the demand side of the muni market is equally fragmented,1,2 with retail investors accounting for 70% of muni ownership both directly and through commingled funds.3
Retail investors often make buy and sell decisions without the benefit of the marketlevel and security-specific information that professional investors possess.
Moreover, individuals are often motivated by liquidity needs and emotional responses that arise in the absence of any fundamental change in the value of their investments. As a result, individual muni issues are often mispriced relative to other securities of similar credit quality, coupon and maturity.
The municipal market's unique combination of illiquidity and fragmentation renders it structurally inefficient, meaning that information about a particular muni bond, issuer or sector is often not quickly reflected in prices. The resulting mispricings can create significant opportunities for experienced investment teams.
Limitations of the Mutual Fund Structure
By availing themselves of active, professional management, investors in municipal securities can exploit mispricings, avoid security-specific and macro pitfalls and attain best execution. No matter how talented the manager, however, if she is operating within the confines of a liquid structure, i.e. a '40 Act mutual fund, certain avoidable risks and missed opportunities remain.
Mutual fund managers are hampered by three factors that are designed to protect retail investors from risk: investment restrictions, mandated liquidity provisions and taxes levied at the investment company level.
Investment restrictions can limit upside
Mutual funds must comply with concentration limits including those on the percentage ownership of a single issuer's debt and on the preponderence of a single industry in the overall portfolio. These measures are protective but can make it difficult for a manager to conviction-weight trades in times of extreme dislocation.
High liquidity can lead to "cash drag" and fire sales
On the liquidity front, mutual funds are required to stand ready to accept daily redemptions at net asset value. This has two disadvantageous implications for shareholders. First, daily liquidity necessitates that the manager hold more cash than her convictions might dictate, leading to "cash drag" on returns.
Worse yet for investor outcomes, in a liquidity crunch, mutual fund managers are often forced to liquidate securities at unfavorable prices.
Tax benefits do not flow through to the investor
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. While a mutual fund may engage in tax swaps where the fund sells a security to book a taxable loss and purchases a substantially similar security in order to maintain the investment exposure without violating the Wash Sale Rule, the ensuing loss accrues to the investment company, offsetting its gains rather than those of the individual investor.
Limited Partnerships advantageous in "brave new world" of muni investing Private municipal funds offered as limited partnerships impose a qualified purchaser requirement and may restrict liquidity to a monthly or quarterly redemption schedule vs. the daily liquidity of a mutual fund or ETF. In addition, these funds may impose gates, or limits on the percent of one's investment that can be redeemed during each redemption window. However, for investors that meet the wealth requirement and that do not need the daily liquidity of a mutual fund or ETF, private funds can provide significant advantages.
Fewer restrictions on investment decisions
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 inure to investors' benefit. 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.
Liquidity terms that support an opportunistic stance
The private fund structure also provides the patient capital needed for opportunistic trades. If there is a pullback in municipal markets like the 2010 shock from Meredith Whitney's prediction of widespread default or the Fed's "taper tantrum" of 2013, mutual funds will likely be forced by redemptions to their role as net sellers.4, 5
Meanwhile, private funds, with an investor base that is protected from its own worst instincts, will be in a position to step in as a provider of liquidity. In a classic example of being "greedy when others are fearful," these funds can buy- very cheaply- the very assets that mutual funds are selling.
One way mutual fund managers can try to reduce fire-sale risk is to keep cash on hand. However, doing so creates "cash drag" for the portfolio, lowering the return to the investor. This cash drag is particularly costly in the current low interest rate environment.
Tax advantages
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.
Conclusion
With equity markets arguably priced to perfection, investors are seeking sources of capital appreciation and income. Particularly on a taxable equivalent basis for high net worth investors, municipal bonds offer a compelling risk/reward profile. However, the typical avenues of access-buying individual bonds, participating in passive ETFs, and purchasing mutual fund shares or SMAs - are fraught with limitations. By hiring an active manager with deep domain knowledge and longstanding relationships in the municipal securities community, investors may benefit from the fragmentation and retail dominance of the muni market. For qualifying investors who do not need daily liquidity, limited partnerships can be quite compelling. LPs 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.
1 SIFMA, Municipal Bond Credit Report, 4th Quarter 2016.
2 https://www.sec.gov/news/statement/making-municipal-securities-market-moretransparent-liquid-fair.html
3 Bloomberg as of June 28, 2016
4 blogs.wsj.com/moneybeat/2016/11/23/bond-.../
5 fortune.com/2010/12/22/stop-panicking-ov.../
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