(PUB) Investing 2015

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Unconstrained Munis? Income Strategist | Elizabeth Foos

Taxable funds also have a broader pick of tools to make big changes to credit and interest-rate exposure quickly and cheaply. For example, for muni managers, nimbly moving in the high-yield space is challenging. That’s because the muni market is much less transparent and liquid than the taxable corporate- bond market. Below-investment-grade muni credits represent a small portion of the overall market, in contrast to the hefty taxable high-yield market, and they can trade infrequently. Meanwhile, the market for credit default swaps, which can be used to take broad-based exposure to credit risk, isn’t as deep or as liquid in the muni markets as it is in the taxable markets. Making swift adjustments to duration in a muni fund can also be challenging. Taxable managers can adjust a fund’s sensitivity to changes in Treasury yields quickly and cheaply using Treasury futures, a large and liquid market. Before the financial crisis, this was also a regular tool for some muni-fund skippers, too, such as PIMCO ’s Joe Deane. However, the further you move away from the Treasury market, the bigger the challenges in using this tool to effectively manage duration. For muni managers, there isn’t any tool that tracks the muni yield curve. Instead, they must either change the mix of long- and short-maturity bonds that they hold or use Treasury futures to adjust duration. Trading securities can be expensive. Mean- while, using Treasury futures can cause problems because muni and Treasury yields don’t always move in tandem. When that correlation breaks down, a muni portfolio hedged with Treasuries can behave in unexpected ways; this caused headaches for many muni managers in 2008 . What does this mean for investors? For now, it’s best to approach these funds with caution. Non-tradi- tional-bond strategies, even in the taxable-bond space, have limited track records. This, together with their broad flexibility, makes it difficult to know how they’ll perform in a bout of real market stress and how best to use them in a broader portfolio. K Contact Elizabeth Foos at elizabeth.foos@morningstar.com

Five years after taxable non-traditional-bond strate- gies started gaining traction, funds with more-flexible mandates have begun hitting the municipal market. At least half a dozen muni-bond funds, including offer- ings from BlackRock, Nuveen, and Goldman Sachs, have been launched or retooled, giving managers more flexibility to manage duration and/or buy below- investment-grade fare. The change comes in response to investors’ concern over the prospect of rising interest rates, an evolving muni market requiring more credit research, and the asset-gathering success of their taxable nontraditional brethren. BlackRock Strategic Municipal Opportunities MAMTX is illustrative of this new flexibility. In 2014 , the firm revamped this strategy allowing managers to set the fund’s duration between zero and 10 years and expanded from a focus on investment- grade municipals to allow up to 50% in below- investment-grade bonds. Shortly thereafter, the fund’s duration, which ran at over six years, dropped to less than three years; below-investment-grade fare now accounts for 18% of assets as of Feb. 28 , 2015 . While these funds promise a lot, investors should be aware of their potential pitfalls. We’ve written before about the risks in the non-traditional-bond Morningstar Category, including the difficulty of competently making big macroeconomic shifts in a portfolio and the tendency of these funds to trade interest-rate risk for credit risk. In addition, muni funds face unique hurdles that could make imple- menting this type of strategy more difficult. For starters, munis have a narrow playing field— municipal bonds make up less than 10% of the $39 trillion U.S. bond market as of the end of 2014 .