Municipal bonds are known for their tax advantages and low default rates¹. Right now they have a lot to offer investors. However, that particular slice of the market is also quite complex due to the number of securities and issuers in the space representing myriad municipalities. The fact that the U.S. is in an election year further complicates the outlook. Given these factors, an actively managed approach seems a logical way to access the space.
Franklin Templeton is uniquely situated to provide such an investment solution largely due to its vast research experience in the municipal bond space, which it has distilled into the Franklin Dynamic Municipal Bond ETF (FLMI ), an active fund that leverages the best ideas of Franklin’s municipal bonds research group – available for an expense ratio of 30 basis points.
Content continues below advertisement
Optimism Around Municipal Bonds
Muni bonds currently offer attractive yields and credit spreads for investors.
A research note published by Franklin.. in January cited a “favorable backdrop” paired with “strong credit fundamentals” as reasons to be optimistic about the municipal space, with bonds overall set to benefit from expected monetary easing and falling yields. In particular, Franklin’s muni analysts highlighted state general obligation bonds, land-secured bonds, and charter-school bonds as sectors within the municipal bond category to watch.
According to Benjamin Barber, director of Franklin Templeton Fixed Income – Municipal Bonds and one of FLMI’s portfolio managers, three months into the year, conditions are good for municipal bonds.
“We believe we’re getting paid too much additional yield, for the incremental credit risk we’re actually taking. That’s a good trade-off for us,” he said.
Barber further noted that the tax-adjusted yields for municipal debt look very attractive relative to corporate and sovereign bonds and Treasuries.
Municipal Bonds A Complicated Category
The U.S. municipal bond market sits at around $4 trillion in terms of size spread across roughly 1 million securities issued by about 50,000 state and local governments, according to the Municipal Securities Rulemaking Board. That’s less than one-tenth of the total size of the more than $50 trillion U.S. bond market.
Consider that the U.S. stock market had roughly 3,500 securities at the end of 2023, according to Wilshire. Publicly traded companies tend to be very transparent. They publish regular reports, meet with analysts, and generally keep the public apprised of what’s going on with their activities. The state and local government entities that issue municipal debt are equally transparent if you know where to look. However, individual municipalities usually are not widely covered by analysts in the way that many companies are. That means navigating the space can be tricky.
Plenty of passively managed municipal bond ETFs are out there. The largest two represent more than $65 billion in assets under management combined. However, the muni bond market’s passively managed funds generally cover broad swaths of their designated asset classes that meet the selection criteria. Because of the nature of indexes, it’s impossible to move quickly to evict an underperforming issue from a portfolio until the next rebalance. Even then, depending on the methodology, the undesirable security can still find its way into a fund’s holdings. However, an actively managed fund can make those changes immediately when the manager deems them necessary.
Portfolio Managers With an Edge
FLMI’s managers partner with the firm’s muni research team to winnow at the vast universe of municipal debt securities, seek out relative value opportunities, manage risks, and allocate among sectors within munis And while its two largest passively managed competitors hold between 5,000 and 10,000 securities, FLMI’s portfolio has fewer than 500 holdings, all selected for their potential to outperform.
The managers weigh the fund’s positions based on their level of conviction. However, Barber indicated that the team is wary of crossing the line from conviction into prognostication.
“[FLMI] seeks to take advantage of whatever we’re seeing in the municipal market, from the two main angles of risk in fixed income. One is duration, just straight volatility, and the other is credit risk. The idea with this fund is we can move both of those levers up and down, depending on our views,” Barber said.
He noted that his group doesn’t use derivatives in its muni strategies.
“It’s around the margin that we’re going to make our calls. We want to have a strategy that we can ride out a whole cycle…