Bonds

How interval funds find a place in the muni market

As investors face credit and interest rate risk — two of the more challenging aspects of the market over the past two years — some are looking to alternative investments such as interval funds.

For investors who have the flexibility, deeper pockets and risk appetite, the funds, which are closed-end not traded on any exchanges nor subject to daily redemptions, are an option. They give municipal fund managers the flexibility to invest in less liquid assets or employ investment strategies more suitable for extended holding periods.

“When you have a mutual fund, you have daily liquidity, and if the mutual fund invests in products that aren’t necessarily liquid within a day, the mutual fund ends up having a lot of problems,” a sell-side source said.

While currently holding a sliver of munis, interval funds address one of the larger issues of the market: liquidity, market participants said.

The interval fund sector, which includes venture capital, real estate, insurance and credit, has seen growth over the past several years.

Interval funds had a total of $79.2 billion in net assets in 2023, up from $63.5 billion in 2022, according to the Interval Fund Tracker. There were 91 active interval funds last year — at least five of which were municipal-related — up from 79 in 2022.

For PIMCO, when it launched its first muni interval fund, the Flexible Municipal Income Fund, or “MuniFlex,” in 2019, the investment management firm wanted to take on the increasingly illiquid muni market.

As PIMCO has been managing its daily liquid municipal bond strategies, the firm was capped at how much liquidity risk it could take in terms of individual muni bonds, said Christian Clayton, executive vice president and strategist at PIMCO.

“Having a vehicle that allows us to access some of these less liquid muni bonds would be an advantage,” he said.

For example, the average individual investor cannot buy a 144A privately placed bond; it has to be bought by a qualified institutional buyer.

“We believe there can be tremendous benefits in including municipals in an alternatives allocation,” Clayton said.

The concept of an interval fund is to “not be as liquid as mutual funds and to take advantage of the inefficiencies in their liquidity out there,” said Robert DiMella, executive managing director and co-head of MacKay Municipal Managers.

For most days, liquidity is “not a big issue,” said Robert DiMella, executive managing director and co-head of MacKay Municipal Managers. “But when we have times of stress, the transaction cost increases substantially, and that’s when you want an active approach that has a cash cushion to insulate you either from not indiscriminately selling when you really shouldn’t be, or just as importantly as to buy when things feel bad, because you have a cash reserve to do so.”

Interval funds allow investors to sell a portion of the shares back to the fund at NAV periodically, which could be monthly, quarterly, or semiannually or annually, said Vikram Rai, head of municipal strategy at Wells Fargo.

“Higher-yielding securities can be harder and somewhat illiquid, but since interval fund managers do not have to worry about providing daily liquidity, they are able to invest in more illiquid and potentially higher-yielding securities,” he said. “So these funds can appeal to investors that have a higher risk appetite and do not need immediate access to their principal.”

Typically when the muni market sells off in relation to USTs, it’s usually sparked by a lead of retail of the pullback in the muni market, said the sell-side source.

A negative feedback loop begins in which retail redeems from mutual funds, which prompts mutual funds to sell and that selling pressure leads to more investors pulling their money out.

That cycle continues until “someone else steps in, stabilizes the market and starts to reverse the cycle,” the source said.

Historically, during periods of large appreciation fund flows pick up afterward “and it lags and mutual funds hate this because it forces them to sell when things are cheap and buy when things are rich. They don’t want to do that but are beholden to it because of the liquidity,” the source noted.

The concept of an interval fund is to “not be as liquid as mutual funds and to take advantage of the inefficiencies in their liquidity out there,” DiMella said.

Interval funds are a natural progression of the increase in “liquid alternative investments,” so “there’s no reason why munis can’t have a piece of that,” he said.

But an interval fund with its non-daily liquidity allows investors to weather the shorter cycles as it gives them better visibility and redemptions, said Alex Chilton, head of municipal securities at Morgan Stanley.

There are only a handful of interval funds in the muni space, and while there has been growth, it is not near the moves that exchange-traded funds and separately managed accounts have made.

The latest Fed data shows muni ETFs were up in Q3 2023, rising $20.9 billion to $107.9 billion, or 24% from Q3 2022. Meanwhile, Citi Research found that muni SMAs grew from $100 billion in 2008 to $718 billion at the end of Q2 2023. Both figures are above the $79.2 billion of total interval fund net assets in 2023.

“We believe there can be tremendous benefits in including municipals in an alternatives allocation,” said Christian Clayton, executive vice president and strategist at PIMCO.

Despite the benefits of interval funds, they have yet to take off, market participants said.

For one, there is the issue of familiarity, Clayton said.

“When most people think of alternatives, and where they’re going to be giving up the liquidity, they’re going into places like private real estate or private credit or private equity, places where you can generate higher returns than what you might get in an IG muni strategy,” he said.

Furthermore, there has been a hesitancy to incorporate interval funds into portfolios, particularly among the big platforms that run SMAs, added Steve Shutz, portfolio manager and director of Tax-Exempt Fixed Income at Brown Advisory.

In Brown Advisory’s case, he said for investors for whom they run SMAs, which are home offices and end users, there has not been a desire to include interval funds in those strategies.

From a strategic standpoint, Shutz noted that it makes sense: “If you’re able to capture a part of the market that might be a little less liquid … and you’re able to put it in a pooled vehicle that then sits within an SMA, that can provide better performance over the long term.”

However, he noted there seems to be resistance to owning fund vehicles within the SMAs, he said.

That resistance could change, Shutz said, if the muni market sees strong performance this year. If that happened, he noted there would be more demand for other funds, such as high-yield and interval funds.

“Investors will start to say, ‘Okay, it looks all clear. It feels like the environment is pretty secure. Give me a little bit more juice,’ and then you’ll start to see the money start to cascade out of SMAs … into different flavors of funds,” Shutz said.

Even if this happens, many market participants do not expect interval fund growth outpacing that of ETFs and SMAs.

“While interval funds may not suit everyone, they can meet the need for a [certain] niche of investors,” Rai said.

But “at the end of the day, the municipal marketplace is fragmented and inefficient,” DiMella said. “It’s not getting efficient anytime soon, and the interval fund is another good example of how clients can attain exposure in a very thoughtful active way in the municipal market.”

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