White paper: What you don’t know about municipal bond benchmarks can hurt your investments

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The municipal bond market is difficult to define and track broadly — and passive investors could be missing out.

 

 

Passively managed vehicles continue to grow in popularity. But when it comes to the municipal bond market, there are multiple challenges with traditional benchmarks. We believe investors should consider a more strategic approach to the intricacies of the muni bond market.

 

Indices exist in large part to measure the value of a given market. While stock market indices offer widely accepted benchmarks, the municipal bond market is difficult to define and track broadly.

 

  • The municipal bond market is composed of $3.9 trillion in market value, which is spread across over 80,000 issuers and roughly one million individual bonds.1
  • Any one issuer can have scores of individual bonds outstanding, each providing varying security pledges, maturities, coupons and call structures.

 

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  • The high degree of fragmentation makes it nearly impossible for index providers to replicate the
    full market opportunity. In fact, popularly tracked municipal indices represent 20% or less of the total investable universe.2

Problem: Traditional indices are debt-weighted

Like their equity counterparts, most municipal bond indices are market-capitalization-weighted. From an equity perspective, this approach makes logical sense — size born from historical success can arguably be associated with value. However, the same does not apply to fixed-income, where the largest index exposures simply represent the most prevalent issuers — not the most profitable investment opportunities. The largest entities have the greatest representation in traditional municipal market indices regardless of their investment merits, which ultimately reduces income and total return potential.

Opportunity: Returns come from multiple sources

The municipal market’s best sources of income and return are not necessarily driven by those entities with the highest propensity to issue debt. Instead, tax-exempt income and total return can be extracted from two primary risk factors: duration and credit — uncorrelated and capable of performing well in different stages of economic cycle.

By allocating across the maturity and quality spectrums, investors may broaden their opportunity set and introduce more chances for positive outcomes. On one hand, a basket of shorter duration, high-quality municipal securities can serve as a ballast during periods of heightened volatility. On the other, longer and lower quality bonds may offer a significant yield advantage that bolsters total return potential. Blending these exposures with a core allocation to bonds of intermediate maturity and quality may smooth the ride for investors as each component behaves differently across market environments.

Bottom line

Rather than simply accepting an imperfect benchmark portfolio, municipal bond investors should consider a strategic approach — informed by insights — to manage the complexities of the market.

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