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Municipal Podcast recorded on June 1, 2016

Muni Benchmarking

Podcast Transcript

Hello this is Natalie Wright and welcome to the Breckinridge podcast. Today, I am joined by Matt Buscone, Co-Head of Portfolio Management here at Breckinridge. Today, we are going to discuss some of the pros and cons of relying on benchmarks and some of the drawbacks of municipal benchmarks specifically. Across all asset classes, we do see investors use a benchmark to measure their returns so we're going to delve in a little bit more into how that can be beneficial and some things you need to watch out for. So Matt, what do investors and managers do to find the best benchmark for a strategy to begin with?

So the best index is going to be one that's most closely aligned with your strategy's characteristics. Ideally, that's going to be an index that's investable. A good index is going to be one that can be replicated by liquid instruments in the market. The more liquid and traded the underlying instruments are, the more representative those returns are and hence, a better reflection of what your strategy is going to look like versus that index.

Well, what are some examples of some good benchmarks?

So on the equity side, everyone's very familiar with the S&P 500, the NASDAQ, and many of ETFs that look just like those. On the fixed income side, Barclay's runs several fixed income indices like the Barclay's Government Credit or the Agg that people are very familiar with. Most of these major indices rely on items such as market capitalization, market prominence and trading volume to determine their constituents. That's not often the case on the muni side.

Okay, so you're talking about the indices that everyone knows and could feasibly be replicated.

Correct, right.

Well, what makes muni indices different?

So the index that we're going to be referring to, the Barclay's 1-10 Year Blended Index, is not exactly a household name. Most municipal indices are merely paper portfolios that are comprised of thousands of different securities that are infrequently traded. In fact, just over 10% of the par value of the bonds in the Barclay's 1-10 Year Blended Index has traded so far year-to-date and the makeup of these indices may be very different than what an individual would like their muni portfolio to look like.

In what way?

So one example is that the indices increase weightings to the issuers with higher debt burdens and issue debt more frequently. Oftentimes, that's the opposite of what fundamental credit analysis usually dictates. Many of these indices will have thousands of bonds that trade infrequently versus a portfolio of 30 to 40 bonds for most individuals. For these reasons, investors and muni bond strategies must exercise caution when selecting indices to set portfolio structure or performance targets.

Well, how does Breckinridge deal with all this? Does Breckinridge look to structure their client portfolios to look like the indices, or what's going on?

We definitely do not. Our performance and structure may differ from the benchmarks because we're intentionally building our portfolios differently. A few examples would be our focus on investing on higher quality securities, owning bonds with less call risk or employing more diversified state exposure than the indices. Since we're active managers, we consciously build our portfolios to have certain structures that we know differ from the benchmark, but it is part of our strategy to manage things like call risk that the benchmarks don't have to do.

I see. Well, let's take a closer look at some of the differences between the Barclay's 1-10 Year Blend Index and the Breckinridge Intermediate Tax-Efficient Strategy. Let's start with ratings.

So the index is generally going to own a higher percentage of A and BBB rated bonds versus our strategies. In keeping with our higher-quality mandate, Breckinridge portfolios are likely to have an average credit rating that's closer to AA-. That's often going to lead to differences in performance depending on the month or the quarter. If there's a time period where risk is getting rewarded very well, those A and BBB securities will do much better and our performance may lag, but investors in our strategy might say I've chosen you because I want a higher-quality mandate and I'm comfortable with that. In periods where there is a risk-off environment and high quality is rewarded, we're going to do better than that. But we're not going to look to adjust our portfolio structure to keep up with the returns of the indices based on what happens on a month-to-month or quarter-to-quarter basis.

I see and what about in terms of sector?

The index has meaningfully larger exposures to what are traditionally considered riskier sectors in the muni market. Those may be industrial development revenue bonds, tobacco bonds, continuing care retirement communities or housing bonds, to name a few. And also given the market weighting, it tends to have more exposure to state general obligation bonds. So for a Breckinridge portfolio that has a national mandate, that would mean being compared to a benchmark that might have much more elevated exposure to, say, Illinois state general obligation bonds and California state general obligation bonds. Those bonds are probably not the best fit for a national portfolio. So therefore, depending on the performance of those two states, the index performance is going to get skewed where a Breckinridge portfolio would not have that performance tied to it.

Well, what will the sector profile of a Breckinridge portfolio look like?

