The Muni Opinion Fixed income

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1 Strategy insights June 2016 The Muni Opinion Fixed income How getting active can potentially help your municipal bond returns Overview There s no doubt that physical activity usually improves a person s health. Can activity trading activity improve a municipal bond investor s return? In other words, what is the value of active management in municipal investing? Individuals can choose from a variety of investment vehicles when buying municipal bonds. They can buy bonds directly, usually constructing a laddered portfolio. They can buy shares of an open or closed end mutual fund or an ETF. And they can hold a separately managed account (SMA) individual bonds purchased by a manager who makes pooled investments for many similar investors. Open end funds are typically the most actively managed of the five choices. It s important to acknowledge that there are good reasons for using more passive investing. Laddered bond holdings provide cash flow from periodically maturing bonds. ETFs provide ongoing liquidity at current prices, often lower management fees, and they can minimize recognized capital gains and thus capital gains taxes. SMAs can offer relatively low fees and ownership of specific bonds. These investment vehicles can be compelling options for some investors, but open-end mutual funds can offer important benefits as well. Why pursue a more active strategy? First, we ll make sure to establish the investment goals we re addressing. Then we ll analyze some unique features of the municipal bond market that result in portfolios having a high degree of active share. Then we ll describe typical muni bond portfolio investment strategies executed by active managers and how these strategies can add to a portfolio s performance. Contributors Philip G. Condon, vice chairman, Deutsche AM Ashton P. Goodfield, CFA, co-head of Deutsche AM s Municipal Bond Department Carol L. Flynn, CFA, co-head of Deutsche AM s Municipal Bond Department Robert J. Fogarty, CFA, investment specialist, Deutsche AM

2 The Muni Opinion Summer 2016 Figure 1: Top active municipal managers have outperformed the benchmark over the past 10 years (annualized returns) (4/30/2006 4/30/2016) 6% 5% 4% 3% % 1% 0% Morningstar Muni National Long top quartile funds Barclays Municipal Bond Index Source: Morningstar as of 4/30/16. See last page for definitions. Past performance is historical and there is no guarantee of future results. It is not possible to invest directly in an index. Investment goals Income vs. Total return Maximizing total return income plus price changes should be a fixed income investor s goal. Granted, municipal bond investors typically want to maximize interest free of federal income taxes. But at Deutsche Asset Management, we seek to maximize both components of total return. Focusing only on income may cost you. Many investors who hold their own bonds say they don t care about interim price changes. Typical comments include, As long as the bonds don t default, I don t care about price changes. I m definitely holding my bonds until they mature, when I ll get par. What could go wrong? While it s unusual in the investment grade municipal market, your bonds could default, reducing your interest payments and the amount you receive at maturity. Your bonds could be called away from you at par before you expect, and you ll need to re-invest likely at lower interest rates. What s more common is that portfolios suffer from lack of attention and added capital, so the ladder gets shorter and less effective as a balance to your overall portfolio. Also, life happens. You may actually need to raise capital and sell a bond or two. You don t want to be forced to do this when the value of your bond is down more than others in the market due to lack of demand because of credit or structural characteristics. To further analyze income vs. total return, consider the comparison of two 30 year bonds one rated AAA at 2.50% and one rated BBB at 3.25%. The BBB bond gives 70 basis points (bps) more yield, or income, per year (Yes, today s credit spreads are tight!) The default probability of that BBB bond is higher (for example, according to Moody s Investors Service, a BBB-rated muni has a 0.38% default rate compared to 0.00% for a AAA-rated bond), but perhaps more importantly, the price volatility of the BBB bond probably will be much higher as these bonds are generally more sensitive to adverse events and liquidity ebbs and flows. We have to consider risks other than just default risk, which is rare in the municipal bond market. More prevalent risks are spread risk (the risk that the bond market perceives risk associated with the credit and the price declines, causing the credit spread to widen) and downgrade risk (the risk that a bond has its credit rating downgraded by a ratings agency and the price potentially declines, causing the credit spread to widen). These risks can be avoided with prudent monitoring and surveillance of existing bond holdings and an active approach rather than a buy and hold strategy. The same comparison can be made with bonds of different maturities and durations. A 10-year AA bond pays 1.86% in yield/income. A five-year AA bond pays 1.21%, according to Thompson-Reuters, as of May 31, The 10-year bond gives you 65 bps more in income, but the duration is nearly twice as long. (8.71 years vs years) Which is better? There s no easy answer. It depends on your expected holding time. It depends on how five-year bond yields change compared to 10-year bond yields over time. They don t always move in a parallel shift. Active share in the municipal bond market A relatively new and intuitive measure of active management is known as active share. Active share measures the difference How getting active can help your municipal bond returns 2

