Perspective published on May 3, 2022
The Case for Active Management
- Attentive, ongoing portfolio management can help investors take advantage of opportunities to that seek to improve a portfolio’s performance and manage risks.
- Our broad dealer network and intense focus on fundamental analysis may be beneficial given potential inefficiencies of the large, diverse municipal market.
- Perhaps the greatest disadvantage of laddered portfolios is the lack of active management of maturity and duration.
Some investors want conservative municipal bond management. The problem is that conservative may mean inactive. A bond is purchased and held until it matures, is downgraded or called. Investment decisions are made solely in reaction to such events. New purchases are restricted to specific maturities regardless of prevailing market conditions.
Breckinridge believes that municipal bond portfolio management should be proactive. The municipal market is large and diverse. It offers greater potential inefficiencies. There are opportunities to improve a portfolio’s performance and manage risks. In our opinion, attentive, ongoing portfolio management that takes into account an ever-changing municipal market is required.
When missed opportunities and transactional costs of passive management are considered, we believe that professional active management offers significant advantages over passive.
BRECKINRIDGE OFFERS THE FOLLOWING:
Broad Dealer Network
Two main benefits of institutional management are improved market access and trade execution. With hundreds of active municipal bond dealers, more than one million outstanding municipal securities, and limited transaction and pricing history, determining the fair value of a municipal bond can be difficult. Furthermore, the municipal market is dominated by unsophisticated buyers, complex security structures and the lack of a central exchange. Trading in the municipal market requires specialized expertise.
Breckinridge traded bonds with over 100 municipal bond dealers for 12 months ending December 2021. In a negotiated market, having broad access and putting dealers in competition are crucial actions when purchasing or selling a municipal security.
Avoidance of “Transaction Chains”
Our broad dealer network also helps to eliminate transaction chains by increasing our ability to execute transactions with the originating institutional dealer. Transaction chains can lead to markups that can materially reduce the client’s income on individual securities.
As highlighted by the Municipal Securities Rulemaking Board (MSRB):
“In certain cases, the difference between the price received by the selling customer and the price received by the purchasing customer is abnormally large, exceeding 10% or more. In reviewing such transaction chains, it often appears that the two dealers effecting trades with customers at each end of the chain—one dealer purchasing from a customer and the other selling to a customer—did not make excessive profits on their trades. Instead, the abnormally large intraday price differentials can be attributed in major part to the price increases found in the interdealer trading occurring after the broker’s broker’s trade.”
The chart above represents the average markup per bond due to intraday trading. Many of these markups are the result of intradealer trading and transaction chains, per the MSRB. By working with a broad dealer network, Breckinridge incurred less than one-third the average markup of the market in 2021.1
As with most markets, the municipal market's most well-connected buyers often see the best opportunities and receive pricing preference over less active market participants. With over $40 billion in assets under management as of December 31, 2021, Breckinridge is an active participant in the municipal market.
Municipal bonds are not always safe2, particularly in the current credit environment. A meaningful portion of today’s credit health has been funded by tomorrow’s dollars, and inadequate pension funding, delayed infrastructure maintenance and deferred hiring for essential services could increase costs later. As a result, a fundamental understanding of underlying obligors and their ability to make timely payments of principal and interest is more important than ever. The depth of knowledge and research required to achieve this understanding is best accomplished through an active manager with municipal expertise and a strong research team, in our view. As a municipal bond specialist,
Breckinridge understands the importance of looking beyond ratings and analyzing each security to minimize credit risks that may be overlooked.
With 10 municipal analysts, including individuals formerly employed by ratings agencies, municipal issuers, buy- and sell-side firms, and bond insurance companies, we believe Breckinridge has a strong municipal research team. The team conducts independent research rather than relying on public rating agencies. Using various resources, our research team reviews new issues and secondary offerings for purchase. It also performs surveillance on our existing holdings to reaffirm buy and hold decisions, and to identify bonds that should be sold for credit reasons. Moreover, each bond we hold is assigned an internal rating and a performance trend that is embedded into our portfolio management and trading systems.
