Defense, it’s often said, wins football games.
It also may be the best strategy for municipal bond investors in 2013, given market conditions. So says Peter Hayes, head of muni-bond portfolio management, research and trading at BlackRock.
In his more than 25 years on the municipal bond desk at Merrill Lynch and BlackRock, Hayes has had front-row seats to some of the biggest changes in asset management, and in particular how they have affected muni bonds.
He brings all of his experience to bear in his near-term outlook on the market, including where to find value, his stance on ratios and returns, and how negotiations in Washington, D.C., for the debt ceiling will affect munis.
“I’ve seen both sides of the market,” said Hayes, who oversees $109 billion in muni assets under management at BlackRock. “I was on the sell-side, so I can appreciate how important the liquidity they provide is to the market. And now I’m on the buy-side, which has a different view, and a different way to think about and implement strategy; it’s more of a longer-term view than a near-term view.”
That longer-term view helps him see into the matter of munis’ tax-exemption status. The issue probably won’t be resolved as part of the debt ceiling discussions, Hayes said.
Rather, it’s most likely to take place as part of a broader effort on tax reform, which, given the complexity of the tax code in the U.S., will take time, he said.
Looking longer-term, Hayes wonders if Washington really can reach a compromise on the tax code, given its complexity and considering how difficult it’s been to do much of anything in a bipartisan spirit. The tax treatment issue becomes very complex at a time when the United States particularly needs more infrastructure and borrowing costs may rise.
“That takes a very intricate knowledge and a real deep dive into the muni market in order to make informed decisions on all those things. And I just don’t think that Washington has the depth or the breadth to do that,” he said. “It’s probably a much longer-term issue.”
That means the threat is going to linger as long as the issue remains unresolved — and subsequently market uncertainty surrounding the status of the tax exemption for munis will, as well.
But investors lately appear to have been reacting to other market indicators.
“The average investor in the market, in general — and recent performance is evidence of this — is really not paying attention to this threat; they’re largely dismissing it,” Hayes said. “So, you have to have something far more concrete for the market to begin pricing that in. And we’re just not there yet.”
Meanwhile, other sources of volatility loom. The debt ceiling issue, for example, brings up some legitimate questions. To begin with, what happens to the U.S. rating? And, if the federal government is downgraded, what does that mean for rates in general? Rates could fall in a flight-to-quality bid. Or rates could rise because people lose faith in the U.S. government.
The debate is important, Hayes said, because it dictates the direction of other fixed-income markets, including munis. As it is, the debate in Washington will give the market a volatile tenor. But as munis have a tailwind from higher taxes, they should also be insulated by strong demand.
“I was just getting started in the business when we had the last big tax-reform scare: in 1985, prior to the tax reform act of 1986,” Hayes said. “I remember being on a trading desk in Boston … I remember the threats to tax exemption. It’s real. It can have a huge impact on the market.”
Hayes’ path to munis was a relatively straight one. He studied economics at the College of Holy Cross, in Worcester, Mass. After graduation, he quickly developed an interest in how the macro economy and interest rates affected the markets.
Hayes got into municipal bonds in the early 1980s while at BBS Inc. in Livingston, N.J., mostly a fixed-income shop that was active in muni bonds. There, he decided to move over to the portfolio desk, where he did tax swaps and looked to do portfolio reviews and tax efficiencies in individual portfolios.
“One of my first mentors was somebody at BBS who was very analytical, took the time to teach me, and his background actually was in municipal bonds,” Hayes said. “That was my first step into the market.”
After a stint on the trading desk at Shawmut Bank in Boston, Hayes in 1987 moved to the asset management division at Merrill Lynch, which merged with BlackRock in 2006 and where he remained for 26 years. He’s led the muni bond group at BlackRock since July 2007.
Hayes’ interest in the asset class has grown as the market has evolved around him. In his role at Merrill and BlackRock, he has witnessed some of the biggest changes in the investment management industry. To begin with, he recalls how the largest muni buyers varied over the years. In the 1980s, it was the banks.
“They largely exited the market,” Hayes said. “They’re back again. They haven’t come full circle, but certainly they’re a presence in the market.”
Insurance firms were very big buyers in the 1990s, a time that saw the growth of the closed-end mutual fund.
In the early 2000s, the industry of the single-strategy muni hedge fund grew rapidly. It largely collapsed in 2008, leaving the market without a consistent, large buyer outside of the general retail customer.
