Municipals
Munique:TheInefficienciesDrivingMuniAlphaOpportunities
5 mins
While potential changes to Federal income tax rates often prompt investors to review their municipal bond allocations, they have additional incentive to do so this year with yields hovering near generational highs. As investors assess their muni holdings, a passive approach may be a consideration. However, those taking a passive approach are foregoing the opportunity to capitalize on the market’s myriad of inefficiencies, the most evident of which is index biasing.
By broadening an investment strategy beyond minimizing the tracking error of the index, a strategy that many passive muni funds pursue, active managers have more flexibility to invest across a wider swath of the market. This way, they can construct portfolios that outperform their respective benchmarks, adding alpha to an already attractive tax-equivalent yield.
Index biasing in the municipal bond market is prominent and straightforward. The Bloomberg Municipal Bond Index is a value-weighted index comprised of the largest issuers, which also happen to reside in the most populous states. For example, issuers in California and in New York each account for nearly 17% of the index.
To mimic the index (or minimize “tracking error”), large passive ETFs frequently steer capital toward the largest issuers. This means that an index-tracking muni fund is likely heavily concentrated in issuers in California and in New York and perhaps underinvested in other issuers that present more attractive relative-value opportunities.
A view of the index composition of the index below drives this point home. After California and New York, Texas is a distant third in terms of index weighting. After that, the percentages decline even more dramatically (Fig 1).
Figure 1
Composition of the Municipal Bond Index (%)
Barclays, Bloomberg Municipal Bond Index. As of April 10, 2024.
The Tax Disparity
While all U.S. residents are subject to the same Federal income tax brackets, investors who purchase municipal debt issued by the state or city in which they reside can also receive a state or city tax exemption. State income tax rates vary from state to state, and this can have a dramatic impact on the in-state demand level for municipal bonds. For example, California’s highest marginal tax rate is 14.4% and New York’s is 10.9%—when Federal and local taxes are considered, total personal income tax rates can exceed 50%. Other states, such as Florida and Wyoming, have no income tax at all (Fig 2).
Figure 2
Top Marginal Individual Tax Rates by State (%)
Tax Foundation. As of February 20, 2024.
Therefore, wealthy California residents are more likely to buy municipal bonds from California issuers than those from Florida. This enhanced demand for California municipal bonds can drive their yields down further, making them less attractive for residents of other states and, at times, overly expensive on an after-tax basis.
This demand dynamic can be seen in the chart below. Of the ten states with the highest individual tax rates, nine fall in the lower half in terms of yields (Fig 3).
Figure 3
States with Top Tax Rates Typically Offer Lower Yields (%)
Barclays, Bloomberg Municipal Bond Index. As of March 31, 2024.
Therefore, when considering the drivers of demand, an effective strategy for a municipal investor would entail constructing a portfolio that underweights states with the largest index weightings and higher individual tax rates, while overweighting states with lower individual tax rates. Notably, this is exactly the type of strategy unavailable to large passive ETFs, which seek to mimic both the returns and the composition of the index, as the 10 states with the highest individual tax rates currently comprise 45% of the municipal bond index (Fig 4).
Figure 4
States with Highest Tax Rates Comprise Nearly Half of Muni Index
Barclays, Bloomberg Municipal Bond Index. As of April 10, 2024.
A Fragmented Market
While index biasing is perhaps the most straight forward inefficiency, market fragmentation, the large diversity of issuers, and the predominance of retail investors also often lead to mispricings or market illiquidity.
The $4 trillion municipal bond market currently includes approximately 30,000 different issuers and over 900,000 individual securities.1 By comparison, the $11 trillion corporate market consists of approximately 9,000 different issuers and approximately 100,000 unique securities (Fig 5).
Figure 5
The Muni Market is Highly Fragmented
Bloomberg, SIFMA, Moody’s Investors Service. As of March 23, 2024.* Based on a 37% Federal Income tax rate.
In addition to immense size and scale, there’s a lack of standardized disclosure among municipal borrowers and many lack dedicated investor relations departments. These dynamics make it nearly impossible for retail investors to follow every credit and price every bond in the municipal bond market, making it far less efficient than the corporate bond market, where financial information gets digested quickly and pricing is readily available. This lack of transparency highlights the benefits that an active manager with size, scale, and credit expertise can bring to a market where bonds with strong credit profiles are sometimes overlooked and mispricings often exist.
A Retail-Dominated Asset Class
A third inefficiency is the embedded volatility that stems from the dominance of retail investors, which hold over two-thirds of all municipal bonds through mutual funds, separately managed accounts, or direct ownership (Fig 6).
Figure 6
Retail Investors Account for Two-Thirds of Muni Holdings
SIFMA as of March 20, 2024.
This creates a market that is more susceptible to retail sentiment, and thus more volatile and vulnerable to market dislocations than some of the more institutionally controlled segments of fixed income.
Increasing the importance of retail investors, banks and insurance companies began reducing their municipal holdings after the Tax Cuts and Jobs Act of 2017 reduced need for the municipal bond tax shelter. Higher retail ownership, along with smaller dealer balance sheets and the growing presence of exchange traded funds (ETFs), has resulted in a more volatile market, which active managers are typically more adept at navigating—especially when rapidly changing prices are a result of changing tax policies.
A passive approach to municipal investing may result in foregoing alpha that could be generated by active management. The market inefficiencies specific to the municipal market make it an especially fertile ground for active managers. While large passive funds typically steer capital toward the biggest issuers in the market, these are often the issuers with the lowest yields and potentially least attractive relative value. With the flexibility to move beyond the benchmark, an active muni manager can remain opportunistic, tapping into potential mispricings and exploiting relative value opportunities to generate returns over and above an attractive tax-equivalent yield.
1 Bloomberg
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