Perhaps the greatest disadvantage of passive and laddered portfolios is the lack of active management of maturities. Typically, ladder strategies set bond maturities at 6- or 12-month intervals over 5- or 10-year periods. Proceeds from maturing bonds are reinvested in new bonds added to the long end of the ladder’s maturity structure, regardless of the relative value in that particular area of the curve.

In effect, this laddered or passive portfolio management approach minimizes—if not fully ignores—the duration of each bond in the portfolio and its impact on the portfolio’s average duration. Duration provides a measure of interest rate risk exposure, which is continually changing during the life of a bond. 

Investment conditions in the municipal market began to change as the Federal Reserve (Fed) began raising interest rates in 2022 to stem inflation. While active portfolio management adapts when market conditions change, passive laddered approaches can be restrictive in their approach. 

Four key changes occurring in the municipal markets over the last two years—higher yields, an inverted yield curve, more credit differentiation, and increased liquidity—help to highlight the contrast between active and passive approaches.

Higher yields: Absolute yields are higher in 2024 than at any time during the last decade (See Figure 1). Higher absolute yields can offer the opportunity to capture higher income across the curve. 

We expect yields to remain high for longer, as the Fed is delaying a move lower in rates because inflation remains above its 2 percent target and unemployment remains low.

Changes in the shape of the yield curve: The yield curve inverted in the middle of December 2022 and remains inverted as of May 31, 2024. With higher yields available to investors at the short and long ends of the curve than in the middle or belly of the curve, we feel that active management of yield curve positioning is very relevant again. 

For example, an inverted yield curve can offer opportunities to capture higher yields through a barbelled maturity structure that overweights holdings on the shorter and longer ends of the curve. In addition, a barbelled structure can provide accelerated reinvestment opportunities (in the form of both purchase/sale swaps and maturities) when rates rise, allowing for a greater ability to potentially build income. 

Ladder strategies are limited in their ability to implement a barbelled structure due to the nature of their maturity structure and approach. A ladder’s equally weighted maturity schedule often forces purchases into a specific area of the yield curve, which can limit an investor’s response to market opportunities. Conversely, as rates fall, a professional manager can assess the various risks to the income stream and structure portfolios accordingly.

Market liquidity and bond issuance: The pace of municipal bond issuance has accelerated in 2024. Increased liquidity in the market offers opportunities to find value through trading strategies. In addition, higher bond issuance in the primary market results secondary market flows and spread widening which we view as an opportunity. Laddered approaches may unnecessarily confine consideration of new bonds to a limited opportunity set defined by a specific maturity term.

In addition, the rise of electronic trading and the growth of separately managed accounts is helping to further increase liquidity and lower transaction costs. As a result, it may be less expensive to capture the additional income and value opportunities available in today’s market that we have described here.

Capturing income through tax-loss harvesting

We believe tax-loss harvesting (TLH) is one such opportunity important to capturing value in bond investing. TLH, or alternatively tax-loss swapping, involves selling one or more bonds in which an investor has unrealized capital losses and using those harvested losses to offset capital gains and increase the income generated by the portfolio. 

If there are remaining losses after offsetting gains (in other words, net losses), an investor may also apply the losses to offset ordinary income. Investors also may be allowed to carry forward for tax purposes in future years additional net losses above this limit.¹

Capturing relative value through credit differentiation

As the municipal market has adapted to a higher rate environment, the expiration of federal aid associated with the COVID-19 pandemic, and increased issuance, opportunities have increased to capture higher relative value based on credit differentiation across issuers and sectors.

The municipal market entered 2024 with credit conditions characterized by strong liquidity, a less-weak hospital sector, modest debt burdens, sturdier pension fundamentals, and rising residential real estate values (See Breckinridge’s 2024 Municipal Market Outlook). Ratings upgrades outpaced downgrades again in 2023, and default rates remain low in 2024. However, we expect that fundamentals may weaken modestly in 2024, especially for state and local governments, as the sector’s excess savings is peaking, and several of market’s largest issuers must now tackle deficits stemming from wage pressures, slowing revenue, unexpected migration, and rising willingness risk (the willingness of tax payers to fund higher levels of debt).

Conclusion

Active portfolio managers, who are less constrained across maturity exposures than laddered/passive strategies may benefit from increasing opportunities in today’s municipal market conditions. Those changes include higher yields, changes in the shape of the yield curve, increased liquidity in the form of higher bond issuance, and greater dimensions of credit differentiation. A passive approach characterized by a buy-and-hold strategy can result in unintended bets on the direction of interest rates. In our view, active management has several advantages that could translate into higher after-tax returns for investors.

[1] Based on 2024 federal tax guidelines, which are subject to change.

BCAI-06122024-vioymdsq (6/13/2024)

DISCLAIMER:

This material provides general and/or educational information and should not be construed as a solicitation or offer of Breckinridge services or products or as legal, tax or investment advice. The content is current as of the time of writing or as designated within the material. All information, including the opinions and views of Breckinridge, is subject to change without notice.

Not all securities or issuers mentioned represent holdings in client portfolios. Some securities have been provided for illustrative purposes only and should not be construed as investment recommendations.

Past performance is not a guarantee of future results. Any index results shown are for illustrative purposes and do not represent the performance of any specific investment. Indices are unmanaged and investors cannot directly invest in them. They do not reflect any management, custody, transaction, or other expenses, and generally assume reinvestment of dividends, income, and capital gains. Performance of indices may be more or less volatile than any investment strategy.

All investments involve risk, including loss of principal. Diversification cannot assure a profit or protect against loss. No investment or risk management strategy can guarantee positive results or risk elimination in any market. Fixed income investments have varying degrees of credit risk, interest rate risk, default risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. Income from municipal bonds can be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the IRS or state tax authorities, or noncompliant conduct of a bond issuer.

Equity investments are volatile and can decline significantly in response to investor reception of the issuer, market, economic, industry, political, regulatory, or other conditions.

Separate accounts may not be suitable for all investors.

Breckinridge believes the data provided by unaffiliated third parties to be reliable, but investors should conduct their own independent verification prior to use. Some economic and market conditions contained herein have been obtained from published sources and/or prepared by third parties, and in certain cases have not been updated through the date hereof. All information contained herein is subject to revision.

Certain third parties require us to include the following language when using their information:

BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg does not approve or endorse this material or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The S&P500 Index (“Index”) and associated data is a product of S&P Dow Jones Indices LLC, its affiliates and/or their licensors and has been licensed for use by Breckinridge. ©2024 S&P Dow Jones Indices LLC, its affiliates and/or their licensors. All rights reserved. Redistribution or reproduction in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC. For more information on any of S&P Dow Jones Indices LLC’s indices please visit www.spdji.com. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC (“SPFS”) and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”). Neither S&P Dow Jones Indices LLC, SPFS, Dow Jones, their affiliates nor their licensors (“S&P DJI”) make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and S&P DJI shall have no liability for any errors, omissions, or interruptions of any index or the data included therein.