Fund managers expect municipal bonds to remain stable compared with other asset classes, even entering a season known to bring volatility to the muni market.
As the April 15 tax filing deadline and spring redemption season approaches, they are optimistic that price volatility or outflows triggered by tax season will provide additional buying opportunities.
"Valuations are fairly attractive relative to other high quality assets, and volatility is largely to some extent on the back burner as the risk markets have gained a foothold," Jim Grabovac, who co-manages portfolios with Dawn Mangerson at McDonnell Investment Management, said in an interview on Wednesday.
They said the continued strong demand and low volatility combined with a modest steepening of the municipal curve convinced them to use the same high-quality, intermediate-focused strategy in the second quarter that they have employed since the beginning of last year.
Grabovac and Mangerson have a low expectation for rate volatility through the end of the second quarter, and believe the time is ripe for opportunity in spread sectors — in select higher-quality credits.
McDonnell oversees $11.3 billion in client assets, 70% of which are tax-exempt municipal assets, including separately managed accounts and two sub-advised municipal mutual funds.
Mangerson said the team will maintain its focus on the 10- to 15-year slope of the yield curve where valuations remain "attractive" at approximately 96% or higher versus Treasuries.
"Muni fundamentals are still improving and are solid, so we are still seeing tight spreads in the municipal market, whereas in corporates we are seeing spread widening," Mangerson said.
The team continues to search for high-quality credits within spread sectors that offer slightly more yield to compensate for the relatively low absolute returns, Mangerson said.
Though she declined to disclose specific credits, she said she expects to find continued opportunities in the transportation, public power, and hospital sectors in the second quarter.
Within the single-A-rated hospital sector, for instance, 10-year paper is providing 75 extra basis points, or yields of between 2.60% and 2.85%, compared with the generic triple-A market, which is yielding 1.85%, according to Mangerson.
"It's a conservative approach, but it provides a little bit more yield for investors," she said in the interview.
Jeffery Timlin, managing director and senior portfolio manager at Sage Advisory Services in Austin, Tex., said he is being highly selective on credit quality, as the majority of credit spreads remain compressed. He is also being cautious and avoiding more speculative, higher risk credits that have exhibited higher price volatility, such as Puerto Rico, Illinois, and Pennsylvania, since there is a lack of adequate compensation.
"Our clients don't want that type of exposure," said the head of Sage's municipal bond department, which oversees the $1.2 billion of municipal assets under advisement in SMAs for high net worth individuals and profitable corporations.
He expects investors will continue to employ a selective "risk-off tone" throughout the second quarter, and a continuation of positive mutual fund flows should help support that approach.
Grabovac said the dip in crude oil has been a big factor in fixed income market direction, because it is driving inflation lower and widening spreads in the taxable and energy markets, which could trigger a future flight to quality in the face of oversees volatility.
Additional opportunities, Mangerson said, could arise as the tax deadline approaches and seasonal effects cause high net worth investors to liquidate municipal assets.
"We typically see some outflows and less demand for municipals beginning in April," she said. "If you see decent supply and a little sell off in the municipal space, we could see some nice purchases with a better yield."
However, Timlin said that seasonal effects of short term outflows resulting from investors withdrawing municipal assets to pay tax debts may trigger a general weakness from April to May, followed by the market regaining its strength at the end of the quarter, when the reinvestment season heats up ahead of the heavy June/July coupon and maturity payment dates.
"We try to position our portfolios to take advantage of these seasonal effects by making sure portfolios are fully invested by the end of May going into that June period," he said.
Timlin is maintaining a neutral duration and keeping an eye on the potential for further yield curve flattening going into the second quarter.
Like Grabovac and Mangerson, he expects the same low yields and low volatility that municipals displayed following the fixed income rally in the first quarter.
"We feel yields in 10-year maturities and longer are constrained in that 50 basis point range," Timlin said.
Municipals, he said, have been very liquid during a period of spotty liquidity in other asset classes, like equities and fixed income, throughout the first quarter due in part to the sell-off in equities and in oil.
"It's definitely been a volatile ride," said Timlin, who oversees three of Sage's municipal benchmark strategies — moderate, intermediate, and core. But municipals have "stayed the course and weathered the storm pretty well."
"If we see that type of environment again and some pick up in risk volatility, we think municipals have the same type of stable principal valuation that we saw throughout the first quarter — despite the general market volatility," Timlin said.