So we're going to emphasize higher-quality bonds and avoid many of the sectors that we mentioned above and we're also going to be more overweight essential service revenue bonds, like water and sewer, or dedicated tax bonds. We also focus less on issue size that will lead us to having less exposure to state GOs and more to local general obligation bonds. That local general obligation exposure is often very helpful in building state bias portfolios as it allows us to build a more diversified portfolio and capture more double tax-exempt income for an investor in that state.

Okay, so it sounds like in general, part of our active management winds up with a situation where we just are going to have a higher quality portfolio than the index.

Higher quality and maybe a little bit more narrowly focused on sectors that we view as more traditional and safer municipal sectors.

Okay, well in the current low rate environment, callable bonds are being used as a way to increase yield. What does the callability of the index look like?

So the index has significantly more exposure to bonds with longer maturities and shorter call dates. Think something along the lines of a bond that has a 15-year final maturity and perhaps a call date that's only five years from now. While we like to have some call exposure in our portfolios, we generally look to limit the distance between final maturity and call date to a maximum of say five years depending on the interest rate environment and the slope of our yield curve.

Why would you care about that kind of structure, or why do you set up your portfolios that way?

So one of our main goals is to provide a stability to the income stream of the portfolio. There are two types of risk for the callable bond, call risk and extension risk. With call risk, if interest rates fall, the issuer is more likely to call in that bond, leaving an investor with proceeds to reinvest in a lower interest rate environment, reducing their future cash flows. With extension risk, it's the reverse. If interest rates start to rise, those bonds are likely to stay outstanding and increase in duration as rates are rising, not giving you the ability to reinvest proceeds in a higher interest rate environment.

All right, so this is just one more way that we may differ from the benchmark in that we are really looking to control these risks.

Sure, and a good example over the last several years, oftentimes those bonds with the longer final maturity and shorter call have performed better so on a total return basis, we’ve lagged behind, but as the years have gone by and rates have stayed lower, many of those bonds have been called away, forcing people to reinvest at lower rates, whereas we were able to go out and buy non-callable bonds or bonds with a tighter structure. As we continue to hold onto those now, the income stream being generated by those bonds is higher than we can replicate in today's market.

Well, let's move onto transaction costs, one of the most discussed parts of the muni market. How does the index account for those?

So the short answer is they don't have to. Index turnover is done at no cost and it's at the evaluations provided by the pricing service. The reality is that transaction costs are relevant in our market and depending on the piece size of the bond or the structure or the rating, the average transaction costs in the muni market could be north of 1% so index performance has a clear but hidden advantage by not having to include them. We certainly look to minimize transaction costs as much as possible by having a vast network of broker-dealers but there is still a cost to trading in the muni market so the index is able to get a pass on what we would say is, frankly, a big issue in the muni market regarding transactions and pricing versus evaluation services versus what you're actually executing in the market.

Well, given all of these differences, why is there still such a big emphasis on benchmarks?

So some aspects of a benchmark can be useful. They offer a bird's-eye view of an asset class to compare relative value and they provide a historical context for performance. They do have their limitations and we believe they are less relevant for municipal bonds because they can't adequately represent the true trading activity or market composition, and often don't match the risk tolerances or investment objectives of many clients.

Okay, well if we don't look to replicate or manage to an index, then what is Breckinridge's goal when building a portfolio?

So we aim to create a portfolio that preserves capital and generates a high quality, reliable tax efficient income stream through different interest rate cycles. These goals supersede the aim to mirror relevant benchmarks. We offer higher-quality portfolios that may allow us to outperform during risk-off periods when broader markets are falling. While we would like to beat our benchmark, we certainly don't let it dictate our management of the portfolios and really, we continue to fall back on our main goals of preservation of capital and generation of tax-exempt income.

All right, thank you so much, Matt. We hope you in the field have found this informative. We look forward to joining us on our next podcast. Have a great day.

 

 

DISCLAIMER: The material in this transcript is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Portions of this transcript may have been edited from the original podcast recording to improve clarity of message. Nothing in this transcript should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. This document may contain material directly taken from unaffiliated third party sources, including but not limited to federal and various state & local government documents, official financial reports, academic articles, and other public materials. If third party material is included, it is believed to be accurate, and reliable. However, none of the third party information should be relied upon without independent verification. All information contained in this document is current as of the date(s) indicated, and is subject to change without notice. No assurance can be given that any forward looking statements or estimates will prove accurate or profitable.