How lower rates are driving year-end investor strategy
Municipal experts are betting on lower credit quality and lower coupon bonds to take advantage of an interest-rate driven swell in issuance as 2019 comes to a close.
Managers said they are seeking out single and double-A-rated bonds for their yield and attractive spread to the triple-A market, while favoring 3% and 4% coupon bonds for their spread to traditional 5% coupons— and because they are better poised to outperform in the declining-rate climate.
Even after a recent back-up, municipal yields on generic triple-A bonds in 10 and 30 years have declined year-to-date to 1.50% and 2.09%, on Refinitiv Municipal Market Data’s AAA benchmark scale as of Nov. 22, from 2.27% and 2.99% on Jan. 2.
The 10-year muni-to-Treasury ratio was calculated at 84.7%, while the 30-year muni-to-Treasury ratio stood at 94.1% on Nov. 22, according to MMD.
“The best value that we have seen has been in A-rated and some double-A-rated paper as the spreads versus triple-A have slightly widened” between 20 and 80 basis points, Howard Mackey, managing director at NW Financial in Hoboken, New Jersey, said in late November.
Spreads on A-rated bonds have widened even more, he said, citing the $350 million New Jersey Health Care Facilities Authority deal on behalf of Valley Health Systems, which was oversubscribed for its attractive yields on Nov. 20.
The single-A-rated deal’s spreads extended to nearly 100 basis points over the double-A and triple-A market, with most of the value on the long end, appealing to large mutual funds that are otherwise credit sensitive, Mackey said.
The availability of 3% and 4% coupons, instead of the standard 5% coupons, helped sell the deal, he said. Its 3% coupons due in 2049 were priced attractively at a 3.15% yield, seven basis points lower than the initial pricing yet still at a spread of 106 basis points to the benchmark triple-A scale tracked by Refnitiv Municipal Market Data.
At the time of the pricing, the generic, triple-A general obligation scale in 2049 yielded 2.09%.
Meanwhile, the 4% coupon bonds were 25 to 30 basis points higher in yield than the standard 5% coupons in comparable deals at the time of pricing, Mackey said.
He said he is watching deals of similar credit quality, yield, and structure to add value to clients’ portfolios as 2019 closes.
“I would say the strategy is going to be looking at where there is value and the credit quality you are comfortable with,” he said, adding that a spread differential of between 20 and 30 basis points or more on double-A and single-A paper would continue to pique interest among investors through year end.
“If you have flexibility in credit, you might be able to find some value with bonds that are not triple-A rated,” even though the demand is high and the supply limited of lower-rated paper, particularly in specialty states like New Jersey.
“You have to look for bonds that are going to give you yield where the credit works for you and where you do your credit work,” Mackey said, adding select triple-B credits to his list of potential yield opportunities.
Adding value is also high on the list of year-end priorities for other managers.
Michael Pietronico, chief investment officer at Miller Tabak Asset Management, is striving to keep all of the firm’s separately-managed account clients as fully invested as possible for the remainder of the year.
“The recent spike up in supply has been a benefit to investors as it created an environment where multiple investment choices were available all along the yield curve,” he said earlier this month. “That, combined with the back up in rates, has opened our eyes to much better entry points to put cash to work,” he said.
Lower coupon bonds have worked well so far, according to Pietronico.
He said he intends to continue buying that structure as the year comes to an end, because the lower coupons “offer significant spread to 5% coupons and are better suited to outperform should rates continue to decline as we expect.”
Pietronico is keeping an eye on overseas developments, too.
“Global growth will remain somewhat challenged for the immediate future, and as such reinvestment risk should be the greatest concern for fixed-income investors,” Pietronico said. “We are positioned neutral to our benchmarks at the moment, but should a trade deal be reached between China and the United States we would expect to see rates move higher and the curve steepen.”
Under that scenario, he said he would extend duration into weakness and position for a new cyclical low to be reached in U.S. Treasury yields.
“We remain concerned that global growth will underwhelm, even if a trade deal is reached, and as such, buying on weakness should remain a theme here,” he continued.
From a technical standpoint, Pietronico added, the tax-free municipal space could see greater demand for less bonds if the current spike in taxable municipal bond supply remains a constant feature.
Laddered and barbell strategies
Managers like Sean Carney, head of municipal strategy at BlackRock Inc., are flexing their municipal muscle by taking advantage of the yield and liquidity available in bonds maturing in zero to five years, while adding income by allocating to the 20-year part of the curve,
“One can achieve 93% of the entire curve by just going out 20 years while accepting less duration risk than going out on the curve,” he said, explaining the benefits of the barbell strategy.
For the remainder of the year, he expects to continue to look for opportunities that have created alpha, such as adding securities subject to the alternative minimum tax, when and where appropriate, given the additional issuance and spread to non-AMT securities.
Like others, Carney favors lower-rated investment grade securities, such as A-rated bonds, that have outperformed the market by more than 50 basis points year to date with a very similar duration measure, he said.
“Since the crisis, the A-rated space has, on average, outperformed the broad market by 100 basis points, which is meaningful in a low-rate environment,” Carney said.
“We also look for opportunities in structure, where there is an appropriate spread between 4% and 5% coupons in the same deal or when a call feature offers additional spread that the market is not properly pricing,” he said.
Others say year-end will bring a chance to benefit from a laddered municipal bond structure and the taxable municipal product available this year.
Alan Schankel, managing director and municipal strategist at Janney Capital Markets, said his firm is recommending clients “stay the course” as the end of 2019 approaches.
With interest rates near historic lows as 2.09% in 30 years, he suggests clients keep target portfolio duration in the mid-range, at four to seven years, in order to balance the yields available from longer maturities with interest rate risk.
Schankel is also using a 15-year laddered structure that favors a mix of 4% and 5% coupons, which provide cash flows and some defensive characteristics.
“We recommend that clients take advantage of the recent surge in taxable muni issuance to broaden diversity in tax advantaged accounts, such as IRAs, by adding munis to traditional taxable positions, like corporate bonds,” Schankel said.
Supply swell, seasonal signs
Ample supply, meanwhile, should continue to generate demand and support the market through the end of the year, as issuers take advantage of lower rates, according to municipal experts.
“Although things may slow a bit next week due to the [Thanksgiving] holiday, we expect the pick-up in primary issuance of the past two months to continue into December,” Schankel forecasted.
“The growth in volume could consist of taxable refundings or shorter call bonds — or simply just new money deals,” John Mousseau, president of Cumberland Advisors, predicted.
“At a time period when rates are low, and the 10-year Treasury is at a rate lower than the rate of core inflation, it would appear to be a great time to sell debt,” he said.
The exorbitant amount of demand this year would have little trouble absorbing even more supply through year end, the muni specialists said. The market welcomed more than $9 billion in new paper the week of Nov. 18.
Carney of BlackRock said the absence of some seasonal strategies could also offer potential opportunities come year end.
“With minimal — if any — tax-loss swapping being done this year, the January effect is something we will look to take hold late in Q4 where demand outpaces supply around the turn of the calendar and in anticipation of a quiet start to the year on the issuance front,” he said. “This imbalance tends to create strong performance in the back half of December carrying into the new-year.”
On the economic front, Mousseau expects to see improved numbers as the recent steepening of the yield curve as well as an increase in European yields would suggest that behavior.
“When you look at the massive flows into bond funds this year it becomes worrisome, as those could be outflows in a bond market which surprises on upside yields,” Mousseau said.
The one thing that no one is counting on is a possible tax loss swap season, he said.
As a result, he advises municipal investors to always “expect the unexpected” as the market bids farewell to 2019.