Rising interest rates sank the total return performance of municipal bond mutual funds that were too heavily weighted in long-term bonds during the second quarter.
Overall, 30-year general obligation bond yields rose 15 basis points during the quarter to 4.63% on June 30, according to Municipal Market Data.
“It has been a frustrating market to be in,” said Kathy Bramlage, a senior portfolio manager at Value Line Inc. in New York, who runs the Value Line Tax Exempt Fund. The fund finished dead last in Lipper Inc.’s general municipal category during the second quarter with a total return loss of 0.71%. The average fund in the category lost just 0.05%.
“It was long going into the end of last year, which has been a troublesome place to be this year, so it’s been a process of trying to shorten up duration a little bit, though trying to keep your yield up,” Bramlage said.
While there have been periods during various months this year when the market has improved, yields have ended each month higher, said Bramlage, who has been trying to create a barbelled maturity structure in the fund by selling off some of its 20-year paper, while keeping shorter maturities and some longer-term bonds for the higher income they produce.
“If you look at the market from the top down from the economics it’s been a little bit conflicting,” she said. “You see some signs of strength in the economy, and then in other parts of the economy you see some weakness. Clearly the Fed — the last time they spoke — said the same thing. You almost feel like you’re in a holding pattern looking for some direction.”
Some of the quarter’s more successful performers found ways to navigate the storm. The two top performing funds in Lipper’s general muni fund category were both run by Joe Deane, a portfolio manager at Western Asset Management in New York.
“We were somewhat cautious on rates and we felt that munis were extraordinarily cheap to the Treasury market,” Deane said. “We positioned ourselves to take advantage of both.”
That meant keeping the Legg Mason Partners National Municipals Fund and Legg Mason Partners Managed Municipal Fund further in on the yield curve over the last year by primarily buying bonds with maturities inside of 10 years. The fund also benefited over the past year by holding onto a number of long-term bonds that were ultimately pre-refunded, according to Deane.
Deane did not elaborate any further on the funds’ strategies. However, the funds’ most recent shareholder reports reveal that they had also sold short a large amount of Treasury futures contracts going into the second quarter. As of March 31, the $411 million National Municipals fund had 1,170 contracts to sell with a basis value of roughly $131 million. The $2.4 billion Managed Municipals fund had 7,015 contracts to sell with a basis value of just over $790 million as of Feb. 28.
The A-class shares of the National Municipals fund produced a total return of 1.24% during the quarter, while those of the Managed Municipals fund returned 1.05%.
The two funds have since been slowly moving away from its stance on rising rates and muni bonds’ relative value, but will continue to benefit from the large number of bonds that were pre-refunded and are now escrowed to maturity with Treasuries, according to Deane.
Mark Otterstrom, a portfolio manager at Waddell & Reed Advisors in Overland Park, Kan., also found that simply holding onto pre-refunded bonds allowed the $460 million high-yield fund he runs to perform well and avoid having to invest in low-quality bonds at current market levels.
“It’s hard for us to buy yield right now because we don’t think we are being compensated for the credit risk,” Otterstrom said.
The Waddell & Reed Advisors Municipal High-Income Fund holds about 11% of its assets in pre-refunded debt from the lower-quality segment of the market that trade like insured debt even though they are nonrated since they are escrowed in Treasuries and are no longer backed by the project revenues, Otterstrom explained.
“Instead of being a long-duration nonrated bond, you roll down the yield curve and increase in credit quality,” he said. “The shorter duration, higher-quality paper is more defensive and that had paid off for us this year.”
The fund’s class A shares ranked fifth in the high-yield category with a three-month total return of 1.43%, according to Lipper.
One of the top-performing bonds in the fund was a block of Maine Health & Higher Educational Facilities Authority revenue bonds for the Piper Shores Continuing Care Retirement Community with a 7.55% coupon due in 2029 that is priced to a 2009 call date. The bonds, which are nonrated and from an issue sold in 1999, were pre-refunded over the last year and are currently priced to yield 3.95% in the secondary market.
“Typically we would sell our pre-refunded bonds with low yields and reinvest in higher-yielding paper, but we’re not doing that because spreads are so tight,” Otterstrom said.
Otterstrom said another strategy that reaped benefits for the high-yield fund was staying invested in smaller tax increment financing revenue bonds from small districts and local municipalities in Kansas and Missouri, as well as high-grade housing bonds and some selective new health care issues.
For instance, he owns Hawthorne, Mo., Transportation Development District revenue bonds for a project in Warrensburg with a 5.25% coupon due in 2026 that are nonrated and are currently yielding 5.32% in the secondary market.
By contrast in the high-grade market, Matt Kiselak, a portfolio manager at Evergreen Investments in Charlotte, N.C., gleaned value in the municipal market by using a combination of yield curve positioning and credit sector overweighting to put the $101 million Evergreen High-Grade Municipal Fund he runs in the fourth ranked spot in the insured debt category.
The fund’s institutional shares posted a total return loss of 0.08% for the quarter, which was well ahead of the average insured fund, which lost 0.32%, according to Lipper.
Kiselak positioned 50% of the fund in bonds due between seven and 12 years to take advantage of the attractiveness of the intermediate range at a time when there was little compensation for going out longer, he said.
Given the overall flatness of the curve, he sold bonds with maturities between 20 and 30 years, and reinvested in shorter bonds instead, he said.
Meanwhile, Kiselak also kept 5% of his assets in cash vehicles, such as attractively-priced auction-rate securities. He also found value in top-performing credit sectors, such as housing.
He also generated a high level of income for the fund by owning health care bonds, such as Lorraine County, Ohio, revenue refunding bonds for Catholic Healthcare Partners. The bonds, which carried coupons of 5.62% in 2016 and 2017, and 5.75% in 2018, have ratings of Aa3 from Moody’s Investors Service, and AA-minus from Standard & Poor’s.
Meanwhile, other managers achieved strong performance by simply keeping a short duration and an inventory of lower-rated paper during the quarter.
Lyle Fitterer, a portfolio manager and head of customized fixed income at Wells Fargo Capital Management in Menomonee Falls, Wis., said his $370 million national fund was able to hold a prominent position in the general fund category because its duration was relatively shorter than its competitors, as well as the Lehman Brothers Municipal Bond Index.
At the start of the second quarter, his national fund had a duration of 5.8 to 5.9 years. The Lehman index had an option adjusted duration of 6.7 years as of June 30.
However, in mid-to-late June, he slightly extended that to 6.5 to 6.7 years, making the fund more neutral to the Lehman benchmark by adding more interest rate exposure to the portfolio.
At the same time, Fitterer kept an overweight position in lower-quality bonds, maintaining an average credit rating of single-A, although that is up from triple-B-plus a year ago.
This strategy helped add income to the fund. Some of the fund’s best performing holdings during the quarter included tobacco bonds, charter school bonds, land development bonds, and some hospital credits.
For employing these strategies, the Wells Fargo Advantage Municipal Bond Fund’s investor shares took 16th place in the general fund category, with a 0.32% total return for the quarter, according the Lipper data.
Despite the uncertainty over the direction of interest rates, some municipal fund managers still have reason to be optimistic.
“As a municipal person, we’ve always looked for the summer months to be the months where you see a little more rally because there’s not a lot of supply in terms of new issues,” Value Line’s Bramlage said. “So I don’t know about any other buyers out there, but my fingers are crossed for that.”
