Munis: A New Flexible Mandate

Five years after taxable non-traditional-bond strategies started gaining traction, funds with more-flexible mandates have begun making their way into the municipal market. At least half a dozen muni-bond funds, including offerings from BlackRock, Nuveen, and Goldman Sachs, have been launched or retooled to give their managers more flexibility to manage duration and/or buy below-investment-grade fare. The change comes in response to investors’ concern over the prospect of rising interest rates, an evolving muni market landscape that provides more opportunity for credit managers to distinguish themselves, and the asset-gathering success of their taxable nontraditional brethren. While these funds promise a lot, investors should be aware of their potential pitfalls.

BlackRock Strategic Municipal Opportunities is off to a good start in its new guise, and its success at garnering inflows suggests that other fund companies might soon follow. However, unconstrained investing comes with its own set of risks, and the muni universe poses particular challenges for this style. We’ve written before about the risks in the non-traditional-bond Morningstar Category, including the difficulty of competently making big macroeconomic shifts in a portfolio and the tendency for many of these funds to trade interest-rate risk for credit risk. In addition, muni funds face unique hurdles that could make implementing this type of strategy even more difficult. For starters, municipal funds fish out of a much smaller pond. Their taxable counterparts work from a far broader universe and can range globally across investment-grade and high-yield corporate debt, developed- and emerging-markets sovereigns, and even municipal bonds.

Taxable funds also have a broader pick of tools at their disposal to make big changes to credit and interest-rate exposure quickly and cheaply. For example, for muni managers, nimbly moving in and out of the high-yield space can be challenging. That's partly because the municipal market is much less transparent and liquid than the taxable corporate-bond market. The combination of thousands of unique debt obligors, ambiguous legal pledges to repay debt, and the lack of timely and consistent disclosure on the part of municipal borrowers can make it difficult to find the right high-yield investment for a portfolio. Also, below-investment-grade muni credits represent just a small portion of the overall municipal market, in contrast to the hefty and expanding taxable high-yield market, and they can trade infrequently. Meanwhile, the market for credit-default swaps, and credit-default baskets that can be used to take broad-based exposure to credit risk, isn't as deep or as liquid in the muni markets as it is in the taxable markets.

Making swift and significant adjustments to duration in a muni fund can also be challenging. Taxable managers can adjust a fund’s sensitivity to changes in Treasury yields quickly and cheaply through the use of Treasury futures, a large and liquid market. However, the further away you move from the Treasury market, the bigger the challenges in using this tool to effectively manage duration. For muni managers, there isn’t any tool that specifically tracks the muni yield curve. Instead, these managers can either change the mix of long- and short-maturity bonds that they hold or they can use Treasury futures to adjust duration. Trading securities to adjust interest-rate sensitivity can be expensive, especially if a manager is making frequent or significant changes to a fund’s interest-rate positioning. Meanwhile, using Treasury futures can cause problems because muni and Treasury yields don’t always move in tandem, which is known as "basis risk." When that correlation breaks down, as it has from time to time, a muni portfolio hedged with Treasuries can behave in unexpected ways. Indeed, this caused headaches for many muni managers in 2008.

What does this mean for investors? For now, it’s probably best to approach these funds with caution. Nontraditional strategies, even in the taxable-bond-fund space, have limited track records. This, together with their broad flexibility, makes it difficult to know how they’ll perform in a bout of real market stress and therefore how to best use them in the context of a broader portfolio. Instead, investors are left with the promise of flexibility and protection from falling rates, which is a tall order to fill.