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Traditional municipal market indices often omit entire sectors of higher yielding municipal bonds.
We recently asked financial advisors about their challenges with municipal bond investing. Their top concern? Finding the right amount of yield to align with their clients’ goals.
Finding yield is particularly challenging for those who rely on passive products that track traditional benchmarks. The reason? Traditional municipal bond indices can be flawed; they’re weighted by debt and exclude viable investment opportunities at the expense of yield. But these flaws can actually present opportunities for investors who choose to take a more strategic approach.
Problem: Traditional indices exclude enhanced investment opportunities in the revenue bond sector
Municipal bonds fall into two primary categories: general obligation (GO) bonds and revenue bonds. GO bonds are backed by the full faith and credit of the issuing municipality and reflect a commitment to use all available funds to repay the debt, including the ability to raise taxes.
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Revenue bonds are secured by the revenue stream generated from the specific income-producing project that’s being financed. Sometimes, in transactions known as conduit financing, municipalities issue revenue bonds on behalf of private entities that subsequently assume full responsibility for debt repayment. Conduit bonds can be issued by hospitals or health systems, private colleges or universities, or other charitable organizations. Without direct government ties, these bonds may be perceived as carrying greater risk. And this could explain why many traditional indices have significant exclusion rules that primarily target revenue bond sectors.
For example, the S&P National AMT-Free Municipal Bond Index specifically excludes conduit issuers, and the Bloomberg Barclays Municipal Managed Money Index excludes hospitals and housing bonds. These exclusions concentrate exposure in the few remaining sectors that are more explicitly tied to governmental activities: tax-backed, water and sewer, public education and transportation. This approach forfeits access to a broad swath of market opportunity and results in an over-representation of lower yielding general obligation debt.
Potential opportunity: Revenue bond sectors offer higher yields
In the last decade, several high-profile municipal downfalls, driven by long-term budget mismanagement, have challenged the sanctity of the GO pledge. More importantly, bond investors have found themselves at the mercy of not only a municipality’s ability to pay, but of their willingness to do so. Detroit and Stockton, for example, emerged from bankruptcy by making cuts to bondholders while largely preserving pensions for retirees. These examples and other recent experiences suggest that GO debt, often valued for its perceived safety and security, is not immune to impairment.
Despite this, GOs experience persistent demand that drives yields lower than many similarly rated alternatives. Representing nearly 70% of the market, revenue bonds lack the taxing authority of state and local governments and often trade at a discount to their GO counterparts. This represents ample opportunity for investors to pick up incremental income and potentially improve risk-adjusted returns — particularly in housing and hospitals, two sectors often excluded from prevailing indices.
Not all segments of the municipal market offer the same income opportunities. Investing across sectors
can increase yield potential.