Active Management Expands Opportunities in the Muni Market

Diversity and Tax-Advantaged Income Potential

Municipal bonds are tax-advantaged securities that state and local governments issue to fund public projects, such as roads and bridges. For investors, they generate income that’s exempt from federal taxes and from state and local taxes in some cases.¹ The muni market is vast, diverse and brimming with opportunities for active investors.

Senior Portfolio Manager Joe Gotelli explains how he and his team identify attractive securities across sectors and the quality spectrum.

What is the advantage of active investing in munis?

We view the muni asset class as a dynamic market of individual and distinct bonds rather than a collection of homogenous securities. We believe investing in this varied market requires an active strategy driven by fundamental credit research. We seek to expand and enhance the investments available to muni investors through these research efforts.

With an active approach, we give investors access to municipal bond opportunities across various sectors, issuers and quality buckets. Conversely, passive strategies that rigidly track a market index are typically limited to a small set of sectors and the largest municipal bond issuers.

What’s more, we have the flexibility to adjust the portfolio in anticipation of shifting markets. Catalysts may include economic influences, tax law changes and sector- and issuer-specific factors. Index-constrained funds do not have this freedom.

How do you build your portfolios?

We also consider where we want to take risk and how much overall risk exposure we want in the portfolio. Together, our fundamental research and our assessments of valuation and risk lead to our buy and sell decisions.

What is the benefit of this process?

Overall, our top-down/bottom-up approach helps highlight places where security prices are out of sync with our estimate of their value. We believe this analysis identifies a broader range of investment opportunities compared with passive portfolios tracking broad market indices.

Meanwhile, our fundamental research expands the investment universe to include:

• Securities with higher yields.

• Lower-rated or non-rated municipal bonds.

• Market segments that may be less liquid relative to the highest quality munis.

Of course, investing in riskier or underfollowed market segments requires market insight combined with in-depth research and analysis. This approach helps uncover promising opportunities and aids in the ongoing monitoring of each security. Equally as vital, the research process helps eliminate the riskiest securities from consideration.

It’s essential to remember that lower-rated munis typically exhibit greater volatility and credit risk than investment-grade securities. However, these lower-rated munis also may help mitigate other risks, such as interest-rate sensitivity. The higher level of tax-advantaged income from high-yield munis compounded over time can generate attractive total return potential for long-term investors.

How does market volatility affect your strategy?

We apply our researched-focused strategy in all market climates. We believe that being consistent in our approach enables us to respond quickly and opportunistically to changing and challenging market conditions.

The last severe market dislocation highlights the benefits of this philosophy. In early 2020, the COVID-19 pandemic and resulting economic shutdowns led to unprecedented volatility and a steep sell-off of credit-sensitive assets. Several muni sectors suffered severely, including bonds tied to mass transit, hotel tax revenues, student housing and hospitals.

Active managers can often uncover value amid sharp and quick market dislocations. In this case, we gauged the credit implications of COVID-19 and identified sectors and securities where valuations appeared to be attractive. We concluded that the fundamental long-term credit risks for many sectors and securities were not as dire as short-term market conditions suggested.

We purchased municipal bonds we believed the market had unduly punished. Ultimately, swift action from the Federal Reserve and the federal government restored market liquidity, and many of these securities rebounded as the economy reopened.

Are the benefits of munis reserved only for high-income investors?

Municipal bonds generate income free from federal taxes—and state and local taxes in some cases. While investors in the highest income tax brackets typically benefit most from munis, the tax advantages are not limited to the wealthiest investors.

You can see the advantages by comparing tax-exempt yields with their taxable counterparts. A taxable-equivalent yield is the yield a taxable bond would have to pay to equal the tax-advantaged yield of a municipal bond.

Figure 2 shows the taxable equivalents for a hypothetical tax-exempt security yielding 3%. In this example, an investor in the 32% tax bracket would need to own a taxable bond yielding 4.41% to match the benefits of the tax-exempt investment. The taxable equivalents are greater for investors in higher federal tax brackets.

You can use American Century Investments’ calculator to determine the taxable-equivalent yield for bond investments based on your state and federal tax situation.

Figure 2 | Your Taxable-Equivalent Yield Rises with Your Tax Bracket

These hypothetical examples do not consider state and local taxes. They are for illustrative purposes only and are not intended as investment, accounting, legal or tax advice. Actual results will vary. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.

In addition to their potential tax benefits, we believe munis can enhance diversification in well-rounded portfolios. Municipal bonds tend to react to market and economic influences differently than stocks and taxable bonds. Because of this, munis may help enhance performance potential while managing risk in an investor’s broadly diversified portfolio.

Of course, diversification doesn’t assure a profit or protect against loss of principal. However, we believe diversification may help investors weather the market’s ups and downs.