Institutional investors seeking ways to find yield in fixed income could find it in taxable municipal debt. Whether they're looking for those managers — or can find them — is another matter.
“There is a dearth of managers with strategies dedicated to taxable munis,” said Brett Cornwell, vice president and fixed-income investment consultant at Callan Associates Inc., San Francisco. “We've found many managers willing to offer a customized mandate, but we didn't find anything off the shelf. Every manager we've talked to, their "off the shelf' is basically simulated or carved out.
“There just hasn't been a lot of demand for taxable muni-only strategies, which explains that dearth,” Mr. Cornwell added.
And the debt can be hard to find as well. The amount of taxable municipal debt sold is small relative to the overall demand for fixed-income investments from U.S. pension funds. In 2012, municipal issuers sold almost $378.2 billion in debt, including $32.6 billion of taxable debt, according to Thomson Reuters data. By comparison, the top 200 U.S. defined benefit pension funds held $1.026 trillion in domestic fixed income as of Sept. 30, 2012, according to Pensions & Investments data.
Although some smaller endowments and foundations have invested in taxable municipal bonds, so far this year only one large pension system — the $22 billion Alaska Retirement Management Board, Juneau — has hired managers to run assets in the strategy, according to P&I and other sources. The board in April hired Western Asset Management Co. and Guggenheim Partners LLC to run about $100 million each, said Gary Bader, chief investment officer.
The investments were the pension fund's first in taxable municipal debt. Funding came from the board's 24% fixed-income allocation; no managers were terminated, Mr. Bader said.
“We have not seen a lot of dedicated mandates (in taxable municipal bonds) — in fact, we've only seen one,” said Callan's Mr. Cornwell. “It's such a small part of the market relatively speaking that we just have not seen a lot of demand.”
But Alaska's move could start a trend, as pension funds and tax-exempt institutional investors seek ways to grind out yield in a tough bond environment and find they can take advantage of the higher yield of taxable municipal debt, which also offers less correlation to corporate or other government debt.
“Correlation of taxable munis to the overall bond market as measured by the ( Barclays Capital U.S. Aggregate Bond) index is modest, and the correlation is even lower to U.S. government bonds at 0.5,” said Ted Disabato, managing director of Disabato Advisers LLC, Chicago, “and taxable municipals have been a better diversifier of risk than the aggregate bond market.”
Taxable municipal bonds had about a 0.6 monthly correlation to the BarCap Aggregate for the five years ended June 30 and about a 0.5 correlation to U.S. government and Treasury bonds. They also they have zero correlation to the S&P 500 vs. the BarCap Aggregate's correlation of 0.1.
Taxable munis offer investors a chance to pick up yield. As of June 30, according to Thomson Reuters Municipal Market Data, the 10-year MMD AAA benchmark yield for tax-exempt municipal bonds was 2.56% while taxable munis were yielding 72 basis points more at 3.28% for 10-years. Also, during the decline in municipal bond yield in May and June, taxable munis held their own. Yields on MMD AAA 10-year taxable benchmark were 2.29% as of May 1 and reached a year-to-date high of 3.29% on June 25 before ending June at 3.28%. In comparison, yields on the 10-year MMD AAA tax-exempt benchmark were 1.66% on May 1, 2.81% on June 25 and 2.56% at the end of June.
Some taxable munis “have terrific yields” compared with tax-free munis or occasionally even corporate bonds, said Kristin Fafard, president and CIO at Federal Street Advisors Inc., a Boston-based investment consultant with $800 million under advisement for foundations. “Taxable municipal bonds can be looked at like corporate bonds; they need to be researched just like you would with a corporate bond, and can be additive by providing improved yield and diversification.”
Although taxable municipal bonds have been around for decades, said Ms. Fafard, “just like any other investment, you can allocate to them in a dedicated way or opportunistically when they're priced right relative to other fixed-income investments.”
The increased yield potential was the motivation for Alaska's search. Mr. Bader said Alaska Retirement wanted to get additional exposure outside the BarCap Aggregate. “It's not as exotic as infrastructure; we look at it as part of our overall fixed-income portfolio.”
Although larger pension funds and others haven't been flocking to taxable munis, institutional investment consultants are interested, said Peter Coffin, president of Breckinridge Capital Advisors Inc., Boston, which managed $18 billion in assets as of June 26, including $434 million in taxable muni bonds, for institutional and retail clients. He said that during the past year, 14 small endowments and foundations hired his firm to manage a total of $107 million in taxable muni bonds; some of the new clients include the $173 million Blue Moon Fund, Charlottesville, Va., and the $69 million U.S. Green Building Council, Washington.
“We're reaching out to consultants, and a number of them have been very receptive,” said Mr. Coffin. “In the aftermath of the (2008-2009) financial crisis, consultants are wary of too much corporate bond exposure. Many of the corporations issuing many of those bonds are the same corporations that equity investors now hold stocks in. When the markets unraveled (in 2008-2009), there was a higher correlation between corporate bonds and equity investments than consultants expected. Taxable municipal bonds can reduce the corporate bond allocation with less correlation.”
"Getting more comfortable'
Ms. Fafard agreed that taxable munis allow investors to diversify a fixed-income portfolio away from the commonly used sectors within the BarCap Aggregate index.
“It wasn't thought about too much before (the recent low yields in fixed income), but investors are getting more comfortable with them as they look for ways to diversify and get better protection from the negative impacts of rising interest rates,” she said. “The amount of Treasuries, U.S. government securities, in the Barclays Aggregate has seen significant growth in the past five years, increasing the vulnerability of the index to rising rates. So how do you outperform the index? You need to think outside the Barclays Aggregate, and this is one way to do it.”
Capacity is a concern
One concern among pension funds, especially large ones, is capacity. Taxable muni bond issues totaled $21 billion in the first five months of 2013, vs. $148 billion for the overall municipal bond market during the same period.
“Among large pension funds, consultants are hesitant because they're not sure if the (taxable muni) market is big enough,” said Mr. Coffin.
But, said Mr. Coffin, “the percentage of market supply that's taxable bonds has been getting bigger lately, partly because while taxable muni yields are slightly higher that tax-free yields, the borrowing cost with taxable bonds has still been quite low in absolute terms and thus, issuers are more inclined to opt for taxable bonds to avoid the legal hurdles of issuing tax-frees.”
There could also be an increased capacity in the taxable muni bond markets because “today, the savings (for issuers) from going tax-free aren't as great today as before the financial crisis. The savings aren't as compelling for issuers.”
This article originally appeared in the July 8, 2013 print issue as, "Hunt for yield might lead pension funds to taxable muni debt".