The content on this website is intended for investment professionals and institutional asset owners. Individual retail investors should consult with their financial advisers before using any of the content contained on this website. Breckinridge uses cookies to improve user experience. By using our website, you consent to our cookies in accordance with our cookie policy. By clicking “I Agree” and accessing this website, you represent and warrant that you are agreeing to the above statements. In addition, you have read, understood and agree to the terms and conditions of this website. The content on this website is not intended for use or distribution outside of the U.S., unless permitted by applicable law.

Investing

Perspective published on May 3, 2022

The Case for Active Management

Summary

  • Attentive, ongoing portfolio management can help investors take advantage of opportunities 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 often means inactive. A bond is purchased and usually held until it matures, is downgraded or called. Investment decisions are made solely in reaction to such events and new purchases are restricted to specific maturities regardless of the prevailing market conditions.

Breckinridge believes that municipal bond portfolio management should be proactive. The municipal market’s large size and diversity offer greater potential inefficiencies than is commonly recognized. There are countless 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 the missed opportunities and transactional costs of passive management are taken into account, we believe that professional active management offers significant advantages over passive.

BRECKINRIDGE OFFERS THE FOLLOWING:

Institutional Trading

Broad Dealer Network

Two main benefits of institutional management are improved market access and better 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.

Purchasing Power

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, 2019, Breckinridge is an active participant in the municipal market.

Security Selection

Fundamental Analysis

Municipal bonds are not always safe, 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.

Call Structure

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.

Portfolio Structure

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

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.2

CONCLUSION

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.

 

#293242 (5/3/22)

[1] 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.

[2] Investors should consult with their financial and/or tax professionals prior to engaging in any tax-loss swaps.

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.

Breckinridge can make no assurances, warranties or representations that any strategies described will meet their investment objectives or incur any profits.

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.