Robert W. Baird & Co. is loading up on municipal bonds, concluding that the potential reward outweighs their risk after a year of volatility and uncertainty.
"The 2013 sell-off has created an opportunity to buy municipals at attractive yields," B. Craig Elder, senior vice president at the Milwaukee based firm, wrote in a Jan. 10 research report entitled "Our Favorite Things."
"2013 was a bad year for the municipal bond market with interest rates spiking higher however, we believe that the yields — especially after-tax yields for investors in the top tax bracket — make this the most attractive of the fixed income asset classes," he added.
Elder said Baird, which serves individual investors, currently maintains an "overweight" position in municipal bonds, after a historic sell-off in June, Puerto Rico's financial crisis, Detroit's bankruptcy, and a flood of investor outflows from municipal mutual funds in the past six months, drove yields higher.
"The number of Chapter 9 filings has actually been trending down," Elder said in the report. "There continues to be only a small number of municipal bankruptcies with a declining trend of municipal defaults."
Through Nov. 26, 2013, $2.74 billion in total outstanding par value of municipal bonds entered into debt service payment default for the first time, compared with $3.81 billion in all of 2012, Elder said.
In 2014, he suggests individual municipal investors continue to take advantage of valuable opportunities within the municipal market. He advises taking a barbell approach by moving out on the municipal yield curve, while mitigating duration risk by owning relatively short paper.
Elder said a typical strategy consists of positioning half of an investor's municipal assets in the two to four-year segment of the curve, with the remaining position invested in 15- to 20-year maturities.
"This provides yield and some interest rate risk protection," he wrote.
Switching to the economic and credit outlook, Elder cited a Standard & Poor's report that predicts gross domestic product growth in 2014 should translate to gradually dissipating fiscal strain across the state and local sector, thanks to employment and tax base growth from continued housing sector strength.
He told The Bond Buyer this week that he agrees with the rating agency's prediction that credit concerns should improve unevenly across the country, since much of that economic growth stems from the housing rebound and energy production.
Elder predicts GDP growth at between 2.5% to 3.5%, but described S&P's housing forecast - which calls for growth of 6.7% in existing home sales and a 26.7% rise in new home sales -- as "somewhat strong."
Ultimately, the outcome will be influenced by interest rates, he said in an interview.
"If mortgage rates broach 5% on 30-year fixed and stay there, housing could be a little weaker than S&P's forecast," he said."We believe the two major threats to the market this year would be another spike in rates like we had last year and weaker economic growth than we are forecasting."
Elder predicts short-term rates will remain relatively steady at their current levels until at least 2015. The 10-year benchmark note yield will hover in a range between 2.5% and 3% for the first six months, he forecasted, with any movement in the last six months dependent on data.
Puerto Rico and Detroit will also remain on his radar screen.
"We believe that further significant economic and financial decline [in Puerto Rico] could be a systemic situation for the municipal market," though the firm doesn't currently expect that scenario he said.
Baird is also overweight in government agency bonds and preferred shares, meaning it owns a greater portion of such securities than are in a benchmark portfolio. The firm is underweight in high-yield corporate bonds, as well as cash and CDs.
It maintains a market weight position in Treasuries, investment-grade corporate bonds, and mortgage backed securities, according to the report.
