With the second half of 2015 set to begin, municipal experts forecast continued outperformance by high credit-quality issues, a decline in refunding volume, continued headline risk for the market's severely battered credits, and the Federal Reserve Board to begin to raise interest-rates before year-end.
"The municipal market despite the interest-rate volatility so far has actually performed pretty well when you consider it to be one of the smaller markets overall," Dan Heckman, senior fixed income strategist at U.S. Bank Wealth Management, said in a June 26 interview.
He said highly-rated, double-A and triple-A credits should perform as well as they did or better in the latter part of the first half.
"High credit quality issuers are going to outperform lower-rated bonds as an increase from the Fed nears," Heckman said.
Elsewhere on the credit front, municipal experts believe troubled credits will continue to face challenges as they previously have, but said investors should look beyond the headlines when considering municipal bonds in the second half.
"I think some of the big news stories will carry out through the second half and reach some big conclusions," Heckman said. "Continued concerns about pension obligations that are underfunded are going to emerge as greater concerns for these lower-rated credits" as well, he added.
"Overall, the muni market is still a very high quality market, but I think the narrative on credit might be dominated by a couple of very specific credits, such as Illinois, Puerto Rico, and Chicago," said Hugh McGuirk, head of the municipal trading team at T. Rowe Price, in a June 22 interview.
McGuirk, whose firm manages $22 billion in municipal mutual funds and separate accounts, recommends that investors look beyond the select issues that are dominating the headlines to the broader, "generally very high-quality" municipal market in the remainder of the year.
While he is cautious on interest rates going forward, he said he will continue to seek value on the long end of the yield curve and pick up additional yields from the spread sectors, like health care or transportation when possible. "While our curve flattened quite a bit, the longer end presents decent value," he said, targeting the best yields in 2030 or longer.
"It's difficult to get bullish on munis, but at the same time, our yields have adjusted substantially off the lows, which offset some of that general bearishness on rates," he said.
While value will be plentiful, the record amount of issuance that made its way to market in the first half will taper off, municipal sources predicted.
"We won't see necessarily as much volume of issuance a lot of it due to a big decline in refunding activity," Heckman said. As rates move higher, refunding deals are less viable, sources said.
But, there will still be plenty of opportunity for value in the months ahead, players forecasted.
Heckman said U.S. Bank is advising clients to adapt a barbell strategy.
That type of portfolio structure, Heckman said, balances a mix of shorter and somewhat longer maturities with a gap in between.
For instance, he suggests creating a barbell of one to two-year maturities on one end of a portfolio, coupled with nine to 12-year maturities on the opposite end to earn the best value in the current market.
"The yield curve is going to be susceptible to yield increases in two to seven years we would want to lighten up on those maturities, especially in the three to six-year time frame," he said.
However, he said he would be willing to participate in that part of the curve if the market offered noticeable value.
"If the market weakens dramatically, we would see it as a buying opportunity," he said.
While he prefers staying invested well under 15 years, at the same time, Heckman suggests keeping duration a little longer to be well positioned ahead of a potential flattening of the yield curve.
"A longer duration is still going to be a good payoff for investors," he said. He also suggests building liquidity to take advantage of opportunities in a rising rate environment.
John Bonnell, senior portfolio manager at USAA Investments in San Antonio, said the duration of his funds is shorter going into the second half but that is completely market-driven not by choice.
"It's not a conscious decision to shorten, but because muni prices have rallied and rates have come down so much now durations are being calculated to the call dates," he explained.
McGuirk said he avoids making big interest rate or duration bets, but instead identifies extra yield opportunities through intense credit research.
He said he will continue his strategy of obtaining incremental yield without taking on much risk in the second half of 2015.
"We try to focus on the income component and use bottoms up credit research and try to get the best relative value in the market," according to Bonnell, who manages almost $4 billion in four municipal mutual funds, including a long-term, California, Virginia, and growth and tax strategy fund.
He said he will continue to seek relative value by analyzing coupons, structure, and credit quality, and relying on the firm's internal independent research to look beyond the ratings.
Overall the experts said municipals will continue to be relatively attractive compared to Treasuries in the second half.
"We think our Treasury rates are relatively high to the rest of the world, and the relative value of munis give it a performance advantage in that they are already yielding well above Treasuries and that's not a normal dynamic," Heckman said.
The actual timing of the potential rate hike is impacting Heckman's investment strategies much less than the economy, he said.
"Whether they raise or not, the beginning of wage pressures as the economy continues to grow that's changing our thought process more so than the timing of the Fed," he said.
"We think the Fed should have likely raised rates by now, and we personally would rather see them do it sooner than later," Heckman said.
Bonnell said overall improvements to the economy foster improvements in state and local credits and municipalities' budgets, which offsets the "one off events" that gained headline attention earlier this year, such as Puerto Rico, Chicago, and Detroit.
He said those situations highlight the value of in-depth credit research in delivering credit quality and stability in portfolios going forward.
Meanwhile, the Fed's desire to raise rates before the end of 2015 is "completely dependent on economic data" and the timetable is unimportant, according to Bonnell.
"It's somewhat irrelevant if they move before the end of the year or not," he said. "More important is how quickly they raise rates and how high will they tick up short term rates until they say 'that's enough.'"
McGuirk is of the opposite camp, adding that the Fed's decision will affect fixed income managers, such as himself.
"We are aware of the reasonable probability the Fed may do something, and we are factoring that into our investment strategy," he said.
Like McGuirk, Bonnell said investors should avoid timing the market with hopes of getting a "big total return pop," but instead diversify their portfolios and generate total return over time by compounding income and investing at higher rates when yields are rising.
"No one likes to see their share price go down, but it ends up being a positive over the long term," Bonnell said.
Meanwhile, other domestic and global developments could have an impact on the municipal market in the second half, Heckman said.
"We think with the Supreme Court ruling, selective health care names have some relative attractiveness," he said, but declined to name specific credits.
The Supreme Court ruled on Thursday that President Obama's Affordable Care Act allows the federal government to provide nationwide tax subsidies to help poor and middle-class people buy health insurance.
Heckman said global pressures could also add value to municipals.
"If we saw that the Chinese stock market continued to fall off, or Greece exits the EU [European Union], the next best entity to Treasuries is munis," he said. "We think munis would do well in any scenarios in the next one to three months" or beyond, Heckman added.
"The softness in the first half will be changing in the second half," he said. "The market will resume getting a better bid once it settles after the first Fed increase," he said. "We think the market could have a pretty good run at some point in the second half."
Christine Albano is the investing reporter for The Bond Buyer.
- Puerto Rico Governor Calls Debt Unpayable as Deadlines Loom
- Munis Hit by Worst Quarter Since 2013
- Muni Default History Poses a Ratings Riddle