- Muni bonds represent an attractive investment opportunity
- Active management is a value add in these volatile markets
- Professional money managers can help investors navigate an ever-changing environment
Where does one invest in a world of uncertainty?
Rising taxes, volatile markets, low yields, economic stagnation, geopolitical unrest. We live in a world of great uncertainty — yet our investment goals remain the same: a comfortable retirement, paying for college, an attractive income. While deciding where to invest one’s hard earned assets is never easy, municipal bond funds offer several compelling advantages in these challenging times. Many investors are turning to muni bond funds for the opportunity to earn an attractive tax-free yield with lower volatility than equities. In addition, munis have historically provided long periods of positive performance, as shown in the Barclays Municipal Bond Index chart below.
Exhibit 1: Barclays Municipal Bond Index calendar-year returns
Past performance does not guarantee future results. It is not possible to invest directly in an index. Source: Barclays, as of March 31, 2014.
Munis are attractive for investors in high tax brackets
Recently, the advantages of municipal bonds have become more apparent as taxes have increased for many investors, new taxes have emerged and taxable-equivalent yields are higher than they were a year ago.
Many high tax bracket investors are keeping less than half of their income after paying the highest federal tax rate of 43.4% (which includes the new 3.8% Net Investment Income Tax) in addition to possible state and local income taxes. Municipal bonds are one of the few investments that remain exempt from many of these taxes, including the NIIT.
Active is the answer
After determining that muni bonds should play a part in a diversified portfolio, the next question is: Which investment approach should one take — active or passive? With so many investment options to choose from, some believe that picking a passive municipal investment strategy is a no-brainer. A passive approach provides exposure to municipal bonds, tax-exempt income and low investment costs. Passive strategies seek to mirror the chosen index, in make-up and performance, via a mechanical investment process, without regard to valuation, portfolio positioning, research, risk management or market environment.
Investors should be aware that, unlike passive equity funds that may use a full replication strategy, passive municipal strategies may find it extremely difficult to fully replicate their index as some municipal indices contain thousands of securities with various characteristics and different levels of liquidity. Passive municipal investments, therefore, may have to use a sampling strategy — buying bonds with similar characteristics as in the index but not the exact bonds — which may lead to tracking error. Furthermore, passive strategies have no defensive measures to protect returns when the market declines.
However, it is our conviction that active management, with the support of a deep investment management bench, can provide investors with a better risk/reward opportunity, especially in today’s unpredictable investment environment.
Actively managed portfolios provide investors with the opportunity to outperform their benchmarks by relying on the investment expertise of a team of portfolio managers, credit analysts and traders. The investment team provides clients vital investment expertise, critical issuer selection and risk oversight to avoid credit minefields. On the security selection level, portfolio managers analyze each security’s characteristics — issuer, credit quality, sector, coupon, yield, maturity, duration, call features — in addition to current market fundamentals and technicals, to determine which securities are most likely to outperform, or underperform. Credit analysts provide their independent, fundamental bottom-up credit research to determine whether a particular bond is a buy, sell or hold opportunity.
Traders deliver price guidance based on relative value and historical analysis. Investors benefit from a team with a strong long-term performance record whose investment process has withstood the test of different market cycles.
In stark contrast to a passive approach, an active investment manager will consider the overall investment and political environment when determining portfolio construction and strategy. Active managers define their strategy by managing the fund’s exposures, or “risk budget,” through the fund’s internal attributes such as yield curve positioning, issuer selection, quality, sector, yield and duration. They manage and monitor these exposures relative to the index, emphasizing securities they believe will outperform over the long term. Active managers can anticipate and respond to changing market conditions, unlike automated passive strategies.
In past years, when more than 50% of the municipal market was triple-A insured, passive investing may have made more sense. Nowadays, with heightened volatility and uncertainty around credit ratings, internal credit research accompanied by consistent credit surveillance of issuers, which active managers can provide, is extremely important to investment returns. Remember, credit rating agencies only rate bonds, they don’t invest in them.
Active management’s forward-looking approach
An actively-managed municipal bond strategy offers a forward-looking approach with the flexibility to analyze the market and economic backdrop to seek relative value opportunities in a constantly changing environment. In what many expect to be a gradually rising interest rate environment, active managers have the ability to determine which bonds are most appropriate to purchase or avoid, based on their macro-economic outlook, the security’s relative value and the fund’s positioning relative to the index. We feel strongly that active municipal bond management, with its ongoing investment oversight, credit research, trading and risk management process, can provide investors with significant advantages, especially in a tax and economic environment as uncertain as we have today.
There are risks associated with an investment in a municipal bond fund, including credit risk, interest rate risk, prepayment and extension risk, and geographic concentration risk. See the Fund’s prospectus for information on these and other risks associated with the Fund. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer-term securities.
Income from tax-exempt funds may be subject to state and local taxes and a portion of income may be subject to the federal and/or state alternative minimum tax for certain investors. Federal and state income tax rules will apply to any capital gain distributions and any gains or losses on sales.
The Barclays Municipal Bond Index is an unmanaged index considered representative of the tax-exempt bond market. Indices are not managed and do not incur fees or expenses. It is not possible to invest in an index.
Columbia Management and its affiliates do not offer tax or legal advice. Consumers should consult with their tax advisor or attorney regarding their specific situation.