Despite speculation over what may befall the municipal market in the fourth quarter, portfolio managers and strategists are not letting concerns over the upcoming presidential election, potential tax reform or an expected seasonal supply surge derail their plans to unfold year-end investment strategies.
“The fourth quarter marks the start of a difficult period in the municipal bond market as a seasonal increase in new issuance begins and lasts until early December,” said Anthony Valeri, a senior vice president and market strategist at LPL Financial.
“Offsetting this negative are attractive valuations, and the favorable supply backdrop remains in place, with the outstanding municipal bond market on pace to be flat or negative in Q4,” he explained.
Some experts see advantages in the uncertainty, others are taking it in stride, while a handful are repeating their third-quarter strategies but staying active nonetheless. Peter Hayes, head of the muni bond group at BlackRock Inc., which has $106 billion in assets under management, said he plans to reap the benefits of seasonal weakness stemming from increasing supply and election speculation through year end.
He said he will employ modest duration extension by taking advantage of yield-curve steepness and focus on revenue sectors that continue to offer value — especially better-quality triple-Bs and A-rated issues.
“Expect some volatility as election time nears to center on the fiscal cliff, tax rates, and tax reform — with particular focus on the impact to tax exemption,” Hayes explained. “We are not expecting an adverse outcome for municipals, and anticipate greater demand in 2013, so any weakness will be a buying opportunity.”
Others said even though there may be bumps in the road, they, too, are posturing for the remainder of 2012 by improving their credit quality, taking advantage of relative value and tweaking their yield-curve positioning.
“We continue to favor municipals as supply is reasonable and demand is strong — and could get stronger depending on tax policy going forward,” said Dan Heckman, senior fixed-income strategist at U.S. Bank Wealth Management of Minneapolis.
“We expect supply to dwindle at the very end of the year and demand to pick up as investors realize the relative value of munis to Treasuries and corporates,” he said, noting that in some cases, municipal bond yields are 10 to 20% higher than investment-grade corporates. Earlier this week, municipals in 10 and 30 years were yielding 105% and 101.1%, respectively, of the comparable Treasury yield, according to Municipal Market Data.
“Strategically, we could see some backup in yields on supply rising in October and early November,” Heckman said. “We would use any backup in yields as a buying opportunity.”
Valeri said because most new issuance is refinance-related, he expects any supply-related sell-off will likely be limited as net new bond supply will be minimal — and likely not enough to offset the amount of maturing bonds.
But he noted that relative value and favorable supply may help limit weakness, and predicted municipal bond returns to be flat to slightly positive — around 0.5% — by the end of the fourth quarter. In his weekly fixed-income report this week, Valeri said October and November are historically among the three weakest months for municipal bond performance.
Treasury yields, meanwhile, will finish the year modestly higher — between 1.75% and 2% in 10 years — which may pressure high-quality municipal bond prices lower, Valeri predicted.
In recent weeks, he said his firm has shifted its investment focus more towards intermediate munis due to the possibility of potential weakness, but still holds both intermediate and long-term, high-quality municipal bonds in its portfolios.
Tom Dalpiaz, senior vice president at Advisors Asset Management in Melville, N.Y., said since the seasonal boost in the final quarter typically leads to higher yields, he is remaining “cautiously positioned” on duration compared to the Barclays’ Municipal 1-10 benchmark.
He said he will avoid testing any new strategies, and continue to focus on investment-grade intermediate maturities, while maintaining a value-oriented, security selection approach.
“We are a bottom-up traditional bond picker, and we will continue to mine the single-A and triple-B space for value” as the year winds down, according to Dalpiaz.
Heckman is also among those strategists that favor high credit quality, but is not averse to finding value.
Instead of buying low-rated paper, Heckman is partial to states that are benefitting from good progress on pension reform and have seen a rebound in real estate markets, such as Arizona.
“Instead of dipping down in credit quality, we would rather buy stronger credits in states that have wider spreads,” Heckman said.
This strategy compares to the third quarter when he said his firm was less aggressive, both from a credit quality and duration standpoint. With a flatter yield curve, “we do not see great value beyond 15 years,” he said. “We do not want to extend out too far on the yield curve since absolute yields are at all-time lows.”
“With the Fed extremely accommodative and loose in monetary policy, there is a major risk that they will allow inflation to run higher than the market expects, and consequently, yields could move up aggressively from current low levels,” he said.
To limit duration risk, Heckman said the firm will continue to target maturities between seven and nine years. He also favors kicker bonds between 12 and 15 years with minimum coupons of 4% that have good call protection and offer substantial yields versus non-callable bonds, and produce higher cash flow.
“These types of bonds should also perform better if interest rates would happen to rise,” he said. “We think they also do well in the interest-rate, yield-range-bound market that we have been in and expect to continue.”
Concerns over supply and demand — as well as possible fluctuations in yield levels — are also driving others to opt for conservative strategies that minimize risks ahead of forecasted volatility, while uncertainty over the impact of the election and tax reform are causing others to avoid big changes in strategy.
“The presidential election will be important, of course, but I would look at the makeup of the Congress as equally important,” Dalpiaz of AAM said. “Will the Republicans maintain control of the House? Will the Democrats maintain control of the Senate? If one party gets control of both houses that would be a major development to contend with.”
“The election could have a major impact as the two parties certainly are on opposing fronts as it relates to tax policy,” Heckman agreed. “We see little likelihood of any legislation passing that would negatively impact the tax-favored status of municipal bonds, but we are always watching developments very closely.”
“By staying with good credit quality, and liquid credits, we should be able to weather any pending storm that may suddenly appear,” Heckman added. “Until municipals are expensive relative to other fixed-income sectors, we are maintaining a positive stance on the market.”
Some market participants, like Valeri, said the uncertainty surrounding tax policy could be a positive or negative. “If Obama wins re-election, an increase in tax rates may boost demand for munis and be a positive,” he explained. “On the other hand, seeking to cap the exemption of munis at 30% would be a clear negative.”
Others, like Dalpiaz, said they will remain active but cautious as political and legislative events unfold. He will avoid adopting any one specific strategy between now and year end because of the pending volatility.
“The complexity of the politics involved, the public’s sensitivity to the elimination of popular deductions, and the uncertainty of what any final legislation might look like all argue against adopting any specific investment posture now just because there is intensified tax-reform talk,” Dalpiaz said.
John Mousseau, managing director and portfolio manager at Cumberland Advisors, is sticking with his third-quarter strategy — a barbell approach — since he believes short rates will remain stable, and the long end has the potential to outperform.
Given municipals’ current relatively attractive ratios to Treasuries, the market “clearly should outperform as interest rates move higher,” Mousseau said. “Where you can buy high-grade bonds close to 3.40% or 3.50% in a 2.90% long Treasury world, there is a lot of chance for munis to outperform.”
He will likely focus on higher-quality paper, such as essential service revenue bonds, as a buffer against declining rates, and will minimize duration going into 2013.
“I think the markets have discounted an Obama re-election together with a House that stays Republican and a Senate which is a toss-up,” Mousseau added.
Concerns aside, experts are largely approaching the fourth quarter and beyond optimistically.
“I expect that Q4 will, overall, be positive for municipals, given the declared stance of the Federal Reserve to keep rates low for an extended period of time,” said James T. Colby 3d, senior municipal strategist and portfolio manager at Van Eck Global.
“Barring any drama coming from the elections — primarily a total rebalancing in Congress — I’d expect munis to perform well, though maybe not as strong a finish as last year, when there was a record amount of cash available for reinvestment,” he said.