Conversations With... James L. Iselin
Managing fixed income accounts for total return has been a widely accepted practice in the taxable bond markets for many years. In contrast, many investors in the municipal bond market still tend to focus solely on the income component of return and favor a passive approach to investing. Myths have arisen based on the way retail investors historically have accessed the municipal bond market. This piece will highlight some of the shortcomings of a passive approach and illustrate how, ultimately, active management can help to improve the purchasing power of a municipal bond portfolio.
Myth #1 It’s all about the income.
Implied bet: Interest rate cycles don’t matter and issuer credit quality won’t change.
If an investor only values income generation, their portfolio will tend to focus on longer bonds and/ or lower-rated credits. That portfolio composition could produce the highest yield available today, but, potentially, at the expense of future income generation. For example, the investor with the long and lower-quality portfolio is subject to erosion of principal should interest rates rise and/or if issuer credit quality deteriorates. The concept of total return balances the needs that an investor has today with the goal of maximizing portfolio value, so future opportunities can be realized.
Myth #2 A ladder will best capture the value in the yield curve.
Implied bet: Each maturity on the yield curve has equal risk/reward value.
Sharp swings in the shape of the yield curve can cause certain duration buckets to significantly outperform other parts of the curve. A laddered portfolio fails to recognize that these moves can create real opportunities to add incremental total return. Conversely, having the wrong yield curve positioning can lead to meaningful underperformance, particularly in a volatile environment. Active managers can use quantitative analysis to locate certain maturities that have higher potential return profiles as bonds roll down the curve.
Myth #3 Par bonds are the only way to go.
Implied bet: Par bonds always offer the best value and will outperform in all markets.
Some investors believe that they should only invest in bonds that trade at or around par. The majority of bonds in the market currently have premium coupons, so the investor that is overly focused on par bonds is severely limiting the amount of available investment opportunities. Given the municipal bond market’s size and inefficiency, that approach could decrease the likelihood of finding undervalued securities. In addition, the above-market income streams associated with premium bonds can help to reduce volatility in a rising rate environment.
Myth #4 Total return in municipal bond portfolios doesn’t really matter because any appreciation will ultimately be lost as bonds mature.
Implied bet: This statement assumes that all portfolios are in run-off mode.
Actively managed accounts seek to preserve previously earned total return through trades that help maintain a portfolio’s duration target. In addition, active managers will attempt to lock in relative outperformance by selling bonds that have delivered above-market returns, ideally replacing them with securities that have better return profiles going forward.
Myth #5 All municipal market environments are the same.
Implied bet: It doesn’t matter when an investor puts money to work.
The reality is that unexpected conditions can often create the best opportunities in the market. For example, negative sentiment combined with a rush of supply in the fourth quarter of 2010 caused a sharp spike in yields. If a passive portfolio did not have cash to invest at the time, the investor would have missed out on a unique opportunity to increase yield in early 2011. In contrast, active managers are paid to think rationally in unsettled times and to take advantage of new opportunities. Selling shorter-dated bonds and extending modestly in the beginning of 2011 generally added significant value to portfolios.
Similarly, talk of “tapering” by the Fed in 2013 led to a swift and pronounced backup in the overall level of interest rates. If history is a guide, we believe that sharp selloffs that occur over short time periods usually represent a bad time to sell and more often create a buying opportunity. When high levels of volatility are added to the mix, the ability to purchase securities at attractive prices should also be enhanced. From our perspective, we believe that there is currently significant value in high-quality, short to intermediate maturity municipal bonds for both capital preservation and total return focused investors.
Myth #6 From a call risk standpoint, munis are just like Treasuries.
Implied bet: Reinvestment and interest rate risk will be predictable.
Unlike Treasuries, many municipal bonds have call options prior to maturity. Investors need to pay close attention to the call features on their bonds in order to properly manage a portfolio’s reinvestment and interest risk. Some portfolios may be overexposed to longer bonds with short call features. We believe this type of structure offers little potential for price appreciation as interest rates decline due to the short call feature. In addition, if the issuer calls the bonds away, the investor may be forced to reinvest in the new lower-interest rate environment. By contrast, in a rising rate environment these bonds may exhibit the volatility of long-dated issues.