3 The Muni Opinion Summer 2016 between the holdings of a portfolio versus the holdings of a benchmark. An S&P 500 Index Fund such as SPY has very low active share (0.73% as of 4/30/16) because it can hold each of the 500 stocks at the approximate weights in the index. Because of the broad depth of the municipal bond market, it s virtually impossible to replicate a general muni index such as the Barclays Municipal Bond Index, which contains over 48,800 issues (as of 4/30/16). A portfolio can mimic the index in terms of duration, sector distribution, and general maturity distribution, but it would not be able to own every issuer name and the exact call and coupon structure of each security. Even a passively managed municipal ETF or index fund will own different securities than the index it manages against. We believe the differentiation in the municipal market presents opportunities to provide better risk-adjusted returns relative to the benchmark using high active share and employing a variety of portfolio management strategies. The many faces of active management Many readers may assume that bond trading is usually for the purpose of duration management. In other words, they may anticipate our discussion here to focus on trades that increase or decrease duration depending on the portfolio manager s interest rate outlook. A portfolio should have an appropriate duration that reflects the investors general risk tolerance. There are a number of ways other than duration management to add alpha (or the risk-adjusted active return) in fixed income portfolios, particularly in municipal bond portfolios. Trading, credit research and portfolio structuring strategies can all be used towards the goal of maximizing total return. Rather than changing duration solely based on an interest rate call, an important role of trading is to maintain a targeted duration. If a portfolio s holdings mature or get called away, and if cash is held rather than invested, then the portfolio duration gets shorter with the passage of time. It can be preferable to sell a bond before it is redeemed and reinvest the proceeds in order to take advantage of a better rate environment or supply availability rather than waiting until the bond is called or matures. The fragmentation of the municipal bond market, with over 50,000 issuers and over 1.5 million CUSIPs, presents trading opportunities due to a large amount of differentiation with regard to credit, bond structure (coupon, call, maturity) and other features. Good trade execution can potentially add to returns. There is significantly more credit differentiation today than before 2008, since significantly fewer bonds are insured and rated AAA. (see Figure 2) Rather than merely using an issuer name found in an index, it s important for an investor to conduct credit analysis before he/she purchases a bond and then to conduct regular surveillance thereafter. Even though rated municipals have an exceptionally low default rate, there are occasional problems, with places experiencing major difficulties such as those endured by bondholders of Jefferson County Water and Sewer, Detroit and Puerto Rico. A credit analysis is a key component in the value assessment. Do you want to pay a Mercedes price for a Smart car? If a credit deteriorates after you buy it, and the AA rating you had is now an A and headed lower, shouldn t you sell it? Confidence in one s credit analysis also can help investors to exploit opportunities. For example, prior to the passage of Proposition 30 (sales and income tax to fund schools and public safety realignment) in 2012, many investors refused to buy any bond from the state of California. While there were budget problems at the state level, there were a number under the opinion that there were many solid credits, such as revenue bonds, that were priced cheaply due to the state s tainted reputation. Figure 2: AAA-rated bonds by S&P have declined from 68% of issuance in 2006 to 21% in 2015 while insurance has fallen from 49% of issuance in 2006 to just 6% in % 70% 60% 50% 40% 30% AAA-rated 68 Bond insurance (% of par value annual supply) % % 10% % 0% 0% Source: Standard and Poor s as of 12/31/2015. Past performance is historical and there is no guarantee of future results. It is not possible to invest directly in an index. 80% 70% 60% 50% 40% 30% How getting active can help your municipal bond returns 3

4 The Muni Opinion Summer 2016 Figure 3: Yield spreads between 5yr AAA and 30yr AAA bonds have created opportunities for active municipal bond portfolio managers Yield spread between 30 yr AAA and 5 yr AAA in (bps) Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14 Mar-16 Source: Thomson Reuters Municipal Market Data (MMD) as of 3/31/2016. Past performance is historical and there is no guarantee of future results. It is not possible to invest directly in an index. Date Yield curve strategy is another factor that may add to returns. A portfolio may earn more income and price appreciation by owning a combination of long and short maturity bonds (a barbell strategy) rather than a ladder strategy or bonds maturing around the same time bullet strategy. Yield curve shifts over time can warrant changes in a portfolio s curve distribution, as illustrated in Figure 3. While bond investors rarely like to see market interest rates increase on the bonds they hold, a rising rate environment provides opportunity for tax loss harvesting. Swapping a bond with a loss for another similar bond can accomplish two things: a recognized loss can offset recognized gains or be carried forward to offset losses in future years. Also, since rates have increased in this scenario, the replacement bond will possibly be at a higher yield, potentially providing higher income. The coupon and call structure of bonds held in a portfolio can have an impact on income, total return during different market environments, and liquidity. Rather than randomly buying any coupon and call structure, a portfolio manager can make conscious choices in an effort to maximize income and total return. In the municipal market, we ve observed that optionality isn t priced as efficiently as in other markets. In other words, call protection is sometimes cheaper than a model would lead you to expect. Changing rate environments can influence how different coupons and call structures are priced, and portfolio managers may want to trade in order to better position their portfolio for expected market scenarios. Relative value trades can also present themselves. For example, if a trader sees an inquiry for a bond in a specific state due to the state tax exemption, and that trader is indifferent as to the state from which the bond is issued, he/she may be able to execute a relative value swap and get paid extra for the bond. The very aspects of municipal bonds that make them conducive to alpha generation through active management can sometimes increase trading costs if not managed strategically. Municipal bond positions often have wider bid/ ask spreads than more liquid markets such as Treasuries or investment grade corporate bonds. But trading in block sizes of $1 million or more, as open end fund managers typically do, reduces this spread significantly. Levels of liquidity in the municipal bond market can change depending on market sentiment. Also, if many bonds in the portfolio have experienced price gains since purchase, which is what we re aiming for, then trading indiscriminately can increase recognized capital gains. If a bond purchased in a higher rate environment is swapped for a bond in a lower rate environment, then a capital gain will be incurred, and the new yield will be lower than previously. Again, tax loss swapping can help offset this. Active investing may be healthy for your portfolio Overall, these active strategies can potentially allow portfolio managers to maximize income, enhance total return and minimize recognized capital gains. Security analysis, a keen knowledge of trading values and an ability to execute trades to maximize value can add to total return. It s important to note that a high degree of turnover isn t necessary. Total return can be enhanced using far less than 100% turnover. For at least part of an individual s municipal bond portfolio, we encourage an actively managed vehicle such as an openend mutual fund. The ability for active managers to add value in a shifting fixed income environment should not be overlooked. While other investment vehicles can also add value, active management in municipal bond investing could be healthy for your portfolio and should be considered a core municipal bond strategy. How getting active can help your municipal bond returns 4

