Michael K. Farr comes well armed in the battle for yield.
Farr, who helps manage over $900 million of securities as founder and majority owner of Washington, D.C.-based Farr, Miller, & Washington LLC, says the firm has six analysts, including two dedicated municipal managers, combing through the data on 1,500 credits to meet the demand for greater returns among its wealthier, savvier retail customers.
“Unfortunately, it’s very easy to get most clients to agree to anything that offers higher yield in this environment,” Farr said, referring to the years of historically low interest rates that followed the 2008 financial crisis.
The extra attention to research, he said, has helped find issuers that underperformed the market during the crisis, and still trade at higher yields, even though their credit has improved.
“The very same municipality may have issued a bond in the last 24 months — and applied for a rating for that credit — yet the old bond is still considered nonrated.”
The research recently turned up a case in which an older block of a local county’s unrated bonds offered a 1.75% yield in 2014, even though it had just obtained a fresh double-A rating on a new issue for the same debt.
The yield on the older bond was much higher than the 0.37% yield that comparable double-A-rated paper was offering in the current market, while the one-year maturity was far shorter than the seven or eight years a client would have otherwise had to extend to to get a 1.75% yield, Farr said.
“Those bonds are considered not rated and, therefore, inappropriate for a lot of conservative accounts, and they are not considered bank-qualified,” he said. While they are still credit-worthy bonds, they carry higher yields because of the perception that they are inherently riskier due to the nonrated status, he said.
In similar scenarios on the long end of the market, Farr said he has has realized yields as high as 5.90% for nonrated bonds due in 2019.
According to Municipal Market Data, a double-A-rated general obligation bond in 2019 yielded 1.44% last Thursday, while even the GOs on the Baa scale only yielded a 2.51% — less than half of the yield Farr obtained for his clients.
Being able to quickly discern between credits allows the firm to be opportunistics, he said.
“We are able to buy [bonds] a lot cheaper and garner better yields and add value, without taking on additional credit risk and without extending maturities.”
Farr uses the strategy among consenting, experienced retail clients, from business owners to entrepreneurs and wealthy retirees, though he limits their exposure to 30% of the attractive paper.
Their portfolios can range from $1 million to $10 million and, because of their size, can tolerate the perceived risk to offset the low returns in the generic, plain-vanilla market, where the benchmark triple-A scale in 30 years hovered at 3.20% last Thursday.
“It’s not that the less-sophisticated investors wouldn’t say yes to owning these bonds — they would absolutely say yes — but we don’t think in the smaller portfolios it’s really going to move the needle in any meaningful way,” he said.
Odd-lots and bid-wanted lists also from the secondary can provide a burst of income for Farr’s yield-buyers.
“Because of our research in the rated world, we take advantage of the odd lots that — for many managers and certainly funds — are too small and ungainly to fool with,” he said.
Farr considers his approach the exception rather than the rule. “I think it makes managing portfolios much harder — it’s much more labor intensive to do things this way, but it’s what our customers are paying for.”
The overall landscape and intense search for yield in today’s market has changed dramatically since Farr started the firm with partners Elmon A. Miller and John A. Washington in 1996.
“I don’t think you had to be as careful 17 years ago,” he recalled. “If you were getting 6% on a municipal bond, the available yields were good enough — you weren’t always under pressure to reach for yield.”
Back then, sacrificing 30 basis points was considered a reasonable trade-off for owning higher-quality paper, he said. “Now 30 basis points matters a lot.”
For his smaller, more conservative retail customers with municipal portfolios averaging around $100,000, Farr said he applies a more traditional investment discipline, rooted in preservation of capital and a preference for high-quality paper. He upholds the safety of those portfolios by avoiding risks, keeping maturities generally inside of seven years.
“We will look for certain call features where we’ve done some of the fundamental work, and think it’s a reasonable price to the call, and, based on our work, the call is unlikely,” he said.“It takes a lot of discipline to stay within our parameters and not extend.”
“We have forgone the yield in order to protect clients and their portfolios from a surge in rates,” Farr said. “That’s come at a price, but we believe that price is going to be worth it.”
Farr favors general obligation and school bonds, in addition to essential service revenue debt, such as sewer system bonds. He remains skeptical of and largely avoids health care bonds due to the uncertainty over funding and the Affordable Care Act.
Similarly, he reminds conservative clients to remain “circumspect,” especially in today’s market where there is much temptation to chase yield with little regard for the accompanying risk.
Complacency about risk is one of the stark differences Farr has noticed over in the last decade.
“As edgy as they say they are about credit-quality, retail certainly doesn’t believe you can lose money in bonds,” he said. “Because we have been through such an extensive bull market in bonds, retail doesn’t understand anymore how prices erode in a rising rate environment.”
Straying from their core discipline to achieve yield is a “big mistake” and “can do significant long-term damage to your financial well-being,” he said. “Muni money needs to be safe; you don’t ever take risk to achieve yield.”
Farr is a paid contributor to CNBC who has also been heard on Associated Press Radio and National Public Radio, appeared on CNN, Bloomberg, Reuters and the Nightly Business Report, and been quoted in the Wall Street Journal, Forbes and Fortune, among other publications.
“The thing we have learned over the past 10 years is that trouble and risk can come from lots of different areas — and much of it is almost impossible to anticipate,” Farr continued. “We’re really in an investing world where the burden is to be prepared for anything.”
At the same time, he said part of investors’ relaxed behavior stems from government intervention.
“Every time we’ve seen the market swoon, the Fed has stepped in and that took away some of their worry,” Farr said, pointing to quantitative easing as the latest example.
Overall, he said his goal is to manage clients’ portfolios to keep them financially healthy into their 90s, while avoiding potential risk and managing market volatility. “You can adapt them to market conditions; it doesn’t mean they invest 100% fixed income or 100% equities just because the market changed,” he explained.
The firm’s focus on research, and a quality-oriented discipline, has led to the growth and portfolio stability.
When Farr decided to start his own money management outfit, he only had nine years of experience as a retail broker, but he knew he wanted to earn more than a routine paycheck and build equity in something that he could call his own.
Farr, who is chairman of the company’s investment committee and is responsible for its day-to-day operations, recalls that 2009 and 2010 were its two biggest years for growth and expansion.
“We had been conservative and relatively stable through the crisis, and had a lot of clients come to us in search of a safer manager — particularly those that had more volatile experiences,” he recalled.
Many of those clients have remained with the firm today, he said.
Farr’s municipal practice is an important part of the firm’s business, which runs the gamut from small mom-and-pop accounts that rely on their muni investments for monthly income, to large wealthy entrepreneurs who need to buffer their high income streams with tax-free securities.
Currently, it manages approximately more than $200 million in fixed income and over $600 million in equities firm-wide, and has two other offices in Philadelphia and Naples, Fla. It also manages a full range of fixed-income products, as well as balanced, ETF and cash-management accounts.
Farr got his start in 1987 at Wheat First Securities as a retail broker selling municipal and taxable bonds to individual investors.
He later went to Alex, Brown & Sons, working as an institutional bond broker, selling mostly taxable securities, and some municipals.
Currently, he is a member of the Economic Club of Washington, D.C., the National Association for Business Economics, and the Washington Association of Money Managers.
In addition to principle protection and capital preservation, Farr said educating investors remains a key concern.
“My job is largely to keep my clients out of trouble,” he said. “I want to be opportunistic, but make sure these folks have enough chips to come back and play tomorrow.”
