Municipal Bonds: Managing Liquidity in an Illiquid Market

In March 2020, the COVID-19 pandemic caused a severe liquidity crisis in the bond market, with municipal bonds (munis) being among the hardest hit. While many investors considered this an outlier event, history tells us that it was not, especially in the municipal market. Market dislocations of this proportion happen every three to five years and we believe they will happen again, with more frequency, due to several fundamental shifts in the municipal bond market. Even so, we see plenty of opportunities in this space. In this paper, we discuss market liquidity and the shifts we are seeing, the risks to investors, and the importance of a nimble approach in navigating this highly inefficient market.

Liquidity, in practice, can mean very different things at different times depending on the market or asset class. But put simply, it is the ability to buy or sell a security at a “fair market price” at a specific time. Yet even then, what is a fair market price? The relationship between liquidity and “fair market value” can very quickly become much more complex when it matters most.

 

Source: MSRB Analysis with data obtained from S&P Dow Jones Indices and MSRB’s Real-Time Transaction Reporting System (RTRS). https://sites.law.duke.edu/thefinregblog/2020/09/21/the-impact-of-covid-19-on-the-municipal-securities-market-during-the-spring-of-2020/

 

Despite the challenges of an illiquid market such as investors experienced in March 2020, illiquidity can often work in an investor’s favor. It is not uncommon to get paid a liquidity premium on a bond from a new issuer that has not accessed the market, or on a bond that rarely trades. Yet through due diligence, an astute investor can gain an understanding of the various factors that may influence how an issue will perform and secure investments in those that can deliver strong, stable financials for a period of time.

 

The Challenges of Liquidity in a Structurally Broken Market

To understand what liquidity means within the municipal market, investors must first understand and appreciate the vast underlying complexities of this market. For example, the municipal market has roughly 20 times more bond issues outstanding than the corporate market, which benefits from more data reporting and analyst coverage.

 

 

It is a market in which most securities do not trade in an entire year, in stark contrast to most corporate bonds, which trade daily. Munis also have heavily implied optionality. Around 70% of the muni market has some sort of implied call or put, making it difficult to price hundreds of thousands of structures across 70,000 individual credits.

There are nearly 1M CUSIPs in the muni market which generally trade through a “bid wanted” process in which investors announce they want to sell a security and interested parties respond with bids. For example, every morning participants try to decide what a $650k block of a 5% coupon bond issued by a private university in Ohio which has a par call in 6 years and otherwise matures in 2042 is worth versus a $2M block of bonds issued by a toll road authority in Florida that has a 3% coupon, which is due in 2034 but could be called at par in 9 years. And this occurs thousands of times a day. This is all on a good, “liquid” day for the muni market. It’s not hard to imagine what happens when there is even a mild amount of market stress or volatility, much less the true liquidity crash like the market experienced in March 2020.

Investors in the muni market also need to determine what they should get paid in terms of a return for all the underlying risks, the optionality of the coupon, and many other considerations. To add to the challenge, the issuers’ financial statements are not always easy to access or analyze. They often are produced in an outdated PDF format, if readily available at all, and are often outdated by three to six months and even up to two years.

 

A Changing Landscape May Be Exacerbating the Risk

While the liquidity crisis in March 2020 was certainly one of the worst, it should have not been a surprise that it occurred. In our minds, this type of illiquidity is just a “price of entry” to work and invest in a structurally broken market. That said, we believe it is getting worse. For some time, we have been watching several shifts in the municipal bond market—on the buy side and in the broker/dealer community—that appear to be meaningfully exacerbating the existing illiquidity issue. The two most meaningful shifts are the creation of municipal exchange traded funds (ETFs) and the proliferation of muni mega funds.

ETFs: Take the case of the largest municipal ETF: BlackRock iShares National Municipal Bond (MUB). On March 20, this ETF closed at a -5.7% discount (Source: Bloomberg) to its underlying Net Asset Value (NAV), or the supposed value of the underlying book of bonds. The average premium/discount to NAV over the last three years was 0.14%. Anyone selling the ETF on that day incurred an additional loss of 5.7% on a fund that at the time was yielding around 2.5%, essentially wiping out two years of income. It is also worth recalling that municipal index funds only include issuers with an issuance size over a certain size which leads to the inclusion of more heavily indebted issuers. This means most issuers, and potentially some of the most attractive investment opportunities, especially during a liquidity crisis, are left out of the index and are too small to be meaningful to large funds.

Mega Funds: The second shift in the muni market that is exacerbating the existing illiquidity issue is the advent of the mega funds (defined as at least $10B in the muni space) and mega asset managers. While there may be comfort in investing in a large fund with a recognized brand name, many investors may not realize the potential risks to their investments during a liquidity event. Consider what happens when a significant outflow cycle occurs, and the ten largest intermediate municipal funds hold 68% of all the assets in a municipal category?  To whom do the managers sell all those bonds? Smaller asset managers know these large players have to sell and likely are not going to be first in line to buy the bonds, especially if they believe there is more “forced” selling to come. While banks and insurance companies may step in, muni bonds have become less attractive to them given the meaningfully lower corporate tax rates. So, it is worth asking again, how one defines the term “liquidity” in the complex muni market?

 

 

Opportunities in a Complex Market

Our view at SBH differs strategically from what we see as consensus. Specific to liquidity, a manager that has had to experience a fire sale of bonds certainly does not wish to experience that again. Given our experience managing client assets through numerous liquidity events, one of the lessons we have learned is that it doesn’t matter if the bond is AA rated or high yield; when liquidity disappears, it takes the valuation of bonds of all sizes and stripes with it. There are few, if any, buyers. Our stance is that investors need to barbell liquidity in the municipal market to be prepared for what may come. As valuations become increasingly rich, we believe investors should be considering municipals as the opportunity cost becomes lower and then expend this liquidity to not only meet liquidity demands, but also become the opportunistic marginal buyers. Liquidity can go from being ubiquitous and therefore less valuable—as was the case in February and today—to being priceless when it dries up for the larger market such as in March. Investors must ensure that the manager they work with has a portfolio that contains positions that have shown they attract buyer interest even on the worst of days. And they should have a manager nimble enough to address the opportunities such markets present such as the ability to take meaningfully positions in smaller credits that are less efficiently traded and flexibility to capitalize on large valuation swings. This, in our mind, is where an astute investor can genuinely add alpha in what a less experienced investor would call the “wild west” of the muni market.

 

Barbell: A barbell strategy is an investment concept that suggests that the best way to strike a balance between reward and risk is to invest in the two extremes of high risk and no risk assets while avoiding middle-of-the-road choices.

CUSIP stands for Committee on Uniform Securities Identification Procedures. A CUSIP number identifies most financial instruments, including: stocks of all registered U.S. and Canadian companies, commercial paper, and U.S. government and municipal bonds.

Past performance is no guarantee of future results.

The opinions expressed are solely the opinions of Segall Bryant & Hamill. You should not treat any opinion in this material as specific inducement to make a particular investment or follow a particular strategy, but only as an expression of the manager’s opinions. The opinions expressed in this material are based upon information the manager considers reliable, but completeness or accuracy is not warranted, and it should not be relied upon as such. Market conditions are subject to change at any time, and no forecast can be guaranteed. Any and all information perceived from this material does not constitute financial, legal, tax, or other professional advice and is not intended as a substitute for consultation with a qualified professional. The manager’s opinions are statements are subject to change without notice and Segall Bryant & Hamill is not obligated to update or correct any information in this material. For illustrative purposes only.

 

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