Managing a smaller-sized municipal bond fund has its advantages, according to Jeffery Elswick of Frost Investment Advisors LLC.
A smaller portfolio allows the manager to be more nimble in taking advantage of market opportunities, he said, while still generating the desired income to high net-worth clients.
The $250 million Frost Municipal Bond Fund he manages may not be massive, but what it lacks in size it makes up for in value, the director of fixed income at the San Antonio-based investment manager said in an interview.
He focuses on providing tax-exempt income for high net worth clients through various strategies, such as holding 55% of the funds' assets in high-quality Texas paper.
"Managing a smaller fund in general is certainly a big advantage for us versus the behemoths that are essentially so large they are the market," he said. "We can generate significant income levels and returns by looking at opportunities in the market - and changing our asset allocation, duration, or interest rate profile quickly."
If he purchases a $10 million block of bonds, for instance, he said it will be a more relevant and prominent holding in his fund than it would be in a much larger fund.
"That position is a larger allocation to our fund — it can be 1% to 3% of our fund — versus a very large fund where it doesn't move the perspective of the fund," he said.
Elswick, who joined Frost in 2006 from Capital One Financial in Washington, D.C., said unlike larger funds, his fund is focused on income generation as a primary goal, yet avoids falling below its benchmark, if possible.
"We do not have constraints on how we can change our duration," he continued. "We give ourselves enough flexibility if we thought rates were going to move shockingly higher," he said. "If we became bullish on tax-exempt rates we could add much more duration in the overall market."
"We want to eliminate sitting in front of clients saying we beat the index, but lost money," Elswick said. "We try to beat our Barclay Municipal Bond Index, but our first objective is to create a fairly reasonably and consistent income."
Elswick began his career 22 years ago, after a stint in the U.S. military, at Stone & Whatley, a small, privately-owned Dallas-based broker-dealer and investment house.
Since the end retail client is highly focused on income, he said, returns are a secondary objective.
"The biggest challenge with us is keeping yield and income as high as we can with interest rates low for so long," he added.
To accommodate investors' quest for income, Elswick's fund has a high concentration of Texas paper. The reason is two-fold: a vast majority of his end clients are Texas residents; and being headquartered in San Antonio provides the knowledge and comfort level of many of the state and local credits.
"We are a higher quality manager and so Texas, generally speaking, is a sound way to do that," he said.
The fund's largest holding is Texas tax and revenue anticipation one-year notes that represent 2% of the fund, he said. While the 1.5% coupon is low, the notes have the highest short-term ratings from all three rating agencies - SP1-plus by Standard & Poor's, F1-plus by Fitch Ratings, and MIG-1 by Moody's Investors Service.
"Texas securities have started to price on the expensive side," but, he said, clients are willing to accept the narrowing because of the state's high quality.
Texas general obligation bonds, as well as Texas Independent school district paper guaranteed by the state's Permanent School Fund, have rallied versus comparably-rated paper, he said.
Other strategies he relies on to add value to the fund include using a one-year macro-forecast based on how the economy is likely to affect the yield curve in the coming year.
Using that one-year time horizon allows him to adjust duration and determine the best income-generation model for the fund at any given time.
For instance, based on the current one-year outlook, he is overweight in the seven to 10 year slope of the curve.
"That's the best way to lower duration, but generate as much income as we can," Elswick said, adding that his holdings include less bonds with maturities 15 years and longer than are in the benchmark.
"We think the 10-year Treasury bond will move to 3% in the next year," he said. "A year from now will be a much better time to invest in 15-year plus municipal bonds."
On Thursday, the triple-A GO benchmark in 15 and 30 years was yielding 2.83% and 3.30%, respectively, according to Municipal Market Data.
In addition to having a focus on high-quality paper, Elswick said he considers select riskier paper, such as charter schools, hospital securities and troubled municipalities, like Puerto Rico — when and if the yield compensation offsets the risks.
For instance, he bought a 1% allocation of District of Columbia GO bonds when the district had some fiscal troubles a few years ago. The bonds are due in 2031 with a 4.75% coupon and offer a 4.25% yield to call, he said, and are among the top performers in the fund.
The D.C. GOs have improved and were upgraded in March to Aa1 from Aa2 by Moody's, while they are also rated AA by S&P and Fitch.
"We don't get too involved in what credit rating agencies say," he explained. "We do all of our own work and due diligence if there is more credit risk involved we will do it if we are being rewarded in terms of the yield."
The fund also owns revenue bonds on behalf of the Julian Charter School in San Diego that have a 5% coupon due in 2025 with a current yield to maturity of 4.87%. That's about 2.25% above the comparable California GO yield, Elswick said.
The fund even has a 1% allocation to Puerto Rico Electric Power Authority floaters due in 2025 with a 10% yield. He bought the bonds three years ago at 80 cents on the dollar. As the bonds were recently trading at 65 cents on the dollar, Elswick admitted it has not been one of the funds' best performers.
"It's not helping the fund on a return perspective, but it has a short duration," which underscores his current investment thesis, he said.
While he will not be increasing his position in island debt, he believes there is a high probability for a restructuring within six months to two years.
He said the potential Puerto Rico workout will be "a more interesting phenomenon" than Detroit because the commonwealth comprises about 3.5% to 4% of the entire municipal bond market.
In the meantime, based on his current outlook, Elswick said he believes the fund can maximize the most return by holding onto the PREPA securities it owns.
"A lot of folks are pretty bullish on some of the paper out there," he said. "Something is definitely going to happen over the next few months because of the liquidity situation."
"We don't have a strong view on how much of a haircut investors will take on PREPA, but we would be surprised if the haircut is as large as what the market is currently discounting," he said.
Outside of the investment strategies, Frost Investment Advisors is also trying to build its shareholder base and expand its brand by switching the Frost Municipal Bond Funds' A Shares to Investor Shares, which removes the front-end sales commission.
The move, which was effective in April, allows new clients to invest in the fund free of charge, according to a press release from the firm.
"We set our funds up in 2008 originally very consistent with other fund managers where the assumption was retail brokerages like Schwab and Fidelity were getting paid on a transaction basis by the load," which usually averages 250 basis points, Elswick said in the interview.
"We have seen — since the financial crisis — a big piece of the business has gone to this area of not being focused on transactions, but more of the fiduciary and management side of the business."
The cost-effective strategy speaks to investors' need for financial efficiency, he said. While the move doesn't affect the management of the fund, he added, it allows the firm to be more competitive and innovative in a changing market and that, in turn, adds value for investors.
