Why muni managers are keeping it short and safe
Two municipal managers are keeping their credit quality high and their duration low as they adapt to improved liquidity, positive mutual fund flows, and wider credit spreads in early 2019.
With the overall municipal landscape in the first quarter starkly different than that of the fourth quarter, LM Capital's Luis Maizel and Ashton Goodfield of DWS Investment Management Americas Inc., say they are being cautious on credit risk and positioning for interest rate uncertainty.
Their stance remains in place even after Federal Reserve Board Chairman Jerome Powell’s Jan. 30 comments that suggested the central bank has changed its tone regarding future interest rate hikes and indicated the case for raising rates has weakened.
"The conservative position in a long term trend to higher rates is to stay on the short side of the curve," said Maizel, senior managing director of LM.
Investors who need extra yield may decide to extend on the yield curve, now that "the Fed made it a bit easier to move longer with somewhat less risk," said Maizel, the founder of the 34-year-old San Diego-based investment company.
The Fed had previously suggested more than one hike was likely in 2019. Powell's comments followed the Federal Open Market Committee’s widely expected decision to leave its benchmark interest rate target unchanged at 2.25% to 2.50%, where it has been since its fourth rate hike of 25 basis points occurred back on Dec. 19.
Maizel is maintaining his strategy and keeping duration short, as well as focusing on credit quality of triple-B-plus or higher for wealthy clients who are defensive, especially after last year's changes in tax law left them with higher tax bills.
Now that the outflows prevalent in the fourth quarter due to tax loss swaps have abated, the current supply-demand imbalance has provided a positive backdrop for the managers to execute value-added strategies as the first quarter progresses.
“There is more value because of wider credit spreads than we have seen in a while and better liquidity than we saw at the end of 2018,” Ashton Goodfield, co-head of the municipal bond department at DWS, said in an interview last month.
Though the municipal climate has transformed, she isn’t altering the value-oriented strategy for the $4 billion DWS Managed Municipal Bond Fund, which seeks to provide consistent long-term total return and minimize long-term volatility.
The fund has a risk-focused management style that seeks to preserve principal. It also has an effective maturity of 6.41 years, a modified duration of 5.17 years, and its maturities are heavily weighted 10 years and beyond, according to data on the DWS website. The largest exposure to bonds greater than 20 years represents 37.80% of its holdings, followed by 10- to 15-year maturities representing 26.80%.
Maizel, meanwhile, currently manages portfolios for high net worth individuals and retail investors across the country ranging in age from 30s to 60s whose portfolios range from $1 to $65 million. He identifies the securities, evaluates them on the basis of duration, convexity, call features, quality, and yield-to-maturity, and matches them to a client’s investment guidelines.
His credit-quality focused strategy concentrates on a preference for sectors, such as water, toll roads, power, and natural gas, that are directly tied to revenue sources and performance of the collateral, and not reliant on government funding.
Since his clients are highly selective, Maizel aims to position their portfolios with short, high quality paper ahead of any rate volatility that could rock the municipal market later this year.
Underweight, but not overlooking opportunities
One of Goodfield's existing strategies is to keep the fund underweight below investment grade credits because it helps protect portfolios from potential uncertainty and volatility. Occasionally she has added some yield paper — if there is enough compensation — from sectors such as charter schools or senior living, while managing risk without compromising principal protection.
While keeping the DWS fund underweight below investment grade paper is her primary objective, Ms. Goodfield said she has recently added some value with select opportunities on attractively-priced bonds.
The fund holds 41% in double-A paper, 37% in single-A paper, 12% in triple-B bonds, 5% in triple-A paper, 3% in non-rated paper, and 2% in double-B paper.
Although she expects to maintain the current strategy for the DWS flagship municipal fund through the first quarter, Goodfield will add attractive paper on a case by case basis when and if the yield reward is worthwhile.
For instance, she recently purchased bonds from a below investment-grade-rated senior living facility deal that was priced at over 400 basis points to triple A bonds.
In addition, she bought a non-rated new issue for a charter school in the fourth quarter that had an internal rating of below investment grade, but was attractively priced at 300 basis points compared to triple-A-rated paper.
“Because of technical factors during the period — outflows from municipal funds including high-yield funds and a fair amount of lower-quality paper coming to market — deals needed to be priced more cheaply,” Ms. Goodfield said.
