Rising yields and the prospect of increased volume are proving to be a favorable combination for portfolio managers like Jonathan Law at Advisors Asset Management.
The vice president and portfolio manager at the Monument, Colo.-based registered investment advisor has been looking for ways to provide value for his separately-managed account clients by capturing attractive risk-adjusted returns and staying defensively-positioned.
“Given the recent market volatility, it’s imperative that you stress test potential purchases under various rate scenarios,” Law, who oversees $325 million in municipal SMA accounts for high net worth individuals looking for tax-exempt income, said in an interview.
For example, the spread between the tax-exempt triple-A two and 10-year bonds has increased to 95 basis points as of Friday, up from approximately 42 basis points on Jan. 2, he noted.
The two-year municipal triple-A maturity is yielding 1.52%, while the 10-year is yielding 2.47% as of Friday morning, he noted.
“Macroeconomic factors pushed out the longer end and kept the shorter end less volatile, and demand for shorter paper was a lot higher, so they didn’t move as much as longer paper,” he said. “It remains a challenging environment to find value with limited supply and market uncertainty.”
However, Law is sticking to his strategy of improving income and risk-adjusted returns through careful security selection, yield curve analysis, bond swapping, portfolio diversification, and credit monitoring for his SMA accounts.
He maintains a short- to intermediate-laddered portfolio that emphasizes defensive duration and above average coupons versus the Bloomberg Barclays Capital Municipal 1 to 10-year Blend Index -- the benchmark he uses to manage performance and risk.
The fixed-income strategy for the SMA’s composite calls for average credit quality of A-plus/A1, an average coupon is 4.98%, and average modified duration of 3.65 years.
Law has uncovered value by participating in high-quality deals from the health care and higher education sectors. Both were double-A-rated credits yet offered attractive yields of approximately 50 basis points at the time of pricing in mid-to-late January just ahead of the market volatility.
With yields rising throughout the year so far, the bonds looked a lot more attractive than they did a quarter ago.
“The spreads found in those two deals were, at the time, double A credits trading like single-A credits -- and offered single A yields,” he said.
“If your M.O. for a general market portfolio is to diversify into different sectors and states, this was a good candidate compared to the typical GOs you would normally see trading,” Law said of the health care deal.
That deal exemplified Law’s investment strategy of providing tax-exempt income and capital preservation as well as value in the intermediate slope of the yield curve through focusing on investment grade paper.
The health care bonds also complemented his strategy and support his view that credit quality is often overlooked between single and double-A-rated paper.
While overall yields have risen, credit spreads for the most part have stayed the same, according to Law.
“It’s no secret when supply is limited, larger block offerings typically command higher yield premiums than that of smaller offerings. That’s why credit spreads often get overlooked,” he said. “There’s less incentive to buy lower-rated bonds if the yield on double A-rated paper is not as far off.”
He prefers the higher rated securities, because the extra yield available in lower rates paper is marginal. “Historically, the spread between double-A paper and single-A paper is approximately 30 bps,” he said.
He also cited the higher education revenue bonds from a recent new issue as an example of a double-A-rated bond that offered an attractive spread of approximately 50 basis points due to its pricing just ahead of the volatility in late January and early February.
On the Horizon
Looking into 2018’s future, Law said investors should remain financially fit and focused now that rising interest rates are a reality.
“Stick to your guns and make sure you know what you’re adding to your overall portfolio,” he said. “Recognize what your muni portfolio is for,” he continued, calling the municipal market one of the most tax efficient solutions for individual investors.
“It still provides a lot less risk and volatility versus most other asset classes,” he said. “It’s a good complement to the rest of your portfolio.”
Retail investors have been yearning for higher interest rates and more supply since the start of 2018, and in the meantime, are cautiously watching the municipal market, according to Law.
Since many issuers brought deals ahead in the fourth quarter, “there was really nothing for investors to pick through” during the early part of 2018, he said.
In the meantime, investors are hiding in shorter paper or are staying on the sidelines, perhaps waiting for the 10-year Treasury benchmark to hit the magic 3% bogey, according to Law.
“This year with the way it’s heading so far, muni investors probably aren’t expecting the same returns that they have been able to capture in recent years,” he said. “Maybe this year it’s more about clipping coupons and interest, instead of chasing yields.”
Law said given all the recent market volatility, investors should “buckle down” on their investment strategy, be extra vigilant, and be extra aware of their portfolio duration.