In an age of instant gratification, we often forget the proverb “Slow and steady wins the race,” but it’s often true, even in building a successful investment portfolio.
We live in an impatient age, when gratification delayed can often seem like gratification denied. No doubt, it was a different world when Saint Augustine wrote, “Patience is the companion of wisdom.” But when it comes to building a municipal bond portfolio, we think he may have been on to something.
Investors may prefer speed, but in a market as inefficient as the municipal bond market, it may not be in their best interests to rush the investment process. Data indicates that the cost of a reasonably extended investment period is low and that the benefit of waiting for attractive new issues is real.
In this blog post we compare an extended investment period as long as 60 days (the patient portfolio) with a rapid investment period of seven days (the instant portfolio). We assume this isn’t a market call; the investor is committing capital to the market and wants to be invested in a timely manner. We’re not trying to time the market and wouldn’t recommend that approach to investors. Instead we’re trying to find an optimal definition of a timely manner.
Obviously, there’s a cost to waiting, but in the current yield environment that cost is relatively small. An investor looking to purchase an A-rated bond portfolio maturing in 10 years will receive a yield of 1%. At that yield the lifetime cost of taking 60 days to get invested instead of seven is 16 basis points (bps), or a 10.47% total return, compared with a 10.31% total return. (Note that this is an extreme example and assumes no purchases for 60 days in the patient portfolio compared with being fully invested in seven days for the instant portfolio.)
For the patient portfolio to outperform the instant portfolio, the investor would need to earn additional yield, but not much additional yield. The breakeven yield comes to 1.015%, or a mere 0.015% difference. This means the patient portfolio needs to yield just 2 bps more than the instant portfolio for the investor to be better off. But why risk waiting if the outcome is uncertain? A bird in the hand, right?
Fortunately, there’s a dependable source of additional yield in the municipal market: the new-issue, or primary, market. For investors in 10-year A-rated bonds and higher-rated bonds of longer maturities, the primary market offers a significant yield concession relative to the secondary market.
Why is there a persistent concession in parts of the primary market? Two important characteristics of the market contribute to this phenomenon: On the demand side, the primary source of demand is individual investors. According to Municipal Securities Rulemaking Board data, the median par amount per trade is $25,000. Aggregating retail demand can be time- and labor-consuming, and individual investor demand skews short to intermediate. Issuance, however, is often weighted toward longer maturities. When state and local governments look to borrow, they generally look to complete their transactions in a relatively tight window. To achieve this, they’re often willing to price their offering with a concession to attract market-clearing demand.
We looked at a year’s worth of Bloomberg data focusing on secondary-market offerings and new-issue pricings. We calculated the offering spreads relative to the AAA MMD benchmark. Next, for both primary and secondary offerings, we determined the average spread for maturities from one to 20 years and for the AAA and AA rating categories. Then we compared these spreads. In our interpretation in the table below, we’ve subtracted the secondary spread from the primary and condensed the data into four maturity buckets.
Yield differential between primary and secondary market offerings
Source: Bloomberg, 7/31/2021. For illustrative purposes only. Not a recommendation to buy or sell any security.
For maturities shorter than five years, where demand outstrips primary supply, the secondary market offers the best value. In the six- to 10-year maturities for bonds rated AA or higher, the primary and secondary markets seem to be in equilibrium. For investors and financial advisors going it alone, AA is often the minimum rating they’ll buy, so strong demand and steady supply appear to balance. For investors willing to take on A-rated credit risk, however, the primary market offers a meaningful concession of 17 bps. This pattern is maintained as an investor moves out along the maturity spectrum.
Let’s revisit our patient and instant portfolios. Each has a 10-year A-rated mandate. As noted above, the instant portfolio yields 1%. If the patient portfolio with the longer investment window can obtain a primary concession of 17 bps, it will yield 1.17%. If we perform the same total return calculation we used previously, the lifetime total return of the instant portfolio is 10.47%, but the lifetime total return of the patient portfolio is 12.16%. Clearly there may be a penalty associated with rushing investment; indeed, patience can pay.
The bottom line
Obviously, markets can and will move over time, making them difficult to predict with consistency. It’s possible movements in interest rates could offset any primary-market concession, but it’s equally possible they could amplify the benefits of taking time to access the primary market. It’s clear that for investors willing to take on A-rated credit risk with a target maturity of longer than five years, taking time to invest patiently is likely to be to their benefit, as long as that time is used to access the value found in primary markets. For those investors, getting invested too quickly may well carry too great a cost.
The hypothetical scenarios presented herein are provided for illustrative purposes only. They do not represent the experience of any investor, nor are they intended to estimate the performance of any investment strategy offered by Parametric. No representation is made that any client account will, or is likely to, achieve profits or losses similar to those shown. Actual performance results will differ and may differ substantially from the scenarios presented. Changes in assumptions may have a material impact on the hypothetical performance presented. The scenarios presented do not reflect the deduction of management fees and transaction costs, which will reduce a portfolio’s returns.