The Advantages of Active Management in Bond Portfolios

An active municipal bond strategy can help improve portfolio tax efficiency, and can reduce portfolio risk by reacting to changes in issuer quality or bond duration.

Among investment professionals, opinions vary on the best way to allocate and manage investors' bond holdings. At BNY Mellon Wealth Management, we take an active approach to bond investing. We believe that by identifying undervalued securities and thoughtfully controlling risk, an active strategy can be more advantageous than a passive one, particularly when investing in municipal bonds.

Understanding How the Strategies Differ

Passive municipal bond strategies are also sometimes referred to as "laddered" or "buy and hold" strategies. Under a passive approach, an investor's fixed income portfolio includes a series of municipal bonds that mature in successive years, creating a “ladder" — each bond maturity date represents a rung on that ladder. The bonds are held to maturity and, as they mature, the proceeds are invested into another municipal bond to create additional rungs on the ladder.

Under an active municipal bond strategy, an investor's portfolio also includes a variety of municipal bonds whose maturities span a range of years. However, that's where the similarity to a passive strategy ends.

Rather than holding those bonds until maturity and reinvesting assets into a new bond with a specific maturity date, the portfolio is actively managed by an investment advisor who monitors a few key criteria. This can help ensure the portfolio's structure and risk levels stay within desired ranges.

Advantages of Active Municipal Bond Strategies

We believe using an active municipal bond strategy can provide several key benefits to investors.

These advantages include the ability to effect municipal bonds trades in a more tax-efficient manner for investors, and the flexibility to react nimbly when there are changes to a bond's credit quality.

Active management for municipal bond portfolios also allows the investment advisor to adjust the portfolio's average duration as interest rates fluctuate, helping to manage risk.

Maximizing Tax-Exempt Income

Income from municipal bonds is exempt from federal taxes. When an investor purchases municipal bonds issued in the investor's home state, that interest income may also be exempt from taxation at the state level too. Of course, these tax advantages apply whether an active or a passive municipal bond strategy is used.

However, municipal bonds can also experience capital gains or losses because of interest rate fluctuations, and because of upgrades or downgrades of a bond's credit quality.

When these capital gains or losses are realized through an active strategy, they can be used to offset losses or gains realized in other areas of a client's investment portfolio. This allows the client's investment advisor to tailor trades to the client's needs or circumstances.

Tax-loss harvesting is a common strategy that can be implemented with a client's actively managed bond portfolio. It involves the selling (or swapping) of one bond and using the proceeds to purchase another bond. The strategy is particularly advantageous when a bond with an unrealized loss is sold. Realizing the loss can reduce a client's tax liability by offsetting any gains realized in other transactions.

Done properly, purchasing another bond with the proceeds from the sale can allow the portfolio to maintain its position in terms of duration and maturity and does not disrupt the stream of income.

In a passive municipal bond strategy, the bonds inside a portfolio are held to maturity, regardless of interest rate fluctuations or changes to the issuer's creditworthiness.

Credit Analysis

Credit analysis plays a much more crucial role in municipal bond portfolios today than it did a decade ago, in large part because of changes in the bond insurance landscape.

Prior to the 2008 financial crisis, there was less of a perceived need to analyze bond issuers' credit because nearly 60% of newly issued municipal bonds were insured by AAA-rated bond insurers.1 However, when the financial crisis hit, the subsequent rise in insurance claims affected the bond insurers' ratings, sending many of them below the credit ratings for the underlying issuers they were insuring.

In 2016, just 5% of new municipal bond issues were insured, with the highest municipal bond insurers rated in the AA range.2

Because fewer municipal bond issues are insured today, credit analysis has taken on an increased importance. In addition, there is a growing concern about many state and local municipalities' ability to properly fund future pension obligations, adding another reason to conduct such analysis.

In an active municipal bond strategy, credit analysis is a foundational part of building a portfolio and of ongoing portfolio management. If an issuer's credit deteriorates for any reason, an active strategy allows (and calls for) selling the affected bonds to avoid a potential loss of principal.

In contrast, passive municipal bond strategies tend to be less concerned with credit analysis. This is because of the presumption that the portfolio's municipal bond holdings will be held to maturity regardless of changes to an issuer's creditworthiness or structure.

Duration Management

The "duration" of a bond is measured in years, and indicates how sensitive a bond's price is to interest rate changes. Bonds with longer durations are more sensitive to interest rate fluctuations; those with shorter durations are less so. Calculating a bond's duration is complex, but the bond's present value, its yield, final maturity, coupon and call features are all factors.

Over time, the average duration of an investor's municipal bond portfolio can shift because of changes to the underlying bonds' durations. Our actively managed approach ensures that our clients' portfolios maintain a consistent duration and level of risk throughout interest rate cycles.

Duration risk can be more pronounced within a passive municipal bond strategy, where bonds are typically held to maturity. This is particularly true for callable bonds within a passive bond strategy. Essentially, the duration of a passive bond portfolio tends to shorten (get less risky) in times when more risk is preferred (when bond prices rising) and lengthen (get more risky) in times when less risk is preferred (when bond prices are falling).

Conversely, an active bond strategy that maintains a consistent duration (level of risk) over time allows an investor to benefit from rising prices and avoid some losses when prices fall. When interest rates rise, bonds that have shorter durations and lower yields can be sold to increase the overall portfolio's yield. When interest rates fall, an active municipal bond strategy can ensure the portfolio benefits from increasing bond prices.

Not All Municipal Bond Strategies Are Created Equal

Every client's financial picture and goals for their wealth are different, so the amount or percentage of assets invested in municipal securities can, and does, differ from client to client. However, investors should understand the potential benefits that come from an active municipal bond strategy.

The municipal bond market is made up of approximately 80,000 unique issuers. The timing and availability of disclosures about issuers can vary greatly, creating a lack of transparency that can impact passive municipal strategies more than active strategies.

When an active municipal bond strategy is used, investors can take advantage of trades designed to improve their portfolio's tax efficiency. Investors in active strategies can also have the peace of mind that comes from knowing their advisor is monitoring bond credit quality and duration.

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