Perspective published on May 21, 2021
When to Bench the Municipal Bond Benchmark
- Investors in municipal bond strategies should exercise caution when using indices to set portfolio structure or performance targets.
- In Breckinridge strategies, we aim to preserve capital and to create a reliable income stream with customized tax efficiencies for our clients.
- Benchmarks offer a birds-eye view of asset classes to compare relative value, and they provide historical context for performance. However, they have their limitations.
To find the most appropriate benchmark for a strategy, investors and managers typically aim to use an index closely aligned to the strategy’s characteristics while representing the return trends of an asset class.
Most major indices for heavily traded, liquid assets such as equities or corporate bonds tend to rely on characteristics such as market capitalization, market sector or market prominence and trading volume to determine constituents.
It is worth noting that it is not possible to invest directly in an index. That is why passive investment strategies seek to replicate a bond benchmark index like the BBG Aggregate Bond Index or the BBG Municipal Bond Index.
A challenge for individual investors is the impracticality of trying to hold all of the securities in the index in proportions that match the index’s changing weightings. In addition, unlike equities, fixed income indices over time increase weightings to issuers with higher debt burdens—the opposite of what fundamental analysis usually dictates. Finally, changes in a key index characteristic such as duration can further complicate the comparability of a benchmark and a portfolio, as we will review with regard to a common municipal bond index.
For these reasons, bond investors must exercise caution when selecting and using indices to set portfolio structure target or performance expectations.
In this piece, we compare the composite for the Breckinridge Intermediate Tax-Efficient Strategy (the Strategy) and its primary benchmark, the Bloomberg Barclays 1-10 Year Blend (1-12) Municipal Bond Index (the Index). Note that individual portfolios within the Strategy may differ from the composite and the Index. Thus, the results presented in the comparison may be very different from a comparison of an individual portfolio with the index.
BRECKINRIDGE VS. THE INDEX
For our tax-efficient strategies, performance may differ from their benchmarks. First, the relevant indices are not investable, so holding all of the securities in the same proportions of the index is a challenge. Second, we intentionally structure our strategies differently from the benchmark in some respects.
For example, we typically invest in investment grade issuers with credit ratings of at least A- or better at time of purchase. We seek to own bonds with less call risk and to maintain exposure to states and sectors in more customized allocations than many indices. The index, in contrast, includes lower-rated bonds and a broader representation of bonds across sectors and security features, some of which we may not find attractive given our philosophy and mandate.
To provide a deeper understanding of these differences, we detail characteristics of the Index and the Strategy below.
Index: The Index is not investable and contains many bonds too infrequently traded for reliable pricing. Illustrating this point, roughly 11 percent of the Index par value has traded year to date as of March 31, 2021, a statistic that is relatively consistent across other municipal indexes.1 The Index consists of over 30,000 bonds, and almost half of the bonds were issued more than five years ago (Figure 1), reducing the likelihood of frequent trading for those securities.
Breckinridge: The Strategy seeks to invest in securities with more-recent issue dates than the Index and adequate liquidity based on their likelihood to trade.
Index: It has meaningfully larger exposure to what are traditionally considered riskier sectors, such as industrial development and tobacco bonds. Additionally, given the market weighting of the Index, it tends to have more exposure to sectors such as state general obligation (GO) bonds, which comprise large issuers.
Breckinridge: We emphasize investment grade assets and completely avoid some riskier sectors that the Index holds (such as those mentioned above). We are also generally overweight essential-service bonds due to our investment grade mandate. Finally, since we focus less on issue size than the Index, the Strategy has a significantly lower weighting to state GO’s and a higher weighting to local GO’s—especially in state-biased portfolios where we strive for diversity among in-state issuers (Figure 2).
Index: It generally owns a higher percentage of A rated and BBB rated bonds versus the Strategy.
Breckinridge: The Strategy is weighted to AA names with a limited allocation to A and BBB credits. The Strategy invests selectively in names meeting our strict standards of credit quality (Figure 3).
Index: It has significantly more exposure to bonds with longer maturities and shorter call dates.
Breckinridge: While we buy callable bonds, we tend to limit exposure to bonds with longer maturities and shorter call dates. In our view, these types of callable bonds introduce two main risks:
- 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.
- Extension risk: By contrast, if interest rates rise, bond issuers will be less likely to call a bond. This could sharply increase the bond’s effective duration and cause it to lose value and liquidity rapidly.
Index: It is heavily exposed to issuers from California or New York due to large issuance volumes in those states (Figure 4).
Breckinridge: State exposure is managed on the individual account level. For instance, we commonly customize portfolios to invest in state-biased municipal bonds.