She still believes its prudent to remain cautious on the lower-quality segment of the market and is keeping an eye on allocations to avoid potential risk and over-exposure.
“You can’t be too complacent with credit right now,” she said. “As the economy slows down there can be some vulnerability to below investment-grade bonds.”
The strategy contributes to the performance of the flagship fund, whose Class A shares generated average annual total returns of 1.68%, 3.77%, and 5.14%, in three, five, and 10-years as of Dec. 31, 2018, according to data on the DWS website. The fund has historical total returns of 0.11%, 5.64%, 0.12%, 3.04%, and 11.51% in 2018, 2017, 2016, 2015, and 2014, respectively, as of Dec. 31, 2018.
Goodfield is also cautious on small private colleges with fiscal struggles in the higher education sector, as well as small, local general obligation credits with budgetary problems. An expected slowdown in growth going forward could reduce tax receipts at the local level and put some pressure on municipalities’ credit quality, she said.
General obligation bonds represent just 12% of the fund’s holdings, while it owns 74% in revenue bonds, according to the DWS website.
According to Goodfield, strong demand for short and intermediate term paper is far outweighing the demand for paper on the long end of the market in the first quarter.
The short-term slope of the yield curve has gained strength as yields declined since the fourth quarter, while the long end has weakened as yields rose, according to historical yield data tracked by Municipal Market Data.
As of Jan. 29, the generic, the MMD generic, triple-A general obligation scale showed five-year maturities yielding 1.81% compared to 1.94% as of Dec. 31, while the 30-year maturity was yielding 3.09% on Jan. 29, up from 3.02% as of Dec. 31.
Steeper yield curve, steady demand
So far in early 2019, Maizel agreed that municipal demand is steady due to a flight to quality sparked by the recent equity market volatility. Municipals fit the bill for his older, wealthier clients hit by the end of the state and local tax deduction in states like New York and California, he said.
He recommends municipals for his clients who want to benefit from the current steeper yield curve of over 100 basis points between two and 30 years, which is creating more attractive value than Treasuries, whose comparable spread is just above 50 basis points.
“Investors are cautiously entering the market,” he said. “They are not in a hurry, but they are getting in,” and deciding to invest in municipals to gain tax exemption, protect their conservative assets, and minimize investment risk, he said.
“If you believe the market is not going up much, longer paper makes sense,” he added. “If you believe the economy will stay strong, then you should stay short.”
The intermediate slope of the curve is the least attractive, Maizel said.
“The [intermediate] yield curve is pretty flat, and you’re not getting enough juice to lengthen your portfolio” and own a six-year maturity when an investor could own a two-year maturity with less risk. “There has been some spread widening, but not enough to justify the risk,” Maizel said.
By the time the second quarter rolls around, he said, there should be more opportunity with the arrival of expected Fed rate increases and the decline of the 10-year Treasury yield to between 2.80% and 2.90%.
“If spreads hold you will get a quarter to a half a point more” in yield for the intermediate range, and investors would have more entry points for value in that slope of the curve, Maizel predicted.
Municipal tailwind ahead
Going forward, the managers favor the municipal sector, though they said investors should be cautious and mindful of everything from interest rates to global economies when making investment decisions.
Overall, Goodfield favors the municipal market. It held up well during 2018’s volatility and should withstand the expected volatility she forecasts will result later this year from weakening in the real estate sector.
“With our expectations in rates and the slow growth in the economy, that sets up good prospects for the year” in municipals, she said.
“Investors need to make sure the holdings they have in sectors such as land development and project finance are robust and can withstand some of the slowdown we are expecting,” she advised.
The declining rates and the demand for tax-free income should create a tailwind in the municipal market in the first quarter of 2019, according to Maizel, who said he expects two more hikes in March and June, but a pause in September.
By then, the economy could be potentially weaker and the Fed may lower rates in December if it doesn’t pause, he said.
He expects to invest in state issuers because they will be among the better-performing sectors due to their stable finances, and doesn’t expect any major defaults in 2019.
Maizel said investors should stay aware of the macroeconomic landscape — everything from the potential for another government disruption, China trade wars, and domestic markets — and how any impacts from these events could potentially put pressure on wages.
“It’s becoming very unpredictable where the U.S. economy is going, so the macro view is becoming more important than it ever was,” he said. “You cannot look at the muni market in an absolute world, but as part of the fixed income world.”