Scott Colyer, a 30-year municipal market veteran, says the payoff for taking duration risk is at the lowest level in a quarter century.
Colyer, the chief executive officer and chief investment officer at Advisors Asset Management in Monument, Colo., is among strategists protecting their clients' municipal assets by minimizing exposure to longer maturity bonds, which risk losing value should rates rise, while boosting yield by dipping into lower credit quality investments.
"We are willing to take a little more credit risk at this point and the trade-off is taking less duration risk," Colyer said an interview on Monday.
That means the firm is trafficking more in health care, educational, university, and airport revenue bonds in the single-A and triple-B category to drive extra yield into his clients' separately managed account portfolios, without extending too far on the yield curve.
The firm limits its credit threshold, however, to triple-B, according to Colyer.
He generally avoids investing longer than 15 years on the yield curve, and said his clients' municipal portfolios have a duration of between four and five years.
It's a strategy that the firm kicked into gear in the first quarter of 2014 due to growing concerns over duration and is still working "incredibly well" in the second quarter of 2015.
"If you have upward rate pressure, at some point in time, the duration risk will come and those not protected will get bitten by it," Colyer said.
As of year-end, the brokerage and advised business at AAM totaled about $16.8 billion in assets, of which $660 million were in AAM's proprietary separately managed accounts and mutual fund assets.
Colyer's strategy involves purchasing premium or "kicker" bonds with three- to four-year calls and maturities averaging 12 to 15 years and with yields to the call that are between 50 and 60 basis points higher than the generic triple-A benchmark tracked by Municipal Market Data.
"We think that's the best structure we can have at this time," Colyer said.
For instance, the firm recently purchased bonds from a Michigan State Finance Authority revenue offering on behalf of Sparrow Health that were rated A1 by Moody's Investors Service and A-plus by Standard & Poor's.
The bonds have two yield-boosting criteria in today's market - they hail from the inherently-riskier health care sector and they are from Michigan.
"We like the underlying credit and on top of that the facility is located in Michigan, which has been trading fairly cheap for a while" due to the Detroit bankruptcy debacle, Colyer said.
"It's got the Detroit tinge on it."
Colyer declined to disclose which maturity the firm purchased for its clients. The deal's 5% coupon bonds in 2021 were priced to yield 2.06% -- a spread of 50 basis points to the comparable five-year MMD scale at the time.
"You are being paid well for that short of a piece of paper," Colyer said.
In Michigan, "essential services like water and sewer do not trade that cheap at all," he said, estimating they only command a 15 to 20-basis point spread to the MMD scale because they are considered less risky than health care.
Adam Mackey, head of municipal fixed income at PNC Capital Advisors in Philadelphia, is also finding opportunities by increasing exposure to revenue bonds in the single-A and triple-B-rated camp, such as those in housing, higher education, and transportation.
While he said the strategy may be counterintuitive, "nothing is excessively cheap," and depending on the sector, there is more value in select lower-rated credits in the current rate and spread environment.
"Others say you are not being rewarded because spreads are tight," said Mackey, who has been in the industry for 19 years. "We agree spreads are tight, but we don't see fundamental drivers for widening."
"Even though we are seeing tight spreads where we are in the cycle, municipals tend to lag other credit-related sectors, so we still think there is some value from going down the credit curve," Mackey said.
Instead of giving up that extra yield, Mackey, who is also a senior portfolio manager and responsible for establishing the firm's municipal fixed income strategy, has been adding exposure to credit and revenue debt for his clients over the last 18 months.
PNC, a Philadelphia-based investment advisory firm, oversees $6.5 billion in separately-managed account assets for individuals and institutions.
Unlike Colyer, who is limiting his exposure to the longer maturities, Mackey is willing to participate up to 20 years. He pays closest attention to the 10- to 15-year range.
He said the lower investment-grade higher education sector, for example, is providing the best risk-to-reward benefit so far this year at an average spread of 80 to 100 basis points above the generic triple-A benchmark scale.
Bonds in the intermediate range under 20 years are offering yields with 3% to 4% handles, which he deems attractive in sectors such as higher education, housing, and transportation, due to the liquidity and credit risk.
Mackey said the value varies depending on the obligor, supply and demand, the underwriter, size of the deal, and what the market is doing when a deal or a trade is completed.
He declined to comment on what sectors or securities he is avoiding.
AAM's Colyer said he is also avoiding the long end of the market, because he believes duration risk in municipals tends to be higher than in a corporate or government bond portfolio since most tax-exempt securities tend to be longer in nature.
He said many municipal portfolios have a natural duration of seven to eight years, compared with five to six years on a corporate portfolio, for instance.
Going forward, both Colyer and Mackey doubt that the Federal Reserve Board will raise rates as early as June.
Colyer said AAM doesn't expect that scenario to play out because of the lack of inflationary pressure and the need for a stronger economy - yet he is increasing protection nonetheless.
"We don't believe rates will rise, but we are still trying to safeguard against it," he continued. "We believe the Fed will continue to err on the side of caution."
Mackey said his clients' portfolios are benchmarked from a duration view point so the direction of interest rates is of little concern to him.
"We don't worry about that in our strategies," Mackey said. While he is tweaking security structure, adding more negative convexity, and increasing lower-rated bonds ahead of a potential rate hike, he said analyzing and planning for rate movement is "not part of our investment philosophy."
Colyer and Mackey recommend taking risks where clients can reap rewards - and managing portfolios without apprehension over interest rates.
"Expressing views on rates is simply a bet, nothing more," Mackey said. "We try to build portfolios based on things we can control, such as credit selection, fundamental analysis, and strategy execution." Colyer said while eliminating duration risk altogether is impossible - unless clients stay in cash - it is manageable in any rate climate.
"You can minimize the duration risk as much as possible - that's about as good as you can get," Colyer said.
