The uptick in new volume over the past two weeks has given portfolio managers an opportunity to diversify their clients' holdings more than has been possible for months.
Managers say they have been able to select new credits, desired coupon structures, and high-quality names for their clients from a wider array of offerings as they look to protect their portfolios from unforeseen market events.
Issuance surged to $8.38 billion in the week of Sept. 22 after hitting a recent low of $1.75 billion in the week of Sept. 1, according to Thomson Reuters. In the week of Sept. 15, volume increased more than $2 billion to $5.5 billion, after a revised $3.46 billion in the prior week. Experts said billion-dollar deals that came to market from New York and California issuers as part of the overall surge in supply boosted diversification opportunities following months of scarce offerings.
"A sustained primary market with more supply could improve secondary conditions and lead to better price transparency," said Jeffrey Lipton, managing director and head of municipal research at Oppenheimer & Co. in New York. "This would be optimal for enhancing portfolio diversification."
Experts said the increased volume allows them to go back to a basic portfolio management strategy.
"When the first Arab oil embargo came along, some toll road bonds lost value because of concerns over less driving, less tolls, and no coverage for the bonds," said Gregory Serbe, president of Lebenthal Municipal Asset Management in an interview on Friday. In that scenario, "if you own 100% toll roads, then irrespective of anything else going on in the marketplace you would lose value," said Serbe, who oversees the management of $200 million of municipal assets in separately managed accounts.
Managers like Serbe aim to mitigate clients' risk by owning a blend of investments that differ both geographically and structurally to protect them from unforeseen market events that might hurt a portfolio concentrated in one type of credit.
"Diversification greatly helps to insulate the portfolio from a specific event and even unforeseen negative headlines tied to a specific credit, sector or security type," Lipton said. "This is something that can certainly have an impact on portfolio valuations. Thus, credit, sector and state diversification tend to be the most important. "While a mix of general obligation and revenue bonds would make sense, having all cities, for example, comprise your GO component would not be prudent," Lipton added.
John Donaldson, director of fixed income at The Haverford Trust Company in Radnor, Pa., said Pennsylvania has 497 school districts that essentially share the same revenue source - two-thirds local property taxes and one-third state support - so owning dozens of those school bonds does not achieve diversification.
"A portfolio with 50 different school district bonds may list 50 names, but is not truly diversified in our opinion," Donaldson said in an interview on Thursday. "We look to true diversification of revenue sources that support bonds rather than simply geographic nameplates."
Alan Schankel, , managing director of credit research at Janney Mongtomery Scott, recommends that not more than 50% of a municipal portfolio be in bonds from a single state.
"State tax exemption often encourages investors to limit municipal holdings to their state of residence," he wrote in a September strategy report. "An unforeseen event such as a natural disaster can have a negative imjpact on bonds from a particular state or geographic area," Schankel wrote. "By spreading risk across multiple states and regions, investors can limit the impact of a single event or long term trend."
Donaldson said he uses out-of-state bonds to reduce risk for clients in states where diversification is limited or in a state with declining credit trends.
Donaldson said this is a common strategy for clients in New Jersey, which he cited as an example of a small state where diversification can be difficult and where the credit has been downgraded several times.
Experts said diversification is critical in helping clients avoid oversaturation of any one particular credit, and can also affect portfolio valuations.
"Adding state GOs, counties, and school districts would help to balance the portfolio," Lipton said. "Revenue bonds should have a dedicated revenue stream with a clearly defined flow of funds as well as protective legal covenants.
"For health care, [clients should] understand the market footprint of multi-site and multi-state hospital systems, as a heavy presence in one particular state could disproportionately expose the portfolio to the vagaries of that state's regulatory/reimbursement practices," Lipton added.
In the past two weeks, investors have found more opportunity to diversify with the arrival of everything from "green bonds" for environmental purposes to the New York City Sales Tax Asset Receivable Corp.'s first issue in 10 years.
The New York STARs bonds were four times oversubscribed and strengthened in secondary trading on Thursday a day after they were priced.
In addition, Donaldson said a dry spell of high-quality hospital bonds made recent new issues for the University of Pittsburgh Medical Center and Indiana University Health all the more attractive from a diversification standpoint.
Managers said diversification can also present challenges in particular sectors or regions with extenuating market and economic circumstances.
"While airports can add quality and general revenue bond diversification to a portfolio, I would limit the portfolio's exposure to multiple airports located in a single state as a way to shield economic and competitive influences," Lipton added.
Similarly, he said, clients should also own bonds of larger block sizes.
"For example, in a $30 million high net worth portfolio, you would not want to position odd-lots throughout the account, as this could have liquidity implications," Lipton said.
Overall, diversification is one of the most important parts of portfolio management, especially for conservative municipal clients who are focused on principal protection and capital preservation, Serbe said.
"People look at their municipal portfolios as the sleep-at-night, staid part of their investment portfolio," he said.
"It tends not to be the glamorous or exciting cocktail party discussion as opposed to the big headline de jour that people talk about on Saturday night," Serbe said. "They don't talk about whether their investment manager got them the [New York] STARs bonds."
Maintaining diversification is like having a safety net under clients' portfolios, experts said.
"There is always going to be something that comes along that someone didn't expect," Serbe said. "Over time, we feel [diversification] minimizes and mitigates some of those surprises."
