As bond investors look to the current municipal bond landscape, one may consider targeted exchange traded fund strategies to incorporate munis into a diversified fixed-income portfolio better.

In the recent webcast, Insights into the Evolving Municipal Bond Market, David Dowden, Managing Director, Portfolio Manager, MacKay Municipal Managers; and Christopher Roberti, Managing Director, Senior Client Portfolio Manager, MacKay Municipal Managers, outlined another avenue for income generation beyond the traditional Aggregate Bond Index exposures through municipal bond opportunities to enhance and diversify yields.

The strategists argued that the municipal bond market might be the final frontier for alpha generation within the fixed-income space as inefficiencies within the category sets the stage for adept managers to weave in and out of the market.

The municipal bond market is too big for fixed-income investors to ignore as it is comprised of $3.81 trillion in outstanding debt with more than nine times the issuers and 50 times the CUSIPS of the U.S. corporate bond market. However, the majority of investors are retail passive based – 70% of outstanding debt is held by retail investors who invest generally based on the tax-exempt yield and maturity, or less based on credit fundamentals.

The MacKay strategists argued that credit analysis is still paramount as underfunded pensions, demographic shifts, and tax reform policies continue to hang over the market. A sharp reduction in bond insurance further exposes the market to underlying credit risks. Meanwhile, the global financial regulations have driven the dealer’s balance-sheet commitment to munis down by two-thirds, diminishing liquidity.

Consequently, the market has become less liquid and more volatile, which increase the potential benefits of active management that can spot opportunities. MacKay argued that today’s muni bond landscape requires active management. Investors can exploit market inefficiencies with better information. Trading costs for larger institutions are lower than for individuals after the post-2008 regulatory environment, and recent tax reform added to challenges for buying individual bonds. Additionally, banks and broker-dealers have committed less capital to munis, diminishing inventory for financial advisors.

“We believe experienced financial advisors recognize the need for professional active management in the municipal bond market,” according to MacKay.

“We believe prudent credit selection combined with relative value analysis will contribute to outperforming the benchmark and passive strategies.”

MacKay highlighted five key themes in the market today, including security selection and bond structure drive performance; tactically positioning portfolios when volatility rises can reward investors; strategic underweight exposures likely to drive outperformance in high-yield munis while quality high-yield investments will be key as cracks appear; taxable municipal refunding trend leaves the weak behind, and investors should beware of fleeting income.

As a way for investors to better access the munis market, IndexIQ with MacKay offers two actively manage muni bond ETFs, including the IQ MacKay Shields Municipal Intermediate ETF (NYSE Arca: MMIT) and the IQ MacKay Shields Municipal Insured ETF (NYSE Arca: MMIN). The two actively managed muni bond strategies could better help investors navigate changing market conditions. MMIT invests primarily in investment-grade municipal bonds. MMIN principally invests in investment-grade municipal bonds covered by an insurance policy guaranteeing the payment of principal and interest.

MMIN and MMIT can help complement or replace laddered strategies and municipal separate account strategies. The two active ETFs can be a better alternative to underperforming passive ETF exposures. Furthermore, MMIN may add a layer of credit production while still providing exposure to the muni market through an active strategy.

Financial advisors who are interested in learning more about the municipal bond market can watch the webcast here on demand.