When municipal bond professionals at New York City-based Lord, Abbett & Co. say they plan for future events, they don't necessarily mean something that may happen in the next few years.
In 1987, the firm established a Texas fund, despite the fact that the state did not have an income tax and therefore little incentive for investors to own local tax-free securities. Municipal investment director John Mousseau said he felt that at the time, Texas credits were underrated because of the state's reliance on the oil industry, which was beginning to dry up.
Lord Abbett's creation of a Texas fund - which now stands at $96 million - is an example of the firm's long-term approach to tax-exempts, despite the fact that it hasn't benefited yet from this particular move.
"It's now been 10 years and there's no income tax, but there could be," Mousseau said.
This level of preparedness led to a tweaking of the firm's muni bond department this summer with the hire of an additional credit analyst in anticipation of wider credit spreads.
A possible economic decline, coupled with a new understanding of credit quality, is likely to produce wider spreads, according to Mousseau. That scenario would finally recreate a world where it might actually pay for investors to go out on the credit spectrum toward more speculative bonds.
Then the firm would need additional research and analysis of each individual credit, opening the door for below-investment grade bonds and even nonrated deals.
"There is no doubt that we have benefited from the reliance on structure over credit," Mousseau said.
To ensure that Lord Abbett maintains its ability to capitalize on the wider credit spreads, this July the firm hired Lina Brandow, who was with Lehman Brothers for 15 years as a credit analyst, to pounce on a burgeoning trend as soon as it rears its head.
Relying on Structure
"We're looking for spreads to widen, so we're studying the issue," Mousseau said. "But right now it pays to be in quality."
Mousseau has relied on credit quality so much that more than 80% of Lord Abbett's $650 million national portfolio is now rated double-A or higher. Nearly half is insured. At a time when investors are looking for greater income, Lord Abbett has stayed its course, avoiding the creation of a portfolio of high-yield credits. But Mousseau and others acknowledge that this might change.
"In the stock market and the high-yield market, you are well compensated for taking significant risk," said Zane Brown, a partner and director of the firm's fixed-income department. "But dipping down in credit in the municipal portfolio compromises the liquidity.''
For now Lord Abbett relies almost exclusively on structure to shape the firm's 14 municipal bond portfolios. By tailoring funds' durations, calls, and convexity, Mousseau and his team have achieved a commendable market presence. Many of its funds compete with the municipal business' big players such as Salomon Smith Barney Inc. and San Mateo, Calif.-based Franklin Investment Advisers.
According to Sarah Bush, a mutual fund analyst with Morningstar, Lord Abbett has one of the peer group's most actively managed funds. Since 1994, the national fund's duration has fallen anywhere from 6.9 years to eight years, reflecting management's position on interest rates and the general direction of the national economy.
Currently Mousseau is veering to the long end of his duration target - ranging between 7.75 years and eight years - while he expects rates to decline further.
"We extended back in April, and I was looking for bonds with good call protection or prerefunding candidates," Mousseau said.
However, this tactic of staying on the long end sometimes backfires. With several unexpected interest rate hikes by the Federal Open Market Committee in 1994, Lord Abbett's long duration hurt the firm's performance.
That year, the national fund's total return declined by 8.27%, compared with the 6.54% decrease by the other funds in the category, according to Lipper Analytical Services Inc.
"The one lesson that we learned was to have a higher threshold for what we considered a defensive bond," Mousseau said.
The funds' current configuration is designed for a falling interest rate environment, he said.
Duration management is one aspect of Mousseau's approach. Others include finding undervalued credits and evaluating the investment community's next step. He uses the national portfolio as the canvas to paint his department's overall strategy.
The single-state funds, however, tend to be at the mercy of issuers and do not have the ability to choose among the specific deals that conform to this style.
Staying Private
Having a handle on the market comes from Lord Abbett's investment culture. Established in 1929, immediately after the stock market crash, the firm started one of the country's first stock mutual funds. Remnants of this fund's holdings still remain in the equity funds.
By 1984, Lord Abbett launched its municipal bond department with the national fund. It added single-state portfolios as the need arose, with the last batch established in 1994. The firm now sponsors funds in such unlikely markets as Hawaii, Washington, and Georgia, in addition to individual accounts and insurance company investments for total tax-exempt assets of $3.3 billion.
Since its first days, Lord Abbett has remained a limited partnership, despite last year's rumors that the firm could be an acquisition candidate for a larger money management complex.
"It's popular to look at firms that are still private, and expect them to go public ," said Brown, brushing aside market gossip. "We try to continue to point out to people that we are expanding the partnership and we have no intention of going public and expect to be private for a very long time."
Being a private firm dictates a conservative investment style across all asset classes, according to Brown. And the municipal funds are exemplars of that approach.
"Private firms tend to be a little bit more hands on," said Joe Deane, director of Salomon Smith Barney's municipal investments at Greenwich Street Advisors, the firm's asset management unit. "But the bottom line for any company is that performance over a long period of time is what matters.
Morningstar's Bush says that the national fund has managed to keep pace with the competition, even against large competitors like Smith Barney. Lord Abbett has done it primarily with high-grade bonds.
Over the last few years, the move in the municipal market has been toward the lower-quality bonds, and many of these funds have become high performers, said Bush. Boston-based Eaton Vance Management, for example, has large positions in high-coupon paper, in addition to nonrated bonds. Despite this disadvantage, Bush said Lord Abbett has held its own by paying more attention to the funds' structure than most of its competitors.
The firm has been aided by the funds' small size. Municipal market participants say that when it comes to fund management, smaller funds have a built-in advantage. They can seek out smaller pieces from lesser-known issuers for additional income. Large funds can sometimes become difficult to maneuver if they cannot find a deal with enough heft.
"For funds with smaller size, it takes fewer trades to effect more significant changes," Deane said.
Both Mousseau and Bush are quick to point out that Lord Abbett also takes a value-added approach to the market, tapping the municipal bond market's natural inefficiencies. Late last year when others were seeking noncallable paper, Lord Abbett backed off from noncallable bonds feeling they were overpriced.
"That was refreshing," Bush said.
Anticipating the Market
Late last year when American Capital Access began insuring lower-rated credits to a double-A grade, some investors groused that additional credit enhancement would dilute yields even more. But Mousseau saw an opportunity. He bought ACA insurance for a slew of his triple-B names in his portfolio, knowing that with the insurance, these credits would now become more amenable to retail investors.
Lord Abbett was able to capture the spread between the amount it paid for the insurance and the appreciation at which it eventually sold those credits.
Mousseau executed another contrarian play this spring. Several weeks prior to the Long Island Power Authority's $4.5 billion sale, Mousseau noticed that fund managers were clearing their inventory of "perfectly good bonds" to make way for the newly minted credits. Prices on these other bonds cheapened and yields increased as portfolio managers unloaded them.
"But I knew nobody was going to get near the number of LIPAs they wanted," he said. So, Mousseau bought up the bonds that were out for bid. Almost as soon as the dust settled on the LIPA deal, June and July coupon reinvestment hit, forcing funds to buy. And Mousseau and his team had bonds to sell.
"That was the play of the year," he said.
Could these tactics be replicated over and over to outsmart the market?
"That horse has left the barn," said Mousseau, adding that each month brings new chances to put Lord Abbett's preparedness credo into action.
