Ronald Schwartz, a senior portfolio manager at Seix Investment Advisors, is sticking with his 2018 strategic plan to take advantage of inefficiencies and opportunities in the municipal market.
The managing director, who oversees investment-grade tax-exempt strategies for the New Jersey-based fixed-income investment management boutique, wants to upgrade credit quality, keep duration neutral to slightly short, and remain selective about diversifying into different sectors, all while trying to add value amid tight quality spreads, limited liquidity, and potential interest rate risk.
“We think quality spreads are very tight at this point of time and there’s a lot of credits where you are not adequately compensated,” Schwartz, who has nearly 40 years of experience in the industry, said in an interview.
“Spreads have tightened and we saw that occurring throughout 2017,” he explained. “The lesser quality credits did well last year, but this year that won’t repeat.”
The illiquidity and volatility sparked by a combination of factors, including the January effect and the changes enacted in the GOP tax bill, could prompt a widening of credit spreads in the near future, but until then Schwartz isn’t convinced lower quality credits are worthwhile.
“The lesser-quality paper is rich on a historic basis, and those bonds are trading tight,” he explained. “If we see those spreads widen out -- which we think could happen this year -- we might invest in that rating or sector.”
Due to the limited supply and liquidity concerns, January has been both a disappointing and difficult month for the municipal market on the heels of the recent tax reform, Schwartz said.
“Everyone anticipated a good January with positive returns due to the lack of supply and that did not develop,”, he said. At the same time, Treasuries have been under pressure due to rising yields.
“There’s a lot of things to discover this year and see how the muni market will evolve after tax reform,” he added.
Doing his homework
Credit analysis, therefore, is a crucial component of his overall investment-grade strategy for the high net-worth individuals who own Seix’s tax-exempt mutual funds and separately-managed accounts, totaling approximately $1.4 billion.
“We look a the credit individually, as well as spreads and yields to see if that’s an adequate compensation for that credit rating and risk,” said Schwartz, who is a member of the firm’s investment policy group.
His quest for high quality is dictated by market conditions at any given time -- and his clients’ investment goals and risk tolerance.
“If the market comes under pressure and there is increased volatility and the market is more illiquid, it’s easier to sell higher-quality bonds than lesser-quality bonds,” he said.
If there is increased volatility, double-A-rated paper will likely offer better capital preservation than triple-B paper, he added.
“If someone is forced to sell in a tough market, there might be limited buyers for the lower-quality paper,” he continued. “If you have a triple-A or double-A bond, that will hold in better than a lower-rated bond in volatile and down markets.”
Schwartz said he uncovers quality in different sectors based on credit analysis, and is currently heavily weighted in revenue bonds, such as those in the transportation sector.
Schwartz said the sector offers the combination of quality and diversity -- two important ingredients of a portfolio’s structure that he believes should help it perform well for investors in almost any market environment.
Within the transportation sector, Schwartz said his clients’ portfolios own airport credits from major national hubs, toll roads, and ports, to name a few. He declined to provide specific credits his clients own.
Additionally, other revenue bond sectors Schwartz favors include water and sewer bonds and special sales tax bonds that he deems attractive based on their fiscal strength, and combination of high-quality and some yield incentive.
On the other hand, he is more selective when it comes to general obligation bonds from different states, and health care credits. After much credit intensive work, he usually passes on those that are under immense pressure and appear in the headlines -- and don’t offer strong relative value to the generic triple-A GO scale, among other criteria.
“With local GOs, we are not as enthusiastic because of pension and health care pressures,” he said. “With health care, we are very selective on hospital bonds due to the pressures that are going on in hospitals,” he said.
Any hospital credits his clients own are typically large, multi-state systems that are well-known, well-run, higher-rated, and appear attractive on a relative value basis.
Preservation and positioning
With a neutral to slightly shorter duration, Schwartz said he recommends owning 5% coupon bonds -- especially if a client is investing beyond 10 years.
“The 5% coupon will be better for capital preservation if rates are going up,” he said. “The 5% will hold in better on a principal basis than a 3% coupon.”
Yield curve positioning is determined by clients’ risk tolerance, he said.
“If you’re duration neutral you want to position in the most advantageous part of the yield curve based on clients’ objectives and constraints,” whether that is the one- to 10-year range, or the one- to 30-year slope.
“We analyze the yield curve and buy bonds in the most advantageous part of the curve – and sell other parts of the curve where retail has a strong demand -- that are better for the overall return of the portfolio,” he said.
“There are times when [the long end] is a very good buying opportunity and other times it’s rich or has rallied quite a bit,” Schwartz added. “Sometimes it’s more advantageous to buy a 30-year than a 2-year – other times the 10-year looks very good.”
He noted that a client is not necessarily adding risk if they buy a 30-year bond as long as they keep their duration neutral.
“We constantly position the portfolios according to analysis of the yield curve, credit analysis, and keeping duration neutral to slightly short – those are our three components,” Schwartz said. “We are active managers looking for inefficiencies in opportunities in either the primary or secondary markets,” he added.
Looking ahead, Schwartz said he will maintain his current strategy through the first quarter and beyond -- barring any major market events.
He predicts that municipals will outperform in 2018 relative to other asset classes, and that there will be heavy appetite for the attractive tax shelter from those investors in a high tax bracket.
“I think investing in munis over the long term for individuals is the only tax-advantaged investment out there -- and I think demand’s going to be very strong,” he said.
“But, in the same respect, this year we will see increased volatility and bouts of limited liquidity,” which Schwartz said raises a red flag regarding credit.
“You have to be flexible this year and do your credit work and be able to react to the market environment,” he said. He warned investors to “be a little more cautious and conservative on credit.”
“I think the lesser-quality credit has had strong performance in the last year or year and a half, so I would say to be a little more conservative on that.”