Until then, he will maintain a neutral duration while yields are below 2% on the 10-year Treasury. However, that is subject to change throughout the quarter, if and when the 10-year Treasury moves.
If, for instance, the 10-year Treasury rate drops to 1.75%, Timlin will start to shorten duration. If it rises above 2.25% he would add some interest rate risk and extend duration.
Either way, he aims to maintain a tactical approach to managing interest rate risk without sacrificing too much in income generation.
"With a positively sloped yield curve, anytime you take some interest rate risk off, you shed yield, while you are picking up yield when you extend duration," Timlin said.
Currently, he is taking advantage of opportunities for incremental yields pickup of between five and 15 basis points on selective new issues versus the secondary market, but is still preserving some cash, he said.
Timlin said he is keeping his "powder dry" for future opportunities that may be created by potential headline risk stemming from the oil crisis, an unexpected sell-off, or ongoing concerns in riskier asset classes, such as hedge funds, taxable high yield, and equities.
"Munis are a good hedge during downside risk," Timlin said. "Maybe [the muni market] doesn't look too sexy, but it does provide investors with stability and accessibility and tax-free income generation."
While Dan Heckman, a senior fixed income strategist at U.S. Bank Wealth Management, is disappointed with the low absolute yields in the municipal market, he is still searching for attractive returns on high-quality municipals, and structuring client assets to perform well in a potential rising rate climate.
"We think it's still a good place to be for investors in high tax brackets," the senior fixed income strategist said of the municipal market. His firm has $125 billion of total client assets under management, including municipals.
He is keeping client assets invested in the seven- to nine-year and 12- to 14-year portions of the yield curve, where they can earn between 30 and 50 basis points of spread compared to the 10-year Treasury bond, depending on credit quality.
The strategy hedges against future Fed rate increases, which could cause a potential slowdown in the U.S. economy, and also provides clients with income and attractive taxable equivalent yields, Heckman said.
"We see an opportunity for that part of the curve to perform very well under the circumstances of the slower tightening of the front end and a flattening overall of the yield curve," Heckman added.
"We gain that roll down opportunity," he said. "As time moves on and you come down the curve, you gain the spread tightening and yield compression and price appreciation for the bonds."
Heckman expects municipal mutual fund flows to remain strong in the second quarter — albeit with some seasonal exodus due to tax time.
"All in all, there's a very good opportunity for flows to remain pretty steady," due to the supply-demand imbalance, Heckman said.
Andy Chorlton, head of U.S. multi-sector fixed income at Schroder's, said flow data is an important consideration in the second quarter, and throughout the year.
"It doesn't really matter why people make the moves, it's just if they make the move, you need to keep an eye on it," he said. "When you get big inflows the market doesn't react as quickly as it does in high yield, so the market tends to get expensive."
In fact the strong performance of municipals is what prompted Chorlton to pare the funds' municipal allocation down to 60% from as high as 90% back in the fourth quarter, buying corporates with the balance.
He oversees $3 billion of tax-sensitive mutual funds and separately-managed accounts. The mutual funds use a cross-over trade that allows them to hold municipals as well as taxable fixed income products, he said.
Even though flows were positive and municipals remained a safe haven amid a risk-off trade, Chorlton said he felt the asset class remained expensive following the Federal Reserve Board's December interest rate increase.
However, he said the funds still maintain 50% asset allocation in municipals to allow for tax-free distributions, he said.
Chorlton favors the five- to eight-year slope of the curve since he thinks it is attractive and "because you get paid more as you roll down the yield curve," he said.
It also coincides with his strategy of targeting long term after-tax total return which, in turn, argues for a duration of between 4 ½-5 years currently due to the steep yield curve.
"We like that part of the yield curve in an outright basis, and it also ties in that it's pretty close to where we want the absolute level of duration to be," Chorlton said.
He also prefers high-quality tax-exempt paper from states such as California, and is anticipating opportunities in the second quarter due to the potential seasonal effects.
Reallocation of assets during tax season may or may not cause volatility, but Chorlton said any movement could produce opportunity.
"If investors do start dipping their toe in the water in the equity market — or even in high yield or emerging markets — and funding those buys out of munis, that would be something we would be keeping a close eye on because it often drives relative value," Chorlton said.
