Buoyed by the strength of the long-term municipal market over the past 18 months, mutual fund assets have climbed to record levels, and portfolio managers have had little need to make major changes to their current investment strategies.
“At this point, we see little risk of rising rates given the sovereign conditions globally,” said Gary Madich, chief investment officer for fixed income at JPMorgan Asset Management in Columbus, Ohio.
“We see the [Federal Reserve] on hold until late this year or early next year due to low inflation, improving — but weak — employment conditions, and weak housing markets,” he said.
Madich said the firm avoids timing the market, instead employing strategies it believes will boost performance and act as a cushion against eventual rising rates.
“Longer-term, upward pressure on real rates seems likely given the growing indebtedness and an improving backdrop to economic conditions,” he said.
With no immediate threat of a substantial rate hike on the horizon, some portfolio managers are focused on positioning their funds to perform well in the current low-rate environment.
Others are tweaking their game plans and exploring opportunities across the fixed-income market — both tax-exempt and taxable — that should pay off when rates eventually rise.
The chief options favored by some municipal managers are lower-rated general obligation bonds, high-grade securities maturing within two years, prerefunded bonds, daily and weekly floaters, and callable premium bonds.
Taxable managers, meanwhile, are increasing their funds’ exposure to attractive corporate securities or are using inflation-oriented strategies, among other options, that offer income, diversity, and liquidity.
Municipal managers have had ample opportunities lately to shop as investors continue to pour record amounts of cash into the growing tax-free mutual fund industry.
Investors deposited cash into municipal mutual funds for 12 of the past 13 weeks, according to Lipper FMI, plunking down $612.5 million of new money during the week ended July 14. That came on the heels of the biggest influx of new money in four months, $676.1 million during the week ended July 7.
Meanwhile, inflows for 2010 exceed $20.7 billion, which combined with $15.2 billion in market gains has pushed the industry’s assets to a record $502 billion for the first time ever, according to Lipper.
Mike Pietronico, chief investment officer at Miller Tabak Asset Management in New York City, said he is using new cash to adjust the firm’s muni portfolios. In order to perform in the historically low-rate climate, he is staying fully invested, neutral to benchmarks, and biased toward single-A rated tax-exempt GOs that offer extra yield and are attractive on risk-reward basis.
This stance, he said, will keep funds well-positioned until there is evidence of much higher core inflation, strong and steady job growth in the private sector, and a clear trend in deficit reduction for federal, state, and local governments — three key factors that he believes signal a bear market is imminent.
Pietronico looks forward to uncovering value — if and when rates rise — even if the opportunity is short-lived and yields soon ratchet back down as they typically do when demand spikes.
“We see any substantial back-up in rates as causing more of a buying frenzy as investors refrain from riskier investments, such as equities, until more clarity on the economic outlook is upon us,” he said.
Miller Tabak is focused on increasing yield and income when possible, using diversification to create liquidity reserves, and employing shorter-duration strategies within its tax-exempt and taxable mutual funds.
“We will employ, in our broad market strategies, shorter duration securities, such as floating-rate bonds, to offer adjustments to market rates. In our more opportunistic strategies, we will use emerging market debt and senior bank loans for diversification and rate reset opportunities,” Pietronico said. “Overall, we will take advantage of sectors that throw off monthly cash flows to allow for reinvestment at higher rates.”
Madich said the firm avoids timing the market to capitalize on excessive returns for its $153.3 billion of fixed-income assets under management, of which $38 billion are municipal assets.
“During this type of environment, price discovery becomes very important … and most of our products offer access to liquid bond sectors and strategies as a means to manage liquidity needs,” he said. “We are discussing Fed exit strategies as part of our process, but see little risk of a less accommodative Fed in the very near term.”
The Fed’s stance has supported steady inflows into municipal mutual funds for nearly two years. This year’s inflows are high, but below the $29 billion in the first half of 2009 and $40 billion in the second half, according to the Investment Company Institute.
Flows were positive for all of 2009 following a stream of outflows in late 2008. The industry has grown 47% since the end of 2008, according to Lipper.
The tax-exempt mutual fund industry’s record inflow activity followed an unexpected drop in assets of $232.3 million during the week ended June 30 — only the third time since the end of 2008 that cash fled muni funds, after the weeks ending March 31 and April 14.
With outflows rare and little evidence that interest rates will rise beyond an occasional spike due to temporary volatility, other municipal managers are focusing on shortening duration and reducing price volatility with premium bonds.
