Fixed-income ETF investors who are interested in the municipal debt market should consider ways to optimize muni bond exposure by diversifying across specific segments.
On the recent webcast, Finding Income Where Muni Benchmarks May Not, Edward Kerschner, Chief Portfolio Strategist for Columbia Threadneedle Investments, helped paint a picture of the current fixed-income landscape, pointing out we are entering a new rate regime after an unprecedented period of low rates.
“As rates return to more normal levels, investing in fixed income will require looking for sources of return beyond just interest rates,” Kerschner said.
Looking ahead, Kerschner argued that the Federal Reserve is targeting normal inflation, with a guidance target of 2%, which is in line with overall average inflation in the U.S. Consequently, investors will expect a gradual rise in interest rates and the removal of the unprecedented quantitative easing initiatives implemented in the post-financial crisis era.
The fixed-income market has enjoyed a three-decade long bull run on the backs of steadily falling interest rates. Municipal bond investors have increasingly turned to benchmark index-based portfolios to ride the wave. However, Kerschner warned that many of these passive, index-based plays only cover a portion of the overall $3.75 trillion muni market with roughly one million individual bonds. None of the indices that are tracked by the largest ETFs cover more than 20% of the total investable universe.
This leaves a broader opportunity set for muni investors, Catherine Stienstra, Head of Municipal Bond Investing at Columbia Threadneedle Investments, said.
Cap-weighted municipal bond indices and related funds are debt-weighted where the largest allocations lean toward the largest or most indebted issuers, like California, which could skew the income and return opportunity.
“The municipal market’s best sources of income and return are not necessarily driven by those entities with the highest propensity to issue debt,” Stienstra said.
Alternatively, “tax-exempt income and total return can be extracted from two primary risk factors: duration and credit –each uncorrelated and capable of performing well in different stages of economic cycle,” Stienstra added. “By allocating across both the maturity and quality spectrums, investors broaden their opportunity set and introduce increased propensity for desirable outcomes.”
Potential muni bond ETF investors may look to the recently launched Columbia Multi-Sector Municipal Income ETF (NYSEArca: MUST) as a way to broaden their opportunity set.
“In order to maximize the potential for risk-adjusted returns and income, the index is designed to exploit inefficiencies inherent in traditional passive approaches,” Stienstra said.
Jay McAndrew, National Sales Manager for Strategic Beta at Columbia Threadneedle Investments, argued that a strategy like MUST could help complement a traditional approach to municipal bond investing and improve investor outcomes. The smart beta methodology leans toward potential opportunity as opposed to traditional market cap-weighting or indebtedness. As a result, the portfolio takes a more active approach to enhance yield and generate improved risk-adjusted returns over conventional municipal benchmarks while following a passive ,rules-based indexing methodology.
Specifically, the underlying portfolio includes a 25% tilt toward shorter, high quality muni debt securities, which provides stability and buoys lower-rated, higher yielding bonds; 45% toward all-weather core positions, which balance duration and credit risk by targeting lower-rated investment grade and intermediate-term revenue bonds; and 30% in longer, low quality debt, which pursues a higher level of income via credit risk in an attempt to mitigate interest rate sensitivity.
Furthermore, the smart beta strategy excludes pre-refunded bonds due to their lower yield potential, California bonds due to high in-state demand leading to lower yields and relatively higher premiums, and U.S. territories and Tobacco to dampen volatility.
Financial advisors who are interested in learning more about the municipal bond market can watch the webcast here on demand.