Munis aren't too heavy if you balance the weight
Sheila King, portfolio co-manager and fixed income research analyst at Eagle Asset Management, is finding a way around the relatively high prices in the short end of the municipal market to deliver tax-exempt returns to her conservative clients.
“The front end of the market looks rich in comparison [with Treasurys], especially in the one- to two-year area,” said King, co-portfolio manager of Eagle’s Fixed-Income Tax Advantaged and Fixed Income portfolios.
The potential for continued richness doesn’t spook King, a portfolio manager who invests in many segments of the fixed income market to achieve capital preservation and diversification for her clients. She manages $800 million in assets in the firm's Tax Advantaged and Fixed Income portfolios.
Eagle is an affiliate of Carillon Tower Advisers, which has over $64 billion of assets under management and advisement.
While King remains cautious on the richness, she is actively managing a barbell strategy — buying bonds in a short and longer maturity and placing no weight in the maturities in-between. The strategy typically benefits from diversification and less risk while offering the potential to obtain higher returns as proceeds of the shorter bonds can be reinvested at higher rates.
The short-term bonds provide liquidity and flexibility since they roll over as they mature.
King constructs her barbell strategy using three- and four-year maturities on one end and seven to 10-year paper on the other, she said.
While she said that strategy lagged in 2018, King still feels comfortable using it in the remainder of the first quarter of 2019.
“I think that is still a good place to be with a continued roll down and turnover fairly low,” King said.
At Eagle, she is also the co-portfolio manager of Tax-Aware Fixed Income strategy, which is diversified with a mix of assets that consists of 47% municipals, 24% corporates, 14% mortgages/asset-backed securities, and 13% Treasurys and Agencies. The remainder is in cash.
“I have a lot of different sectors I can invest in,” she said. If municipals start to get "very rich, I’m not afraid to sell that and look elsewhere — either corporates or Treasurys or longer on the muni curve,” where there is select value in the 20- to 30-year range.
Municipal managers and strategists acknowledge that the short and intermediate sector of the yield curve remains rich relative to taxable comparisons due to the heavy investor demand and lack of supply, yet the market has outperformed.
King observed that the continued growth of separately managed account demand on the short end of the yield curve is contributing to the richness.
“Richer relative value ratios illustrate the point that munis continue to become more expensive compared to UST given the technical landscape,” Jeffrey Lipton of Oppenheimer & Co. Inc. wrote in a March 6 weekly report.
As of March 12, the 10-year ratio was at 78%, while the 30-year was at 95.4%, according to Municipal Market Data.
After 31 years with the firm, King has seen many different types of municipal markets, from advantageous to volatile and everything in between.
“If munis become richer I can certainly find value in other markets, but right now I continue to like munis,” she said. The market is “still attractive, even though there might be some richness in the percentage of Treasurys. You can still find value in certain names. The market technicals are strong and new issuance is driving the first quarter so far. If we continue to see large demand over the next two quarters, munis are going to continue to perform well.”
For instance, as of March 1, the 10-year triple-A municipal-to-Treasury yield ratio dropped to a multi-year low of 79% and the average 10-year triple-A muni yield declined to 2.17% — a 13-month low, Anthony Valeri, portfolio manager at Zions Bancorp, noted last week.
Municipals have still outperformed their Treasury counterparts so far in 2019 and have shown good resilience to modest global government bond weakness, Valeri said.
Compelling municipal technicals continue to temper any weakness in overall fixed-income bond prices, resulting in tax-exempt outperformance, Lipton wrote in his report.
Much like the Fed, King is data-dependent on the economic front, and is “positioned comfortably” for the remainder of the first quarter and beyond, she said.
“Just as the Fed is, we are looking at economic numbers coming out of China and Europe and certainly seeing slowing there,” King said.
That data-dependent view will help identify any needed changes in her barbell strategy.
“If there is expanded growth, we would want to be a little more conservative,” waiting for yields to increase due to inflation fears, she said. “If we start to see yields increase and prices dropping, we would sell our shorter duration and buy value on the long end if it became available”
Eyeing value, minimizing risks
Part of King's strategy is owning securities for long-term, after-tax returns. She cautions higher tax bracket clients against taking short-term gains due to higher tax consequences.
“We are confident knowing we are not taking untold risks,” she said. “We are focused on a conservative agenda and we are not looking to hit home runs in the fixed income market.”
Eagle Asset Management's Tax-Aware Fixed Income strategy has returned 2.69% over a 5-year period, 3.97% over a 10-year period, and 5.02% since inception, as of Dec 31, 2018, beating its benchmark over each period, according to data provided by Eagle.
In a fairly stable market environment, King said she focuses on keeping the turnover rate to a low of 30% to 35% in her portfolios.
“If the market is more volatile that gives you more opportunity to do more trading, and we will do that” if value presents itself, she said.
With a conservative approach to capital preservation as her goal, revenue-backed bonds, such as those backed by sales and property taxes, for instance, are currently on her radar screen as she views them as stronger than state and local general obligation bonds.
For instance, she recently purchased higher education revenue-backed bonds for their attractive spread of 32 basis points to the 2030 yield to maturity, and 71 basis points — as well as 100% of the Treasury yield — to the 2026 yield to call.
The bonds, which are rated A1 by Moody’s Investors Service and AA-minus by Fitch Ratings, benefit from five years of positive operating performance and has stable enrollment and strong overall coverage of debt by student fees.
King said she is avoiding states like New Jersey, Kentucky, Connecticut, Illinois, and Pennsylvania, which are facing pension issues.
“We want to make sure states are being responsible on a budget standpoint and pension front,” she explained. “It’s very important, or states end up paying a lot more yield.”
She said she is underweight state and local bonds — and avoiding those troubled municipalities — in lieu of states with solid financial positions, such as Washington, Texas, and Florida, and credits with stability and upgrade potential, such as airports, transportation, and special tax bonds from other states, she said.
King is also highly selective in the hospital sector, and prefers multisite hospitals in states with growing population levels over riskier single-site facilities from less populated states.
King said she wasn't rattled by the January decision by the Federal Reserve Board decision to pause interest rate hikes.
“We were already thinking only one hike or two max in 2019, and we were positioned for that,” she said, giving a nod to her barbell strategy.
The Fed’s decision, she said, “really doesn’t change what we were thinking already at the last quarter” and added that “the Fed came our way.”
King said the Fed adopted a neutral stance in the fourth quarter and that was “the start of the 180” in their tightening pause — something Eagle expected.
The firm recognized Treasury yields at 3.25% as “the highs of the year” back in the fourth quarter.
“We knew it likely would go through 3% and probably hit 2.85%, but it was amazing how fast it happened,” King said, noting that the same yield dropped to 2.55% by Jan. 3.
She said the Fed’s pause, leading to less pressure and uncertainty clouding the market, may benefit munis and Treasurys, boosting confidence for retail investors in the backdrop of a slowing economy.
“Munis typically are more defensive versus corporates and other fixed income sectors, and with the economy slowing, municipals retain their value,” she said.
The threat of rate increases typically spooks retail investors, King said. “Feeling the fed is on hold for a while you will see retail flow back into the market,” she said, pointing to a reversal of fund flows as money came into muni funds after the January Fed announcement. “Retail investors are starting to be calmed knowing the Fed is on hold for a while, due to less uncertainty.”
As the end of the first quarter nears, King said investors should look for value and take advantage of municipals’ low volatility, while also monitoring fund flows and potential price richness on the short end.
She advised investors to stay fully invested and keep cash to a minimum.
“There’s a lot of demand for munis and if you’re sitting on a lot of cash you will have a hard time buying bonds at a good value."