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The case to zig – not zag – with bond diversification
(pictured: Cynthia Clemson)
By Greg Bright
J.K. Galbraith, the radical Canadian-American economist, called it “private affluence amid public squalor”. What he was referring to, in the 1960s, was the long slow decline of much of his adopted country’s infrastructure. Since the GFC, however, things are improving, thanks in part to the evolution of the municipal bond market.
Taxable municipal bonds have become the best-performing sector of mainstream fixed income over the past five years.
At an investor roundtable in Sydney last week, Cynthia Clemson, Eaton Vance Management co-director of municipal income, discussed the relative merits of the market with several asset owners and asset consultants.
For various reasons, Clemson said, the US had been reluctant to fund infrastructure development and maintenance for a long time. One reason, perhaps, was that politicians received more accolades from building a bridge than repairing it. In a recent study only two countries rated well for infrastructure development – Japan and Australia.
But state and municipal governments pay for about 75 per cent of all infrastructure spending in the US and since the GFC there have been some interesting structural changes to their bond issuances.
Historically, Clemson says, the bigger part of the market, which is non-taxable and predominantly for US retail investors, was dominant. However, after the American Recovery and Investment Act and the passage of the Build America Bond program the taxable part of the market, increasingly popular with non-US institutional investors, started to take off.
Today, taxable municipal bonds make up about US$500 billion of the total US$3.7 trillion. Japanese and European investors, having low yields or even negative interest rates, have been big buyers. Of the approximately 60,000 bonds on issue, 13,000 are taxable.
The five-year total return of the Barclays taxable muni bond index was 8.53 per cent in the period to January 2016. This compares with 3.78 per cent for US Treasuries, 5.17 per cent for US corporate investment grade, 4.93 per cent for corporate high yield and 6.08 per cent for the JP Morgan emerging markets ‘plus’ index for the same period.
Clemson said that the fragmentation in the market which followed the withdrawl of some big bank-owned insurers, means that it is a “characteristics” market, most suited to active management because of the rewards to good research. The top 100-or-so issuances are very liquid, she said, and well known. “We deal with about 125 broker dealers.” Eaton Vance is one of the biggest managers in the market, accounting for about US$30 billion. It has 15 analysts, three portfolio managers and four traders, mainly in Boston.
“It’s a big market,” Clemson said. Furthermore, the total return and risk profile of muni bonds adds well to a fixed income portfolio’s diversification, with a low correlation with corporates.
“We think about munis as an attractive alternative to corporate high-grades,” she said. “It’s an interesting and growing market.”
Of course it is not without risks. Last week’s news of the looming default of Puerto Rico’s municipal bonds, which are in the index, and the recent troubles of Detroit, highlighted this.
Clemson said Puerto Rico was a tiny part of the index, as was Detroit. Most professional investors, too, knew the troubles Detroit had had for many years. “That problem was 20 years in the making,” she said.
Eaton Vance actually made money from Detroit’s troubles, buying the bonds for 89c in the dollar, after others had taken “a hair cut”, and selling above par.
Since 1986 there have been 81 defaults in muni bonds, Clemson said, compared with 1387 in the corporate market. “Most issuers are well behaved and manage their finances well.”
Currently the manager is also watching New Jersey very closely because its taxes were already high, Clemson said. Illinois is also out of favour with investors but it has more room to move on its taxes. In the past four years there has been a net negative issuance in the muni market as issuers are getting their balance sheets in order.
According to John Wilson, the head of the investment committee for the A$9.5 billion LGIAsuper and a former chief executive of PIMCO Australia, shifting people’s opinions on investments, such as to include new asset classes, is very difficult. “The status quo is a comfortable position,” he said. “But if you are happy to be a holder, the credit’s good and revenue bonds have predictable cashflows… most are long-dated, it’s the holy grail. It takes a great deal of gumption to get an investment committee to zig when everyone else is zagging,” he said. “But I’d encourage it.”
[There are three types of taxable muni bonds: general obligation bonds backed by the ‘full faith and credit’ of the issuer; revenue bonds, backed by the revenue from a specific project rather than ad valorem taxes; and dedicated tax bonds, backed by specific taxes.]
Another super fund CIO suggested that muni bonds could be a “lever” in a more diversified portfolio but you needed specialist skills to get someone else to use the lever.
“You are changing the risk profile by moving from traditional sovereigns to something with credit in it and the challenge is finding the returns without doing much with the risk.”
