PAC bonds find a home in muni portfolios
Greg Ortman
Fixed Income Investment Director
Jose Guzman
Product Specialist - IPM
KEY TAKEAWAYS
  • Planned amortization class (PAC) bonds can provide municipal bond investors exposure to the housing market.
  • PAC bonds can provide a pickup in yield relative to other short duration, investment-grade bonds.
  • Investors seeking this potential yield premium may wish to consider mutual funds, exchange-traded funds (ETFs) or separately managed accounts (SMAs) that hold PACs.

The state of housing has dominated headlines for months: if to buy, when to buy and how to buy in a real estate environment struggling with high interest rates. The sector has been interesting to municipal (muni) bond investors as well, but in a different way. Our research analysts have uncovered an intriguing opportunity for investors desiring tax-exempt income while picking up yield relative to other short-duration investment-grade (BBB/Baa and above) bonds.


Housing bonds: the lay of the land


A type of muni revenue bond, housing bonds, are issued by housing finance agencies (HFAs). HFAs help fund affordable housing programs, vital in today’s challenging market. These housing bonds are divided into two sub-sectors: single-family and multi-family. Single-family housing (SFH) bonds – the majority of the outstanding bonds in the housing sector – are issued by HFAs to finance mortgages for lower- to middle-income first-time homebuyers. 


Sources: Aladdin, Bloomberg Municipal Bond Index. Data shown based on the Bloomberg Municipal Bond Index. As of 12/31/23.

As a group, PAC bonds are typically investment grade and are one of the highest quality segments in the muni market. SFH bonds are typically secured by the underlying mortgages. In some cases, they are insured by private entities or federally backstopped agencies (i.e., guaranteed mortgages) such as Fannie Mae, Freddie Mac or the Federal Housing Association (FHA). Coupon payments generally come from the interest payments on the mortgages the bonds were used to fund.


SFH bonds also tend to offer a yield premium over other similarly rated munis due to their risks. While there are several classes of SFH bonds, we believe planned amortization class (PAC) bonds are the deepest segment. As such, PACs offer a distinct opportunity in the muni market today to pick up yield relative to other short duration, investment-grade bonds.


PAC bonds: A deeper dive into a premium yield asset


PAC bonds are designed to mitigate prepayment and extension risks by implementing a steady payment schedule. As a result of this imposed schedule, they tend to have shorter average lives than their stated final maturities. Average life is defined as the average expected time it will take to pay off a bond. Average life is different than stated maturity, as average life takes into account embedded options, such as the ability for a bond to be called (i.e., redeemed early). PACs typically offer a yield premium over other comparatively-rated munis and are generally issued with average lives of five years.


As an example, as of 12/31/23, based on our analysis, PACs offered yield to worst (YTW) of 4.06% and spreads (the difference between two yields) of +84 basis points (bps) and +102 bps over the Bloomberg Municipal Bond Index and Bloomberg Municipal Bond AA Index, respectively. The Bloomberg Municipal Bond Index YTW was 3.22%; the Bloomberg Municipal Bond AA Index YTW was 3.04%.


When comparing PAC yields to indexes with similar average lives, the spreads offered were even more attractive, and in some cases, more than +180 bps. These high-quality spreads are especially attractive in an environment where broad investment-grade and high-yield spreads are tighter than their historical averages and the range of possible economic outcomes are wide. This leads to a logical question: why aren’t all investors loading up on PACs?


Sources: Bloomberg, Capital Group. As of 12/31/23. Indexes shown, from left to right, are the BVAL Municipal AAA Yield Curve (Callable) 5 Year; Muni Index 5 Year, which is a subset of five-year bonds from the Bloomberg Municipal Bond Index; Revenue Index 5 Year, which is a subset of five-year bonds from the Revenue Bond Index within the Bloomberg Municipal Bond Index; and Bloomberg Municipal Bond BBB Index, represented by the Bloomberg Municipal Bond BAA Index. Yields for PAC bonds are based on Capital Group analysis. 

The opportunity to benefit from PACs requires research


Quite simply, PACs require special attention. Extensive resources, tools and experienced investment professionals are needed to apply proper valuation and assessment to PAC investments.


PAC bonds face prepayment, extension and liquidity risks. Prepayment risk represents borrowers paying a mortgage off earlier than expected. Extension risk represents borrowers that repay the debt more slowly than expected, possibly extending the length of time in which the debt is paid off. Liquidity risk is the risk the bond cannot easily be sold on the secondary market (i.e., “less liquid”). All of these risks should be carefully analyzed.


