Many investors are familiar with the concept of buying undervalued equities thanks to famous value investors like Warren Buffett. The idea is to determine a company’s intrinsic value — by looking at things like free cash flow — and purchase its stock below that value. Over time, many value investors have realized above-market returns by capitalizing on the market’s inefficiencies at valuing these companies properly at all times.

For some reason, few investors try to mimic this approach in the bond market by determining a bond’s intrinsic value and trying to purchase undervalued issues. Most of these investors assume that a bond’s price is fixed, and they simply focus on finding higher yielding issues. Although it’s true that a bond’s cash flow is fixed, market inefficiencies come into play with credit analysis, which discounts a bond’s price based on various risk factors.

In this article, we will take a look at what makes a muni bond ‘undervalued’ and how investors can mimic some of the same strategies used by fixed income professionals.

Many companies are considered undervalued when they have growing levels of free cash flow and the discounted value of those cash flows is greater than the current market price. Similarly, bonds have regular cash flows over time that are discounted to present value. The key difference is that these cash flows are fixed, which means that the only variable in the discounted cash flow analysis is the discount rate — or interest rate.

In some cases, a bond’s price may trade at a premium or discount to its fair value, which is determined through a discounted cash flow analysis. These kinds of discounts aren’t very common in liquid bond markets because institutional investors would jump on the opportunity to make a quick profit through arbitrage. These days, it’s more common to see overvalued bonds that trade at a premium to their fair value due to changes in interest rates.

Investors should try to avoid overvalued bonds that trade at a premium and seek out undervalued bonds that trade at a discount. In the case of municipal bonds, it’s important to note that investors purchasing undervalued bonds may be forced to pay capital gains tax on the profit when they sell, although the interest payments may still be free from income tax. This may mitigate some of the benefit for investors in higher tax brackets.

Many investors assume that bonds — and especially municipal bonds — are safe-haven investments and have little risk. But it’s important to realize that some bonds are riskier than others, and these risk factors justify a discount price. Credit analysts attempt to quantify these risks in the form of probabilities of default, as well as credit spread risk and downgrade risk. Based on these, analysts assign credit ratings to the bonds. Bonds with lower credit ratings tend to trade at a “discount” because of the higher risk.

In some cases, investors may be able to identify bonds that are misjudged by the market and have too much of a risk premium built in. This can cause the bonds to be undervalued because investors are overcompensating for the credit risk. Although most credit analysis is complex, individual investors may be able to glean some insights from the politics in given states or cities and identify situations where Wall Street analysts may be off the mark.

Economic trends may reveal situations where there is a disconnect between perceived risk and reality. For example, a rebound in real estate could increase real estate tax revenue and boost a bond’s credit quality in a market that has suffered from minor budget issues. The disconnect in valuation may be especially apparent in thinly traded bonds that don’t necessarily react immediately to changes in economic and political reality.

Investors purchasing bond funds may have an easier time identifying potentially undervalued opportunities. Although open-ended mutual funds don’t usually trade below net asset value, closed-end funds (CEFs) frequently present opportunities for investors. These are publicly traded investment companies that use a combination of cash and debt to acquire bonds and return the interest payments to investors in the form of dividends.

In some cases, CEFs specializing in municipal bonds have yields in excess of 10% due to the leverage used on their positions. This leverage increases risk in some cases, but the muni bond asset class tends to have higher credit quality than many other types of bonds.

Investors interested in undervalued CEFs should look for companies trading below their net asset value — data that is often published. In essence, this means investors are purchasing the underlying bonds at a discount to their intrinsic value. However, investors should take a closer look at fees and other expenses to discover the true cost of the investment. An unskilled manager may also invest poorly and justify a discount to net asset value.

Municipal bonds may trade below their fair value for a number of different reasons, ranging from evolving interest rate expectations to underlying risk factors. In addition, investors may want to consider purchasing CEFs trading below their net asset value, which essentially provides a discount to an entire portfolio of muni bonds. However, it’s important to keep in mind the risk factors and tax implications when making these choices.