In addition, the bond insurance industry grew and changed the way people looked at munis, according to Hayes. When he started in the 1980s, muni bond insurance was mostly in its infancy and a fairly small part of the market. It grew dramatically, reaching its highest market penetration of 57% in 2005.
“People were able to get in and out [of a muni bond],” he said. “It became a very liquid, actively traded market because of insurance. And now insurance is fairly insignificant again.”
Hayes found the 1990s exciting, marked by the advent of closed-end funds and some other structural changes. And the past six years have been “extremely interesting,” he said. Most important, the asset class has completed its transition away from an interest rates market to a credit market.
The regional nature of the business has changed, as well, Hayes said. Large regional centers in places such as Boston, Philadelphia, Dallas, Los Angeles and San Francisco had very strong trading, underwriting and distribution operations.
“Everybody had their own bond club: the Bond Club of Boston, the Bond Club of Chicago, etc.,” Hayes said. “Now some of them still exist, but the very strong regional presence that did business more exclusively with that particular customer in that particular area” has declined.
There are still a lot of strong regional players, and some of the big money-center banks and dealers are also a big presence in the market, Hayes said. But Bloomberg terminals have changed the way muni participants interact, he added. Participants used to conduct business mostly over the phone. Today, a large percentage of the business is done over Bloomberg terminals.
“Through email and Bloomberg terminals, information travels faster than ever before,” Hayes said. “However, a result of this is the regional presence isn’t what it used to be.”
Still, it doesn’t take a Bloomberg terminal to show that muni investors are in for a change this year. Those who have gotten accustomed to the robust total returns of the past two years should adjust their expectations, Hayes said; it’s likely to be a year of coupon-clipping for them.
Unlike the past two years, investors should not just pour money into munis and long duration and expect great returns in 2013. They need to remember why they bought munis in the first place: because the taxable equivalent yield on them is so compelling versus their alternatives.
Buying in 2013 will be a timing issue, Hayes said. Amid some of this volatility, there should be opportunities to put some of the money on the sidelines to work in any sell-offs.
“You have to really pick your spots,” Hayes said. “Your timing is going to be critical to when and how you invest. This year is really going to be about playing defense. It’s trying to protect all that you’ve earned over the last two years.”
To do this, investors must come down a little in duration along the yield curve, according to Hayes. The Federal Reserve has broached the possibility of ending some of its quantitative easing. If the market begins to anticipate that, it will react ahead of Fed actions.
Regarding credit, there has been a big reach for yield the last couple of years, shown by interest in high yield. This year, investors should look upward a bit in quality, Hayes said.
“The A-rated part of the credit spectrum offers the most value,” he added.
Still, BlackRock isn’t telling investors to get out of high yield. But investors must compare how much high-yield exposure each has in his overall portfolio to his risk profile to see if he is overweight what he normally would be, Hayes said.
“If he is, it’s a good time to pare back,” he added, “because the liquidity in the high-yield market is still very good.”
And as for sectors, BlackRock still likes housing, hospitals and some areas of transportation.
Muni ratios to Treasuries have been a key component of one the market’s transitions from a rates market to a credit market, according to Hayes — and today they must get cheaper, he added.
Although the front end of the yield curve seems pretty well-anchored by the Fed, intermediate and long-term ratios are too rich for investors. The market has to reach levels that lure crossover buyers more consistently. Otherwise, it will be too volatile, Hayes said, which discourages retail.
Because munis have been less volatile over the past couple of years relative to most fixed-income and equities markets, they have attracted other types of buyers.
“And that means ratios stay elevated,” Hayes said. “In the absence of supply, ratios are down. When supply comes back, it’ll take better levels to clear the market, and that’s where we see the adjustment.”
In BlackRock’s view, if the transition from a rates market to a credit market is truly complete, then munis are always going to exist in a higher ratio environment and attract other buyers on an ongoing basis. “You can’t always be a retail-driven market,” Hayes said.
The process started around 2008, when the bond insurers started to lose their ratings and the credit nature of each issuer became more important. It concluded during the market disruption in late 2010.
When the market saw a big adjustment in ratios then, crossover buyers uncovered the value and entered the market more regularly. They became consistent buyers and sellers and provided liquidity.
“And that’s why we think we’re going to exist in this world of higher ratios, because we don’t have that big buyer on the margin that we always had,” Hayes said. “So, we need to exist at higher ratios in order to attract” crossover buyers.