Short and selective. That’s the fixed-income philosophy Guy LeBas, director of fixed-income strategy at Janney Montgomery Scott, is increasingly focused on in 2013 due to the predominance of interest-rate risk in the market.

While LeBas has been implementing the strategy for a while, he said it’s more important than ever to maximize returns by favoring shorter maturities with a hint of credit risk, and limited exposure to the long end of the yield curve.

“Much of the risk in the U.S. markets is related to interest-rate risk — the possibility of the Fed to change policy and inflation. Even though they are not likely, they are still major risks,” he said. “It stands to reason the best risk-return tradeoff is to look at those securities in the bond market not related to this level of major risk,”

Since ratings generally correlate with credit risk, investors can maximize their returns by taking on select credits that actually have a slightly speculative nature, or are perceived as riskier, he said.

Given the current slope of the muni yield curve, to achieve this strategy, LeBas urges focusing on credits in the investment-grade health care and single-family housing sectors in the 10-year and under range — especially the seven-year area, which he deemed “attractive” enough to give investors more bang for their buck and the best cushion against higher rates.

So far, the strategy has proved to be a winning one in the first two months of the year, he said. In the muni market, single-A and double-A health care credits and housing paper are delivering the results that LeBas expects. “Spreads are still relatively wide because of perceptions of those two sectors in the post-2008 world,” he noted.

He’s also quick to point out that ratings are only an initial indicator and not a wholesale recommendation for owning a credit. His firm still advocates strong credit analysis when weighing the pros and cons of individual credits on a case-by-case basis, as well as maintaining guidelines for credit limits in a fund’s prospectus.

For investors subject to redemptions due to calls or maturing bonds on the long end of their portfolios, LeBas recommends shortening duration by rotating out of the long, higher-rated assets that are more sensitive to interest-rate risk in exchange for shorter, credit-sensitive securities.

For instance, double-A-rated health care credits with seven- and 10-year maturities both on Wednesday traded at a 61 basis-point spread to the generic triple-A curve, according to Municipal Market Data.

Double-A-rated single-family housing bonds due in seven years traded at 90 basis points higher, while those due in 10 years traded 95 basis points higher than MMD’s generic scale Wednesday when the 10-year triple-A rated GO scale was a 1.28% in 2020 and a 1.85% in 2023. Due to the low absolute level of rates, LeBas said muni investors have warmed to the idea and have recently been inclined to favor limiting interest-rate risk, in exchange for increasing credit risk, if and when possible.

“There is a willingness from investors across the spectrum to take on credit risk, even though it’s a little bit non-traditional” in a market historically known for having a bias toward high-quality paper, he said.

LeBas said most of the trading at Janney is taking place in the new-issue market, where he said volume has been a little bit slower on average, “but not a huge problem.”

He expects to be able to execute his philosophy for the remainder of this year and early next year — during which he expects only a moderate rise in interest rates — and that health care and housing bonds will continue to outperform in any instance where rates are rising.

In general “credit spreads have compressed a great deal across markets, including munis,” LeBas said. “The triple-A and triple-B spreads have contracted, but they have further to go.”

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