J.B. Golden is buying short-to-intermediate maturity municipal bonds, using a "laddered" approach to combat spread compression in a rising interest rate environment.
“We are more concerned about making sure that we are defensively positioned with what’s going on with rates,” Golden, who helps oversee $300 million in separately managed accounts for retail clients as a first vice president and portfolio manager with Advisors Asset Management, said in a May 7 interview.
To achieve performance and limit the risk for the SMAs, he follows the Barclays Bloomberg 1-10-Year Municipal Blend benchmark and positions his clients accounts with about 85% to 90%, or 3.60 to 3.75 years, of the benchmark’s 4- to 4.10-year duration.
“Although we are certainly cognizant of rates and cognizant of a flattening of the yield curve, we are a little more comfortable with duration being closer to benchmark, because there are some factors that likely make munis a little bit better place to be [than corporate bonds or Treasurys] if high-grade bonds for preservation and income are your goal,” he said.
“We like to try as much as possible to take the interest rate risk out of the equation in the front end of the curve by moving to a little bit more of a mechanical laddered structure.”
Golden's preference for this disciplined laddered approach is prompted by the spread compression in the municipal market over the last couple of years. He also focuses on the one- to 10-year area of the yield curve – but not longer than 12 years – and plans to maintain that defensive strategy through the end of 2018.
“The muni curve isn’t as flat as the Treasury curve, but you are seeing term premiums really collapse,” Golden said.
Golden has has nearly 15 years of investment experience and has served AAM in both a fixed- income sales and trading capacity since joining the firm in 2004.
He doesn’t buy anything less than a 5% coupon and avoids taking any specific bets within the context of the short end of the yield curve. “You wouldn’t want to overallocate to the two- or three-year sector as that is likely most impacted by the Fed,” he said.
“You want to keep a very diversified bucket of maturities within the context of the 10-12 year bond ladder and look for higher-than-market cash flows, which is the reason we only buy 5% coupons,” he said, although he declined to disclose any specific holdings. “Over time that will mitigate and reduce the volatility associated with interest rates moving up.
“You will probably see the yield curve beginning to price in the rolling over of the economic cycle, so we like to maintain a diversified mix of revenue sources, and a very diversified basket of maturities within the content of a fairly defensive duration,” he added.
Golden is “not very excited” about the compensation for duration risk in the current market, but realizes keeping a short duration provides a ballast against equity volatility that his clients rely on from their municipal investments.
“With no duration, you get no ballast, but it’s kind of like threading a needle for us right now – we want to stay very defensive,” he said. Focusing on the short end of the municipal curve, he is able to obtain attractive taxable equivalent yields north of 3% for high-tax liability clients – versus a 3.15% on comparable Treasury bonds as of May 7.
Front-end yields have come back, but the 30-year slope of the curve has not followed suit, Golden noted.
“We have seen increasing inflationary expectations, but the 30-year section of the curve just isn’t buying that we’re going to have inflation for any significant amount of time, so as a result you really haven’t seen duration get punished as much as we’ve reset rates,” he said.
Lower quality opportunities
To offset the lack of yield on term premiums, Golden is continuing to participate in select lower-rated sectors of the market, such as health care and airports, though he's not making it his strategy to dip in credit quality across the board.
“To keep pace we would continue to defer to pushing the credit lever forward a little more obviously within the context of our strategy, which is very high grade,” he said.
Even while he is seeking yield opportunities due to the spread compression in the credit sector, he is also taking a slow migration up in credit quality whenever possible.
He said the Barclays Bloomberg 1-10 Year blend has an average credit rating of double-A, while the core tax-exempt strategy maintains an average of A-plus.
“From an interest rate standpoint, we’re probably long credit,” he said. “You have seen spreads compress, so we are taking a look at some of our low A-rated credits to potentially call them – but when and where available we’d probably still take a slight tilt down in credit quality.”
“As maturities roll off our laddered structure we’re finding ourselves more and more deferring to quality because at the point in time there’s virtually no spread between A and AA bonds,” he continued.
Golden said that is an indication that credit quality might be slightly undervalued given the market climate, and as a result he is monitoring lowered-rated credits in areas that are most susceptible, like health care.
“We want to see a migration up in credit quality as we approach the end of the economic cycle, but we are not forcing it," he said. "We are letting it happen somewhat naturally through maturities and very selective culling of some of our weaker A-rated credits.”
This strategy is one that Golden began implementing in late 2017 and has accelerated with the commencement of Jan. 1 calls and redemptions earlier this year – and one he says will remain in use through at least the spring reinvestment season.
Other areas of the market that have performed well for Golden in the last year or so include the essential service revenue sector, as well as power, water, and airport bonds. He has also increased his exposure to annual appropriated debt, such as high-quality bonds for local municipal projects, like court facilities.
“There has been a general tilt toward some of the areas that do have a history of being a little bit more volatile from a municipal standpoint, like appropriations, and health care names, but all of our health care names are very broad-based statewide type systems,” he explained. “We would be very careful with single location, rural-type hospitals at this particular juncture.”
Golden is also utilizing premium, or kicker, bonds to hedge longer-term maturities with shorter-term calls as a way to get exposure to the eight to 12-year slope of the yield curve, though he still maintain a fairly defensive duration.
Golden said it is the perfect time to implement the use of premium bonds because of the extra cash they provide in the current market.
“The reason you are paying a premium for the bond is the incremental increase in cash flow or the higher coupon that comes along with it – that also means the bond is less sensitive to interest rates,” he said. “You have a larger portion of your money coming back to you for reinvestment and it lets you keep pace in a rising rate environment a little bit better.”
While some clients are on edge about rising rates in the high-grade bond market, maintaining the defensive duration helps allay some fears, according to Golden.
His biggest advice to the advisors and retail clients is to keep in mind why they invested in municipals in the first place. “They lend themselves to capital preservation and they provide the highest levels of income available in the marketplace on a risk-adjusted basis for clients that carry high tax liability,” he said. “And that’s not going to change.
“The reality about investing for preservation and income is: time in the market is paramount,” he continued. “So for us it’s staying invested and doing so in an intelligent and defensive manner,” including maintaining above-market 5% coupons, a high-quality stance, and short to intermediate duration, he said.
Future stability, strength, and support
With the yield curve flat, the potential for an inversion may give Golden reason to consider new strategies for the future.
“Should we begin to see an inversion of the yield curve it probably indicates we are two or two and a half years from the end” of the current economic cycle, he said. “After an inverted yield curve you typically have positive equity market performance on average for the next two years.”
Golden said he would need to see an increase in term premiums and more compensation for extending past 12 years versus the current “very modest pick up in return for two-thirds increase in duration risk.
“As long as we see a fairly healthy globally synchronized growth story we are going to maintain the same stance,” he said.
In the meantime, Golden intends to keep his laddered, disciplined, and diversified approach within the context of high-grade bonds in tact as he finishes out 2018 – with a watchful eye on rates.
“I do think munis end up as the best performing asset class in fixed income; it doesn’t mean I think they’re going to have positive returns, it just means on a relative basis they are going to be better than high-grade corporates and Treasuries,” Golden said.
“You have certainly seen an argument for high-grade bonds as a ballast given the recent equity market volatility recently,” he continued. “I think you’re in the beginning stages of an expectation that higher-grade bonds and bonds used for capital preservation and income are coming back into vogue a little bit.”