Municipal investors shouldn't be preoccupied with fears about inflation, interest rates, or credit quality, according to municipal analysts and managers.
Past performance shows the muni market has the resilience to overcome headline risk stemming from fiscal debacles in Puerto Rico and Illinois, recent steady outflows and the uncertainty over the timing of the Federal Reserve Board interest rate increase, the experts said.
With interest rates range bound and inflation well contained, investors should have little fear of significant declines to their principal when it comes to their municipal assets, said Jeffery S. Timlin, managing director and senior portfolio manager, who oversees municipal bond strategies at Sage Advisory Services.
The independent investment management firm is based in Austin, Texas, with approximately $11 billion in assets under advisement - of which approximately 10% represents municipal separately-managed accounts.
Timlin said a 25 basis-point interest-rate rise has already been priced into the municipal market, where the back of the curve 10 years and out remains range bound.
"The initial price movement, in the front end of the yield curve should be limited as the market doesn't anticipate more than two increases of 25 basis points by the end of this year," Timlin said. "If the Fed decides to raise rates 25-to-50 basis points, which is market consensus, we could see further strengthening of the U.S. dollar."
With the tightening of monetary policy, inflation indicators such as the consumer price index and personal consumption expenditures should remain well contained going forward, Timlin said.
Meanwhile, in Treasuries, Timlin expects to see the 10-year benchmark yield hover between 2% and 2.50% heading into year end and early 2016.
"Inflation is well contained despite the Fed's desire to generate some type of inflation," Timlin said.
"Sage believes we are positioned well for a rate hike and relatively stable interest rates in this range bound environment," Timlin said.
While investors may see and hear market volatility and interest rate uncertainty, Susan Courtney, managing director and head of the municipal bond desk for Prudential Fixed Income in Newark, N.J., said investors need to take that in stride.
The $3.7 trillion municipal industry remains generally very high-quality, as it has since 2007 and through the subsequent financial crisis, she said.
"It's best not to react to some of the headlines," Courtney said. Her firm, which is a division of Prudential Investment Management, manages $15 billion in U.S. municipal assets -- $10 billion of which is taxable municipals and $5 billion is tax-exempt.
Courtney oversees the management of four separate, open-ended mutual funds, including a $216 million California and $684 million national fund, a $715 million traditional high-yield portfolio, and a more than $85 million short-duration high income fund with duration of less than four and a half years. She also oversees assets in the firm's own municipal insurance portfolio.
"If an investor is in a diversified mutual fund, that is going to protect them from some of the downside from some of the negative stories out there," she said.
Courtney said demand for municipals has been positive, as she has seen inflows to her four municipal funds year to the date.
The funds are also positioned for any impact from a gradual rate hike, she said.
"We have seen a flattening since the second quarter and we expect that to continue," Courtney said.
"The market is pretty well positioned," Courtney added. "The technicals typically soften up in the fall, which means better buying opportunities, especially if supply picks up."
Focusing on high-quality credits with relatively attractive yields is one strategy investors can follow in the current market, experts said.
"Once you cut through the headline noise created by some high profile credits and dig deeper, investors should feel comfortable with the credit direction and safety of most muni bonds," said Paul Mansour, managing director and head of municipal research at Conning & Co.
He said investors should be actively seeking value in the municipal market. His firm has remained "overweight" in municipal bonds, because of revenue growth and cautious spending for most municipalities, which has led to more upgrades than downgrades from the major rating agencies.
Conning, an investment management company for the global insurance industry, has $92 billion of assets under management, of which more than $10 billion consists of municipal assets for institutional accounts.
"Focusing on revenue bond credits and high quality states while avoiding a handful of states with high legacy costs is our approach," Mansour said. "There are some definite trouble spots, but there is a lot of good news out there that is not being reported."
He said large states continue to thrive through rebuilding their fund balances and improving their credit, while sectors like utilities and airports offer value due to recent economic growth.
"We don't see any likelihood of tax reform that would reduce the value of munis in the future, and moderate economic growth is very supportive of strong municipal credit quality," Mansour said. "It's not real sexy right now - it's slow and steady. Building portfolios with credits in states and sectors we prefer, and really being alert to the trouble spots, is our strategy."