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6 Definitions Alpha refers to returns in excess of a benchmark s return. Basis point (bps) One basis point equals 1/100 of a percentage point. The Barclays Municipal Bond Index tracks the performance of investment-grade, fixed-rate municipal bonds with maturities greater than two years. Morningstar Municipal National Long-Term Category consists of national funds with an average duration of more than seven years, or average maturity of more than 12 years. Credit quality measures a bond issuer s ability to repay interest and principal in a timely manner. Rating agencies assign letter designations such as AAA, AA and so forth. The lower the rating, the higher the probability of default. Credit quality does not remove market risk and is subject to change. Credit risk refers to the risk that a borrower will default on any type of debt by failing to make payments which it is obligated to do. Duration, which is expressed in years, measures the sensitivity of the price of a bond or bond fund to a change in interest rates. CUSIP stands for Committee on Uniform Securities Identificaiton Procedures. A CUSIP number identifies most financial instruments including stocks of all registered U.S. and Canadian companies, commercial paper, as well as U.S. Government and municipal bonds. Moody s Investor Service is a firm that provides credit ratings and other financial research and analysis. For its credit ratings, Moody s uses the following nine symbols to designate least to greatest credit risk: Aaa Aa A Baa Ba B Caa Ca C. Barbell strategies involve investing half a portfolio in long-term bonds and the other half in short-term bonds. Bullet strategies involve purchasing bonds with similar maturity dates. An exchange-traded fund (ETF) is a security that tracks an index or asset like an index fund, but trades like a stock on an exchange. Ladder strategies involve investing in a portfolio of bonds in which each has a significantly different maturity date. The SPDR S&P 500 (SPY) is an ETF Trust seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the S&P 500 Index. ALPS Distributors, Inc., a registered broker-dealer, is distributor for SPDR S&P 500. The S&P 500 Index tracks the performance of 500 leading U.S. stocks and is widely considered representative of the U.S. equity market. The yield curve is a graphical representation of how yields on bonds of different maturities compare. Normally, yield curves slant up, as bonds with longer maturities typically offer higher yields than short-term bonds. Yield ratio is a comparison of the expected yield of one bond to the expected yield of another. Yield-to-maturity is the rate of return anticipated on a bond if it is held until maturity. Yield-to-worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting. The opinions and forecasts expressed herein do not necessarily reflect those of Deutsche Asset Management, are as of June 2016 and may not come to pass. Important risk information Bond investments are subject to interest-rate and credit risks. When interest rates rise, bond prices generally fall. Credit risk refers to the ability of an issuer to make timely payments of principal and interest. Investments in lower-quality and non-rated securities present greater risk of loss than investments in higher-quality securities. Inverse floaters are derivatives that involve leverage and could magnify gains or losses on tax-free investments. Investments that generate federally tax-free income may have a portion of their distributions subject to federal, state and local taxes, including the alternative minimum tax. Investment products: No bank guarantee Not FDIC insured May lose value Investment products offered through Deutsche AM Distributors, Inc. Advisory services offered through Deutsche Investment Management Americas, Inc. Deutsche Asset Management represents the asset management activities conducted by Deutsche Bank AG or any of its subsidiaries. Deutsche AM Distributors, Inc. 222 South Riverside Plaza Chicago, IL [email protected] Tel (800) Deutsche Bank AG. All rights reserved. PM (6/16) R (6/16) MUNI-OPIN-JUN RETAIL-PUBLIC