U.S. Trust is selectively adding high-quality municipal bonds to its investment mix as part of a larger strategy to rebalance portfolios and position for year end.

While yields are approaching all-time lows, the spreads over Treasuries offered by some fixed-income securities, including high-grade munis, are appealing enough to make the case for participation in the sector, according to the firm's 2013 mid-year outlook.

The firm prefers high-quality general obligation and tax-backed bonds of state and local governments, as well as revenue bonds issued by utilities, transportation, higher education, and healthcare systems that may boost returns in a rising interest rate climate. Despite recent pricing volatility stemming from pending tax reform initiatives, these high-quality securities are more appealing than Treasuries, which the firm said are both "expensive and vulnerable" to rising rates.

"Relatively attractive spreads mean that we continue to prefer credit sectors of the fixed-income market for now," Christopher Hyzy, chief investment officer at U.S. Trust, wrote in the report. "Within fixed income, we continue to prefer credit over Treasuries, with an emphasis on corporate bonds, high-quality municipals, mortgage-backed securities, specific non-U.S., non-European, and non-en sovereign bonds for their yield and currency advantages," he added.

Attractive muni-to-Treasury ratios are also a key selling point for high-grade tax-exempt securities, the report said.

As of Tuesday, the 10-year triple-A municipal benchmark bond was yielding 100.7% of the comparable Treasury yield, while the 30-year provided 112%, according to Municipal Market Data. That "is a good indicator that municipal bonds are cheap, particularly given their even greater tax advantage starting this year." Hyzy said. The top marginal income tax rate was increased from 35% to 39%.

The firm avoids municipal high-yield debt, however, versus other attractive alternatives in the high-yield space, according to the report.

"We are maintaining our neutral weight to global high yield, where we are relatively more comfortable with corporate high-yield than municipal high-yield because of the risk that high-profile municipal defaults may cause spread widening in municipals," the report stated.

"While rates remain historically low and future increases will be gradual, we believe that the shift in tone from the [Federal Reserve] and the prospect of higher rates will undermine the attractiveness of yield-plays at the margin."

The firm's overall stance is defensive on the fixed-income side and it is limiting its investment in Treasuries. "We recommend that investors reduce duration in long-duration portfolios to protect the portfolios in a rising interest rate environment," Hyzy said in the report.

U.S. Trust believes June's sell-off in the municipal market was overdone and that the investment environment remains favorable.

"Volatility has been exacerbated by high-profile distressed entities, such as Stockton, Calif., Detroit, Mich., and the Commonwealth of Puerto Rico; and by growing unfunded pension liabilities in certain states, such as Illinois and Connecticut," Hyzy wrote. However, municipal bonds in general remain secure investments, according to the firm, "with the overall economy improving and income and sales tax revenues growing."

Hyzy said the firm expects select areas with weaker local economies, stagnant property tax revenues, and growing pension and other post-employment benefit expenditures to contribute to an increase in municipal downgrades and default rates.

In general, the firm is overweight in domestic equities, meaning it holds more such securities than are in a benchmark portfolio. It also has an emphasis on emerging markets, commodities, and real estate, according to the report.

In addition to concerns over the Federal Reserve Board's exit strategy and the long-term national debt in the United States, the firm is wary of China's slowing growth and shadow banking system, Europe's financial system, the emerging markets' structural deficiencies, and geopolitics across the Middle East.

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