Municipal bonds are an important component in a well-diversified fixed income allocation. We recently caught up with Sylvia Yeh, co-head of municipal fixed income at Goldman Sachs Asset Management, to dive deeper into this unique bond category.
The discussion explores the unique characteristics of muni bonds, the evolving opportunity set under different market conditions, and considerations for implementation from investment style to investment vehicle choices.
Question: Let’s start with a quick overview of the opportunity set in munis. What are the key characteristics of municipal bonds that make them an interesting security for a tax-aware investor?
Sylvia Yeh: There are so many characteristics inherent to munis that make them an important investment consideration, including their relatively low risk profile, predictable income streams, and low correlation with other assets. But the biggest and probably most popular aspects of munis are their tax-exemption features.
Generally speaking, interest income from municipal bonds is exempt from federal income tax, and sometimes from state and local taxes as well if the investor resides in the state where the bond was issued. You’ll often hear us refer to munis as “double” or “triple” tax-exempt, meaning that your bonds can be exempt from federal, state and local taxes. There are other types of munis, however; namely, taxable munis and private activity bonds, known as alternative minimum tax (AMT) munis, where interest income is taxed differently than traditional munis.
While the case to own munis is often clear for investors in the highest federal tax bracket, it’s important to note that munis may also be interesting for investors who are in lower tax brackets. More and more investors are becoming “tax-aware” and focusing on what they keep. With that in mind, do the math ― there are opportunities to enhance your investment within the asset class just by assessing the impact of the different tax exemption features. Taking this a step further, taxable equivalent yield calculations will help investors assess the value of munis when comparing individual muni securities and/or when comparing munis with taxable fixed income alternatives, like Treasuries and corporate bonds, for example.
Munis can allow investors to generate tax-preferred income while also serving as a conservative and stable investment within portfolios.
Question: When you think about issuer risk on a bond, are revenue bonds riskier? How do revenue bonds compensate investors for the additional risk relative to general obligation bonds, since they are tied to project revenues?
Yeh: The premise of the question is really broad, and like many aspects of the muni bond market, the answer is, “it depends.” At a high level, revenue bonds are backed by a specific revenue stream set aside for repayment of the bond, and general obligation bonds are backed by either the full faith and credit of the state government or ad valorem taxes; for example, property taxes.
Evaluating source of repayment is only one factor to consider when looking at a bond or comparing bonds. You must go deeper than that when assessing the risk of a security. For example, essential-service revenue bonds, such as water and sewer systems, tend to be highly secure monopoly systems and can be stronger credits than the same issuer’s general obligation bonds. Revenue bonds, however, are secured by more narrow and less essential services, such as parking systems, and may be viewed as weaker credits than the general obligation bond of the same issuer.
Evaluating the risk of any bond will go beyond source of repayment ― there are multiple factors at play. Research analysts will review security, ratings trends, financial performance, timeliness of disclosures, debt ratios, budget practices, and even economic and demographic factors when assessing the credit worthiness of a bond. Portfolio managers will use this analysis and couple it with evaluating a bond’s structure, duration, and deal size to determine what these bonds are worth in the marketplace. We don’t discriminate between revenue bonds and general obligation bonds ― we like all bonds!
Question: Types of munis, credit quality, and risk are clearly all important considerations. What else is key to making sense of the opportunity set in munis?
Yeh: The muni market is broad and deep, but clients will drive the opportunity set in munis. What is their objective? What are we solving for? Risk profile? Liquidity preferences? Income needs? These inputs will determine what bonds go into portfolios. These inputs may even determine what type of investment vehicle to leverage to optimize a client’s specific situation.
For those not as familiar with munis, it’s worth highlighting that the asset class is a bit more opaque than others (not fully efficient and not traded on an exchange, for example). The market is so broad and deep, how do you get your arms around all of that? Professional managers with big data capabilities, solid analytical tooling, and a robust order management and execution platform are positioned well to identify opportunities achieve to excess returns and/or income for clients.
The opportunity set for the asset class today is driven by a largely benign credit environment, an elevated interest rate environment currently, and a declining rate environment on the horizon.
We own fixed income/munis for a reason ― tax-preferred income generation, capital preservation, and diversification. We believe that yields have likely peaked and are likely to continue to decline in the coming year ― so catch yields while you can!1,2
Question: What does supply look like right now?
Yeh: New-issue supply is up 40% versus the third quarter of 2023 and continues to surprise the market with its record-setting activity. We didn’t even experience the typical summer lull in issuance, as $43 billion was priced per month on average during July/August/September. And $49 billion was issued in the month of August ― the highest supply for that month on record!3
The increase in supply can be attributed to a number of factors, including issuance for new projects, refinancing activity, and issuers looking to get ahead of potential volatility related to the U.S. presidential election. From a sector perspective, issuers within the healthcare, transportation, and utility sectors have materially increased their borrowing this year. Refinancing activity has been partly driven by issuers exercising extraordinary redemption provisions (ERP) on a subset of taxable muni bonds (Build America Bonds/BABs).
