Municipal strategists differ on how to approach yet another quarter of waiting out the Fed.
The Federal Open Market Committee last week left its fed funds target rate unchanged at between 0.25% and 0.50. That fueled expectations that the next increase won't come until policy makers' December meeting and left muni pros to adjust their strategies to minimize interest rate risk while capturing yield in the remaining months of 2016.
Some say they will increase credit quality and shorten duration for overall risk protection, while others are identifying premium bonds, bonds with short calls, and those with average life structures to boost yield.
"Given that tax-exempt yields have backed up from when muni bond prices reached their highs during the first week of July, it makes sense to move a bit out along the yield curve to capture the new-found yield benefits," Jeffrey Lipton, managing director and head of municipal research and strategy at Oppenheimer & Co., said in an interview on Sept. 21.
His strategy of extending on the yield curve to pick up value is centered around recent opportunities, such as bonds maturing in 21 years that, as of last week, provided 94% of the yield on the curve.
While Lipton is focused on extending, others believe shortening duration and increasing credit quality will yield benefits in the upcoming fourth quarter.
Jeff MacDonald, director of fixed income strategies at Fiduciary Trust Company, is decreasing his interest rate risk by buying bonds in the three to five-year part of the yield curve. In the last three months of 2015, he preferred maturities in the 8-to-10-year range.
"With rates lower and the curve flatter we don't see extending maturities to the 8-to-10-year part of the curve as attractive as we did in the fourth quarter of last year," he told The Bond Buyer in a Sept. 21 interview.
He is responsible for setting the firm's fixed income policy and strategy and managing fixed income assets across a diverse group of Fiduciary Trust's clients, including high net worth individuals, families, small institutions, and endowments that total $5 billion, of which a lion's share is municipal assets.
Municipals are on MacDonald's radar screen heading into this fourth quarter, versus the fourth quarter of 2015 when the curve was steeper.
"Now, given where spreads are and where muni ratios are, we are more focused on the muni sector versus the crossover trade that was available in investment grade corporates last year," MacDonald said. "We are finding value in health care: adding and building up exposures that had been reduced over time."
MacDonald said his strategy in the last three months will involve buying structures that have two or three-year short calls, and those that trade according to their average life.
Housing bonds are an example of securities that can offer between 25 and 50 basis points of yield pick-up – without the added interest rate risk – compared with bulleted serial bonds with set maturities, he said.
"There is a lot less in terms of yield and curve steepness so we are needing to look a little harder to find yield opportunities than in the fourth quarter of last year," MacDonald said.
Although he could not discuss the specific holdings of the firm, he pointed to a recent market example of an attractive housing revenue refunding bond from the Wisconsin State Housing & Economic Development Authority.
The single family housing revenue refunding bonds with a 3.50% coupon due in the final 2046 maturity with an average life of 4.9 years were originally priced to yield 1.95% -- 45 basis points more in yield than the five-year bullet maturity in 2021 with comparable interest rate risk.
"The final payment isn't received until 2046, but the average life of the bond is 4.9 years, so it has a comparable amount of interest rate risk as the five-year bullet, but with a yield of 1.95%," MacDonald said.
The 2046 bonds, which are rated Aa2 by Moody's Investors Service and AA by Standard & Poor's, are subject to the first par call in 2025 and a super sinking fund in 2028.
Mark Paris, head of portfolio management and trading at Invesco, said continued interest rate jitters and overseas turmoil should provide attractive yield opportunities in the fourth quarter of 2016, just as it did at this time last year during the start of the corporate bond market sell-off and healthy municipal bond mutual fund flows.
"We were in a mode of wait and see and weren't sure how strong flows would be," he said in a Sept. 21 interview reflecting back to the fourth quarter of 2015. "There were a few things blipping up and not sure how munis would react to the equity sell off and the corporate bond market selling off," Paris said.
Since then, talk of another potential rate hike by the Federal Reserve Board has sparked opportunities that have allowed him purchase selective deals at wider spreads and cheaper prices for clients of the Atlanta-based independent investment management firm.
"The retail investor has been spooked a little with talk of rising rates, and munis have gotten a little weaker," Paris said. "The chatter causes some cheapness from time to time, and we have been using that cheapness to buy."
Essential service revenue bonds for toll road and infrastructure projects are a prime example.
He recently participated in the Metropolitan Transportation Authority's $1.06 billion of Hudson Rail Yards trust obligation bonds.
Backed by lease payments on the 26-acres of land being transformed into residential towers, and business and commercial space in New York City, the final 2056 maturity was repriced with a 5% coupon and a 2.625% yield. That was 34 basis points cheaper than the 30-year, generic triple-A general obligation bond tracked by Municipal Market Data at the time of the pricing. The bonds were rated A2 by Moody's Investors Service and A-minus by Kroll Bond Rating Agency.
Meanwhile, two new strategies Paris expects to facilitate in the approaching quarter are upgrading credit quality and slightly lowering duration to prepare for and minimize any potential interest rate or maturity risk.
He prefers 20-year paper from what he calls the "sweeter" part of the yield curve. "We are not shying away from longer duration, but we get a little more value in 20 years than 30 years," he said.
"We're selective in looking for the dips and just being cautious because there's a lot of noise out there from retail and a lot of fear of rising rates," Paris said. "We have been picking our spots and waiting for things to cheapen and fear to weaken."
Like Paris, Peter Block, managing director at Ramirez & Co., said he will also increase credit quality and shorten duration as an added measure of risk protection as the end of the year nears – even though the flat curve is expected to continue to keep rates fairly range-bound.
"Given where valuations are currently and the prospect of higher rates going forward, we think lower risk makes sense both in terms of credit and duration," Block said. "Shorter durations are particularly important now if forward curves are wrong and fail to account for further rate hikes, and, instead of flattening, we get steepening."
Last year heading into the fourth quarter, curve positioning was "paramount" in mid-September given the expectations for a flattening, as the market priced in Fed rate increases and the MMD curve steepened by about 30 basis points to 302 from 269 on Jan. 1, 2015, Block said Sept. 20.
This year, "market valuations are generally high, driven by a lack of Fed rate increases post-Dec. 2015, low global yields, and 50 consecutive weeks of inflows."
In addition to extending slightly on the curve to find yield, Lipton of Oppenheimer said he also expects to use a barbell strategy to reduce reinvestment risk and add premium bonds for their potential for maximum tax-free income and high cash flow He believes the strategies will provide a cushion against rising rates.
The additional tax-free income on the premium bonds also compensates for a higher purchase price, Lipton said.
"Premium bonds can provide less secondary market price volatility than similar maturity bonds selling near par or at a discount – and can offer higher yield to maturity and yield to call than bonds priced at discounts or close to par," he said.
Regardless of which strategy experts use, Lipton said fourth-quarter positioning can present opportunities as the curtain closes on 2016.
"Institutional window-dressing ahead of year-end, which generally entails some degree of portfolio realignment to harvest gains, as well as duration shortening in anticipation of rising rates, may also present better price points and bond selection for the opportunistic investor," Lipton said.
