Smaller Muni SMAs Leave a Bad Taste in SALT-Seasoned Market
Big-ticket, ultra-short notes force muni SMAs with low minimums to buy longer-term paper at rich prices, likely giving clients more heartburn than total return.
Are tax-paying municipal market bond investors in smaller separately managed accounts being well served? Perhaps not. A recent anomaly in pricing of ultra-short and longer-term muni paper starkly illustrates the challenges facing SMAs that have modest minimum investment requirements.
Although the pricing aberration has abated somewhat, investors and financial advisors in smaller muni SMAs are likely still seeing their total return prospects strained if their accounts are stocked with pricey longer-term paper yielding the same as the ultra-short notes.
At the end of April, yields on tax-exempt muni issues known as variable rate demand notes (VRDNs), which reset daily or weekly, effectively matched the roughly 2.30% yields on AAA-rated muni bonds maturing in 2036 and 2037, according to Bloomberg data. The downward price pressure on VRDNs, which are also high quality, comes amid rising prices (and falling yields, which move inversely to prices) of muni bonds more generally. What gives?
During tax season, muni funds aren’t immune to investors redeeming shares to cover their obligations to Uncle Sam, so rising yields on VRDNs at this time of year aren’t surprising. But this time around, VRDN yields sky-rocketed nearly 80 basis points, about four times the usual increase. The last time VRDN yields rose by such magnitude was 2008.
SALT, Supply and Demand
The yield spike doesn’t portend another financial crisis, though, because it’s driven largely by the 2017 tax reform, which capped the deduction on state and local taxes (SALT) at $10,000. Despite the pressure on VRDNs, the SALT limit has broadly made munis, which generally benefit from favorable federal, state and local tax treatment, an attractive refuge for wealthy residents of high-tax states. That demand has also come amid significantly less new muni issuance.
April muni sales of around $25 billion were off 16% from their April 2018 level. Meanwhile, flows into muni mutual funds rounded $7 billion last month, compared with net outflows of $1.8 billion in April last year, according to the Investment Company Institute. Over the first four months of 2019, muni mutual fund inflows exceeded $34 billion, far outpacing the $9.4 billion collected during the year-earlier period. No wonder the benchmark Bloomberg Barclay’s Municipal Bond Index returned 3.2% over the first four months of the year, its best January-through-April run since 2014.
Following the tax-related selling, VRDN yields ebbed to an average of roughly 2% by May 6, on cross-over demand from taxable money market funds and as muni investors top back up their muni fund holdings now that tax season is over. But that’s what paper out to 2031 and 2032 yields. So investors with smaller muni SMAs would still be well advised to review how their managers are investing their capital.
“No Economic Sense”
“It makes no economic sense to buy AAA-rated muni bonds maturing more than a decade out but yielding the same as VRDNs maturing tomorrow,” Thornburg portfolio manager Nicholos Venditti points out. Because VRDNs cost $100,000, smaller SMAs, say with $250,000 in assets, can’t afford to have just more than 40% of their assets wrapped up in a single security, he notes.
Once a separate account is established, muni SMA investors typically want their managers to quickly invest the cash seeding it. But allocation speed doesn’t necessarily translate into attractive returns if the cash goes into pricey, high-grade intermediate-term bonds from states like California or New York that yield the same as zero-duration VRDNs. Duration risk is worth taking only when compensation for it—the yield—is adequate.
To be sure, clients with smaller SMAs may raise an eyebrow at lowish yields. But they have to weigh them against complex after-tax yields on the taxable investment alternatives, and, in the aftermath of the SALT cap, they may be more focused on the tax-favored status of munis. Nonetheless, those who bother to run the numbers may discover they would be better off in Treasuries if their SMAs’ are buying richly priced muni bonds, Venditti says. When the next bout of market volatility arrives, that will become painfully apparent, he warns.
SMAs with more assets don’t necessarily face the same structural constraints if they can buy VRDNs and find high-quality muni bonds at attractive prices. Clients of those that can’t, though, might be better off in a muni mutual fund that can do both, anytime of year.