There are many potential advantages to investing in tax-exempt municipal bonds, but not all advisors are aware of additional strategies and investment vehicles that can help them meet muni-focused client needs. In this Q&A, we outline the potential benefits of pairing municipal bonds with separately managed accounts (“SMAs”) and interval funds.
Q: Many fixed income investors prefer to have immediate access to their holdings in the form of highly liquid funds. Are there drawbacks to that strategy?
A: There can be. In general, there are positives and negatives to accessing fixed income markets through mutual funds or individual bonds via SMAs. Neither vehicle is better than the other, but they may be better suited for certain clients or situations based on specific needs and objectives.
We’ve found that fixed income investors tend to overestimate their need for liquidity, and municipal investors are no exception. In fact, many municipal investors hold almost all of their assets in daily-liquid vehicles. That runs contrary to their generally long-term investment horizon and may dampen yield and total return potential. That’s because managers of highly liquid funds have to be prepared for potential redemptions, which can prevent them from investing in less-liquid but potentially higher-yielding securities.
Q: What are interval funds and how can they help municipal investors who don’t require as much liquidity?
A: An interval fund is a type of non-listed closed-end fund that isn’t subject to daily redemptions. The interval structure gives municipal fund managers the flexibility to invest in assets or execute investment strategies that may be less liquid and better suited to longer holding periods.
It also may help to prevent investors from making behavioral investment mistakes, such as selling when prices are depressed. This allows interval fund managers to maintain lower levels of liquidity because they don’t have to worry about unexpected redemptions, which avails them greater capacity to go on offense when the rest of the market may be selling. Managers can harness the features of the interval fund structure and capitalize on the outflow cycle, which can be volatile and destructive, by buying bonds at dislocated prices.
The interval fund structure allows the manager to pull a few different levers both offensively and defensively. On the offense, they can create dry powder with leverage when opportunities are plentiful, and defensively, they’re not forced to sell into an illiquid market.
Lastly, the interval structure gives fund managers the option to make use of term leverage rather than relying on short-term leverage, such as tender option bonds, which can be called away at the worst possible time. Fund managers can dial up leverage or adjust risk up or down depending on market conditions, and with fewer restrictions and a longer holding period, interval funds can potentially generate higher yields and higher risk-adjusted returns, which is especially important in a low-yield environment.
Q: What kinds of securities can municipal interval funds hold?
A: An interval fund structure with a flexible mandate enables access to less-liquid, more complex, and privately issued muni bonds, which may have higher return potential. This structure also provides access to a wide range of investments and investment strategies, including listed, non-listed, public, and private investments. There’s a fairly broad investment set from which to choose.
For example, interval funds may have the option to invest in closed-end funds when they offer attractive value. Traditional closed-end funds listed on an exchange, trade in the open market and can have prices that vary widely or trade at a discount from their net asset values (NAVs). This can offer attractive opportunities, particularly during market sell-offs, but they tend to be thinly traded and may be one of the last things an investor would want to be forced to sell to obtain liquidity.
Q: How about separately managed accounts (SMAs)? How can they help advisors address municipal client needs?
A: Separately managed accounts offer a high degree of flexibility to tailor portfolios to clients’ specific objectives – primarily because the investor owns the underlying securities, rather than shares in a fund. So while the investment manager invests the funds at the direction of the client, the client never relinquishes ownership.
For advisors, SMAs also have distinct advantages. SMAs allow for aggregating client accounts and can provide added transparency into client portfolios. SMAs also often come with fees that are competitive relative to traditional mutual funds. Here we’d caution, though, that advisors should understand the tradeoffs that come with transparency and liquidity.
Q: Can investors combine an interval fund with allocations in SMAs?
A: Absolutely. We believe the two can be a natural complement to each other. Municipal investors concerned about liquidity issues can pair SMAs with interval funds to help address concerns about interval fund liquidity. Conversely, interval funds may help clients overcome SMA objections, which might include lower after-fee SMA yields in a low-yield environment.
In our experience, municipal SMA holders rarely tap their portfolios for liquidity and tend to have a “buy and hold to maturity” mindset. However, SMA investors may be sacrificing some return for lower volatility, and, given the current rate backdrop, may find their current portfolios lacking in income distributions.
Q: Can you provide an example of combining the two?
A: One example that seems to be resonating with SMA investors is to carve out a portion of their individual holdings, say 20% or 30%, and move that into something more opportunistic. This allows them to increase income and return potential without materially changing the risk metrics of their portfolio on the whole. In particular, we think interval funds are appropriate to be this complementary, opportunistic asset for investors who can afford to give up daily liquidity on a portion of the portfolio they were unlikely to tap it in the first place.
Q: Do you see similarities in investment philosophy between SMA investors and interval fund investors?
A: There are definitely some overlaps. In general, investors in both SMAs and interval funds – and municipal investors as a whole, for that matter – have a long-term investment horizon and are generally not quick to sell when prices fall. That comes with some degree of risk, but it also has important implications for performance, since municipal securities with less liquidity can carry added return potential.
Q: How can PIMCO help advisors address muni-focused client needs?
A: PIMCO offers municipal investors a wide range of thoughtful strategies, including mutual funds, exchange-traded funds (ETFs), interval funds, and SMAs. Our municipal interval fund, PIMCO Flexible Municipal Income Fund (“MuniFlex”), is one of the first interval funds to focus on federal tax-exempt income. It allows us the opportunity to exploit the inherent structural illiquidity in the municipal market. Couple this with separately managed accounts that can be customized for geography, tax-loss harvesting, and special-impact areas like ESG, and advisors have access to a broad suite of municipal product offerings that can help them pursue municipal client investment objectives.
Learn more about PIMCO Separately Managed Accounts.
© PIMCO
Read more commentaries by PIMCO
