Today’s complex, fragmented and fast-moving muni market is rapidly outpacing the capability and capacity of traditional portfolio-construction methods. The municipal market has changed significantly over the last 20 years, though most investors have barely adjusted their trading, research or portfolio-management methods. To be successful today, muni managers must be better, stronger, faster.
Time is money. Every day it takes to invest a portfolio is a day missing income. No one expects a construction crew to build an interstate highway with only a shovel and a hoe. Still, every day, muni managers try to assemble investment portfolios with one hand tied behind their back and antiquated tools in the other.
Simply navigating bonds offered is a case in point. Managers looking at a single bond trade may have to access four different systems to determine if (1) they already own the bond, (2) they like the credit, (3) the bond is priced correctly and (4) it is appropriate for one or more portfolios. By the time someone can check that list manually, the bond may be gone.
The muni market’s current structure is rife with persistent inefficiencies that impede the unprepared and accelerate the equipped. Investment managers must embrace technology that seamlessly connects market intelligence and real-time security information with individual client portfolios to unlock these significant yet unconventional sources of alpha: trading alpha and speed alpha.
The Current Landscape
One of the biggest challenges facing investors today is ﬁnding the right bonds to build a muni portfolio that generates attractive income.
The muni bond market is complex, fragmented and in a constant state of change. The muni market has more than one million individual bond issues outstanding, representing more than 50,000 distinct issuers. More than 100,000 unique issues are available for sale every day, with anywhere between 30,000 and 50,000 trades of 10,000 to 20,000 individual securities (Display).
By comparison, the entire US stock market has fewer than 4,000 tradeable tickers. Tracking the municipal bond market requires an incredible amount of horsepower.
Further complicating matters, most municipal trades happen in small lots—approximately 95% of all municipal transactions are for less than $1 million (Display).
Why does the size of the trade matter? How and where a position trades—and the discount or premium that may apply to that trade—often depends on its size. The same bond trading in a $25,000 lot on trading platform A could have signiﬁcantly different pricing than a lot of $500,000 trading on platform B, with size, venue and other factors making the difference.
For standard managers building out new muni portfolios, sourcing and allocating large blocks of bonds across thousands of portfolios is much easier than ﬁnding small, mispriced opportunities that are appropriate for only a portfolio or two. Those large blocks are often also more expensive, as traditional muni managers bid for them against one another. Of course, that leaves abundant beneﬁts for the clients of managers who have the technology to ﬁnd quality bonds at discount prices (Display – Left Below).
Liquidity in the muni markets has also changed signiﬁcantly over the last 20 years, even though many managers trade like it hasn’t changed a bit. Large, simple trades of over $1 million made up 9% of all transactions before the global ﬁnancial crisis but dropped to 4% in the 2016–2020 period. And the number of transactions under $100,000 increased from 70% to 80% over the same periods.
The size, or par value, of bond trades has also shifted: Before the global financial crisis, 85% of the dollar value of munis traded in $1 million increments. Today, that has dropped to 73%. And the par value of munis traded in lots under $100,000 has doubled (Display – Right Below).
What accounts for this phenomenon? Market structure changed. Bond dealers’ 2019 inventories were already 67% below their pre–global financial crisis levels. By 2020, that 2019 level looked huge—dealer holdings were down by half again. That means there are fewer large trades available through dealers. Instead, managers are having to build portfolios by sorting through small lots offered via the bids wanted in competition (BWIC) method to find bonds to fill portfolios.
Even time of day can matter. Total liquidity peaks early in the day, when dealers offer bonds for sale from their inventories. The composition of that liquidity changes, as bonds traded using BWIC become a bigger share of available bonds as the day goes on (Display).
Today’s muni manager faces an increasingly complex market with roadblocks and hurdles everywhere. Overall trading volume has dropped. The size of individual trades is trending smaller. Time of day and type of trade matter more than ever. And speed is of the essence. This market is a far cry from the days when bonds traded over the telephone.
- Terrance Hults
- SVP/Portfolio Manager—Municipal Portfolio Management
- Matthew Norton
- Co-Head—Municipal Portfolio Management—Municipal Impact Investment Policy Group