Shortening duration, buying premium bonds, and minimizing risk are three paths municipal managers are taking as the second half of 2014 gets under way in anticipation of higher interest rates.
According the latest minutes of the June meeting, the Federal Open Market Committee is planning to end its federal stimulus program in October, some 10 months after it first began cutting bond buying. Analysts predict the Fed will start raising interest rates as soon as the second quarter of 2015.
Premium bonds fit the bill when it comes to mitigating portfolio risk because the higher coupons offer portfolio protection in a rising rate climate, said Bill Walsh, a partner at Parsippany, N.J.-based investment advisory and wealth management firm Hennion & Walsh.
"Since bond values fluctuate inversely to changes in interest rates, a rise in general market interest rates will cause the value of your portfolio to decline," Walsh said. "This type of bond, priced above 100, will have a lower relative duration than par or discount bonds of the same maturity," and therefore a lower sensitivity to interest rate changes, he explained.
The kick to maturity, he said, often provides higher rates of return than alternative structures and strategies in the current market.
"Premium bonds with a call option are priced as if the call date was the maturity date," he said. "With the stated yield to maturity higher than the yield to the call, investors will receive a higher rate of return if their bonds are not called at the first scheduled call date."
John Mousseau, managing director at Cumberland Advisors in Vineland, N.J., is steering clients toward premium bonds, also known as cushion bonds, with 18- to 21-year call dates that are advance refundable. "They are not really a place to hide as much as a better value for unit of duration," he said. "With rates nominally a lot lower — though the longer end is still relatively cheap — it's not bad to take some duration off the table, especially since we extended last year."
In addition, shortening duration is also a common strategy among portfolio managers.
Greg Serbe, president of Lebenthal Municipal Asset Management, recommends staying defensive by maintaining short duration — largely hovering in the three-year range - to model the performance of the Barclays Municipal Bond Index five year benchmark. He is also including premium bonds, and keeping credit quality at an average double-A to avoid the tight spreads in the triple-B sector as part of his cautious strategy ahead of the potential Fed rate hike.
"The excess coupon repayment effectively returns principal early and when rates do increase, we want to be able to reinvest readily in the better environment," Serbe explained.
To satisfy the need for income and retirement security among a growing baby boomer generation, Wayne Schmidt, chief investment officer at Gradient Investments in Arden Hills, Minn., is adopting a conservative strategy for minimizing risk and preserving capital
He recommends that the firm's retail investors from high-taxed states stay well diversified, maintain liquidity, and keep duration relatively short.
Besides recommending strategies for retail clients, Schmidt works with the approximately 115 independent advisors around the country that use Gradient as a third party money manager.
Schmidt, who has worked at Gradient for six years, said the firm generates $30 million of new cash monthly due to baby boomers looking not only to increase assets, but shelter them as retirement approaches.
Clients' assets range in size from $50,000 to $1 million, with an average account size of $85,000. The firm currently has $600 million in total assets under management.
"Through the working years they put money in 401ks and then closer to retirement they wonder how they can keep that 'pay check' coming in," Schmidt said.
He advises those clients from high-taxed states to own municipal investments to supplement a pension, and to provide long-term growth and staying power in the market, he added.
His strategy calls for maintaining a comfortable risk level based on investors' time horizons, investing in the 20-year slope of the yield curve because it offers growth and helps investors stay ahead of inflation - and never timing the market.
Similarly, Karissa McDonough, director of fixed income of the wealth management division at People's United Bank in Burlington, Vt., aims to expand andhi protect clients' portfolios by managing liquidity, credit, extension, and rate risk as the market heads into "uncharted territory" later this year or next.
"This is a very different market we are heading into," said McDonough, whose firm has $5.2 billion in total assets under management, of which $100 million is municipal assets.
"This is a market where the Fed is removing liquidity and I don't know to what degree the removal of liquidity will impact the market."
Ahead of that, though, McDonough is protecting clients from potential dislocation and uncertainty - even though analysts predict the tightening won't happen until 2015, she noted.
"We are using discretion and trying not to take on any undue levels of risk," she said.
While earning yield is also a key concern for Gradient's retail clients, Schmidt said he, too, cautions investors from being too aggressive where income is concerned.
"With the stock market valuations, people are nervous about equities," he said, and on the municipal side, stretching for yield means taking on additional duration risk and principle fluctuation.
"Yield comes with a price," he said, pointing to the fiscal debacle in Puerto Rico.
"There's been, in the last 10 years, more credit concerns in the municipal market than in the 1980s and 1990s," he added. "That was a more stable marketplace."
Only 10% to 20% of the firm's $600 million in assets under management is comprised of high-yield and risky investments, he said.
McDonough agrees some risk is OK, but she also cautions yield-driven investors to limit exposure, and avoid troubled credits like Puerto Rico and Detroit altogether.
"As long as you are not reaching for those headline risks there are opportunities in higher yield, but you have to do your research," she added. "There might be select opportunities, but you have to be careful."
Her total return investors that view absolute return as crucial, meanwhile, favor highly-rated solid general obligation and essential revenue bonds with relatively lower levels of credit risk, but still with some attractive spread pick-up. She also recommends staying short of specific municipal benchmarks, while also looking for credit opportunities in the sweet spots five years and under and the long end beyond 20 years. She would avoid the belly of the curve between five and 10-years where investors can get hurt.
"We also want to stay away from any of those city-specific cases that seem to have out-sized budget issues and unfunded pension liabilities," she said.
Given the federal deficit and lack of fiscal discipline among some states and municipalities, Schmidt said he avoids depressed credits in favor of those with strong taxing or revenue support.
"There are solid issuers that are better positioned through a taxing authority and school district bonds, revenue bonds, and collections, and there is a stream of cash flow to service the debt," he said.
There are opportunities, however, in cases of a default or bankruptcy - as was the case with the Meredith Whitney scare, when munis plunged on the analyst's forecast of widespread defaults, and the California bankruptcies of recent years, he recalled.
"There's an opportunity for the astute person to look for the broad-based sell-offs, and other opportunities for headline credit events," he explained. "You get more exposure to the market or an entry point to get into the market."
Overall, McDonough, like her colleagues, is paying close attention not only to future Fed movements - but also to economic statistics in coming months.
"For total return investors, we would upgrade credit quality if the Fed was preparing to act," McDonough explained. "If we see the Fed was really determined to move forward or global economic growth picking up that would be a reason to dial back credit exposure, neutralize durations bets, and dial back the yield side."
