Talk about a volatile year. It’s hard to believe that, less than three months ago, the incipient US recovery was pronounced doomed by the dysfunctional political process in Washington D.C. Against the backdrop of a Federal government shutdown and a looming political budget showdown in early January, it was certainly hard to conceive the Fed could start reducing its QE efforts before the first quarter of 2014.
Yet, the US economy came roaring back in the fourth quarter, displaying remarkable resilience in the face of all the fiscal headwinds. Even the politicians in the nation’s capital have confounded our (admittedly low) expectations by passing a compromise budget agreement. The Federal Reserve finally became comfortable enough with the economic outlook and the potential market response to start tapering earlier than expected. The end result: for the first time since September, the 10-year Treasuries are once again re-testing the psychologically significant 3.00% mark. Assuming this latest rate rise is not entirely a byproduct of thinly-traded holiday markets, we may just have entered a new phase of the interest rate cycle.
If rate volatility is indeed here to stay, how should muni investors position themselves in such an environment? Here are some of our thoughts.
For decades, one of the ongoing debates among professional muni investment managers has revolved around whether tax-exempt portfolios should be managed for “yield” or for “total return” (“total return” also takes into account changes in the market value of the portfolio). On the one hand, proponents of the “yield” approach would argue for maximizing a portfolio’s income stream and letting that income stream compound on a tax-free basis over the investment horizon. “Total return” managers, on the other hand, would try to adjust the credit quality and duration characteristics of their portfolio, depending on market conditions, to achieve the best combination of income and capital gains (or losses, as the case may be).
Now that the secular decline in interest rates is on its last leg, the tide may finally turn in favor of “yield” investors.
As discussed in our recent book, both approaches may be equally valid, depending on where we are in the economic cycle. In a weak (or weakening) economy, which implies falling interest rates and widening credit spreads, a total return strategy emphasizing duration risk over credit risk should produce the best performance. Conversely, a strengthening economy should be more supportive of a credit-driven, yield-oriented approach.
In strongly trending markets, such as the one we’ve had over the last decade, with interest rates declining to generational lows, the two investment approaches can produce sharply different results. In 2011 and 2012 and through the first quarter of this year, “total return” managers by-and-large outperformed “yield-only” managers, as the capital gain component of muni returns significantly outstripped the income component. Duration-driven strategies which rely on high quality, very liquid issues also outperformed strategies based on higher-yielding but liquidity-challenged investments.
That was the past. Now that the secular decline in interest rates is on its last leg, the tide may finally turn in favor of “yield” investors. As a matter of fact, in 2014, assuming we go into a moderately rising rate environment, you should expect the bulk of the return on your tax-exempt investments to be derived from the income component. And why not? Given the recent increase in marginal income tax brackets, this tax-free income stream is more valuable than ever, particularly when compared with other fixed-income asset classes on a risk-adjusted basis.
Ideally, assuming the US economy continues to improve, one should look to bolster portfolio income through credit-driven opportunities, rather than by extending out on the curve. Admittedly, this could be hard to achieve in the high yield sector, where yield and duration usually go hand-in-hand and short duration instruments are hard to come by. In that case, the best compromise may well be a higher coupon/longer maturity and short call structure.
Paradoxically, we’re becoming very wary of the current common wisdom promoting an “intermediate maturity/high quality” strategy. This approach probably worked well during the initial phase of this year’s bear market, when everyone’s first instinct was to pile into the front end and belly of the curve to reduce duration risk. By now, however, the intermediate maturities have become somewhat overbought and therefore, vulnerable to a correction. With the current slope of the muni curve at its steepest historically, it wouldn’t surprise us if the long end of the curve ended up performing much better than expected in 2014, in spite of all the inherent duration risk. When everyone in the market is looking for the same thing, it might be time to take a contrarian stance.
Yield is not all that matters. More than ever, given the potential market changes we discussed in a recent article, investors also need to be extremely mindful of liquidity. Granted, “liquidity” is quite a relative notion in the muni market, where less than 5% of the outstanding issues trade on a daily basis. Nevertheless, in this new market environment characterized by reduced broker-dealer participation, owning bonds that can be sold within a short time frame and at the lowest transaction cost could be a critical ingredient to your investment success.
Contrary to popular beliefs, liquidity may not always be related to credit quality. High grade bonds may always get a bid but they may be treated as a commodity product without any special appeal. Even high yield bonds, with the right structural characteristics and whose credit story can be communicated quickly and efficiently, may be deemed liquid.
On the flip side, the absence of a “private placement” label is no assurance of liquidity either, not if timely credit information about the issuer is hard to come by and the original underwriter takes no responsibility for maintaining a market on the bonds.
In the case of narrowly distributed issues with few holders, liquidity can also be managed by making sure salient credit information is always readily available to potential bidders. Needless to say, strong disclosure practices by issuers, perhaps with the assistance of the underwriters, should also be encouraged.
And lest we forget, the pricing services may also play a big part in promoting liquidity. Evaluations that stray too far from real executable levels do detract from liquidity. By keeping the evaluators fully informed, you will help ensure that your holdings are correctly marked and that the marks are reflective of market reality.
All in all, next year’s more volatile rate environment will surely test muni investors’ mettle but it should also provide astute market participants with more opportunities to garner an attractive tax-free income stream.
Disclaimer: The opinions and statements expressed in this column are solely those of the author and Axios Advisors, who are solely responsible for the accuracy and completeness of this column. This column does not reflect the position or views of RICIC, LLC or MuniNetGuide.
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