Headline Risk Can Pay Off

Analysts and managers say they are finding value in the municipal market by taking advantage of attractive intermediate yields and buying opportunities presented by credits that find themselves in the headlines, among other strategies.

Global uncertainty continues to create volatility in the market — see last week’s reaction to news about progress to a resolution of the debt crisis in Europe — and that can lead to avenues of opportunity in the municipal market, according to Laura LaRosa, director of fixed-income management at Philadelphia-based Glenmede Investment and Wealth Management.

Muni ratios to Treasuries are still attractive, she said, even after the news from Europe caused demand for safe-haven investments to fall and sent bond yields higher. “With the back-up in yields, I still think munis make sense to an individual in a high tax bracket. The markets are going to be volatile until we get further clarification on what is going on in Europe,” LaRosa added.

The recent flight to quality “coupled with the fact that the Fed has been very clear that they intend to keep rates low for an extended period of time, has made municipal bonds yields look very attractive, especially when you look at the ratios of municipal yields to Treasury yields,” she said.

As of Thursday, 30-year municipals were yielding 110% of comparable Treasuries, according to Thomson Reuters.

Chris Mier, managing director of the analytical services group at Loop Capital Market LLC, said the market is currently in a trading range that provides plenty of opportunity to buy select bonds relatively cheap given that yields have backed up about 35 basis points since late September and there has been some spread compression in certain sectors.

The generic 30-year, triple-A general obligation bond yielded a 3.80% after last Thursday’s weakness — compared to 3.44% nearly a month ago on Sept. 23, according to Municipal Market Data.

In the current environment, Mier recommends taking advantage of extending slightly on the curve to find yield opportunities — on the front end in nine years, and in the intermediate range bonds due in 13 and 15 years.

LaRosa agrees that is where investors are getting the most bang for the buck, and said she is weighting her portfolios in 15-year maturities through year-end to gain additional income with minimal added risk — after keeping duration a bit shorter than normal in the third quarter.

“As uncertainty on a global scale began to boil to the surface this past summer, ratios of longer-duration bonds became more compelling in mid-July, and extending duration became a much more attractive strategy,” she explained.

Investing in the intermediate range “insulates” investors from a long-term rise in rates and offers “compelling values” following the sell-off two weeks ago, said Peter Hayes, head of municipal bond trading at BlackRock. Besides the intermediate sector, he recommends keeping a neutral duration and buying for income since there is less potential for total return in the current low-rate environment.

“October price action is part of the ebb and flow we expect to see in the municipal bond market over the remainder of the year,” said Anthony Valeri, senior vice president of research at San Diego-based LPL Financial.

Valeri said investors are being paid to extend duration and by doing so, are earning attractive after-tax yields on intermediate and long bonds.

Meanwhile, other strategies Hayes suggests include buying high-quality, liquid names. That allows BlackRock managers to position themselves for any potential increase in rates, which would cause bond prices to fall. Some sectors, such as health care, airports, state-backed housing bonds, and utilities, are offering attractive yields with less risk of cuts from deficit reduction than other sectors.

LaRosa, too, is focused on high-quality, particularly 5% to 5 1/2% coupons due in the 15-year range with a 10-year call.

She recently purchased 5% coupon bonds on behalf of the Children’s Hospital of Philadelphia due in 2028 and callable in 2021 for their credit quality, scarcity value and attraction for Pennsylvania clients in the highest tax bracket.

Rated Aa2 by Moody’s Investors Service and AA by Standard & Poor’s, the bonds have a yield to call of 4.35% and a yield to maturity of 4.56% — 126 basis points cheaper than the generic triple-A scale in 17 years.

Recent spread compression due to ongoing credit concerns is also making a similar quality and liquidity trade advantageous, according to Mier, who said top-tier state GOs, such as Maryland and North Carolina, have recently benefited from relatively attractive yields. To further uncover value in the plain-vanilla market, he is also capitalizing on a spread relationship trade using unlimited-tax GO bonds from Chicago — recently a trading anomaly.

Rated Aa3 by Moody’s, the city’s bonds recently traded at 145 basis points cheaper than the generic MMD scale, and offer more yield than Cleveland, for instance, which is rated A1 by Moody’s and recently traded at just 70 basis points cheaper than the scale, he pointed out.

“You are getting double the spread to own Chicago GOs... and a higher Moody’s rating,” Mier explained.

He said the Chicago trade also compares favorably to double-A Colorado hospital bonds sold on behalf of Catholic Health System, for example, that are trading at 120 basis points to the MMD scale.

“You can buy double-A unlimited-tax GOs from one of the three largest cities in the country versus a double-A hospital bond that faces uncertain prospects from the new health care bill under Obama care,” Mier said. “Normally, the market would regard a double-A hospital as riskier than a double-A city, and therefore, offer more yield.”

Others, meanwhile, are recommending premium-priced “kicker” bonds — callable high-coupon paper — as an alternative to investing in the first five maturities of the curve where yields are ultra low.

“In our view, there is still good value out to 15 years or so — even longer on some newly issued paper in states with heavy supply,” according to George Friedlander, a muni analyst with Citi.

He is taking advantage of the still-steep slope of the yield curve but recommends against holding concentrations of weaker local government bonds, including GOs, lease debt and certificates of participation. Friedlander said these weaker credits are likely to be vulnerable when Congress acts to reduce the federal deficit.

“We expect to see more downgrades and possibly an uptick in defaults, especially if the U.S. economy enters a double-dip recession triggered by the European crisis,” he added.

Muni experts say timing is everything. “The key for investors is to choose your spots: sell at the richer ends of the range, and buy at the cheaper yields,” Mier said. He is monitoring volume and potential legislation in Washington.

“We’ve had some weeks that were pretty heavy, so you wonder how the year is going to wrap up,” he said. “If supply reaches a level where it overwhelms demand temporarily, you could have a backup.”

This week, the primary market is poised for the arrival of $8.24 billion of new volume, versus a revised $7.04 billion last week, according to Thomson Reuters.

At BlackRock, Hayes also has his eye on liquidity and supply going forward.

“Liquidity is always a concern in the fourth quarter as dealers are less willing to use balance sheets for inventory,” he noted. “Should supply increase significantly in the fourth quarter, that could challenge the market,” he said, adding that his firm would view that as “opportunistic.”

Others say municipal valuations remain attractive to Treasuries and there should be limited interest-rate risk ahead because rates should remain “relatively range-bound,” according to Valeri of LPL.

“Overall, we believe the municipal bond market has delivered the bulk of performance investors are going to see for 2011,” he said. “The remainder of 2011 should be a 'coupon-clipping’ environment where investors merely collect their income and prices are relatively stable.”

But with a volatile 2011 nearly over, others aren’t eager to make such bets before year-end. “We still have two months to go, and there are still plenty of things that can happen, positively and negatively,” Mier said.


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