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Municipal Blog published on October 21, 2016

Out with the Old? Don’t Get Carried Away When Transitioning Your Muni Bond Portfolio

 “Out with the old, in with the new” may be the perfect mantra for tasks such as updating a wardrobe or spring cleaning. However, when it comes to transitioning a municipal bond separate account to a new investment manager, a complete overhaul and replacement of current holdings may be exactly the wrong path.

Indeed, an important consideration for investors is how to handle an existing municipal bond portfolio when moving it to new management. It turns out that much of the outcome will depend on the new manager’s investment philosophy for funding new accounts. Separate account managers who are more flexible in accepting municipal bond securities as a source of in-kind funding could help clients avoid punitive transaction fees and steep tax hits on capital gains.

Below, we describe various philosophies for funding new municipal bond accounts. These examples illustrate that an inflexible, “out with the old” approach to funding new accounts may provide a suboptimal outcome for the client. We also provide insight to the Breckinridge philosophy on in-kind funding.

Through this process, we strongly encourage all investors to consult with their investment professional before making any investment decisions as these scenarios do not fully consider each individual’s investment objectives or goals, risk profile, financial and tax situation, asset allocation strategy, and other such matters that would be important in investment decisions.

Philosophy No. 1

To transfer holdings to a new municipal bond separate account manager who solely accepts cash funding, investors must sell all the securities in their existing portfolios and contend with transaction costs on these sales. Due to the opaque, fragmented nature of the municipal market, these costs can be high. For municipals, transaction costs average 123 basis points (bps)

In addition, given the 30-year fixed income bull market, many municipal bondholders now own portfolios with embedded gains. Selling bonds could cause them to take a considerable tax hit from capital gains. Also, managers may turn around and purchase bonds that could be very similar in credit fundamentals or structure to ones sold, taking investors on an unfavorable round trip with expensive consequences.

Often this philosophy is in place so managers can start from scratch and completely change to their own set of parameters. So, by selling all their holdings, investors are being flexible to a manager’s parameters, instead of the manager being flexible to an investor’s parameters. Also, by selling to meet new account requirements rather than to make a tactical choice, an investor is again accommodating a manager rather than the other way around. Even though in general, advisors are obligated to act in their clients’ best interests, we think it is important to note these potential disadvantages from this funding philosophy. 

Philosophy No. 2

In some cases, clients will be able to turn over a limited number of municipal securities as a funding source. Since the client is not forced to sell all holdings, the client will potentially have fewer transaction costs and capital gains tax payments than in all-cash funding. However, the sales required could be detrimental and different from client preferences in much of the same ways as discussed in Philosophy 1.

Philosophy No. 3

This is the philosophy Breckinridge follows. We work with the investor to thoughtfully decide how to use existing muni holdings to fund a new strategy. We understand that for many investors, managing a heavy tax burden is one of the most important components of municipal bond investing. Additionally, we know that some investors have state or security preferences that should be considered in making decisions on new positioning. We aim to take in existing municipal holdings when we are able to according to our infrastructure and credit rule sets.

Breckinridge has particular strengths that enable us to provide flexible in-kind funding. To begin with, our significant breadth of municipal coverage allows us to evaluate accepting a wide array of in-kind securities. Our large credit team and proprietary technology enable us to cover a large universe of over 3,000 municipal credits. While Breckinridge is restrictive on the securities we can accept to ensure our portfolios are managed in alignment with our goals of capital preservation and income generation, our in-kind philosophy centers around maintaining tax efficiency and conforming to client preferences as much as possible.

In addition, the Breckinridge funding philosophy focuses on collaboration with clients. We begin by looking closely at a client’s existing holdings to determine any heightened risks or missed opportunities in positioning. This could include a heavy weighting to a particular state, a substantial amount of call risk in the portfolio [2] or an exposure to low-quality credits deemed too volatile for a client’s risk tolerance and goals.

Finally, if the decision is made to sell bonds, we of course take great care to sell tactically and over time, rather than blowing out of positions quickly to fit our recommendations. By taking a thoughtful approach to in-kind funding, we can help clients more confidently transition to new management and stay aligned with their investment goals.

 

[1] MSRB. The trade spread of 1.23 percent represents trades between January 1, 2015 and December 31, 2015. The figure is an average of all of the individual differences between all buys and sales of the same CUSIP on the same day. The figure excludes trades where the spread of the buy/sell is 0 or above 3, and trades where the coupon is null.

[2] Call risk: If interest rates fall, bond issuers will be more likely to call a bond and reissue debt at the lower rates available in the market. This could reduce the bond’s effective duration and disrupt expected cash flows. For this reason, bonds with longer maturities and shorter call risks present risks that duration could drop significantly if broad market rates decline.

DISCLAIMER: The material in this document is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Nothing in this document 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.