Safety First -- Muni Experts Take Conservative Approach To Wealth Management

Risk aversion still rules in the municipal bond market.

While Detroit and Puerto Rico make the headlines, a cautious and conservative approach is a better bet, according to two municipal bond portfolio managers who say they are finding value and safety in high-quality, revenue-backed credits and large state general obligation bonds in the short to intermediate slope of the yield curve. For the most part, they're snubbing the precarious credits like Detroit and Puerto Rico, which lured yield hungry hedge funds into the muni market with its $3.5 billion deal last month.

Rich Steinberg of High Tower Advisors and Mark Muller of Loews Corp. both prefer premium bonds for their high coupons and extra yield "kick" to maturity as compensation for being subject to early calls. They are also staying defensive by investing inside of 12 years and limiting their duration risk now so they can extend as those bonds mature and interest rates rise.

"This is the pillow under our clients' heads at night," Steinberg, managing partner and advisor of the New York-based investment advisor, said of his clients' muni assets.

Both managers are preparing to take advantage of rising interest rates, and in the meantime are limiting their maturity, credit, and sector exposure. Their strategy is representative of the conservative approach used by as much as 75% of municipal fund managers that oversee investment-grade funds, according to Richard Ciccarone, president and chief executive officer at Merritt Research Services, an independent research and data provider.

They typically avoid bonds with headline risks that tend to spook retail investors, especially those like Detroit and Puerto Rico in the current market, where matters are still unresolved and there is potential for risks to multiply.

"The 'steady as she goes' practice is still relevant for investors today, and perhaps even more so when so many investors are reaching for yield and today's risky assets pay like yesterday's high grade," added Jeff Tjornehoj, head of research for the Americas at Lipper FMI. "For cautious investors staying diversified across sector, quality, and duration is still essential."

Steinberg's municipal clients range from late 20- and early 30-year-old technology entrepreneurs to 70- and 80-year-old retirees whose portfolios are sized at $500,000 to upwards of $50 million. They hail from high-tax states, like California, New York, and Massachusetts and non-taxed states, like Florida and Texas.

Steinberg said his customers like municipal securities - specifically individual bonds — because they are more predictable than the volatile equity market and offer capital preservation and steady income.

"Our clients are large enough where they can get proper diversification and still own the underlying bonds and they have an actual maturity as opposed to a mutual fund which doesn't," Steinberg said. "We have tended to stick with this strategy for over a decade - we are not going to adjust it based on short-term or near-term type issues."

He and his team of eight people oversee approximately $250 million in municipal bond assets for high net worth private banking and advisory clients who want to preserve and increase their holdings, and rely on the predictable income stream offered by municipals.

Muller, a senior portfolio manager with New York based Loews, is equally conservative. He finds the 10-year slope of the yield curve delivers the best safety of principal, a defensive stance against rising interest rates and the most reasonable returns against the backdrop of a steep yield curve.

He gauges the relative value of municipals by how they relate to other fixed-income sectors, such as Treasuries, investment-grade corporates, and asset-backed securities, and makes asset allocation decisions accordingly.

Loews' municipal assets represent approximately 25% of the firm's nearly $51 billion portfolio, which includes assets from CNA Financial Corp., a property and casualty company and 90% owned subsidiary.

Steinberg says he favors high-quality paper versus high-yield credits. "We are not trying to get cute and own Puerto Rico or Detroit where they are a lot of issues," he explained. "We don't want that type of risk."

Muller, on the other hand, said he has some exposure to Detroit and Puerto Rico, but limited to the Michigan Finance Authority - Detroit State Aid -- and Puerto Rico's COFINA bonds. He feels these positions are safe in the Detroit bankruptcy and a potential restructuring of Puerto Rico because they are both secured revenue credits.

He has even exited a position he owned from the island's $3.5 billion GO deal last month.

"We distinguish at times between opportunistic and long-term investments," Muller said. "That was an opportunistic investment," he said of the 8.72% yields on the long end that came at 93 cents on the dollar.

He said the heavy participation by hedge funds and other taxable and cross-over buyers was an attribute that led him to realize the deal offered a trading opportunity.

Meanwhile, to further minimize his risk, Steinberg, maintains duration at 3.5 to 4.5 years - due to his expectation for rising rates.

"As rates rise, we have a bond maturity we can reinvest at the higher rates," he said. Currently, he prefers bonds with final maturities in the six to 12-year slope of the yield curve.

Among premium bonds, Steinberg favors 5%, 5.25%, and 5.50% coupon bonds. "Those bonds have better yields because they trade at a premium," Steinberg said. "Some of the higher coupons are being left by the side of the road and that creates opportunity."

Steinberg also uncovers value by overweighting his portfolio with essential service revenue bonds, like water and sewer systems, and environmental facility bonds, versus GOs because they are secured by a dedicated revenue, levy, or fee.

"With revenue bonds you are investing in a management team or business people delivering a service, as opposed to politicians," he added.

His clients own GO bonds - but chiefly high-quality state GOs, or large, diverse city GOs. "We avoid the small local school districts, and GO issuers where the fiscal pressure has been pushed from states and counties to those little towns with more of a struggle," Steinberg explained.

"The key thing is that the credit metrics in the municipal area have improved and credit really does matter," he said.

Steinberg said he prefers the GOs of large states with decent or improving fiscal health due to budget reform and strong revenue growth, like California and New York, as opposed to those that have been struggling with pension liabilities and unfunded pensions, and where negative headlines have impacted bond prices, like in Puerto Rico and Detroit, he said.

Muller also prefers tax backed revenue-secured bonds and local GO securities - and generally avoids high-yield paper, such as tobacco, corporate airline, industrial development revenue, and project finance bonds, as well as the lower tier of the health care sector.

He said he is focused on maintaining the high-quality of the firm's holdings, and benefitting from the next interest rate increase by staying active at a moderate point on the yield curve to keep capital invested.

Muller cautions investors from sitting on the sidelines -- and forgoing income -- while waiting for rates to potentially head higher.

"When interest rates are spiking you are more concerned about the destruction of principal as those rising rates do damage to your bond prices, but historically strong rallies follow those spikes," Muller said.

"If inertia develops from that caution you could miss a rally that pays off handsomely to keep your capital invested."

Steinberg said he will also continue to own municipal bonds for his clients, but cautions them against expecting the gains they enjoyed in the first quarter in the remainder of 2014.

"Issuance will pick up and supply will grow a little and I do believe once we see some improving economic data into the spring, interest rates will start to trend higher and that will weigh on munis a little bit," Steinberg said.

But, he doesn't look at the potential pullback as a negative. "There's a reason there should be a piece of your portfolio exposed to high-quality muni bonds - especially for clients in a higher tax bracket," Steinberg said.

He will continue to implement a conservative stance going forward, barring any deteriorating credit trends, inflation ramping up dramatically, or the possibility of legislative changes that impact the tax status of munis bonds.

"Absent of something like that," Steinberg said, "we're not going to adjust a strategy that is critical in providing a stream of after-tax income that helps secure the lifestyle objectives of our clients."

"With outflows abating and stable to slightly positive inflows and supply reduced there is good support for bonds," versus 2013, he noted. "With tax rates having gone up and with interest rates gone up due to the talk of tapering, the absolute levels are a bit more attractive, and the credit metrics are improving in general - that's a pretty good combination in my book."

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