Myth #7 Credit deterioration doesn’t matter because I am going to hold all of the bonds to maturity.
Implied bet: Objectives for these funds will never change.
A buy-and-hold strategy ignores the fact that credit quality can change over the life of a holding. “AAA”-rated bond insurance that was commonly used to protect municipal bond investors before the financial crisis in 2008 is generally no longer available. Today, if a bond is downgraded, it can have a material impact on the interim value of the investment. If an investor wants to shift their asset allocation or use their bond proceeds for other purposes, a portfolio that has experienced a meaningful decline in credit quality will be poorly suited to achieving that goal.
In summary, taking a passive approach to investing in municipal bonds not only misses opportunities, but can also expose the portfolio to greater risk as rates rise or credit quality deteriorates. Neuberger Berman’s institutional presence can provide better access to the marketplace. Our ability to buy and sell bonds allows us to seek to add value over a buy-and-hold passive strategy. Because we can sell bonds in a cost-effective manner, we consistently seek to take advantage of opportunities to improve the return profile of a portfolio.
An investor should consider Neuberger Berman Municipal Intermediate Bond Fund’s and Neuberger Berman New York Municipal Income Fund’s investment objectives, risks and fees and expenses carefully before investing. This and other important information can be found in each Fund’s prospectus, and if available summary prospectus, which you can obtain by calling 877.628.2583. Please read the prospectus, and if available the summary prospectus, carefully before making an investment.
A bond’s value may fluctuate based on interest rates, market conditions, credit quality and other factors. You may have a gain or loss if you sell your bonds prior to maturity. Of course, bonds are subject to the credit risk of the issuer. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the investor’s state of residence.
The municipal securities market could be significantly affected by adverse political and legislative changes, as well as uncertainties related to taxation or the rights of municipal security holders. Changes in the financial health of a municipality may make it difficult for it to make interest and principal payments when due. In addition, changes in the financial condition of one or more individual municipal issuers or insurers of municipal issuers can affect the overall municipal securities market. Changes in market conditions may directly impact the liquidity and valuation of municipal securities, which may, in turn, adversely affect the yield and value of the Fund’s municipal securities investments. Recent declines in real estate prices and general business activity are reducing tax revenues of many state and local governments. In recent periods an increasing number of municipal issuers have defaulted on obligations, been downgraded, or commenced insolvency proceedings. Financial difficulties of municipal issuers may continue or get worse. Because many municipal securities are issued to finance similar types of projects, especially those related to education, health care, transportation, and utilities, conditions in those sectors can affect the overall municipal securities market. Municipal securities backed by current or anticipated revenues from a specific project or specific asset may be adversely impacted by declines in revenue from the project or asset. Recent declines in general business activity could affect the economic viability of facilities that are the sole source of revenue to support various private activity bonds. To the extent that the Fund invests in private activity bonds, a part of its dividends will be a Tax Preference Item.
This material is intended as a broad overview of the portfolio managers’ current style, philosophy and process. This material is presented solely for informational purposes and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. Readers should not assume that any investments in securities, companies, sectors or markets identified and described were or will be profitable. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Certain products and services may not be available in all jurisdictions or to all client types. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
A bond’s value may fluctuate based on interest rates, market conditions, credit quality, political events, currency devaluation and other factors. You may have a gain or loss if you sell your bonds prior to maturity. High-yield bonds, also known as “junk bonds,” are considered speculative and carry a greater risk of default than investment-grade bonds. Their market value tends to be more volatile than investment-grade bonds and may fluctuate based on interest rates, market conditions, credit quality, political events, currency devaluation and other factors. High-yield bonds are not suitable for all investors and the risks of these bonds should be weighed against the potential rewards.
Neuberger Berman Investment Advisors LLC is a Registered Investment Advisor. The “Neuberger Berman” name and logo are registered service marks of Neuberger Berman Group LLC.