Municipal portfolio managers say they are finding value in various pockets of the market, ranging from premium bonds to potentially refundable debt.

Managers say they are letting their risk tolerance and interest-rate outlooks dictate how and where they are uncovering value in the second half of 2011, and are optimistic about continued opportunities should weekly volume reach the $8 billion average seen in the fourth quarter of 2010.

Volume is down about 44% for the first half compared with the same period last year. In June it averaged more than $5 billion a week, up from an average of $3 billion a week for most of the year.

While absolute municipal yields now remain at historic lows, managers are gleaning value by using various strategies: shortening their duration, increasing exposure to lower investment-grade credits, and buying short premium bonds for high current income and protection from rising rates.

The first quarter roller-coaster saw the 10-year triple-A general obligation bond yielding 3.31% as of Jan. 31, according to Municipal Market Data, while the 30-year was at 4.78% at the height of municipal volatility and heavy speculation about widespread defaults and bankruptcies.

By June 30, the end of the first quarter, the 10-year dropped to 2.75%, while the 30-year dipped to 4.35%, according to MMD.

On Tuesday, the benchmark 10-year muni yield fell four basis points to 2.66%, while the 30-year yield also lost four basis points and closed at a 4.30% — both 32 basis points under their averages for the year.

Dick Berry, managing director at Invesco Ltd. in Houston, said he is maintaining a conservative stance and is focusing on quality and safety at the short end of the market. As an example, he cited non-callable premium bonds due in 10 years or less with an A rating or better.

“I would rather protect principal and sacrifice income,” said Berry, who manages the $1.3 billion Invesco Tax-Free Intermediate Fund and the $500 million Invesco Municipal Bond Fund, as well as several high-net-worth private accounts.

“The premium is amortized against income over the life of the bond, so there’s no problem with the net-asset value being affected in a negative matter,” he said.

He used the same approach in the first half, Berry said, adding that it appeals to baby-boomers whose focus has shifted from growth of assets to income as they get closer to retirement.

“We are not altering our portfolios, but maintaining a defensive posture,” he said.

As of Tuesday, the Class A shares of Berry’s intermediate fund posted a year-to-date return of 3.96%, while the Class A shares of the municipal fund posted a year-to-date total return of 4.34% as of June 30, according to Invesco’s website.

While he declined to provide specific examples, Berry said he is active in the revenue sector, and prefers water and sewer and other utility bonds whose predictable cash flow makes them attractive, as well as select “out of favor” hospital bonds.

The website said hospitals make up 22.09% of the intermediate funds’ total assets and 15.02% of the muni fund’s total assets, while municipal utilities and wastewater bonds make up 11.38% of the muni fund’s total assets.

But because his cash flow has been flat to moderate, Berry is relying on reinvestment cash instead of net inflows these days. “Cash flow has leveled off to practically nothing,” he said.

“We maintain what I call a flexible ladder — with bonds coming due each year where we are constantly reinvesting the principle — or if rates do go up we have maturities to reinvest,” Berry said.

After enjoying net inflows in three of the previous four weeks, the week ended July 6 saw net outflows of $272 million for muni bond funds that report their flows weekly, according to Lipper FMI. The previous week saw investors allocated $163 million in muni funds.

Berry said he is anticipating a spike in volume before year-end to further bolster availability and value.

“Supply has been very modest this year, but there’s an incentive for issuers to come to the market place because rates are at historical lows,” he explained. “I think new-issue supply in the second half will be in the form of refunding more than anything else.”

Other managers say they are also reaping rewards from sectors and structures they now deem attractive.

 “For our faster-trading institutional investors, one of the keys to outperformance in the second half of 2011 will be to stay nimble and stay liquid,” said Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott, a Philadelphia-based financial services firm.

“Being able to take advantage of shifting investor risk-aversion by buying munis when nervousness is high and selling when calm ensues will help performance in this low-rate environment,” he said.

To help Janney’s institutional clients do so, LeBas is recommending a strategy of investing in larger, more liquid issues, generally maturing in the 10-year-plus part of the yield curve where LeBas says investors “get the most bang for the volatility buck.”

He said one example of a nationally traded bond that fits that bill is New York City Municipal Water Finance Authority 5% coupons due June 15, 2032. A $1 million block of the bonds, which are rated Aa2 by Moody’s Investors Service and AA-plus by Standard & Poor’s, traded on Tuesday at a 4.34% yield to the 2021 call.

Meanwhile, for its buy-and-hold institutional and retail investors, LeBas said the firm is recommending higher-quality names in out-of-favor sectors, such as double-A rated hospitals in the 10-year slope of the curve trading at spreads between 85 and 90 basis points wider than the triple-A benchmark.

While credit concerns have dictated many investors’ buying habits so far this year due to the market’s volatility and uncertainty, Nat Singer, a partner at Swap Financial Group in South Orange, N.J., said he is relying on structure to influence the performance of his portfolios.

“My focus personally has been in the secondary market buying premiums — 5% to 5¼% coupons — priced to three to five-year calls with 10-to-13-year final maturities,” he said.

“The yield pick-up to the call is huge versus serial bonds — often over 200 basis points — and the kick is significant enough to offset the limited negative convexity.”

“Advance refundable structures provide the added potential for a pop if yields remain low and negative arbitrage can be sufficiently offset,” Singer said. “Even under a moderate inflation scenario, this structure provides an attractive trade-off between tax-exempt income and a fairly defensive overall posture.”

Lyle Fitterer, head of tax-exempt investments at Wells Capital Management, says he’s in no rush to spend cash, but added that he prefers A-rated and select triple-B credits maturing in less than three years or beyond 10 years, while he has continued to be overweighted on credit for several months.

“The ratios in terms of high-quality munis don’t look that attractive in the three- to 10-year part of the curve, so it could underperform if there was a further sell off,” Fitterer said.

Specifically, he sees value in state general obligation bonds, like Illinois and California, short-term health care paper, and select tobacco bonds, like those from the Illinois Railsplitter Tobacco Settlement Authority.

Fitterer now owns Railsplitter bonds with 6.25% coupons due June 1, 2024, which are rated A-minus by Standard & Poor’s and BBB-plus by Fitch Ratings.

On Tuesday in the secondary market, there were two trades to customers on those bonds at a $106, or a 4.85% yield, according to the Securities Industry and Financial Markets Association’s website,

Fitterer said you get much better liquidity with A-rated and triple-B bonds, adding that “triple-B bonds look more attractive than high yield does.”

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