Tim McGregor craves volatility.
McGregor, the director of municipal fixed income management at Northern Trust, relies on market inefficiency in his quest to deliver maximum income and total return for his individual and institutional clients who benefit from the tax-free advantages of a high-quality municipal bond portfolio.
He said there is value to be found in a market that remains "inefficient and fragmented" due to the presence of over 50,000 issuers and investors ranging from small retail accounts to global wealth funds who are negotiating prices and vying for price discovery on a daily basis.
"The market is not cushioned against volatility as much as it used to be, but that volatility creates opportunity from the management side," McGregorsaid in an interview this week.
"The opportunity for long-term value is greater in this environment," he said. "The volatility is a good thing for long-term investors rather than a market where prices don't move at all."
McGregor said he uses an "active relative value" strategy when managing the more than $30 billion in long duration municipal assets within the separately-managed accounts he oversees at the Chicago-based asset management firm where he has worked for 26 years.
In addition to managing separately-managed accounts, he also manages the Northern Intermediate Tax-Exempt Fund and the Northern Tax-Exempt Fund.
He began his career at Northern Trust in 1989 where he held positions as investment manager representative and tax-exempt fixed income manager for high net-worth individuals before becoming director of municipal fixed income management.
Maturity selection and yield curve positioning are part of McGregor's strategy for both funds and separately-managed accounts.
For instance, he described a 3% to 3.50% tax-free yield maturing in 2030 to 2035 with a 10-year call as "generous" and "attractive" in the present market.
"There are a lot of natural parts of the curve that offer more value than others," he said. "Right now the whole tax-exempt market is cheap within fixed income, and municipal yields are higher than Treasury yields."
Besides volatility, McGregor said munis' relative cheapness to other fixed income sectors is another key component of adding value for SMA clients.
On Friday, the 10-year municipal yield as a percentage of Treasuries was 104.1%, a percentage that inched up to 111.2% for the 30-year municipal to Treasury comparison, according to Municipal Market Data.
In addition, the taxable-equivalent yields on select municipal bonds provide attractive, tax-free returns for his SMA clients who range from small individual, retail account holders to large institutional customers, like insurance companies.
They have a low risk tolerance and even those that remain in the short to intermediate slope of the yield curve can earn 2% tax-free yields in seven years, which translates to roughly a 3.85% taxable equivalent yield, according to McGregor.
A seven-year Treasury bond yielded 1.79% as of Friday morning, according to data on the U.S. Department of Treasury's website.
Meanwhile, establishing key duration targets and interest rate exposure depends on his individual SMA clients -- who range in age from young entrepreneurs to retired professionals and have different investment goals, risk tolerance, duration thresholds, and income needs, he pointed out.
However, they all share the need for maximizing income and total return, as well as principle preservation and growth in the current market environment, McGregor noted.
He said he is flexible when it comes to strategies for investors with different investment objectives.
For instance, an SMA investor with a four-year duration target can either hold a laddered portfolio of one to 10-year bonds, or choose a barbell strategy comprised of two and three year maturities.
"Both would give the same overall portfolio duration, but different income streams and total returns based on whether the yield curve is steep, or flat, or stagnant," McGregor said.
One option he won't consider, however, is sacrificing quality for yield.
Since his clients' portfolios are all investment-grade, he places a heavy emphasis on credit and security selection as part of his overall relative value strategy.
"They want safety - so we make credit a priority," McGregor said. "We tend to be higher quality in nature."
The average credit quality in his clients' portfolio is double-A, and it doesn't fall below triple-B minus. "There is not a lot of value in the lower investment-grade space," he said.
Getting the best risk to reward combination in the credit market is crucial to adhering to the safety and comfort level his clients expect from a municipal bond portfolio, he said.
Strong sectors, such as those backed by unlimited tax, voter approved general obligations, or dedicated essential service revenue bonds, currently fit the bill for his quality-conscious and conservative clients.
"We think you are not being compensated for a limited tax bond or a lease or appropriated bond today," he said. "They yield a little more, but in our opinion, they don't yield enough to justify the risk."
Other securities on his radar screen include transportation and airport revenue bonds, sales tax bonds with strong debt service coverage, as well as paper from both New York and California.
The high tax states' paper usually trades expensive to the market, but with the recent glut of supply lately, they have been trading at a discount to the general market in the last six months.
The paper provides a yield pick-up of between 15 and 20 basis points to the generic market versus times when supply is less robust, according to McGregor. That enhances the total return opportunities for clients who reside in these states, he said.
"The whole market is cheap today, but issuers in New York and California are cheaper," he added.
He recently purchased New York Transitional Finance Authority sales tax dedicated bonds, California Department of Water and Power dedicated revenue bonds, California GOs, and Los Angeles Community College District GO bonds.
Meanwhile, as he is not overly concerned about interest rate movements, he is emphasizing bonds with premium coupons to better position portfolios to perform well in a rising rate environment, he said.
While higher coupon bonds offer added protection on the downside should rates rise, McGregor believes rates are range bound in the near term.
"We think the Fed is going to move very slowly," he said. "We are confident in their ability to combat inflation down the road."
McGregor said he anticipates Fed movement in the latter part of this year - or even next year.
Following the first quarter's weak economic data, "I don't think that's the kind of environment they would be raising rates in," McGregor said.
As municipals remain relatively attractive and the Fed slowly transitions to higher rates, McGregor recommends taking advantage of value across the yield curve in the meantime.
"For whatever your interest rate risk tolerance is, don't be afraid to use a broad maturity structure," McGregor advises his SMA clients. "Utilize as much of the yield curve as you can."
"Ironically, the market is as inefficient as it was 20 years ago - as long as [the volatility] remains our philosophies will continue to work," McGregor said.
