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Credit, Curve Selection Proves Valuable: Strategists

Two municipal strategists are taking different roads to minimize risk while adding value in a market fraught with uncertainty over interest rates.

B. Craig Elder, an investment strategist at Baird Private Wealth Management favors a so-called barbell strategy, while Stephen Winterstein of Wilmington Trust Investment Advisors Inc. is focusing on large, liquid names in the revenue sector. Both strategies are intended to work regardless of where interest rates go.

"It's been anticipated for so long, I don't know if it has any effect at all on the long end of the curve," Elder, senior vice president and fixed income strategist at the Milwaukee-based asset manager, said of the expectation for rising interest rates.

While he thinks there is a likelihood of the Federal Reserve raising rates sometime between June and September, Elder said he isn't preoccupied with that outcome when recommending strategies for the private wealth management business, which oversees more than $109 billion in client assets for high net worth individuals and institutions as of Dec. 31.

In 2013, Baird ranked 23rd on Barron's Top 40 wealth managers in the United States, and has been consistently on the list since 2007.

In the meantime, Elder said the firm is finding value by focusing its exposure on the ultra-short and intermediate sectors of the municipal yield curve.

He said it uses a barbell approach - investing in securities in the one to five-year maturity range and between 15 and 20 years. The strategy allows the firm to be defensive and hedge against short-term volatility while also providing money for reinvestment if rates do rise.

"In the 15- to 20-year range, you have to go out that far to get yield," but many investors are reluctant to invest beyond that where the yield curve is flat, he said. "If I'm going to pick up 13 basis points of yield to go out from 20 to 30 years I would just as well stay at 20 years." On Friday, bonds maturing in 2030 on the triple-A general obligation scale were yielding 2.27%, while the 20-year paper was yielding 2.49%, Elder noted.

"If it were steep from 20 to 30 years it might get my attention," he said.

While he said the intermediate yields are "nothing to write home about," the attractive relative value of municipals versus Treasuries justifies ownership.

For instance, 15-year municipal bonds offered 125.4% and 20-year paper offered 137.6% of the yield of 10-year Treasuries as of Friday, according to Municipal Market Data.

The barbell strategy also offers attractive after-tax returns for conservative investors in the top tax bracket who want to maximize their investments.

The 20-year paper, for example, offers 35 basis points more on Treasuries on a taxable-equivalent basis.

Winterstein, managing director of research and chief muni strategist at Wilmington Trust, was voted to the Third Team for Smith's 2014 Municipal All-Star Team, is a member of the S&P Municipal Index Advisory Panel, and is one of four founding members of the newly-former Philadelphia Area Municipal Analyst Society.

He said his firm's municipal portfolios have a neutral duration and are managed with no regard for interest-rate swings or actual yield curve shifts.

"Nobody has been able to call where rates are going, and no one can consistently forecast the path of interest rates," Winterstein said.

Rather, the firm is focused on sector, security, and structure selection, as well as relative value and credit research when it manages the $4 billion in tax-exempt municipal assets consisting of separate accounts for ultra-high net worth individuals.

The firm uses three maturity models -- a short strategy, a short-intermediate strategy and an intermediate strategy - all managed against respective S&P municipal indices, he said.

"We shift the curve all over the place - down and up in increments of 50 basis points and 100 basis points" to give investors a range of potential outcomes over three, six, and 12 months, Winterstein said.

"Like any investment, before we commit our clients' capital we ask ourselves, 'where do we think this is headed and what is our exit strategy?' " he said.

Risk management is crucial to the firm's strategy, according to Winterstein. "The process is largely geared for managing risk and allowing for if the market proves us wrong, we protect ourselves on the downside," Winterstein said.

"We don't wilt away from risk," he said, "because in order to get excess returns one has to assume a measure of risk. But we want to take that risk in a measured way and prepare for the possibility that if we are wrong and if we are right we have an out."

He said the strategy has nothing to do with positioning for future interest rates and everything to do with owning assets that have high liquidity value, such as large credits in the public and private higher education sector and multi-state hospital systems that are actively-traded, as well as high-grade general obligation tax-backed securities.

"Whether or not spreads widen or if we are right in our sector selection or security specific selection, we try to assure we have an exit strategy that works in favorable or adverse market conditions," Winterstein said.

The strategy, he said, has been proven over a 10-year track record, and is more reliable than "venturing into unchartered waters" and estimating interest rates.

Finding value in the revenue sector is currently a challenge given the tight spreads. Winterstein and the firm's four credit analysts try to undercover securities that offer relatively attractive spreads against benchmark indices and other revenue sectors.

"Everything is trading to its own historically-tight level, so what we focus on is areas where -- although they seem to be tight levels - we can get the most pick up in yield," Winterstein explained.

He said the firm adds duration exposure in sectors in which it has a neutral or favorable outlook. Meanwhile, the firm limits exposure to value in sectors where it may be slightly negative on a name so "if spreads were to widen, we wouldn't be that adversely affected."

At Baird, Elder said solid revenue bonds, such as water and sewer debt, select health care credits, as well as local high-quality school or infrastructure bonds are generating value, minimizing risk, and building a comfort zone among clients.

"People tend to be more comfortable with schools they drive by, or hospitals if they are familiar with it," Elder said. "It's a simplistic view but it works with investors."

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