Municipal

Blog January 27, 2017

Proactive vs. Reactive: A Case Against Passive Ladders

Some active municipal bond managers will often make big, speculative bets with credit quality, duration or interest rate risk, prompting increased transaction costs and tax inefficiencies. Breckinridge has always cautioned against overly tactical management that speculates in this way, as it tends to be more costly and create greater volatility. We are sympathetic to those exiting these sorts of active bond strategies, but we also believe that many fixed income investors have shifted too far to the other extreme of management: the passive ladder approach.

In an efficient market like U.S. Treasuries, a passive ladder may make sense because a manager can build cookie-cutter, boilerplate portfolios that can more predictably offer the advantages of maturity diversification. However, in an inefficient market like the municipal bond market, we believe that passive laddering is inappropriate.

There are many reasons why the municipal bond market is widely recognized as inefficient. One challenge is that unlike investors in most public markets (i.e. U.S. Treasuries), municipal investors are unable to select bonds from a steady pool of investable securities. The municipal market is actually more like a river of securities than a pool, and the flow of bonds is fairly unpredictable. A good manager must continuously monitor the market’s flow and be poised to execute when attractive bonds present themselves. This requires opportunistic trading, supported by a very strong research capability. It also requires some measure of flexibility. The rules for a passive ladder limit this flexibility due to constraints that we think impede the ability to invest successfully in the municipal market.

There are other factors that prove problematic for passive ladder strategies, for several reasons:

  • A passive ladder may not take into account structural nuances. A ladder normally refers to a portfolio’s maturity structure, which is typically designed to diversify interest rate risk. However, maturities are a crude and imprecise measure of interest rate exposure. A far more accurate measure is effective duration, which along with in-depth portfolio analytics, can more effectively and consistently manage a portfolio’s interest rate exposure.
  • A passive ladder waits for a maturity before reinvesting in a new bond that is at the long end of the ladder’s maturity range. The problem with this approach is that the portfolio can drift well short of its average duration target by the time maturity occurs. This can produce significant variability in a portfolio’s interest rate exposure.
  • A passive ladder will not take into account seasonality. The municipal market exhibits seasonality due to tax payment dates, heavy reinvestment periods or other reasons. For example, January has typically been a month with tighter pricing, given large reinvestment-driven demand accompanied by lower supply. Specifically, January’s supply has averaged nearly 30 percent lower than December’s, per Municipal Market Analytics (MMA) data since 1988. This seasonality creates imbalances that warrant a more proactive approach. The graph below shows that January’s gains are often followed by lackluster performance in February.

  • While it’s speculative for us to suggest, we worry that passive ladders are likely to receive much less attention from investment managers relative to their more active strategies. This potential for neglect is especially troubling now, at a time when we believe uncertainties in the municipal market bring about the need for even closer attention.


Our Approach

Breckinridge has always sought to achieve a proper balance between an active and passive investment approach. We are active – in that we are attentive to market inefficiencies, flexible in taking advantage of value and rigorous in using the best analytical tools to precisely manage portfolio structure. At the same time, we are well-aligned with the goals of passive investors. Breckinridge has always avoided speculative or excessive trading and remained faithful in our commitment to preserve capital, while building a reliable income stream through fundamental credit analysis and a well-diversified portfolio structure. Our commitment to striking the right balance in the mix of active and passive approaches, has been, and always will be, a central part of our mission to provide the highest caliber of fixed income management for investment-grade portfolios.

 

DISCLAIMER: This material has been prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors, Inc. Information and opinions are current as of the date(s) indicated and are subject to change without notice. Any specific securities or portfolio characteristics are for illustrative purposes and example only. They may not reflect historical, current or future investments in any client portfolio. Nothing in this document should be construed or relied upon as tax, legal or financial advice. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. This document may include projections or other forward-looking statements, which are based on Breckinridge’s research, analysis, and assumptions. There can be no assurances that such projections will occur and the actual results may differ materially. Other events that were not taken into account in formulating such projections may occur and may significantly affect the returns or performance of any account. Past performance is not indicative of future results. This document includes information from companies not affiliated with Breckinridge (“third party content”). Breckinridge reasonably believes the third party content is reliable but cannot guarantee its accuracy or completeness.