The argument for municipal bond mutual funds

March 19, 2012

For retail fixed-income investors, there are three main approaches to owning municipal securities: buying actively managed mutual funds, buying individual securities and laddering them to mature at intervals (see explanation below), or buying municipal ETFs like BlackRock’s MUB.

Because investors have different goals and needs as well as varying amounts of knowledge and time to research their options, there are advantages to each approach. AllianceBernstein sent over this blog post, which makes a very good argument for active management through mutual funds. It’s from Guy Davidson, the director of municipal bond management. I’m hoping to run pieces from other professionals in the next week or so advocating the other approaches.

The importance of being active: The problem with ladders

By Guy Davidson

Laddering entails buying bonds with a range of maturities and holding them to maturity. In our view, laddering has always left potential gains on the table that an active manager could scoop up, but the strategy has become especially problematic today.

Before 2008, about half of newly issued bonds came to the market as AAA-insured bonds. This made it appear fairly safe for individuals or their advisers to choose among the wide array of available bonds.

But several of the major bond insurers went out of business in the last few years after expanding into subprime mortgages tied to individual homes. As a result, only about 5 percent of bonds have come to the market with insurance so far this year, and the pool of AAA-rated municipal bonds has been dramatically reduced. Individual investors can no longer rely on a AAA rating for safety. Now more than ever you have to understand the credit particulars of the bonds you buy.

And understanding what you’re buying requires detailed research. The municipal bond market is vast: The major municipal bond indices include between 27,000 and 47,000 securities of various maturities and features, issued by about 2,500 entities. That’s in contrast with the 500 stocks in the S&P 500 and the approximately 1,500 stocks in the Morgan Stanley Capital International World Index.

A simpler path?

There are other good reasons to question laddering and other buy-and-hold approaches. Such strategies rest on the principle that as long as the issuer doesn’t default, investors are assured of getting regular interest payments and 100 percent of their principal back when the bonds mature, regardless of whether the value climbs or falls during the life of the bond.

But bond values constantly change in response to market conditions, so locking into a bond or group of bonds means losing out on the higher yields that may be available as interest rates rise, credit conditions shift or the shape of the yield curve changes. In essence, it means forfeiting potential return opportunities and ignoring potential risks. Active managers can add value by exploiting these changes. Bonds, like stocks, offer potential capital appreciation (or loss), as well as income, and total after-tax return is a combination of all these factors.

Furthermore, a laddered portfolio doesn’t provide much liquidity. While coupon payments are likely to arrive on schedule, for the investor who unexpectedly needs to raise cash, selling a bond before maturity can be expensive: Wide bid-ask spreads for infrequently traded bonds can take a big hit.

Bond investing may appear to be as simple as buying bonds with the highest yield, but there’s far more to it, especially in today’s world. As a strategy of benign neglect, laddering can be costly, both in terms of realized risk and opportunities forgone.

The financial crisis taught us that financial conditions can change both quickly and dramatically. Investors should be in a position where they can actively adapt to these changing conditions and even profit from them.

The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

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