Institutional plan investors historically have been uninterested in the U.S. municipal bond market. Unlike mutual funds and certain hedge funds, which seek to benefit from the tax-exempt status of interest income on such securities, pension plans and other tax-exempt institutional asset pools have tended to focus on other fixed-income asset classes within U.S. credit to achieve long-term income and total return objectives.
On the surface, municipal bonds might only appear as an attractive alternative solely as a result of their tax-exempt status. However, on both a tax-adjusted and non-tax-adjusted basis, municipal bonds have remained strong market outperformers over the years.
The question is: Are tax-exempt institutional investors missing out on income and total return opportunities that exist within the $3.6 trillion U.S. municipal bond market? The answer is yes, for three important reasons: performance, diversification and investibility.
Municipal bonds' solid performance in 2015 has continued in 2016. In 2015, the non-tax-adjusted S&P Municipal Bond Total Return index, at 3.3%, outperformed the S&P Treasury index by 2.5 percentage points, the Investment Grade Corporate Bond index by 3.22 percentage points, the High Yield Corporate Bond index by 7.31 percentage points and the S&P 500 by 4.05 percentage points.
Most recently, municipal bonds have outperformed the Barclays U.S. Aggregate Bond index over the one-, three-, five- and seven-year periods by 2.47, 3.69, 13.01 and 12.08 percentage points, respectively.
How can investment executives pass up an asset class with such a stellar performance history; just because they don't need a tax break?
When accounting for the volatility investors have experienced in the past few years, municipal bonds also stand out on a risk-adjusted basis — particularly over longer investment horizons. As Figure 1 shows, investment-grade municipal bonds averaged a total return of 5.1% (which increases to 8.29% on a tax-equivalent basis) over the 10-year period, outperforming almost all other asset classes. From a high-yield perspective, while U.S. high-yield corporate debt has been an adored asset class by institutional managers, high-yield municipal bonds generated competitive returns, with much less volatility, relative to high-yield corporate bonds.
On other measures, such as commonly traded exchange-traded funds, high-yield municipal bonds have outperformed high-yield corporate bonds over the one-, three- and five-year periods by 12.14, 8.35 and 23 percentage points, respectively.
If viewed by municipal bond subsector, performance metrics continue to remain compelling. While risk-adjusted returns vary greatly sector by sector, it is worth noting a recent 10-year sector analysis, which shows relative strength in health care and transportation — with annualized returns of 6.23% and 5.75% on a non-tax-adjusted basis, respectively.
It is often said the U.S. municipal bond market beats to its own drum. Return data show that this is in fact true. Since 2008, investment-grade and high-yield municipal bonds have demonstrated low correlations of total returns to both traditional fixed income (e.g. investment-grade sovereign and corporate debt) and equities, providing ample diversification benefits. The correlation matrix in Figure 2 uses commonly traded ETFs as proxies.
The low correlation of U.S. municipal bonds makes intuitive sense, primarily because the factors affecting municipal borrowers differ from those impacting private corporate borrowers. While macroeconomic factors matter to both, most municipal borrowers offer essential services, or hold monopolistic or oligopolistic positions in the delivery of their services. Income, therefore, is more reliable and less vulnerable to cyclical factors, as well as product or service obsolescence.
In addition, municipal borrowers do not have shareholders — often, their constituents and customers are their largest creditors. To put this in perspective, think about the number of state of California general obligation bonds that are owned by California residents. The interests of municipal bondholders are thus intuitively more aligned with the interests of the municipal borrowers, specifically when compared to private corporate borrowers.
In many cases, municipal borrowers should be viewed like sovereign creditors; who are actually quite similar in size when assessed according to gross domestic product standards, rather than that of private corporate borrowers. For example, if the state of California were its own county, its stand-alone GDP would be the seventh largest in the world, roughly equivalent to France.
U.S. municipal bonds make up a significant portion of the outstanding U.S. fixed-income markets. According to Securities Industry and Financial Markets Association data at year-end 2015, there were more municipal bonds outstanding than federal agency securities, asset-backed securities and money markets. Only U.S. Treasury securities, corporate bonds and mortgage-related securities had a higher amount of debt outstanding.
The U.S. municipal bond market is populated by thousands of issuers. As a result, many investors falsely assume that the high number of municipal bond issues outstanding means they will never trade, but trading data indicate otherwise. While overall fixed-income trading volumes have declined over the past five years, with U.S. Treasury securities and agency MBS dominating activity, municipal bonds still trade more volume on average than other fixed-income asset classes. Such securities include non-agency mortgage-backed securities, ABS and federal agency securities — all of which are standard investment staples for most institutional bond managers.
For context, municipal bond trading has averaged almost $11 billion per day over the past six years, a little less than half the volume of corporate bonds.
The $3.6 trillion U.S. municipal bond market presents both an underinvested and often misunderstood asset class for many institutional tax-exempt asset owners. By overlooking U.S. municipal bonds, such investors continue to miss out on big — and relatively safe — opportunities based on relative performance, diversification and investibility metrics.
Regardless of how pension funds and other long-term investors decide to gain exposure to U.S. municipal bonds (i.e. direct purchases, or allocations to a long/short credit, high-yield credit or other alternative credit strategies), such investors are advised to spend more time evaluating the investment opportunities available from U.S. municipal bonds, as well as understanding the opportunities that exist within various municipal subsectors, and incorporating this asset class into their existing fixed-income and alternative fixed-income strategies.
Alan Hart is managing partner and chief investment officer, and Jeff Hudson and Guy Benstead are partners at Cedar Ridge Partners LLC, Greenwich, Conn.