Buy Side

Balm for BAB Buyers

Of all the risks facing owners of Build America Bonds, a spike in interest rates is one of the most alarming.

Cumberland Advisors thinks it has found a way to neutralize this risk. The Vineland, N.J.-based firm is sympathetic to clients who are buffeted on both sides.

Clients who want to play it safe and stick with short-term paper can earn only fractions of a percentage point with money market funds or Treasury notes.

On the other hand, those looking for better returns with long-term bonds face the risk that a jump in interest rates will thrash their portfolios.

Peter Demirali, who manages the firm's taxable municipal bond portfolios, offers clients a BAB-Treasury spread "style" investment that out-earns yields on short-term debt without assuming the daunting interest-rate risk of long-term bonds.

The strategy sacrifices a few percentage points off BAB yields in exchange for a position that is better fortified against the risk of rising rates.

The strategy starts by buying BABs, the taxable municipal bonds created under the $787 billion stimulus legislation last year. Investors earn a taxable yield, while 35% of issuers' interest costs are paid by the federal government.

According to a Wells Fargo index, the average yield on BABs is around 6.2%.

But considering the average maturity on BABs is more than 28 years, the position is subject to a great deal of interest rate risk — or the vulnerability of the value of a bond to a shift in rates.

The average modified duration of BABs is 12.3, according to Wells Fargo. That means that a one percentage point spike in interest rates would knock 12.3% off the value of the average BAB.

Demirali seeks to shelter the value of his clients' long-term BABs through a hedge. It entails buying a combination of two exchange-traded funds: the ProShares UltraShort 7-10 Year Treasury fund, and ProShares UltraShort 20+ Year Treasury fund.

Both funds target a Barclays Capital index tracking Treasuries. But instead of mimicking the indexes, these funds try to move in the opposite direction — at double the magnitude.

In other words, if intermediate-term Treasuries decrease 1%, the UltraShort 7-10 Year Treasury fund strives to increase 2%.

By complementing BABs with a magnified short position in Treasuries, the strategy seeks to offset any loss on BABs from rate increases through a gain on the ETFs. If interest rates increase and hurt the value of a BAB, the same increase would hurt Treasuries and therefore bolster the value of the short Treasury ETF.

Because the ETFs offer double the inverse returns of Treasuries, Demirali can generally hedge each dollar of BAB exposure with around 50 cents of the ETF.

As a result, instead of a risky 6% on BABs, this strategy is offering much safer returns of about 3% to 4%, Demirali said.

About $3 million of the roughly $150 million the firm has invested in BABs utilizes this strategy, Demirali said.

He acknowledges the hedge is not perfect. The challenge is blending the intermediate- and long-term ETFs so that their combined duration matches the BAB's duration, Demirali said.

"What you're trying to do is get as close as you can to neutralizing that interest rate risk," he said.

Even with a perfect match, the hedge assumes Treasury rates and municipal rates move in lockstep, when in fact they might not.

Furthermore, capturing 3% or 4% with this position only makes sense when the yield curve is steep, Demirali said.

If short-term rates increase relative to long-term rates, Cumberland will be able to deliver safe returns other ways.

As the yield curve flattens, Demirali said the positions will be closed out and devoted to other strategies.

While Cumberland has been involved in taxable municipal bonds for years, the launch of the BAB program in 2009 greatly expanded the taxable sector and may be introducing new types of investors to municipals.

According to Ipreo — which has a database of aggregated institutional investors' holdings — such investors have reported owning $9.68 billion of BABs.

It should be noted that these filings do not portray the complete universe of BAB ownership.

The reported bonds constitute 13% of the $74.7 billion of BABs that have been issued since the program launched just over a year ago.

Insurance companies and pension funds do not have to report ownership to the Securities Exchange Commission. Information about mutual funds — which must report ownership — is delivered to Ipreo from Morningstar at varying lags after they are reported.

In addition, even for the entities that have reported ownership, the data obtained from Ipreo does not appear to be complete.

Eaton Vance, for example, reported owning seven BAB issues as of the end of January, according to Ipreo. The Boston-based company, however, runs a mutual fund dedicated to BABs that itself owns 29 issues.

That said, Pacific Investment Management Co. is the biggest institutional holder of BABs, according to Ipreo. The Newport Beach, Calif.-based firm, which manages more than $1 trillion, reported owning $2.21 billion of BABs at the end of last month.

Pimco is followed by Wellington Management Co. and Delaware Investments, with $831.9 million and $744.7 million, respectively.

Plenty of life insurers appear on the 173-company list, including State Farm, MetLife, Penn Mutual Life, Hartford, Protective Life, and American United Life, all in the top 20.

"These are taxable bonds with tax-exempt credit qualities, so they provide a nice diversification, particularly for life companies that have historically not enjoyed the tax benefits of traditional munis," said Marty Hollenbeck, chief investment officer at Cincinnati Financial, which reported owning $108.9 million of BABs for a rank of 16th.

Life insurance companies have not historically been big buyers of munis, keeping less than 1% of their assets in state and local government debt from 1988 until the end of 2008.

They now own $50 billion of municipals, representing 1.1% of their assets, according to the Federal Reserve.

"We purchase assets to offset the long-term liabilities that we write, making the long duration of Build America Bonds a good fit for our asset-liability management approach," MetLife said in a statement.

Also in the top 20, according to Ipreo's data, were mutual fund complexes like Vanguard, Franklin Advisers, and Lord Abbett.

Dodge & Cox landed at number seven on the list, with a reported $448.1 million of BABs under ownership. The investment firm, which is based in Boston, bought a number of California's general obligation BABs for its $19.3 billion income fund last year.


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