Short term municipal bonds, after posting negative returns in December, may still have value as an alternative to staying in cash while waiting for the Federal Reserve Board to raise interest rates.
The attractive relative value of the short municipal curve versus Treasuries makes a good case for investing in that segment of the market, according to some analysts.
"The short end doesn't give you the rates you'd like to write home about, but the ratios are high enough that it suggests people should be in short munis rather than short Treasuries," said Phil Fischer, managing director of research at Bank of America Merrill Lynch & Co.
For instance, ratios of two-year and five-year high-grade municipals tracked by Municipal Market Data yielded 79.4% and 82.5%, respectively, of the comparable Treasuries on Tuesday, Fischer noted.
In addition, the positive returns investors earn in the short muni market are a better alternative to staying in cash and earning virtually nothing, he said.
"The front end represents value relative to cash," he said. "No matter what the Fed does, short-term rates are going to be extremely stingy, but they give you positive returns and a defense against rising rates."
John Derrick, a portfolio manager and director of research at U.S. Global Investors, said his $90 million Near-Term Tax-Free Fund benefits from its size, weighted average maturity of five years or less, conservative nature, and strategy of turning volatility into opportunity on the short end of the yield curve.
Derrick, who has managed the fund since 1999, described it as a classic municipal bond fund in that it is conservative, high-quality, and has both low turnover and risk.
"It's a sleep-all-night type of fund," he said. That agrees with the San Antonio-based firm's retail clientele who want steady income-generation and capital preservation.
The fund's benchmark is the Barclay's Capital 3-Year Municipal Bond Index, and its ticker symbol is NEARX, according to firm's website.
He avoids timing interest rates - and market gyrations -- but instead looks for periods of volatility to glean value from the short end of the municipal curve.
"If we buy paper on the front end and we are comfortable with it and intend to hold it to maturity, we let that extra 10 or 15 basis points work for us over the long run," he said. "I have probably added more value that way than making sector calls."
Similarly, he benefits from advantageous credit and sector volatility.
For instance, he currently prefers buying state-backed issues from large municipalities, like New Jersey, whose financial turmoil has brought the state some bad press - but opportunity for Derrick.
Negative headlines have contributed to a cheapening of N.J. general obligation bonds by as much as 40 to 50 basis points versus comparable credits, he said.
"It's not totally risk-free - you could get a downgrade - but at the end of the day, New Jersey is going to be around in five years," he explained.
Overall, Derrick uses a barbell approach -- owning paper that matures within a year and securities maturing in six to eight years. "The curve is pretty steep, so I feel like the sweet spot is in that seven-eight year range," he said.
"My thought process is it gives the fund optionality," he explained of the barbell strategy. "We will continue to have maturities coming due in 2015 and if the Fed is raising rates I have three to nine months to reinvest and maybe find better opportunity."
"And if it turns out that the long end rallies because the Fed can't raise rates, I still benefit," Derrick added.
His fund has generated inflows where its peer category has experienced outflows recently.
For example, on Jan. 13 and 14, short-term municipal bond funds had outflows of $16.5 million and $46.5 million, respectively, according to daily flow data Fischer obtains from EPFR Global.
Flows were positive on Jan.. 12 at $6.8 million.
"Flows generally follow return," Fischer explained. "When returns are positive, you tend to get inflows and when they are negative you get outflows."
Year to date, short-term municipal funds have posted a total rate of return of .0185%, according to the EPFR data.
But at the same time, there is often a lag in flows, Fischer said.
"We are probably seeing outflows induced by performance in December" in which short-term municipal funds returned negative .103%, according to the EPFR data.
Derrick said he is comfortable sitting on new cash as he waits for volatility to strike. "You try to be patient when you have money coming in when the markets is rallying," he said.
"I appreciate the fact that munis are up and people want to invest, and that's good for the industry, but a little volatility would be better for me," he continued.
While Derrick said he prefers a sell-off to initiate that opportunity, he is not pressured to spend cash in the meantime. "It's a simple strategy, but I'm not overly anxious if we build up cash over a period of time waiting for the market to come our way," he said.
Due to its size, the fund is able to find nuggets of opportunity during times of shortage, such as last year, Derrick said.
"We can pick up 500 bonds and still have a reasonable position" in a bond trading cheap to the market, he said. "We do a lot of sub-$1 million blocks."
Besides focusing on the short end, the fund manager said his portfolio benefits from its investment-grade only policy. The fund invests at least 80% of its net assets in investment-grade municipal securities, and has a five-star overall rating from Morningstar, according to the firm's website.
"People appreciate that, and it attracts people that want a relatively conservative piece of their portfolio to generate income and also preserve capital," Derrick said.
Double-A paper accounts for 39.93% of the fund's holdings, followed by 23.84% in single-A paper, while 3.62% of its holdings are in triple-B securities, according to the website. The lower-rated investment grade paper has contributed value to the fund following the collapse of the insurance market, Derrick said.
Overall, he continues to find value in the municipal market because it is both eclectic and interesting. "It's not as transparent and it is not exchange-traded, but good or bad, that gives it character," he said.
Meanwhile, Fischer said the strategy of staying short could remain a good alternative even after the Fed starts raising rates.
"The Fed is going to be moving in 25 basis point increments and there's a tremendous demand for liquidity around the globe," he explained. "It's not at all clear if the Fed funds rates goes up by 25 basis points that the money market funds go up by that much," Fischer warned.
