(PUB) Investing 2015

214 / 772

20
Five years after taxable non-traditional-bond strate-
gies started gaining traction, funds with more-flexible
mandates have begun hitting the municipal market.
At least half a dozen muni-bond funds, including offer-
ings from BlackRock, Nuveen, and Goldman Sachs,
have been launched or retooled, giving 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 requiring
more credit research, and the asset-gathering
success of their taxable nontraditional brethren.
BlackRock Strategic Municipal Opportunities
MAMTX is illustrative of this new flexibility. In
2014, the firm revamped this strategy allowing
managers to set the fund’s duration between zero and
10 years and expanded from a focus on investment-
grade municipals to allow up to 50% in below-
investment-grade bonds. Shortly thereafter, the fund’s
duration, which ran at over six years, dropped to
less than three years; below-investment-grade fare
now accounts for 18% of assets as of Feb. 28, 2015.
While these funds promise a lot, investors should be
aware of their potential pitfalls. 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 of these funds to trade
interest-rate risk for credit risk. In addition, muni
funds face unique hurdles that could make imple-
menting this type of strategy more difficult.
For starters, munis have a narrow playing field—
municipal bonds make up less than 10% of the
$39 trillion U.S. bond market as of the end of 2014.
Taxable funds also have a broader pick of tools to
make big changes to credit and interest-rate exposure
quickly and cheaply. For example, for muni managers,
nimbly moving in the high-yield space is challenging.
That’s because the muni market is much less
transparent and liquid than the taxable corporate-
bond market. Below-investment-grade muni credits
represent a small portion of the overall market,
in contrast to the hefty taxable high-yield market,
and they can trade infrequently. Meanwhile, the
market for credit default swaps, which 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 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 using Treasury futures, a large
and liquid market. Before the financial crisis, this was
also a regular tool for some muni-fund skippers, too,
such as PIMCO ’s Joe Deane. However, the further you
move away 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 tracks the muni yield curve. Instead, they must
either change the mix of long- and short-maturity
bonds that they hold or use Treasury futures to adjust
duration. Trading securities can be expensive. Mean-
while, using Treasury futures can cause problems
because muni and Treasury yields don’t always move
in tandem. When that correlation breaks down, a
muni portfolio hedged with Treasuries can behave in
unexpected ways; this caused headaches for many
muni managers in 2008.
What does this mean for investors? For now, it’s
best to approach these funds with caution. Non-tradi-
tional-bond strategies, even in the taxable-bond
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 how best to use them in a broader portfolio. K
Contact Elizabeth Foos at
Unconstrained Munis?
Income Strategist | Elizabeth Foos