Buy Side

Shell-Shocked Strategists Weigh Yield, Risk

Asset managers are trying a little of everything after a historic selloff catapulted municipal bond yields some 60 basis points higher a week ago.

As the start of the third quarter and summer reinvestment season neared, some managers were limiting their exposure by sticking with bonds maturing within five years and increasing their credit surveillance and liquidity to protect assets from further weakness. Others were buying, taking advantage of rare 5%-plus yields on the long end -- particularly in new issues.

"Once the sting of the decline wears off, the municipal market will see some inspired demand from retail investors who have been starving for attractive income levels for a long period of time," Michael Pietronico, chief executive officer at Miller Tabak Asset Management, told The Bond Buyer on Tuesday.

Though some new issues were still being postponed on Thursday due to market conditions, the market firmed up starting Wednesday, allowing underwriters to cut yields 20 basis points on new deals. The single-A-rated $1.3 billion Illinois general obligation sale was more than six times oversubscribed and the yield on its final 2038 maturity was cut to 5.65% from 5.85% from the original scale at the time -- yet still 180 basis points higher than the comparable generic triple-A GO scale at the time, according to Municipal Market Data.

On Thursday, the benchmark GO scale continued to fall and ended at 3.83%, down eight basis points from 3.91% the prior day.

Investor reaction to the historic market turmoil was running the gamut from pleasantly surprised to shell-shocked. How they ultimately react may be a key determinant in the market's performance as the new quarter begins.

"The early summer months normally equate to a much firmer market based on historically-high levels of cash hitting portfolios in the form of bond interest payments and maturities," Pietronico said.

Due to the market turmoil, however, that cash may take longer to find its way back into the market, according to Anthony Valeri, senior vice president of research at LPL Financial.

"We had expected the municipal market to benefit from seasonal strength at the start of July, but that will likely be pushed back until mid-July," Valeri said in a weekly market commentary. "While some compelling opportunities are emerging in the municipal market, illiquid markets and the approaching quarter-end suggest investors may be better served waiting until after the July 4th holiday."

In addition, the "extremely sharp correction" has thrown expectations for strong summer performance into disarray for portfolio managers, Matt Fabian, managing director at Municipal Market Advisors said in his weekly commentary.

"While prices have not yet found a bottom, and while municipals may continue to sell off strongly for a week or more, the current crisis reflects an endemic condition of our market," he explained. "In the long-term, this proclivity to crisis means fewer investor dollars -- in particular from large and concentrated investors who prize liquidity the most -- especially when better alternatives abound."

Some managers said they will continue to be active in the municipal market, while others are adapting renewed cautiousness in the aftermath of the selloff.

Triet Nguyen, managing partner at Axios Advisors and 32-year municipal veteran, said his independent research firm specializing in municipal bonds, including high-yield and distressed sectors, will pay closer attention to credit, liquidity, disclosure, and available cash.

"Given what we just went through, we will have to be much more mindful of the liquidity characteristics of our portfolios," he said on Tuesday. "The best way to improve liquidity, in high-grade as well as high-yield, is to stick with decent size issues with broad distribution or index-eligible issues."

In addition, he said the firm - a sub-advisor that provides credit research and strategies for clients with $2.4 billion in assets under management - will adapt a larger cash cushion of 10-20% and improve its credit vigilance.

Though rates have rebounded, Pietronico said his firm will largely maintain its conservative management in terms of duration and credit quality, and recommends taking advantage of high-quality municipals yielding 4% and 5%.

"We see this municipal market dislocation as an enormous opportunity to lock in overly generous absolute yield levels relative to economic growth and inflation as we see it evolving," he said.

Robert Doty, president of municipal consulting firm AGFS, said on Tuesday that investors should be buying short to intermediate-term maturities - not longer than five years - to buffer against future interest rate volatility on the long end of the curve.

"Investors should be very conservative because of the risk in the bond market," Doty said. "If you are holding bonds to maturity, you will have a lower return, but at least you won't lose principal."

At the same time, he said investors should avoid panic selling, and reaching for yield in the backdrop of rising interest rates and inflation fears. "I don't think it makes sense to buy longer term bonds," he said. "People who are stretching for yield and buying long-term, high-yield bonds are going to get hurt, and they are probably going to panic and lose a lot of principal."

Views also varied on the other short and long-term effects of the sell-off.
"I think the market will catch a bid and stabilize once we get past this week," Nguyen said on Tuesday. But "going into quarter-end, and with the surge in supply, I think it's not inconceivable another 20 to25 basis-point adjustment will be required to move the new issues."

Jim Colby, portfolio manager and senior municipal strategist at Van Eck Global, noted that the ratio of municipal bond yields to Treasury yields at or above 100% for most durations could provide potential value not seen in over two years.

Colby helps to oversee nearly $2.1 billion in municipal bond Market Vector ETFs.

Valeri of LPL noted that municipal to Treasury yield ratios are at their highest levels of the past year as the average triple-A-rated 10- and 30-year municipal to Treasury yield ratios were at 119% and 117%, respectively, in the past week.

"At a time when taxes are more likely to go up than down, municipal yields well above Treasury yields are an extraordinary value," said Jonathan Lewis, chief investment officer of Samson Capital Advisors in a June 21 market bulletin.

But just how far rates move in either direction and how the sell-off will affect future market volatility has experts at odds.

"One should not expect a bounce higher in prices anytime soon, but as the year progresses and higher rates take their toll on the economy and financial markets, we expect rates to come back down gently," Pietronico of Miller Tabak explained.

Nguyen of Axios said another major selloff in the September-October time frame "cannot be ruled out" as further back-up might be necessary to move potential supply bulges between the third and fourth quarter.




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