Breckinridge has always practiced thorough fundamental, bottom-up research. Basing credit opinions and investment decisions on broad, sweeping judgments of the municipal market can result in missed opportunities and present unnecessary risks in municipal bond portfolios.
Municipal bonds often have embedded call features. These features can create both risks and, when properly understood, opportunities. In unmanaged portfolios, the probability of calls being exercised is typically not analyzed, as these portfolios generally have passive, rather than active, management.
This exposes the portfolio to significant reinvestment risk. As yields fall, the probability of bonds being called increases just as the yields on reinvestment opportunities become less attractive.
On the other hand, the proper assessments of call probabilities and return horizons of callable municipals can bring about potential opportunities.
To produce a diversified investment grade bond portfolio, Breckinridge routinely assesses coupon structure, credit enhancements, sector allocation, obligor exposure and tax-equivalent yields, among other security characteristics that can impact risk-adjusted returns.
We believe one of the greatest disadvantages of laddered portfolios is the lack of active management of maturity and duration. There are a variety of institutional strategies (such as bullet or barbell positioning) to structure maturity distribution and market exposure.
As an example, a barbell provides accelerated reinvestment opportunities (in the form of both swaps and maturities) when rates rise, allowing for a greater ability to build income. A ladder’s equally-weighted maturity schedule can present potentially inopportune timing for reinvestment, which can limit an investor’s response to market opportunities. Conversely, as rates fall, a professional manager can assess the various risks to the income stream and structure portfolios accordingly.
Active management can allow different structures at different times. The chart below displays a barbelled target maturity structure during a steep yield curve environment, and a bulleted target maturity structure during a flat yield curve environment.
Tax Efficiency and Tax Loss Harvesting
The primary and most widely known tax benefit of active municipal bond management is the benefit derived from tax-loss swapping. Should interest rates rise and a portfolio incur an unrealized loss, Breckinridge has the ability to use its institutional trading capabilities to efficiently liquidate holdings, and then to reinvest the proceeds.
This process may also allow the client to offset capital gains realized in other assets, or carry losses forward, should there be no immediate gains to offset.
Active management can not only facilitate the generation of tax-loss swaps, it can also insulate portfolios from two potentially negative tax consequences: the Market Discount Rule and the Alternative Minimum Tax (AMT).
The Market Discount Rule was passed on to municipals in 1993. When bonds are purchased at a significant discount to their original issue price, a portion of the return on the bond may be subject to ordinary income tax. Through a rigorous security selection process and ongoing portfolio surveillance, Breckinridge seeks to limit the volatility, price depreciation, loss of liquidity and potential tax consequences that accompany ownership of securities purchased at a discount.
Municipal bonds not deemed fully public-purpose are subject to the Alternative Minimum Tax (AMT). As an increasing number of taxpayers become subject to the AMT, ownership of these bonds can lead to unintended tax consequences. It is important to fully assess the adverse impact of the AMT on the after-tax income stream. At this time, Breckinridge does not purchase any bonds subject to this tax.
Active managers may be better equipped to assess the issues regarding taxation of municipal portfolios and the impacts of state income taxes on after-tax returns. They may also be more capable of realizing gains in portfolios when directed and performing crossover trades between tax-exempt and taxable bonds when appropriate.3
In our view, active management has several advantages that could translate into higher after-tax returns. The benefits of institutional access and execution, coupled with the expertise and flexibility of professional portfolio managers, help make a strong case for active management.
 Individual client portfolio results may differ from what has been depicted in the graph. Further, there is no guarantee that Breckinridge will continue to achieve the same results in future years.
 Please consider the investment objectives, terms, risks and time horizon before investing. Municipal bonds are generally illiquid and yields generally increase with risk and time to maturity. Municipal bonds generate tax-free income, and therefore pay lower interest rates than taxable bonds. Therefore, municipal bonds may not be suitable for all investors.
