Municipal managers say they're continuing to shield their clients' assets from higher interest rates, even though some are skeptical that a spike is imminent almost six-years after the Federal Reserve cut its target to near zero.

Managers interviewed this week said they are sticking with a "better to be safe than sorry" approach and adopting defensive strategies aimed at enhancing credit quality and limiting interest rate sensitivity. Dan Genter, chief executive officer and chief investment officer at RNC Genter Capital Management in Los Angeles, is among those preparing for the rate hike, even though he doesn't believe it will happen any time soon.

"Everyone is assuming it's going to happen, but we have been hearing that for the past three to four years," Genter said in an interview on Tuesday.

The Federal Reserve has held its benchmark rate at between 0% and 0.25% since Dec. 16, 2008, waiting for the economy to pick up steam, and municipal fund managers have been on guard against a spike in interest almost as long.

Concerns reached a high ebb last year after then Federal Reserve Board Chairman Ben Bernanke signaled an end to the quantitative easing program. The 10-year Treasury yield rose to a peak of about 3% at year end, up from 1.7% in April. That benchmark rate has since retreated back to 2.50% and some believe it could return to 3% within the next 12 months as the Fed continues to unwind its economic stimulus.

"Instead of looking at dot plots of where interest rates should be going, we are looking at the fundamentals and we don't see a lot of fuel that is going to push rates higher," Genter said. "Overall inflationary pressures are relatively subdued."

Even if rates were to rise by 50 basis points by the second quarter of 2015, he said that would not have a "major effect" on the yield curve because it is "especially steep in the municipal area and the long end is not going to move much."

Jeffrey Timlin, managing director of the municipal bond department at Sage Advisory Services, said he is underweighting his clients' municipal exposure to the one to five year slope of the yield curve and positioning duration to be less sensitive to interest rate moves.

"It will obviously put pressure on the front end of the curve," he said in an interview on Tuesday. "The shorter end will rise faster than the long end, so the back end of the curve is more stable," Timlin said of the potential rate rise.

Earlier this year, the Federal Reserve Board announced it would cut bond purchases and end its economic stimulus program next month.

The FOMC said last week that it expects to halt asset purchases after its next meeting, on Oct. 28-29, and reiterated a pledge to keep its benchmark interest rate near zero for a "considerable time" after the bond buying campaign had ended.

In the meantime, Timlin is keeping duration 5% to 10% short of the Barclays 1-10 Year Municipal Bond Index he uses as a benchmark.

Timlin is one of three senior portfolio managers who oversee nearly $1 billion of municipal assets in separately-managed accounts at the Austin, Tex.-based independent investment management firm. The munis represent about 10% of its total assets under management.

He is also limiting credit risk by upgrading the quality of bonds in his client's municipal portfolios, which includes shying away from paper rated triple-B or lower in order to maintain capital and principle preservation, Timlin said.

"Spreads have compressed because of the lack of supply … to levels that I feel are rich at best," he said. "We feel that you need to be compensated a little more for that risk."

For instance, he is upgrading to double-A bonds from single A, and to triple-A from double-A where it makes sense. "We're doing that selectively and finding opportunities to reduce the risk because some people are willing to pay for the extra yield," he said.

Timlin said the firm doesn't own any Puerto Rico or Detroit bonds.

Security selection is another strategy he is implementing ahead of a rate hike - looking for credits that have stabilized balance sheets, and expenditures that are under control, such as credits from states like Florida, California, Arizona, Nevada, Michigan, and Texas.

"We're looking at protecting clients on the downside," Timlin said. That includes purchasing credits that will remain stable and have limited credit widening, or difficulties coming to market in the future.

Still, fear of the unknown is not a reason to become complacent, managers said.

Genter said he has been maintaining duration at neutral to slightly above neutral compared to the Merrill Lynch Intermediate Municipal Bond Index and Barclays Municipal Intermediate Bond Index -- which both have duration of roughly 4.7 years.

For instance, by investing in the seven- to 10-year and 10- to 15-year slopes of the curve investors can earn 79% and 93% of the yield of comparable Treasuries, respectively, he said.

"You are picking up very little incremental yield beyond 15 years," he added. "There is a massive increase in the slope in five to 15 years where you are picking up 115 basis points, but only picking up 50 basis points from 15 to 30," he said.

Genter's strategy to buffer against rising rates also includes buying higher coupons, and like Timlin, buying higher quality, liquid names.

"You are not getting paid for going down in credit quality," Genter said.

Since many new issues are getting oversubscribed as a result of the recent supply scarcity, he said he was fortunate to be able to purchase premium coupons in the primary market this week, including revenue bonds from San Jose Airport, the New York STARs deal, and San Antonio electric and gas. His investment and financial management firm has $4.8 billion in total assets under management, including about $2 billion of munis.

While timing of the rate hike may be several quarters away, managers said they will remain vigilant.

Timlin said despite having a defensive posture, he is trying to uncover opportunities to generate income and return for clients while the market is in a holding pattern when it comes to rising rates and the potential for widening credit spreads.

"We are waiting it out in a safe zone with highly liquid portfolios," Timlin said.

"If one event resonates with the market and everything sells off we want to be prepared for that event," Timlin added.

Genter said a potential rate hike hinges on three "wild cards"-- Janet Yellen's new appointment as chairman of the Federal Reserve Board, the upcoming November election, and the ongoing "sanguine economic environment" of low growth, and low employment.

"Yellen may want to allow the economy to grow a little faster rather than risk a double-dip recession," Genter added.

TImlin, meanwhile, said he is being patient and waiting for the next opportunitiy that will "spook the market."

"The market is in such a risk-on trade that any little news that could reverse that [event] could magnify those movements," Timlin said.

"There are still a lot of aberrations occurring in the market place," Genter agreed. "It's hard to see right now the unusual catalytic event that is going to sneak up and bite you."

Christine Albano is a reporter for The Bond Buyer 

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