Jonathan Law applies a traditional three-pronged strategy of defensive duration, holding average coupons above his benchmark, and maintaining portfolio diversity, to reap rewards for the separately-managed accounts he oversees as a portfolio manager at Advisors Asset Management.
However, it’s also the ability to be agile in volatile market periods that has allowed his SMAs to continue to find valuable opportunities as the market braced for rising interest rates over the past three years.
“In this environment, it’s crucial to be flexible and nimble,” Law, a vice president at AAM, told The Bond Buyer in an interview last week from the New York office of his brokerage and advisory firm.
Assets under management total $19.8 billion, including $370 million of municipal securities as of Dec. 31, according the firm, which specializes in asset management and sales and distribution services for institutional managers.
AAM’s Core Tax-Exempt Strategy is focused on investment-grade techniques to maximize stable income and returns, maintain credit quality, safety, and diversity, while minimizing investment risk, according to Law.
To help achieve his investment goals of earning tax-exempt income and capital preservation, he manages his SMAs to replicate the Bloomberg Barclays Municipal 1 to 10 -Year Blend Index, which has a duration of four years, and includes investment-grade tax-exempt bonds with maturities between one and 12 years.
He aims for his SMAs to achieve 85% of the benchmark’s duration.
His objective is to be nimble enough to know when to veer from his traditional three-tier strategy in order to provide value for his clients – even if that means being slightly more or less defensive or postponing trades.
“Given where the markets are at any given time, we make sure we don’t always have to be aligned with our benchmark,” he said. “Or, we can choose to delay reinvesting our cash positions just because the market appears frothy to us, or because of where ratios are, or due to a number of things maybe it’s time to be a little more cautious,” Law added.
This agility gives him the opportunity to hold or swap when the markets are rallying, according to Law, who has nearly a dozen years of experience in the investment industry, including the last four years as a portfolio manager at AAM, where he originally began as a municipal analyst in 2009.
The strategy has proven successful lately as the Core Tax Exempt SMA – one of the accounts Law manages – received a 5-Star Morningstar rating for the 3-year, 5-year, 10-year and overall category as of 3/31, according to the firm.
“Even with that defensive duration, on paper you are expected to underperform, but because of our careful positioning and buying on the dips and selling on rallies we have the ability to keep pace,” Law said.
Law has been in the investment industry for nearly a dozen years. Prior to AAM, he was a portfolio analyst at Pilot Advisors, a New York City-based hedge fund/investment manager, where he researched equity and fixed income securities, executed trades and monitored long-only portfolios.
He said another part of his strategy at AAM is to consistently find value in the single-A-rated space that compensates clients for the lower duration.
Meanwhile, Law’s goal of upholding portfolio diversity leads him to own bonds from the airport, transportation, health care, and higher education sectors that have single-A ratings – when and if available. In addition, he often buys single-A-rated paper backed by special taxes, like sales tax revenue bonds or gas tax bonds, as well as a small amount of general obligation or lease revenue and annual appropriation bonds.
Portfolio diversity, according to Law, is one of the most underrated aspects of a municipal portfolio. “You often don’t see the benefits unless or until something goes wrong,” he said. Even though he buys strong performing states and sectors, unforeseen budgetary or political stress could be problematic if a client’s portfolio is over-weighted in one credit or state, and lacks diversity, Law said.
This could be difficult, for example, if an investor who owns 100% of their municipal assets in one particular state such as New York, California, or New Jersey.
“No state is immune to rising pension liabilities,” or potential budgetary stress, he said, adding that states like California experienced financial difficulties in 2009, and New Jersey is one of the latest states to face fiscal debacles.
“As long as our eggs are spread across different states, sectors, and maturities, that is the most efficient way that we perform adequately and have a sound portfolio – and stay away from negative headlines,” Law said.
Law prefers 5% coupons that are above the Barclays benchmark so that the “vast majority of the total return is derived from interest income verses relying on the market price fluctuations of discount bonds offer.”
That helps with liquidity, he said, since most professional asset managers also prefer 5% coupon bonds.
Scarcity makes it challenging to find both single-A-rated and 5% coupon bonds in today’s market – but Law said it’s a function of supply and demand.
“Finding any bond that’s not in the headlines or with a stable credit within the short to intermediate space where we dwell has been challenging – not necessarily just 5% coupons,” he said.
Despite the struggle, Law said it is just as important to know where to look for yield as is to know where not to look.
His core principles of maintaining diversification with a stable credit profile – and not reaching too far for yield – helps keep his portfolios on track and minimize investment risk, he said.
“If you look back five years ago, a significant portion of the highest yielding bonds back then are plastered all over the headlines now,” he said. “If you stay away from those you come out with a strategy that keeps pace with benchmarks and during a bull market – and outperforms during a bear market.”
The strategy has attracted inflows over the past year as investors seek shelter from market volatility stemming from expectations of rising rates, as well as the changing political landscape.
He cited the Federal Reserve Board’s two interest rate increases since the fourth quarter of 2016, as well as the pro-growth Trump administration, among triggers of recent market volatility. At the same time, he feels his clients’ municipal portfolios are well positioned for the third quarter and doesn’t expect to alter his initiatives.
“We are staying the course,” he said. “We are comfortable with keeping defensive duration, above average coupon, but moving moderately down the credit space with single A bonds to compensate for a defensive duration,” he said.
Even with uncertainty regarding health care and tax reform later this year – as well as the expectation that the Fed will raise rates in June and September – Law is prepared for the ride.
“The vast majority of our portfolios have multiple maturities coming due in the next few years so we will have natural opportunities to reinvest at potentially higher levels,” he said.
His advice to investors going forward is simple: invest in municipals for their inherent purpose, which is stable income, reduced volatility, and as a means of diversifying away from traditional equity and corporate portfolio allocations.
“For investors who understand the underlying principles, there should be no reason to panic and sell out” during volatile market periods, Law said.
While equity strategies may allow investors to switch asset allocation to more defensive sectors in a downturn, selling out of municipal positions during volatile cycles can result in opportunity loss, he added.
“There is opportunity cost of not collecting coupons and interest during that [volatile] time, and history tells you it’s very hard – if not impossible – to time the markets," Law said.