While new issue supply has been robust to date, we expect new-issue supply to slow down as we get closer to the election. Any underperformance or backup in yields caused by excess supply could be seen as a buying opportunity.
Interestingly, high yield issuance has been lackluster year to date and a driving force behind the sector’s performance ― solid and consistent demand chasing fewer bonds.
Question: This sounds like a case for active management in munis.
Yeh: Yes, the muni market is complex and fragmented, and as a result, provides opportunities for active investors to add value and deliver for clients.
To level-set, for a market only $4 trillion in size, as I’ve mentioned, there are over 50,000 different issuers and 1 million CUSIPs (securities)4. Each bond has a unique structure and story. There are hundreds of dealers active in this marketplace ― munis do not trade openly on exchanges. Asset managers with robust infrastructure can ingest/digest all of the available information to identify and execute on opportunities. We need to and do look at every bond available. The market has evolved from a rates market into a true credit market (post-GFC and deterioration of monoline insurers). We believe there is a strong case for professional management and active management.
We discussed the complexities around credit and risk assessment earlier. An experienced research team with access to big data and inherent rigor in their processes is key to identifying opportunities and avoiding risk in both traditional IG and high yield sectors. Active credit management not only focuses on the bonds you own but also the bonds you work(ed) to avoid.
Active management allows portfolio managers to take advantage of market inefficiencies, employ tax-loss harvesting strategies and adjust portfolio risk profiles/duration targets based on the outlook for interest rates.
Question: Earlier this year, in your outlook, you called for a return to duration. How should investors think about duration in munis, especially as tied to different types of bonds?
Yeh: For obvious reasons ― a prolonged and very low-interest rate environment ― investors have been overweight cash and short duration for some time. Adding duration to your fixed income portfolio/muni bond portfolio offers many potential benefits ― the ability to lock in attractive yields, enhance income potential, ensure portfolio stability, and position defensively ahead of a declining interest rate environment.
There are so many ways to consider duration in muni-land. A bond’s structure (couponing and callability in particular) influences its duration, and that can be dynamic. Callable bonds, specifically “optional” calls, allow issuers to redeem bonds earlier than their stated maturity, and therefore can result in a shorter duration than expected. Conversely, if issuers do not exercise a call, an investor may end up holding a bond longer than originally intended at time of purchase. Both situations result in less-than-ideal outcomes for the bond holder. If a bond is called away from you earlier than anticipated, that means that prevailing interest rates are low, and you now need to reinvest those proceeds into a low-interest-rate environment. Conversely, if yields are rising, so your bonds have not been called, now you are stuck holding a bond at a lower interest rate versus what is offered in the current marketplace. Professional management can help navigate some of these risks. Another option is to avoid callable bonds to mitigate that risk and ensure greater certainty in income earned/paid out.
The last two things I would say here are: 1) let bonds be bonds; and, 2) an allocation to cash is not considered fixed income. It is important to understand all the reasons you own fixed income. And duration is important to a long-term strategic allocation to fixed income. This is especially true when you are in a high-interest-rate environment in which you are being compensated to take on duration risk.
Question: How have munis benefited from the uptrend in equities? Does the equity market play a significant role in muni performance?
Yeh: Munis do benefit from an uptrend in equities, and this can vary across the country. The muni market benefits and muni issuers benefit.
A booming equity market translates into additional dollars for municipalities through increased capital gains and thus larger tax collections. These additional dollars often strengthen the financial health of the municipalities and/or can be directed toward pending projects and additional services needed in the underlying communities.
The muni market tends to benefit from additional wealth creation connected to equity gains. Investors often have more demand for municipal bonds. Profits are often reinvested, and portfolios rebalanced.
Question: So, there’s no one-size-fits-all solution. Would you talk about the various investment vehicles, their evolution, and use cases?
Yeh: The markets have evolved from a one-size-fits-all solution, and that has again been driven by the client and their preference for personalization. From mutual funds to ETFs to SMAs to a combination of the three ― clients have choice and should demand personalization.
Mutual funds have been around for a long time. They are easily accessible and liquid. Structured as big pools of assets, they provide investors with deep and broad exposure to the muni market in this case. Professional and active management and a deep and experienced research team can and is expected to enhance return. Mutual funds are popular with investors that do not require customization and just want access to an asset class or, more specifically, access to certain parts of an asset class that really cannot be implemented on an individual bond basis.
ETFs typically provide broad market access with greater tax efficiency than mutual funds and at a lower cost because of their historically passive management style. Having said that, the ETF market is also evolving, and actively managed ETFs are trending with the launch of new funds. Active ETFs provide investors with all the benefits of actively managed mutual funds plus the transparency provided within SMAs.
Personalization draws attention to SMAs, and while they were once only accessible to high-net-worth individuals due to large minimum accounts sizes, improvements in technology have democratized SMAs, making them more accessible to individual investors.
To optimize investment outcomes, investors are encouraged to have a vehicle-agnostic approach when thinking through potential solutions.
For more news, information, and analysis, visit VettaFi | ETFDB.
