It is a widely known fact that the municipal bond market is dominated by retail investors. Less understood, however, is the influence retail dominance has on the yield curve, credit spreads and volatility. Our view at M. Austin Investments is that this dominance creates a unique market environment for investors to build a more productive and opportunistic municipal bond portfolio by taking advantage of the liquidity premium offered by municipal bonds.
According to the Securities Industry and Financial Markets Association (SIFMA), during Q1 2022 individuals made up 40.4% of municipal bond holders and mutual funds accounted for 28.8%. The combination of the two amounts to almost 70% of the municipal bond market being heavily influenced by retail-minded investors.
Mutual fund managers and financial advisors managing individual bond accounts certainly mitigate some retail influence, however their decisions reflect shareholder demand and individual client risk appetite. Thus, the retail effect still guides trading decisions, and, at times, can be extremely impactful.
Defining Retail
A retail investor is an individual who buys and sells securities for their own account. Compared to institutional investors, retail investors generally trade in smaller block sizes and are less informed. Furthermore, they are thought to be more emotional and more susceptible to behavioral biases such as loss aversion and herd mentality.
Retail investors in the municipal bond market are generally 'risk averse', seeking stable, tax-efficient income to complement their broader, multi-asset class portfolio. For this reason, their demand preferences, which ultimately drive portfolio construction and asset allocation, are for higher quality assets with lower volatility. They also typically hold their bonds to maturity which reduces liquidity and trading activity within the market.
Retail Influence on Market Structure
The Yield Curve:
Retail investors that are primarily focused on quality and stability are likely to gravitate towards short-to-intermediate duration assets with little, if any, exposure to long duration bonds. The lack of demand for long-dated municipals is illustrated in the chart below comparing the yield differential between 10-year and 30-year bonds in US Treasuries versus AAA-rated municipals. As seen, the pick-up in yield by purchasing a 30-year US Treasury bond is 22 basis points (bps.) compared to the municipal curve which offers an additional 114 bps. Even more compelling, after adjusting for taxes, the yield pick-up jumps to approximately 193 bps.
April 14, 2023 Tax Rates: 37% Federal Income Tax, 3.8% ACA
This yield pick-up relative to US Treasuries is often confused with additional credit or duration risk, despite the fact that the Muni market has relatively low credit risk and duration when adjusting for call structures. Therefore, the additional yield is largely a result of liquidity risk and lack of investor demand.
Credit Exposure:
According to Moody’s, most of the municipal market is issued with high-quality investment grade ratings. Risk averse retail investors are generally more comfortable owning high-quality bonds with limited exposure to BBB, high-yield, or even non-rated bonds. This lack of demand for lower- and non-rated Munis creates a compelling yield advantage even after considering credit and default risk.
Munis have historically had a lower default rate with higher recovery rates compared to corporate bonds of similar credit quality. According to Moody's, the 20-year cumulative default rate for Baa-rated Munis is 1.86%, compared to global corporate bonds at 9.01%. Across all rating categories, the 20-year cumulative default rate for Munis is 0.26%, versus global corporate bonds at 15.28%. While rare amongst municipal issuers, defaults do occur, but are typically idiosyncratic. For this reason, we would recommend investors do additional credit research before adding exposure to lower and non-rated Munis.
With significantly lower default risk, many investors might assume the yield on municipals would be considerably lower than corporates on an after-tax basis, but this is rarely the case. As of April 11, 2023, the yield-to-worst on the S&P Municipal Bond BBB Rating Band Index is 3.90% with a tax-equivalent yield of approximately 6.60%. Comparatively, the yield on the S&P/ASX Corporate Bond BBB Rating Band Index is 5.07%.
Therefore, the additional yield on lower and non-rated Munis does not result from increased credit risk alone, but also reflects a liquidity premium originating from a lack of investor demand. Thus, for investors with a long-term time horizon, and lower liquidity needs, appropriate exposure to lower and non-rated Munis can increase the risk-adjusted yield on their bond portfolio.
Volatility
Studies have shown that retail investor influence is most notable during volatile market movements and can even exacerbate volatility in financial markets. For municipal bonds, it is especially evident during periods of rising rates. As retail investors get nervous and begin selling shares of their mutual fund/ETF holdings and/or individual positions, bond prices can decline precipitously. In extreme instances, portfolio managers at mutual funds are forced to sell bonds at depressed prices in order to meet redemptions. Large fund outflows in mutual funds and steep discounts of net-asset-values (NAV) relative to book values can indicate extreme selling pressure and provide a helpful guide to retail sentiment during volatile markets. These periods of volatility can offer attractive entry points for patient investors with a longer-term time horizon.
Build a Better Municipal Bond Portfolio
The retail dominance of municipal bond market participants can have wide ranging impacts on valuation and market fundamentals. More importantly, it creates a unique environment for sophisticated market participants to add value to a generic municipal bond portfolio by extracting the resulting liquidity premium.
At times, adding exposure to long duration assets in a barbell strategy can boost the yield on a portfolio while keeping the overall duration in-line with investor risk objectives. Additionally, investors with local knowledge of the market who focus on fundamental credit analysis can add yield by incorporating lower and non-rated bonds. Lastly, patient-minded investors with a longer-term time horizon are better positioned to take advantage of market disruptions when volatility presents opportunity.
At M. Austin Investments, we believe that there is a better way to construct a municipal bond portfolio; one that starts with understanding the unique market dynamics exhibited in the municipal bond market as a result of retail dominance. We assess our clients’ investment objectives and risk profiles and build an optimal portfolio for their needs. For clients with appropriate risk tolerance, we seek to take advantage of the liquidity premium defining these unique market dynamics. Instead of following the herd and investing alongside everyone else, consider the value offered in areas of the market that most investors ignore.
Sources:
Securities Industry and Financial Markets Association (SIFMA)
Moody’s US Public Finance – US municipal bond defaults and recoveries, 1970-2021
Disclosures:
This content has been prepared for informational purposes only and should not be considered as investment advice. We recommend all investors to consult with a financial and/or tax advisor before taking investment decisions.
Investing in bonds exposes the investor to the risk of loss of principal. Lower and non-rated securities are more volatile and less liquid than investment grade bonds. Liquidity risk relates to the timing of converting a security into cash without affecting the market price. Municipal bonds and preferred stock tend to be less liquid than government or corporate bonds. Higher-yielding, longer-maturity, lower-rated, non-rated, or certain bond restrictions limit or reduce the liquidity of bond holdings.
Please visit our website for a complete list of disclosures and risks: www.maustininvestments.com.
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