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Fund Managers Eye Economy as They Set 2nd Quarter Strategy

MAR 24, 2014 1:21pm ET
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Municipal portfolio managers are keeping a wary eye on the economy as the second quarter approaches.

Managers said they plan a range of strategies to buffer their portfolios against expected rising interest rates, low supply and tighter credit spreads, from tweaking duration to adding to high-yield exposure or upgrading credit quality. They also said they will be ready to alter those strategies mid-quarter should market or economic conditions not pan out the way they expect.

"We are always concerned that the Treasury market might lose sponsorship should the economy improve," said Michael Pietronico, chief executive officer at Miller Tabak Asset Management. "All fixed-income managers will be on the lookout for that possibility."

The firm, which manages $980 million of tax-exempt assets, will continue to be overweight in general obligation and essential purpose revenue bonds, particularly in the secondary market, where supply may be more plentiful, given predictions for continued low new-issue supply.

"Miller Tabak Asset Management will be looking to upgrade the credit quality of our client's portfolios as spreads have tightened during the early months of 2014, and compensation has diminished for those buying medium-quality bonds," Pietronico said.

He also said the firm plans to remain focused on the one- to 15-year slope of the curve, though there could be some wiggle room on that strategy. "Ratios to Treasuries will likely determine where most of our client's cash will be spent during the upcoming quarter," he said.

On Friday, the ratio of municipal to Treasury yields in 10 years was reported at 92%, while the ratio in 30 years was at 103.3%, according to MMD. Since Dec. 30, the 10-year ratio has reached a maximum of 98.1% and a minimum of 88.4%, while the 30-year ratio hit a maximum of 108.8%, and a minimum of 101.4%.

Credit-spread tightening and the lack of supply "will be the real story" in the second quarter, said John Mousseau, director of fixed income at Cumberland Advisors, which manages $1.3 billion of tax-exempt assets. "In some real hard to find states, supply will get even harder to find," he said.

Long-term municipal bond issuance is down significantly so far this year by 33.4% in January and 40.4% in February driven by a steep decline in refundings.

The continued lowering of the municipal-Treasury ratio will also be a prime concern in the upcoming quarter, according to Mousseau, "especially as you get beyond the fallout last year with the bond funds liquidating."

Municipal funds reported the arrival of $107 million in the sixth consecutive week of inflows in the week ended March 20, according to Lipper FMI data. The influx marked the ninth week out of 10 that mutual funds have reported inflows. The report arrived a day after Federal Reserve Board chairman Janet Yellen announced another $10 billion cut in the monthly stimulus program to $55 billion.

Investors recorded their first inflows into weekly reporting municipal bond mutual funds earlier this year when they added $103 million in the week ended Jan. 15 - the first time since the week ended May 22, 2013 -- after 33 consecutive weeks of outflows.

Investors were spooked by fears over the Federal Reserve Board tapering its $85-billion monthly economic stimulus program and decided to run for the exits.

Nearly a year after that phenomenon, Mousseau expects flows into municipal bond funds to continue to resume in the second quarter.

"I think a lot of people are looking back right now and realizing that the fear of tapering was worse than tapering, and that a lot of that fund selling at the end of June and up to the middle of July was pretty silly in respect to the actual fear of inflation," he said. "It was a retail-driven event and we saw somewhat of a retail-driven cure."

David Litvack, managing director and head of tax-exempt research at U.S. Trust, Bank of America Private Wealth Management, said he will be among those supporting the market in the upcoming quarter as an active buyer of medium investment-grade GOs, essential service, and infrastructure bonds with stable or improving credit characteristics.

"We believe maturities of five to 10 years represent the sweet spot on the yield curve," Litvack said.

On Friday, the generic, triple-A GO scale in 2044 ended down one basis point at 3.74%, while the comparable double-A scale yielded a 3.98%, according to Municipal Market Data.

The mostly steady mutual fund inflows so far this year and the stronger demand for municipals in general is being driven by the fact that interest rates have remained low as well as a "renewed appreciation" of municipal bonds' tax advantages, Litvack noted.

