Municipal managers are making last minute adjustments to their holdings in anticipation that the Federal Open Market Committee’s meeting next week will mark the beginning of the end to the Federal Reserve’s bond buying program.
Jeffrey Elswick, director of fixed-income at Frost Investment Advisors in San Antonio, Texas, is limiting interest-rate risk in his mutual bond fund and buying high-grade paper in the intermediate range, while Scott McGough, director of fixed-income at Philadelphia-based Glenmede is also keeping the duration of investments shorter than the benchmark he tracks, while using available cash to capture yield opportunities.
Concern that policy makers would withdraw economic stimulus has spurred interest rates higher for much of the year, contributing to outflows for municipal bond funds. Speculation that the Fed would decide at the Sept. 17-18 meeting to announce plans to taper its monthly bond purchases from the current $85 billion a month continued, even after a report showed job growth was slower than forecast in August.
“Last week’s employment report needed to be very weak to see the Fed change their mind,” said Anthony Valeri, senior vice president of research at LPL Financial. “Fed officials have made so many public comments about reducing bond purchases that it appears difficult to turn back now.”
The August employment report from the Bureau of Labor Statistics showed that payrolls were up 169,000 -- less than forecast -- and the June and July figure was cut to 74,000. Still, the unemployment rate dipped to 7.3%, closer to the 6.5% rate that the Fed has set as a target for removing interest rate stimulus altogether.
“I think the municipal market has been one of the hardest hit sectors, and the probability is fairly high, in my opinion, that the sector is going to come under more stress with the Fed a little less accommodative,” Elswick said.
Elswick remains concerned about the impact of additional pressure on his fund, which he said hasn’t suffered the substantial redemptions that other funds did, but “hasn’t seen large inflows either.”
The arrival of new issuance in June and July and secondary selling pressure from fund redemptions kept funds like Elswick’s stagnant, yet stable, against a backdrop of Fed tapering expectations.
“As a municipal manager I am worried that we haven’t seen the worst in terms of negative returns,” Elswick said. He is minimizing risk by limiting the duration of the firm’s $250 million municipal bond fund to five years, compared to the duration of almost eight years in the Barclays Municipal Index that it tracks, he said. Duration is a measure of the sensitivity of the price -- or value of principal -- of a fixed-income investment to a change in interest rates.
To further insulate his fund, Elswick is focusing largely on high-grade paper with maturities between five and six years.
Munis have followed the lead of Treasuries amid talk of potential tapering. Yields on the benchmark 30-year triple-A general obligation bond has soared about 165 basis points since January, according to Municipal Market Data. The yield was unchanged at a 4.48% at the end of trading on Tuesday.
“During any sell-off, the muni market is rarely immune from taxable weakness,” Valeri said.
McGough said the market reaction to tapering concerns has created some opportunities.
“Anytime there is a dislocation in the market, there is an opportunity to add value to client portfolios,” said McGough, who oversees the management of $2.8 billion of municipal assets in separately-managed accounts and has been with Glenmede for 15 of his 20-year career in municipals. “The pop up in rates is an opportunity to invest a little longer and roll down the yield curve.”
McGough said he manages for total return, and prefers high-grade individual municipals with a large, national presence and strong underlying ratings of single- A or higher, such as credits from the essential service and hospital sectors with dedicated revenue streams.
McGough said that increasing talk of the Fed contributed to a change in sentiment that spurred outflows to epic proportions, as weekly reporting municipal bond funds recorded outflows that hit a peak of $4.53 billion in the week ended June 26, according to Lipper FMI.
“People realized, 'Even though I was getting an income stream, I can [also] lose that income stream,” McGough said. Some of those investors gravitated out of fixed-income into equities when municipal fund outflows approached the highs of the early 1980s, and yields began rising precipitously, he said.
The sell-off has given way to more opportunity, as benchmark yields are more attractive than they were six to nine months ago.
Through May, the market “was a sleeper, and investors were not being fairly compensated for risk,” McGough said. “Since then, it’s gotten a lot more interesting because cash flows have been out of the door for mutual funds.”
“When you have these sizable reductions and the number of bids dramatically reduced, you have to be more nimble and opportunistic in your strategy,” McGough added. For him, that means participating in the high-grade sector with maturities between six and nine years where the curve is the steepest, but where he feels protected from long-term risk and compensated with a fair amount of yield.
He keeps the duration of his clients’ portfolios at four years -- shorter than a 1-12-year benchmark he follows. He actively uses available cash to invest slightly longer if the opportunity arises and clients are comfortable with the decision, he said.
“Some clients are unwilling to take price volatility, and others are willing to ride that out as much as possible,” McGough said.
At Frost, which has $9.5 billion in total assets under management, of which $4.5 billion consists of fixed-income, including approximately $1.5 billion in municipal debt, the strategy is “pretty conservative from an interest-rate perspective, and on the credit side,” Elswick said. “We have been focused on the five to six-year part of the curve and have been under-weight, or lower allocation than normal, to riskier credits.”
However, because the firm is a relative-value buyer, he said it has been in hot pursuit of Development Bank of Puerto Rico revenue bonds, which have been battered while the commonwealth struggles to cure budgetary and fiscal hurdles. For example, the firm owns 2017 bonds that are currently yielding 4.50%, which he purchased three months ago at a 4% yield.
“Those bonds have been beaten up these last few months,” Elswick explained. Even though it generally avoids the high-yield sector because of stress from heavy outflows, the firm believes the commonwealth’s five to 10-year financial forecast is positive.
Meanwhile, McGough and Elswick agree there is positive news ahead with respect to tapering, as it will help the market regain the mobility to function on its own.
In the initial stages, Elswick predicts that 10-year Treasuries could rise as high as 3.20%, and once the market stabilizes near year end, it will present a window of opportunity for investors.
“The market has become so manipulated, so it will help over the long-term if the Fed starts cutting purchases,” he said, echoing the market’s expectations for at least a $10 billion cut at the first meeting, with larger reductions later.
“As the plan develops or is different than what the market is expecting, fixed-income yields will adjust to that,” McGough said.
He said the Fed’s exit strategy indicates that “the market is healing itself and the Fed will have a less dramatic effect” on its operation. As tapering progresses, he expects economic growth to be subdued and fixed-income returns to improve over the next 12 months or so.
In the meantime, the managers are on keen on value now and in the aftermath of tapering.
“Investors should stay pretty conservative and wait for a better time to come back into the market,” Elswick said. “Once we get closer to the end of the year, it will be a better time to increase portfolio risk both on the rate and credit sides.”
McGough, meanwhile, advises investors to: “Be nimble and willing to put cash to work when the market gives you the opportunity to invest at higher yields.”
