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How to Perform Active Municipal Bond Management

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What is active municipal bond management? This is an investment strategy where we actively manage our municipal bond portfolio. Bonds are typically not held till maturity. Municipal bonds are bought and sold to maximize total return. Active bond managers apply this type of strategy to their portfolios. Mutual funds will also employ these strategies, but because shares are bought and sold daily, they are more subject to market interruptions.

Who are municipal bond managers?

Many of the large investment firms have bond management available as a service. Companies like PIMCO, Nuveen, Morgan Stanley, Goldman Sachs, J.P. Morgan, etc. all participate in this area. Local and regional firms may also provide the service. There also some small shops that specialize in bonds such as Envision Capital. Expenses can range from 0.375% to 0.50% of assets managed.

Techniques Professional Bond Managers Use

Buying in large blocks – The large firms buy large blocks of municipal bonds and receive a lower price because of the volume. They can split these up into little chunks for different account holders. This technique allows for better pricing, spreads, and IPO allocations. Some reason that this aspect alone helps pay the management fees.

Selling internally – When an investor needs to sell bonds, they are typically sold on the open market to whoever is willing to offer the best price. A large firm can sell the bond essentially to another client. This helps had to liquidity, but may not yield the best price.

Dedicated research department – Professional bond managers should have a dedicated research department on staff with professionals who help analyze bond quality, critique bond ratings, understand the financial condition of municipalities based on internal research. They should be able to identify issues that could possibly be upgraded or downgraded. Professionals should hopefully be able to sell bonds before their fundamentals deteriorate too much.

Selling bonds at an optimal price – Professional managers should be able to sell bonds before they mature, at a higher price than what was paid for them. Due to a characteristic dubbed Roll, that is present in a typical upward sloping curve, long term bonds yield more than short-term bonds. Roll is the tendency of bond prices to go up over time, and to sell bonds before maturity to exploit gains. Bonds get younger with age! The yield of a secure bond is greater than the yield of a five-year bond within the years., But still pays the original coupon rate or interest rate.

If interest rates are stable, the value of the bond goes up, so it’s price rises to a peak just a couple years before maturity. As it gets closer to maturity, the bonds value goes down from its peak.

More cash flow – With a professionally managed portfolio, more turnover is likely to occur, so more cash will be made available for those that need income.

Optimizing portfolios – Professionals can tailor portfolio based on the current yield curve and future projections. They can concentrate on a particular maturity, while laddered holdings spread bond maturities out evenly. Portfolio holdings can take on a barbell pattern splitting the portfolio between short-term and long-term bonds to maximize performance.

Tax loss harvesting – Professionals will sell losers when they sell winners to offset each other. We have seen literature that suggests that this achieves a 0.2% gain every year.

Leverage, shorting, special securities – These are some controversial techniques that clearly can increase gains but also lead to bigger losses. As interest rates go up, investors could short sell municipal bond ETF’s as a hedge. Professional bond managers have access to ill liquid securities, like auction rate securities. While there is some performance advantage, the markets for auction rate securities seized up after the credit crisis causing massive problems. Sometimes it’s better to keep it simple with the part of your portfolio that is supposed to be the safest.

Overall Performance advantage

As you can see, professional municipal bond managers employ many techniques that are difficult for individual investors to utilize.  What type of performance advantage do all these techniques actually yield?

We have seen figures advertising an overall 0.5% advantage to professionally managed bond accounts over a pure buy-and-hold strategy. This is that after fees, and doesn’t factor in additional markup retail investors would probably incur.

Additional Related Municipal Bond Educational Articles:

What are municipal bonds?
How to Research Municipal Bonds
The Risks of Owning Municipal Bonds
How to Buy And Sell Municipal Bonds
Municipal Bond Mutual funds – Municipal Bond Managed Accounts
What Are Closed-end Municipal Bond Funds?

What are Municipal Bond Exchange Traded Funds or ETFs
How to Make a Municipal Bond Ladder
How to Select Municipal Bonds
Municipal Bond Trading Example
How to Perform Active Municipal Bond Management
Municipal Bond Books and Educational Resources

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