 Breckinridge Capital Advisors, Inc. does not provide tax/legal advice. Investors should consult with their financial and/or tax professionals prior to engaging in any tax-loss swaps.
This material provides general and/or educational information and should not be construed as a solicitation or offer of Breckinridge services or products or as legal, tax or investment advice. The content is current as of the time of writing or as designated within the material. All information, including the opinions and views of Breckinridge, is subject to change without notice.
Any estimates, targets, and projections are based on Breckinridge research, analysis, and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.
Past performance is not a guarantee of future results. Breckinridge makes no assurances, warranties or representations that any strategies described herein will meet their investment objectives or incur any profits. Any index results shown are for illustrative purposes and do not represent the performance of any specific investment. Indices are unmanaged and investors cannot directly invest in them. They do not reflect any management, custody, transaction or other expenses, and generally assume reinvestment of dividends, income and capital gains. Performance of indices may be more or less volatile than any investment strategy.
Performance results for Breckinridge’s investment strategies include the reinvestment of interest and any other earnings, but do not reflect any brokerage or trading costs a client would have paid. Results may not reflect the impact that any material market or economic factors would have had on the accounts during the time period. Due to differences in client restrictions, objectives, cash flows, and other such factors, individual client account performance may differ substantially from the performance presented.
All investments involve risk, including loss of principal. Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk. Fixed income investments have varying degrees of credit risk, interest rate risk, default risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. Income from municipal bonds can be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the IRS or state tax authorities, or noncompliant conduct of a bond issuer.
Breckinridge believes that the assessment of ESG risks, including those associated with climate change, can improve overall risk analysis. When integrating ESG analysis with traditional financial analysis, Breckinridge’s investment team will consider ESG factors but may conclude that other attributes outweigh the ESG considerations when making investment decisions.
There is no guarantee that integrating ESG analysis will improve risk-adjusted returns, lower portfolio volatility over any specific time period, or outperform the broader market or other strategies that do not utilize ESG analysis when selecting investments. The consideration of ESG factors may limit investment opportunities available to a portfolio. In addition, ESG data often lacks standardization, consistency and transparency and for certain companies such data may not be available, complete or accurate.
Breckinridge’s ESG analysis is based on third party data and Breckinridge analysts’ internal analysis. Analysts will review a variety of sources such as corporate sustainability reports, data subscriptions, and research reports to obtain available metrics for internally developed ESG frameworks. Qualitative ESG information is obtained from corporate sustainability reports, engagement discussion with corporate management teams, among others. A high sustainability rating does not mean it will be included in a portfolio, nor does it mean that a bond will provide profits or avoid losses.
Net Zero alignment and classifications are defined by Breckinridge and are subjective in nature. Although our classification methodology is informed by the Net Zero Investment Framework Implementation Guide as outlined by the Institutional Investors Group on Climate Change, it may not align with the methodology or definition used by other companies or advisors. Breckinridge is a member of the Partnership for Carbon Accounting Financials and uses the financed emissions methodology to track, monitor and allocate emissions. These differences should be considered when comparing Net Zero application and strategies.
Targets and goals for Net Zero can change over time and could differ from individual client portfolios. Breckinridge will continue to invest in companies with exposure to fossil fuels; however, we may adjust our exposure to these types of investments based on net zero alignment and classifications over time.
Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.
The effectiveness of any tax management strategy is largely dependent on each client’s entire tax and investment profile, including investments made outside of Breckinridge’s advisory services. As such, there is a risk that the strategy used to reduce the tax liability of the client is not the most effective for every client. Breckinridge is not a tax advisor and does not provide personal tax advice. Investors should consult with their tax professionals regarding tax strategies and associated consequences.
Federal and local tax laws can change at any time. These changes can impact tax consequences for investors, who should consult with a tax professional before making any decisions.
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