1 The economic and market forecasts presented herein have been generated by Goldman Sachs Asset Management for informational purposes as of the date of this presentation. They are based on proprietary models and there can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this presentation.
2 Diversification does not protect an investor from market risk and does not ensure a profit.
3 Source: Goldman Sachs Asset Management, Bloomberg, BVAL Muni, Bond Buyer, Lipper Fund Flows. As of September 30th, 2024. Past performance does not predict future returns and does not guarantee future results, which may vary. Past correlations are not indicative of future correlations, which may vary.
4 Source: MSRB Muni Facts. As of March 2024: https://www.msrb.org/sites/default/files/2022-09/MSRB-Muni-Facts.pdf
IMPORTANT DISCLOSURE INFORMATION
THIS MATERIAL DOES NOT CONSTITUTE AN OFFER OR SOLICITATION IN ANY JURISDICTION WHERE OR TO ANY PERSON TO WHOM IT WOULD BE UNAUTHORIZED OR UNLAWFUL TO DO SO.
Prospective investors should inform themselves as to any applicable legal requirements and taxation and exchange control regulations in the countries of their citizenship, residence or domicile which might be relevant.
This material is provided for informational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell any particular securities or to adopt any specific investment strategy. This material is not intended to be used as a general guide to investing, or as a source of any specific investment recommendations, and makes no implied or express recommendations concerning the manner in which any client’s account should or would be handled, as appropriate investment strategies depend upon the client’s investment objectives.
This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. This material has been prepared by Goldman Sachs Asset Management and is not financial research nor a product of Goldman Sachs Global Investment Research (GIR). It was not prepared in compliance with applicable provisions of law designed to promote the independence of financial analysis and is not subject to a prohibition on trading following the distribution of financial research. The views and opinions expressed may differ from those of Goldman Sachs Global Investment Research or other departments or divisions of Goldman Sachs and its affiliates. Investors are urged to consult with their financial advisors before buying or selling any securities. This information may not be current and Goldman Sachs Asset Management has no obligation to provide any updates or changes.
Goldman Sachs has not authorized financial intermediaries to use and distribute this material, unless such use and distribution is made in accordance with applicable law and regulation. Additionally, financial intermediaries are required to satisfy themselves that the information in this material is appropriate for any person to whom they provide this material in view of that person’s objective and circumstances.
Goldman Sachs does not provide legal, tax or accounting advice to its clients. All investors are strongly urged to consult with their legal, tax, or accounting advisors regarding any potential transactions or investments. There is no assurance that the tax status or treatment of a proposed transaction or investment will continue in the future. Tax treatment or status may be changed by law or government action in the future or on a retroactive basis.
Although certain information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness. We have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources.
Views and opinions expressed are for informational purposes only and do not constitute a recommendation by Goldman Sachs Asset Management to buy, sell, or hold any security. Views and opinions are current as of the date of this material and may be subject to change, they should not be construed as investment advice.
There is no guarantee that objectives will be met.
All investing involves risk, including loss of principal.
Municipal securities are subject to credit/default risk and interest rate risk and may be more sensitive to adverse economic, business, political, environmental, or other developments if it invests a substantial portion of its assets in the bonds of similar projects or in particular types of municipal securities. While interest earned on municipal securities is generally not subject to federal tax, any interest earned on taxable municipal securities is fully taxable at the federal level and may be subject to tax at the state level.
Exchange-Traded Funds are subject to risks similar to those of stocks. Investment returns may fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed, or sold, may be worth more or less than their original cost. ETFs may yield investment results that, before expenses, generally correspond to the price and yield of a particular index. There is no assurance that the price and yield performance of the index can be fully matched.
Mutual funds are subject to various risks, as described fully in each Fund’s prospectus. There can be no assurance that a Fund will achieve their investment objectives. The Fund may be subject to style risk, which is the risk that the particular investing style of the Fund (i.e., growth or value) may be out of favor in the marketplace for various periods of time.
Economic and market forecasts presented herein reflect a series of assumptions and judgments as of the date of this presentation and are subject to change without notice. These forecasts do not take into account the specific investment objectives, restrictions, tax and financial situation or other needs of any specific client. Actual data will vary and may not be reflected here. These forecasts are subject to high levels of uncertainty that may affect actual performance. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes. These forecasts are estimated, based on assumptions, and are subject to significant revision and may change materially as economic and market conditions change. Goldman Sachs has no obligation to provide updates or changes to these forecasts. Case studies and examples are for illustrative purposes only.
Past performance does not guarantee future results, which may vary. The value of investments and the income derived from investments will fluctuate and can go down as well as up. A loss of principal may occur.
United States: In the United States, this material is offered by and has been approved by Goldman Sachs Asset Management, L.P. and Goldman Sachs & Co. LLC, which are registered investment advisers with the Securities and Exchange Commission.
Confidentiality
No part of this material may, without Goldman Sachs Asset Management’s prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient.
© 2024 Goldman Sachs. All rights reserved.
Compliance code: 393655-OTU-2132311