Timlin, meanwhile, said he favors a barbell approach for the firm's intermediate strategy, for example, buying paper in one year or less maturities and remaining overweight in the 10-year area.
Timlin said he is also being credit defensive, and is rolling up the credit curve to own bonds with higher ratings with the same spreads as comparably lower-rated paper to minimize any loss of yield.
"This is a prudent strategy to implement as credit spreads are trading at or near cycle lows" and general market uncertainty remains elevated, Timlin said.
Courtney, meanwhile, said diversification is a key strategy at Prudential, so she is considering bonds from various sectors.
"There's still value on the long end, but we are looking across the curve for various funds," she said.
Her traditional high yield fund, for instance, maintains an average credit quality of triple-B, even though it holds high quality, liquid paper, as well as nonrated and lower-rated paper, she said.
Courtney said she prefers revenue to general obligation bonds because of the availability of incremental yields.
All of the experts touted municipals as attractive as year-end approaches.
The biggest concern investors should have, according to Timlin, is assessing market valuations and fundamentals to gauge how their portfolios have done this year.
"If things seem overvalued maybe it's time to take some chips off the table," Timlin said, suggesting that investors may want to reassess their overall asset allocation.
Timlin expects the fixed income market to outperform cash in the next six to 12 months, since the majority of the likely rate moves have already been priced in.
"Because of the barbell strategy, [short-dated bonds] will roll off with minimal price volatility," Timlin said. "Munis will remain stable - well within the 50 basis point range -- as long as you are in the strong credits and not Puerto Rico and Illinois, to name a few."
He expects the 10-year Treasury bond to trade between 2% and 2.50%, which should lend support to the fixed income market, including municipals. "We should be able to weather any storm we see coming in the next six to 12 months."
"For Sage clients, liquidity has been phenomenal," Timlin continued. "The ability to sell has been extremely easy. On the flipside, picking paper up that is attractively priced has required more effort."
Puerto Rico, Timlin said, should be a "non-issue" for traditional investors since the island's financial shortfalls have been highly publicized since 2013.
"People who are surprised just haven't listened to the news in the past two years," Timlin said.
Other investors, who can tolerate higher levels of risk and principal volatility, can withstand the island's illiquidity because they believe the recovery value, in the event of a default, will be above market levels.
"If you are invested [in Puerto Rico paper] then you should be comfortable with equity-like volatility and holding speculative-type paper," Timlin said.
While Mansour believes the situation in Puerto Rico is "grave," and as the island is facing "an economic, social, and political crisis" that has no quick solution, he also views it as an outlier with "a unique set of circumstances and political structure" that currently provides a buying opportunity in the municipal sector.
Still, experts, like Mansour, said traditional investors are wise to opt for states that are doing better and sectors that are benefitting from recent economic recovery.
"Once you look past Puerto Rico you see an improving credit future for almost all credits," Mansour said.
Even outflows have reversed and stabilized in recent weeks, he added.
"In the corporate sector we are seeing more downgrades, and somewhat higher yields or price depreciation we are not seeing those things in munis right now," Mansour said.
Meanwhile, Timlin said what investors should prepare for going forward is "the next unknown" that could affect the municipal market.
While it's difficult to project and the current headline and event risk is low, Timlin said large issuance states, like California, could see a "significant reduction" in economic growth and fiscal health in the event of an unexpected recession.
"Their tax receipts do well in bull markets and suffer badly in a recession," he said. If these concerns become more of a factor than what the market is anticipating, that could trigger large outflows and selling pressure, Timlin said.
Credit quality is "very stable," even though many municipalities are still recovering from the latest recession and continue to implement additional revenue generation and cost-cutting measures, Timlin said.
Mansour agreed that a sooner-than-expected recession could be problematic for large states with fiscal problems, like Illinois, which are "running out of ideas and short-term fixes following years of bad practices."
Unfunded pension liabilities are another risk to monitor, Courtney added.
Mansour suggests investors "stay the course" and look for buying opportunities amid the headline risk.
"Keep some powder dry and take advantage of times when there is bad news for selected high profile credits as these problem credits are not representative of the overall market," Mansour said. "As retail dominated market bad news can create buying opportunities for savvy investors."