"After a challenging 2013, municipal bonds have rebounded so far this year," he said.

"We expect continued good performance based on improving credit fundamentals, low new-issue volume, and strong demand from tax-sensitive investors," Litvack added.

Meanwhile, the economic landscape will dictate whether Jeffery Elswick, director of fixed income at Frost Investment Advisors, decreases or increases the interest-rate risk when it comes to the any core allocations in the tax-exempt municipal holdings beyond the current eight-year profile.

"Our expectation is that the macro-economy will pick up some momentum heading into the spring," Elswick said. "To the extent we begin to see more tangible improvements in the U.S. economy validating that the recent pull back in economic growth has had more to do with poor weather and less to do with some other type of underlying problems, we would look to lower our average maturity closer to the six to seven-year range." Elswick added."If on the other hand, we unexpectedly see the macro-environment in the U.S. not improve even as the spring rolls around, then we would look to maintain, or even increase somewhat, our current eight-year maturity profile," he said.

In addition, Elswick, whose firm managed just under $2 billion of tax-exempt assets at the end of 2013, plans to add some high-yield exposure to his portfolio, although on the ultra-short slope of the curve.

"When we do decide to add to some of the riskier credit sectors, such as high-yield, we will lean toward the five-year and under portion of the curve if we can find opportunities," he said.

He said he will avoid the longer-end of the lower-rated spectrum where prices are "too rich" in his opinion - and will also refrain from increasing his fund's exposure to Puerto Rico credits. The tax-exempt holdings currently include a 0.5% allocation in five-year paper from the island.

The commonwealth sold $3.5 billion of GO debt earlier this month that was oversubscribed as hedge fund and cross-over buyers were lured by yields north of 8%.

"In particular with the P.R. story, their new bond issuance was certainly a positive and it helps their short-term liquidity, but before we would think about increasing our allocation in our tax-exempt fund," Elswick said. "We want to see if they are able to meet the fiscal targets that the government leadership has recently announced for this year and into next."

Litvack will also be watching the headline risks associated with Puerto Rico, as well as Detroit, for any potential ripple effects in the broader market. He also has concerns about unfunded pensions that are keeping him at arm's length from owning that debt for fear of potential downgrade activity.

Litvack believes much of the pension debacle "is borne disproportionately by a limited number of states and local governments," and supports the issue being in the forefront.

"We are encouraged that pension underfunding has gained a high level of visibility, because this has spurred many issuers to implement reforms to ameliorate the problem," Litvack said.

Portfolio managers will likely be scrambling for bonds to implement their various investment strategies given the low supply forecast in the second quarter.

"With interest rates expected to rise, we believe there will be fewer opportunities for municipal issuers to refinance outstanding bonds for economic savings," Litvack noted. "State and local governments are still enduring some residual austerity from the Great Recession, with less taxpayer willingness to finance expensive capital programs through new bond issues."

The managers, meanwhile, said they are armed for a challenge, and will remain active, even though April can be seasonally sluggish due to personal and corporate income tax season deadlines.

"Given that new-issue deals are likely going to see considerable interest in this low-supply environment we expect to find greater value in the secondary market as yields are likely to be more generous in our view," Pietronico said.

Despite the reduced supply, there will probably be a better overall perception of municipal credit with the arrival of the second quarter, especially since the Puerto Rico deal is behind the market, Mousseau of Cumberland noted.

Participation in the island's GO deal by many different cross-over buyers bodes well in terms of demand for municipals going forward, Mousseau noted. "You probably have some buyers out there that will look to buy tax-free bonds if they get relatively cheaper than Treasuries," he said.

Litvack agreed that the outlook for municipal credit is generally positive, in large part due to increased revenues, particularly at the state level, driven by growing income and sales tax collections.

"Local government finances have improved more slowly, because they receive the lion's share of their revenues from property taxes, which have lagged in the U.S. economic recovery," he said, adding that property taxes are starting to pick up in many areas.

"We believe the combination of strong demand and restrained supply will be a tailwind for municipal bond returns this year," Litvack said.

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