PAC bonds also exhibit significant structural complexity. Structural complexity refers to the difficulty of valuing PACs. For example, to properly value PACs, it is helpful to have a strong prepayment model plus the ability to accurately calculate the average life. In fact, the value and risk of PAC bonds are largely dependent on prepayment speeds.


Another aspect to consider is inefficient pricing. Inefficient pricing can be the result of many factors. For PACs, the investments are complex, trade less frequently than other bonds and may not be properly analyzed by some investors — all of this can lead to pricing inefficiency (i.e., mispricing).


Inexperienced investors could have greater risk in mispricing PACs without research and extensive experience. For example, virtually no PAC bond has ever met its full term. The average life and payment schedules of PACs may deviate from expectations.


Therefore, research also plays a key role. PACs are available in a multitude of markets, so selectivity is crucial. Not all real estate markets are created equal. Housing prices may be more stable or have the potential to appreciate in the real estate markets of regions where economies are stronger and trends in population growth and demographics are more favorable. 


Sources: Aladdin, Bloomberg Municipal Bond Index. As of 12/31/23. Top 10 SFH issuers by market value within the Bloomberg Municipal Bond Index.

In addition to ascertaining which PACs to purchase, the same research capabilities are also required for ongoing monitoring. PAC average lives and durations may change, based on changes in the underlying mortgages. Such changes should be considered by investors to determine the impact on the overall portfolio, and if the changes in PACs require additional changes within the portfolio to maintain the desired objectives. Changes in the credit fundamentals of PAC issuers need to be continually evaluated as well.


How to access PAC bonds in portfolios


While PAC bonds today overall offer attractive spreads, selectivity within the group is critical, given their varied risks. In general, our research team believes PACs offer strong credit quality and attractive spreads. We also believe mortgage prepayment rates may rise from their recent very low levels. Mortgage prepayments, such as refinancings, tend to slow when interest rates are high. Additionally, some investment team members believe whether the economy experiences a soft landing (a gentle slowdown that avoids a recession) or a hard landing (a faster slowdown with a potential recession), either scenario will likely lead to a pickup in prepayment rates. This is a positive dynamic for HFAs, as they typically generate a key source of revenue from the difference between the mortgages they originate and the rates they charge. This is one of many other factors that support the credit profile of an HFA.


That stated, PACs do not come without their risks. PAC prepayment speeds could drift outside of their expected schedules. PAC spreads may also not tighten as expected if typical institutional buyers (e.g., banks and insurance companies) eschew the sector as a result of competition and value in other segments of the broad bond market.


However, we believe PAC bonds provide value today in the muni market housing sector, especially given our experienced research teams. For example, the research team views value particularly in bonds from certain state agencies. The team prefers bonds with underlying portfolios that have low delinquency rates, federal agency guarantees and additional collateral to staunch potential losses. Team members also like longer term housing bonds secured by a first-lien position on a mortgage and trading at deep discounts in the secondary market.


Investors can access PAC bonds as part of a diversified portfolio in several of our muni bond mutual funds and ETFs. Muni SMAs also potentially provide exposure to PACs.


Opportunities with PACs in Capital Group Muni Bond Funds, ETFs and SMAs


Bottom line


We continually research the market to find opportunities to enhance our mutual funds, ETFs and SMA offerings. PAC bonds can be an intriguing way to add yield and increase diversity as part of an overall portfolio solution, with relatively less interest rate risk. For maximum efficacy, investors should have experience, capabilities, tools and resources to monitor and adjust PAC exposures as needed. Investors may wish to consider investments that contain PAC bonds for their portfolios.


* Holdings are based on the representative portfolio of the Capital Group Short Municipal SMA Composite or Capital Group Intermediate Municipal SMA Composite, as applicable. Specific individual account holdings may vary from the representative portfolio.


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Published on April 30, 2024

Greg Ortman is a fixed income investment director with 27 years of industry experience (as of 12/31/23). He holds a master’s degree in economics from Claremont Graduate University and a bachelor’s degree in economics from St. Edwards University.

Jose Guzman is an investment product management specialist with 8 years of industry experience (as of 12/31/2023). He holds a master's degree in philosophy from California State University, Los Angeles and a bachelor's degree in philosophy from University of California, Los Angeles. 

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