Buy Side

Fund Managers Try to Boost Returns from a Dreadful 2013

After two years of double-digit gains, returns for the Lord Abbett AMT Free Municipal Bond A have tumbled in 2013.

The long-term national open-end muni bond fund, which launched in 2010 and returned 10.44% through Nov. 18 in 2011 and 13.37% through the same period last year, has thus far returned negative-6.12% this year.

The fund's results aren't an anomaly. In fact, they're only slightly worse than those of its national, long-term open-end fund peers, Morningstar numbers show. Long-term muni funds are having their worst year since 2008, as rising interest rates and headlines about Detroit's bankruptcy filing and Puerto Rico's fiscal problems fueled outflows of investor money.

"We've obviously gone through a tough stretch, particularly in June, July and August," said Daniel Solender, partner and director of municipal bond management at Lord Abbett & Co.

"They really saw their worst performance of the year in the second quarter," said Steven Pikelny, a fund analyst at Morningstar, Inc., speaking about muni funds that have durations of seven years or longer. "That being said, they really didn't do much better in the third quarter and closed-end funds got hammered even worse."

What's more, muni bond mutual fund portfolio managers appear to be in a pickle. Interest rates are expected to rise eventually, which would bruise many funds' returns even more. But though portfolio managers of long-duration funds are constrained by their investment mandates from altering their strategies appreciably, they still have options to improve performance.

"Even though there have been outflows continually, liquidity has been pretty good the last month, or so," Solender said. "There are quite few things that portfolio managers can do because liquidity's there."

They can reposition to strategic maturities along the yield curve, select higher-coupon bonds to cushion against rising rates and look to outperformance in such an environment from single-A- or triple-B-rated paper, Solender said.

Long-term muni bond funds' struggles this year stand in stark contrast to their performance over the past three years, according to Morningstar numbers.

Long-term closed-end muni funds have lost 6.77% in value through Nov. 18. That compares to positive returns of 16.87% in 2012, 13.97% in 2011 and 3.82% in 2010.

The past two quarters alone, they've dropped 8.12%.

By comparison, long-term open-end muni funds have posted negative returns of 4.28% through Nov. 18. That compares to gains of 10.07% in 2012, 8.45% in 2011 and 2.61% in 2010. Over the past two quarters, they've fallen 5.00%.

Long-term muni closed-end and open-end fund returns last plumbed these depths in 2008, when they plummeted 20.43% and 9.45%, respectively, over the same year-to-date period.

Many muni investors have decided to the exit the sector, reallocating their money from muni bond funds. Muni bond mutual funds of all stripes have seen $29.6 billion leave the market in 2013 through the week of Nov. 13, Lipper FMI data show. And those outflows have been weighted more toward long-end funds.

Also, the overall holdings of muni bond funds have decreased, according to the Federal Reserve Flow of Funds. Mutual funds through the second quarter of the year comprised $641.2 billion of the $3.72 trillion market; they'd fallen by $5.4 billion from the preceding quarter and should show a decline during the third quarter, as well, when the Fed releases its data on Dec. 9.

If interest rates climb from historic lows seen almost one year ago, many long-duration funds should see more hits to returns, Pikelny said. Interest-rate risk for them remains elevated due to investment mandates which limit them to debt farther out the yield curve.

"Really, the best they can do if they're afraid of rising interest rates, or if they want to make a bet on the shape of the yield curve, is maybe go toward the shorter end of the long-duration range," he said, "but even that's still pretty interest-rate sensitive."

Still, the present steepness of the yield curve presents opportunities for these funds, said Terry Hults, a portfolio manager at AllianceBernstein.

From lows in 2012, the 10-year triple-A yield has risen 114 basis points through Tuesday, Municipal Market Data numbers show. The 30-year triple-A yield, by comparison, has rocketed 162 basis points.

Returns for the AllianceBernstein Muni Income National A fund have fallen 3.96% this year through Nov. 18. Over the preceding three years, they averaged a positive 7.59%.

Though returns have fallen in 2013, maturity selection has helped temper the volatility that affects fund holdings, Hults said.

That translates to underweighting the longer maturity part of the market generally, and for longer-intermediate-type funds which have durations of around 5.5 years, focusing on bonds in the 15-year range of the yield curve, Hults said. Such bonds benefit heavily from roll, he added, a reference to a bond's price changes as it shortens in maturity, or "rolls down" the yield curve.

"The roll-down effect, that's pretty powerful with a relatively steep yield curve," Hults said. "That combination of yield plus roll gives us a better return with less duration risk, less interest-rate risk, than just buying the longest maturities."

Lord Abbett's Solender, noting that the yield curve is steep and that certain areas of the market have done better than others, looks for the best positioning along the curve and among sectors, as well as undertaking the right amount of credit risk.

For Solender, that means looking at a combination of the 10-year and 20-to-25-year ranges along the yield curve for attractive returns. To protect against rising rates, including bonds with 5% coupons, or higher, should suffice.

Rising rates could help with credits, he added. If rates start rising, there's a strong possibility the Fed will view the economy as improving and be more amenable to tapering purchases of fixed-income securities.

"Given that scenario, at some point, credit quality will be viewed as improving, too, which could help if you own bonds rated triple-B or some of the lower-A range," Solender said. "Some of those could outperform in that kind of environment, too."

For their part, many closed-end funds traded at premiums or close to their net asset values earlier in the year, Morningstar's Pikelny said. When investor interest waned, the funds saw depreciation to their NAVs and share prices.

Also, most closed-end funds use leverage, Pikelny added. And many long-duration funds that use leverage to amplify their interest-rate sensitivity saw returns plunge more than 10%; the share prices fell even faster, further widening discounts.

But closed-end funds which rely heavily on leverage can benefit from a steep yield curve, Pikelny said. Levered funds generally favor a steep yield curve because then investors basically borrow at a short-term rate which is near zero and invest those proceeds at a longer rate.

"So, you're basically getting that spread between the short-term and the long-term rate," Pikelny said. "If you're an investor and you think the yield curve is going to remain steep, then closed-end funds are a good way to make that bet."



Comments (0)

Be the first to comment on this post using the section below.

Add Your Comments:
Not Registered?
You must be registered to post a comment. Click here to register.
Already registered? Log in here
Please note you must now log in with your email address and password.

Upcoming Events

Already a subscriber? Log in here
Please note you must now log in with your email address and password.