Ghosted

If you have teenage children, you are probably familiar with the concept of ghosting — deliberately failing to answer a message. If you are a fixed income trader, you probably have experienced this phenomenon when trying to sell a bond during tough times. We have little doubt that both the record-pace of fund redemptions and declining liquidity contributed to last year’s bond market turmoil. In an ideal world, investors should be able to transact in large volumes, on short notice, with little impact to prevailing prices or yields. U.S. Treasuries have the best liquidity in the bond market, with credit-oriented sectors trailing, sometimes significantly.

For reasons related to its basic market structure, municipals have never been renowned for their liquidity, even in normal market environments. Last year, record fund redemptions in response to Federal Reserve (Fed) interest rate hikes exacerbated existing liquidity challenges. In the over-the-counter bond market, sectors with the following characteristics benefit from greater liquidity:

• High quality with easy substitutability of issues
• High level of outstanding debt with large individual issues
• Deep pools of ownership capital
• High trading volumes with narrow bid-to-ask spreads
• Large number of market makers

It is easy to see why U.S. Treasuries are the gold standard in terms of liquidity as they satisfy every item on the list. But recently, even the Treasury market has not been immune. Behind U.S. Treasuries, government agency mortgage-backed securities, federal agencies, investment grade corporates, asset-backed securities, and high yield corporates would round out the dollar-denominated taxable markets. How does the municipal bond sector fare? Based on the criteria listed above, not very well.

Within the U.S. bond market, municipal debt ranks as the fifth largest sector at $4 trillion (see Exhibit I). The municipal market is without peer for its diversity and fragmentation. With dozens of bond structures, tens of thousands of issuers, and over one million outstanding bonds, municipals may be high quality, but they are far from homogenous. It is a market of nuance, individuality, and many small individual issues. While bond insurance once offered an impression of fungibility, less than 10% of new municipal issuance is covered by insurance today. Ever since the Global Financial Crisis (GFC), when upwards of 60% of new issues featured insurance, investors have been much more sensitive to the underlying credit risks of their bonds.

The major taxable bond sectors enjoy strong support from a range of deep domestic and international capital pools, including sovereign wealth funds and pension funds. In contrast, U.S. households own nearly 70% of outstanding tax-exempt bonds, with banks and insurance companies comprising most of the rest. Municipal trading volumes are much lower than other sectors, a reflection of the prevalent buy-and-hold strategy employed among many households. This type of passive strategy helps minimize taxes and transaction costs, but it also drains the market of available float, reducing overall liquidity.

Healthy market growth often stimulates liquidity. Again, municipals stand in contrast to the other major fixed income sectors. The aggregate size of the municipal market has stagnated for the past decade. In addition to fiscal austerity measures in response to the GFC, the 2017 Tax Cuts and Jobs Act restricted the ability of municipal issuers to refinance old debt with new tax-exempt bonds, reducing new supply by roughly 25%. More recently, issuers have scaled back borrowing plans in response to higher interest rates.

Municipal bond dealers, along with those in other sectors, are still contending with financial reform measures enacted in response to the GFC. Higher capital requirements and dealer consolidation have raised the cost of balance sheet-intensive activities, such as market making. As a result, the cost of maintaining inventories has grown and large trades are more difficult to execute. This has also resulted in higher transaction costs from wider bid-to-ask spreads (see Exhibit II).

Low liquidity might give our traders headaches, but it also helps provide opportunities, especially during periods of heightened volatility. In our view, there are three keys to successfully investing in less liquid bond markets: 1) Discipline; 2) Patience; and 3) Understanding clients. There are many bona-fide investment strategies. At BBH, we are value investors, and our approach is straightforward:

• Consider credits we believe to be fundamentally resilient under a wide range of economic and political circumstances.
• Purchase and own a limited number of those credits at attractive valuations when viewed over a long-term horizon.

Through this strategy, we regularly pursue higher yields in less-liquid structures while preserving credit quality. For example, our State Housing Finance Agency bonds all carry Aaa or Aa ratings and provide 50 to 100 basis points¹ more yield than traditional, high-grade bonds. We also enjoy this liquidity premium in non-standard coupon structures such as zeros and floating rate notes. Value investing in bonds confers the important advantage of contractual maturity dates. In other words, to realize the value we have identified in our securities, we can simply hold them and collect the income. We cannot overstate the importance of owning durable credits.² Investing in less-liquid structures places an even higher hurdle on our credit research.

While we can never predict market direction and liquidity conditions, discipline, selectivity, and patience remain firmly in our grasp. This is surely aided by the long-term nature of our client relationships. We seek to partner with clients who understand and appreciate our approach, invest for the long-term, and share our constructive view of volatility. Deploying capital during periods of high volatility and forced selling (by others) has consistently benefited our clients’ returns over the years.

The size, structure, and diversity of the municipal market represent a double-edged sword— reliable security selection opportunities, but at the cost of lower liquidity. We frequently own bonds in niche sectors, and those with less traditional coupon structures, because they persistently offer attractive incremental yield. Despite their lower liquidity, they play a central role in our strategy by allowing us to generate extra income without assuming additional interest rate or credit risk. As always, credit research remains critical to taking advantage of these types of opportunities and mitigating the risk of vanishing liquidity. Or said differently, we ain’t afraid of no ghosts.