Q&A: Municipal Bonds in the Wake of COVID-19

When the COVID-19 pandemic hit in 2020, municipal bond investors braced for a slew of defaults by overburdened state and local governments. But more than a year later, these municipalities are holding up better than expected.

With the help of stimulus payments, tax revenues from workers who were able to continue working remotely, and quick rallies in the stock and real estate markets, some states (California, for one) are even showing budget surpluses for the fiscal year starting in 2020. The result was far fewer state and local municipal bond defaults than anticipated.

To get a clearer picture of the municipal bond market and where financial advisors and investors can look for investment opportunities in the sector today, we spoke with Catherine Stienstra, senior portfolio manager and head of municipal bond investments at Columbia Threadneedle Investments.

She shares the challenges and opportunities facing municipal investors and how Columbia Threadneedle’s strategic beta multisector municipal exchange-traded fund, the Columbia Multi-Sector Municipal Income ETF (ticker: MUST), aims to take advantage of the inefficiencies in today’s muni markets to provide more consistent tax-exempt income for investors. Here are edited excerpts from that interview.

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What are the biggest challenges investors and financial advisors face when investing in municipal debt markets today?

Investing in the municipal market can be a challenging proposition for financial advisors. It’s never as simple as just tax considerations. Investors must consider the market’s wide breadth of issuers and bonds, structures and call features, and the creditworthiness and income potential of each investment. When we look at the shape of the market today, one of the biggest challenges is generating attractive income in a low-yield environment while simultaneously protecting portfolios against the prospect of rising rates.

What makes this balancing act more challenging in today’s market environment is a supply-demand imbalance that has left municipal investors with less inventory from which to choose. A clear push toward higher taxation has sparked record inflows into the asset class this year, while at the same time new issuance has failed to keep pace. Added to this dynamic are the summer seasonal impacts where municipal investors typically receive substantial principal and coupon payments. This year, an estimated $145 billion in municipal reinvestment capital is expected to be returned to investors between June and August.

Given this backdrop, financial advisors who are accustomed to buying individual bonds or building their own municipal ladders may find it more difficult to find attractive investments, particularly if they want to build an income stream that outpaces inflation. Without the tailwind of a 30-year bull market in rates, solely purchasing high-quality municipal bonds is less likely to meet a client’s income or return expectations today. Meeting those expectations is going to require expanding the opportunity set.

Tighter valuations within the higher-quality segments of the municipal market may require investors to step outside the normal confines of traditional benchmark-like investing. With state budgets weathering the COVID-19 pandemic better than expected, most high-quality state general obligation (GO) bonds offer limited upside potential moving forward. While on the one hand, this is a positive, it does mean that uncovering attractive income opportunities will require adept security selection and allocation to revenue sectors where a post-pandemic recovery still offers potential for improvement. The added benefit offered by these typically higher-yielding investments is that they provide a more substantial income cushion against the threat of rising rates.

[Read: Will IRS Funding Proposals Result in More Audits for Wealthy Clients?]

Where are you seeing opportunities in today’s municipal debt market?

Investors who are willing to explore every area of the municipal market can still find compelling investment opportunities. With the post-pandemic economic rebound occurring and an uneven distribution of those economic gains, there are opportunities to capture performance through security selection and sector allocation.

Many revenue sectors of the municipal market stand to benefit from this reopening theme. Likely beneficiaries such as airports, toll roads and hospitals will see large portions of their issuance excluded from traditional GO benchmarks. Targeted exposures to lower-investment-grade and quality higher-yield segments of the market can also provide opportunities given the backdrop of improving credit fundamentals and typically low default rates. Also, their higher income potential can help protect against the threat of higher rates and inflation.

How can investors use exchange-traded funds to capitalize on those opportunities?

With rates so low, investors are increasingly turning to ETFs for fixed-income exposure, and comfort with municipal bond ETFs has continued to grow over time. Through the end of April, growth in municipal bond ETFs was more than double that of other fixed-income ETFs.

As demand for municipal bonds increases, pressure is put on the supply side, which can make even the simplest laddered strategy hard to assemble. One benefit of ETFs is that they are managed by asset managers, who likely have better access to available inventories than advisors, and the research capabilities to dip further down the credit spectrum in pursuit of attractive income.

Also, in environments where supply and demand are out of balance, some investors may be less willing to take on the liquidity risk that those imbalances can cause, preferring to offload liquidity risk to ETF issuers. The ability to quickly access a diversified portfolio is appealing, particularly if that portfolio offers a higher yield than one could construct with individual bonds at today’s yields.

It’s also worth noting that at these low yield levels, cost matters, making the cost-effective approach provided by ETFs even more compelling.

Why do benchmark-based ETFs fail to address investors’ needs around yield and diversification?

Traditional municipal benchmarks were never designed as investment portfolios. Their construction rules place more emphasis on issuance, capturing those municipalities that issue the most debt and excluding some very viable sectors that have historically offered higher yields and better risk-adjusted returns over time. Take the S&P National AMT-Free Municipal Bond index, for example: It skews over 70% AA-rated or better, holds a substantial portion in general obligation bonds, and concentrates its allocation in high-tax states where demand from state residents has a tendency to artificially suppress yields relative to other states.

While the sheer number of bonds may give investors in traditional passive ETFs a false sense of diversification, in practice exposures are rather concentrated by geography, issuer type and sector. True diversification requires thoughtful construction and an appreciation of the correlations, or lack thereof, that sectors or quality segments have to one another. In other words, real diversification doesn’t happen by accident.

[READ: Q&A: How to Build Better Portfolios With ESG ETFs.]

What does it mean to be a strategic beta multisector municipal income ETF?

It means being strategic about the risks you introduce into your investments through thoughtful allocation decisions based on what creates a better investment portfolio, not on who issues the most debt.

We recognize that over time, income has been the primary driver of total returns in municipal bonds. By beginning with the basic premise of optimizing income while controlling risk, we made decisions to include sectors often excluded from traditional benchmarks. We controlled risk by creating a more balanced maturity profile and making the case for including a modest allocation to below-investment-grade bonds as an income enhancer.

What are the advantages and disadvantages of taking a strategic beta multisector approach to municipal debt investing?

A strategic beta approach produces larger allocations to portions of the municipal market with demonstrably higher risk-adjusted returns. It reframes the conversation about bond benchmarks by designing an index that is income-focused versus issuance-focused, because investors are much more concerned with the former. It is an approach that structures a maturity profile based on what creates a more balanced portfolio, rather than allowing issuance patterns to drive how far out on the maturity spectrum investment dollars are allocated. And it is also an approach that allows investors to access the best thinking of active portfolio managers in a cost-effective, index solution.

Like all benchmark-based ETFs, the index design and therefore construction is fixed, meaning the allocation is unable to adapt to changing market conditions. That said, over time, we believe it should be more advantageous to emphasize superior long-term yield generation and risk-adjusted total return potential. As with any index investing strategy, there may be times throughout various market cycles when an index is out of favor and produces suboptimal returns. Planning for these scenarios with a thoughtfully designed index may help to alleviate some of those concerns.

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Q&A: Municipal Bonds in the Wake of COVID-19 originally appeared on usnews.com

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