Issue #07

Custom bond management can add considerable value to muni bond portfolios through patient purchases on the secondary market. The municipal bond market is inefficient. Investment Managers specializing in municipal bond portfolios can exploit the inefficiencies in the secondary market for muni bonds and thereby increase client returns. How can this be, you ask?

Well, since there is not always a buyer for every muni bond at every point in time, the patient bond manager is able to construct a portfolio of individual bonds at a discount if he buys them in the secondary market over time. Over time is the operative word here. Many high net worth clients let the large wirehouses like Merrill Lynch and Salomon Smith Barney manage their muni bond portfolios. These wirehouses are notorious for eschewing “time”. When they have a mandate to invest client funds in muni bonds, they simply buy out of their own in-house inventories, or they participate in new offerings which their investment banking department underwrites. Either way the typical hidden charge, also known as a “mark-up” or “bid-ask spread” endured by clients can be additional 1%-3%. This source of broker profits is in addition to the managed money fee that many brokerages embed into their client accounts.

Let us explain some other aspects of the municipal bond market and how an investment manager can take advantage of, rather than be taken by, these characteristics.

By exercising patience, a bond manager can construct a municipal bond portfolio at 1% to 2% less cost than an equivalent portfolio constructed by the Merrill Lynch’s of the world. This is actually not a one-time cost. Due to laddering (a common technique in portfolio management where the portfolio is constructed with an assortment of differing maturities), a manager may be purchasing another 15% of new bonds each year (10% for maturing issues and perhaps 4-5% for the reinvestment interest earned). If clients are still accumulating more wealth, than this number can be higher as they add new assets each year to their muni account. Custom management can add an additional savings of another 1/4-1/2 percent per year through the annual purchases of these replacement bonds.

Another advantage that the patient manager can exploit is the mismatch between the supply of newly issued bonds and the supply of municipal bonds available for purchase at in the secondary market.

One common mistake that we have seen among municipal bond portfolios is the tendency to buy longer bonds than might be appropriate for the client. This common occurrence is partially the result of the natural imbalance in the supply of new issuance of shorter maturity bonds (under 10 years). There is a mismatch between the number of 1-10 year bonds and the demand for bonds of these maturities. Bonds with maturities of 10 years or fewer are issued in much smaller sizes, on average, 1/4th the size, of the issuance of long-dated municipal bonds (an average of $10 million versus $40 million). Brokers at wirehouses will often recommend 20 or 30-year muni bonds to their clients, simply because those are the bonds that are being newly issued. They may even be encouraged to “move the merchandise” into client accounts by their Sales Managers. Remember, wirehouses make loads of money serving as underwriters of newly issued municipal bonds.

In summary, Muni’s are not that liquid, in short supply, and yet, can be purchased at a discount in the secondary markets. To take advantage of this requires skill and preferably relationships with other bond trading desks (so that you are shown the municipal bonds for sale seeking bids). There is too few shorter maturities issued, and therefore the secondary market offers a better selection for investors in shorter maturity municipal bonds. Bond managers specializing in custom muni bond portfolios can add increase client returns by building portfolios through patient purchases on the secondary market.

In the next issue of Insight, we will present our views on Gold, an asset known for its “Storehouse of Value”. Our next letter will come out around December 1st.

Happy Holidays and 1st Advent!
Daniel Barnes, CFA

Barnes Capital is a Registered Investment Advisor located at in downtown Lafayette. With RB Capital Management, Barnes Capital develops custom tailored portfolios for its clients. Specialized in retirement income portfolios, financial planning in an integral part of our process. Call 925-284-3503.

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