Conversely, for national market portfolios, we focus on bonds from states with lower (or no) state income taxes.
Index: It does not account for transaction costs. Index turnover is done without cost at evaluated prices despite the average transaction cost per bond for intraday trades being 122 basis points in 2020.2 Therefore, Index performance has a decided but hidden advantage by not including them. By the same token, any Breckinridge composite will be at a disadvantage versus the Index, because the transactions all include embedded costs.
Breckinridge: We account for and manage transaction costs. With more than $37 billion of exposure in municipal bonds as of March 31, 2021, we work with an extensive network of broker dealers which supports our best execution efforts.
Index: Indices do not consider the tax consequences of removing bonds and for holding alternative minimum tax (AMT) securities if a client is subject to the AMT. Additionally, the Index does not account for individual tax considerations.
Breckinridge: We seek to maximize after-tax income and tax efficiency,3 including exclusions to AMT bonds. We also consider the tax advantages or disadvantages a client may encounter by investing in particular states. For many clients, the tax-free income is the most important feature of municipal bonds. For other investors, having exposure to taxable municipal bonds is another way of potentially increasing portfolio yield in that segment of the municipal bond market.
In addition, tax-loss harvesting and tax swaps, two proactive portfolio strategies, are available in actively managed strategies that are not offered in passively managed or index strategies.
Index: Duration is a key risk factor that active investment managers seek to mitigate. For example, a bond with a one-year duration would only lose 1 percent in value if rates were to rise by 1 percent. In contrast, a bond with a duration of 10 years would lose 10 percent if rates were to rise by that same 1 percent. Conversely, if rates fell by 1 percent, bonds with a longer duration would gain more while those with a shorter duration would gain less. Duration of unmanaged indexes change—sometimes substantially—as influenced by market conditions. For example, among other factors, index duration is governed by changes in the amount and composition of new-issue supply. Figure 5 illustrates a fairly consistent shortening of duration for the BBG Managed Money Short Intermediate (1-10) Municipal Bond Index and the BBG 1-10 Year Blend (1-12) Municipal Bond Index during the last two decades.
Breckinridge: Breckinridge actively manages duration, building portfolios with exposure to bonds across the yield curve as appropriate to the strategy’s stated maturity objective. By doing so, portfolio managers seek to hedge risks of both falling and rising rates.
Index: It has no liquidity costs to manage.
Breckinridge: We try to ensure ample liquidity of holdings to meet clients’ cash needs and to execute our investment strategy. Breckinridge invests in what has historically been the most liquid part of the municipal bond market: investment grade securities from sectors such as GO and essential revenue bonds.
STRATEGIC POSITIONING WHEN INVESTORS NEED IT MOST
In our strategies, we aim to preserve capital and to create a reliable income stream with customized tax efficiencies for our clients. These goals supersede the aim to mirror relevant benchmarks, especially given that the benchmarks do not adequately represent the available municipal market, the risk profiles of many of our clients or the allocation that will maximize risk-adjusted, after-tax income for them. Simply put, while we want to outperform the benchmark, we do not let it dictate our management.
By design, Breckinridge tax-efficient strategies offer investment grade positioning, allowing us to potentially outperform during “risk-off” periods when broader markets are falling. In our view, the times when risk is out of favor are precisely when investors need this investment grade mandate the most.
In some respects, benchmarks are useful. They offer a birds-eye view of asset classes to compare relative value, and they provide historical context for performance. However, benchmarks have their limitations. For some asset classes, such as municipal bonds, benchmarks can be less useful because they can neither adequately represent actual trading activity and market composition nor match the risk tolerances and investment objective of many clients.
 Breckinridge Capital Advisors and the Municipal Securities Rulemaking Board (MSRB), as of March 31, 2021.
 MSRB. The spread reflects the average difference between dealer purchase price and sell price per bond (face value of $1,000) for intraday trades. For illustrative purposes, a $1 spread on a bond purchased by a dealer at par $100, would be a sale price of $100.1 (or $1001.00 per bond). The MSRB figure is an average of the individual differences between all buys and sales of the same CUSIP on the same day and is not par weighted. The result excludes Breckinridge cross trades, trades where the spread of the buy/sell is negative, 0 or above 20 points, and trades where the coupon is null. Such trades have been excluded to eliminate potential data input errors and the presence of floating-rate bonds, which do not have spreads (i.e., they trade at par). Since large buy/sell spreads (i.e., over 20 points) are not common, we have excluded these as they may signal a reversal of price and yield, or some other type of error in data entry.
 Breckinridge is not a tax advisor and does not offer tax advice.
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 cannot assure a profit or protect against loss. 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.
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