They are also staying defensive with short and prerefunded securities to uncover value for their tax-exempt mutual funds, while also buying floating-rate paper for their tax-exempt money market funds.
John Mousseau, a managing director and portfolio manager at Cumberland Advisors in Vineland, N.J., said his firm is promoting strategies focused on mitigating investor fears about rising rates.
That hasn’t been too difficult given the backdrop of low, real, after-tax rates on municipal bonds and expectations of continued low inflation over the next year, he said.
“We expect the Fed will be on hold with short-term rates at least through the balance of the year and possibly into mid-2011,” Mousseau wrote in a recent report to clients.
Cumberland is reducing potential price volatility in its muni portfolios by holding on to existing callable bonds that were purchased in late 2008 and early 2009 that have coupons in the 5 1/2% to 6 1/4% range and have been trading as premium bonds for over a year.
“The calls on the bonds, which were originally nine- to 10-year calls, are now seven- to eight-year calls,” Mousseau said.
He added that portfolios holding such bonds “are becoming self-shortening as their call dates become closer and the effective call moves down at what is a very steep yield curve.”
In addition, Mousseau said many of the same premium-coupon bonds are candidates to become prerefunded as the relationship between longer-maturity, tax-free bonds and Treasuries “moves closer to normal.”
“As some of these bonds become prerefunded, and thus have their call dates become their maturity dates, that will further shorten portfolios,” he said.
Dictated by the very steep municipal yield curve, Mousseau said Cumberland is also finding value by structuring portfolios with a barbell approach.
It holds 25% to 35% in shorter-term paper and the balance out longer between 15 and 35 years — depending on credits and yields — in order to alleviate potential income losses.
“A two-year portfolio would produce about 1 to 1.5 points of income, while a longer municipal portfolio would produce 8.5 to 9 points of tax-exempt income. A portfolio could lose 8 points in unrecognized losses and still be ahead on a total return basis,” Mousseau said. “As this happens, a total-return manager will be taking more defensive steps and selling some longer bonds and moving more assets to the shorter part of the barbell to mitigate loss.”
Bob Auwaerter, head of fixed income at Vanguard, said his firm’s tax-free money market funds hold a large position of daily and weekly floating-rate notes and short-term high-grade tax-exempt securities due within two years.
Meanwhile, its mutual funds hold prerefunded bonds that provide adequate liquidity and protection from unexpected outflows in a rising rate scenario.
“When market liquidity declines there generally continues to be a good bid on those securities,” he said. “They are on the expensive side, but they provide liquidity — even if that liquidity comes at a cost in terms of lower yield.”
Auwaerter said the three types of securities currently represent 8% of Vanguard’s tax-exempt assets, which include $36 billion in municipal money market fund assets and $89 billion of muni mutual fund assets as of July 8.
“I believe rates, by the end of the year, are going to be higher,” but current weak economic conditions could delay any substantial increases until 2011, he said.
“The economy has hit an air pocket right now in terms of growth,” Auwaerter said. “We started to see upward momentum in the job growth, and that has flatlined. The market is reacting to the European sovereign default and European banks are having trouble funding themselves in the money market sector.”
Likewise, taxable fixed-income fund managers also believe a Fed tightening could still be several months away, but some plan to weather a potential rate hike by sacrificing credit quality to increase yield.
“At this moment, our view is the opportunity cost associated with a strategy geared solely toward protecting against rising interest rates is an opportunity lost for investors,” said Joe Balestrino, fixed-income strategist at Federated Investors Inc. in Philadelphia.
“Investors seeking to protect against raising rates — possibly putting their money in short-duration fixed-income products — may be leaving money on the table during what continues to be one of the biggest bull markets for non-Treasury bond products in modern history,” he said.
For Federated’s taxable portfolios, Balestrino favors high-yield and higher-grade corporate debt that “has had a remarkable run that shows little sign of a significant pull-back in the current economic environment.”
“In our minds, and in our portfolios, the more significant impact to total return can be to take advantage of the stronger scenario by going down in quality by increasing corporate bond exposure,” he said. “In doing so, you give yourself the opportunity to participate in the upside.”
He said this strategy works well, especially since “many investors may be overly focused on only protecting the downside of higher rates.”
“The goal is to strike a balance between two variables — average quality and maturity — so that investors can maximize their returns in an improving economy,” Balestrino said.