Passively managed vehicles continue to grow in popularity. But when it comes to the municipal bond market, there are multiple challenges with traditional benchmarks. We believe investors should consider a more strategic approach to the intricacies of the muni bond market.
Indices exist in large part to measure the value of a given market. While stock market indices offer widely accepted benchmarks, the municipal bond market is difficult to define and track broadly.
- The municipal bond market is composed of $3.9 trillion in market value, which is spread across over 80,000 issuers and roughly one million individual bonds.1
- Any one issuer can have scores of individual bonds outstanding, each providing varying security pledges, maturities, coupons and call structures.
- The high degree of fragmentation makes it nearly impossible for index providers to replicate the full market opportunity. In fact, no publicly available municipal index represents more than 20% of the total investable universe. 2
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Problem: Traditional indices are debt-weighted
Like their equity counterparts, most municipal bond indices are market-capitalization-weighted. From an equity perspective, this approach makes logical sense — size born from historical success can arguably be associated with value. However, the same does not apply to fixed-income, where the largest index exposures simply represent the most prevalent issuers — not the most profitable investment opportunities. The largest entities have the greatest representation in traditional municipal market indices regardless of their investment merits, which ultimately reduces income and total return potential.
Opportunity: Returns come from multiple sources
The municipal market’s best sources of income and return are not necessarily driven by those entities with the highest propensity to issue debt. Instead, tax-exempt income and total return can be extracted from two primary risk factors: duration and credit — uncorrelated and capable of performing well in different stages of economic cycle.
By allocating across the maturity and quality spectrums, investors may broaden their opportunity set and introduce more chances for positive outcomes. On one hand, a basket of shorter duration, high-quality municipal securities can serve as a ballast during periods of heightened volatility. On the other, longer and lower quality bonds may offer a significant yield advantage that bolsters total return potential. Blending these exposures with a core allocation to bonds of intermediate maturity and quality may smooth the ride for investors as each component behaves differently across market environments.
Bottom line
Rather than simply accepting an imperfect benchmark portfolio, municipal bond investors should consider a strategic approach — informed by insights — to manage the complexities of the market.
1. Source: Wall Street Journal, Muni Bonds May Not Be the Reliable Bet They Once Were, January 7, 2018.
2. Source: Bloomberg, as of 05/08/18. It is not possible to invest in an index.
Securities products offered through Columbia Management Investment Distributors, Inc., member FINRA. Advisory services provided by Columbia Management Investment Advisers, LLC.
Columbia Threadneedle Investments (Columbia Threadneedle) is the global brand name of the Columbia and Threadneedle group of companies.
The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that any forecasts are accurate.
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