Municipal analysts and strategists are looking in the health care and housing industries and at credits with intermediate maturities for potential bargains that may be created by irrational fears over the government shutdown and the debt ceiling.
"There may be buying opportunities if yields rise because of fears of negative market fallout," said Dick Larkin, senior vice president and director of credit analysis at Herbert J. Sims & Co. As of last Friday, he said municipal trading had been uninterrupted since the Oct. 1 start of the shutdown.
Volatility may be fueled by the pending resolutions to the now week-long government shutdown and the uncertainty over the estimated Oct. 17 deadline to extend the country's $16.7 trillion limit on borrowing.
"I feel that for munis, any fear of negative fallout because of heated political discussion on the U.S. budget, or media reports of potential defaults on U.S. Treasury will be irrational," Larkin said.
An irrational market reaction to the political tug-of-war in Washington would probably spur wider spreads among the weaker health care credits at a time when investors may want to exit the market altogether, these experts say.
The shutdown was fueled by an attempt in the Republican-controlled House of Representatives to force defunding of the Affordable Care Act, known as Obamacare, as well as Congress' failure to agree on a fiscal 2014 budget. The health care sector is highly dependent on federal funding, so concern that it could be subject to credit impacts may trigger spread widening across the sector.
"Health care would be the area of greatest concern as the sector is already struggling with the potential impact of Obamacare," said Triet Nguyen, managing partner of Axios Advisors LLC and a 34-year veteran of the municipal industry.
The market impact from the outcome of both the shutdown and the debt-ceiling debate will be "credit specific" and "any wholesale sell-off or spread widening should provide opportunities for discerning investors," Nguyen said. He said current spreads don't appear to reflect the potential risks and volatility. "The health care market appears a bit too complacent at this time," he added.
"What has happened over the last four months and with the budget stalemate in Washington, there are a lot of reasons for investors to shy away from the market," said James Colby, a portfolio manager and senior municipal strategist with Van Eck Global. He recommends that investors position their core holdings in the intermediate range, between six and 17 year maturities, where they can earn attractive yields with less risk from rising interest rates.
Colby oversees Van Eck's Market Vectors' suite of five municipal bond exchange traded funds that currently total approximately $1.8 billion in assets under management. He advocates the intermediate range for its steady and predictable income over the last five years, which he said helped boost the performance of Van Eck's own Intermediate Municipal Index to a total return of 6.19% over five years, as of Sept. 30, according to Van Eck research.
"If investors are disgusted with the political wrangling in Washington and if that's keeping them on the sidelines this should catch their attention," Colby said of the value in the intermediate range.
Colby gleaned opportunities from the intermediate sector over the past five years due to the shape and performance of the curve during the financial crisis of 2008 and again in 2010, which was characterized by massive outflows, rising rates and "the Meredith Whitney moment," he recalled, referring to the banking analyst's prediction of widespread muni defaults.
"We grabbed that part of the curve because it provided returns that were pretty consistent not in the short run, but in longer periods of time," Colby said.
Colby said given the recent flatness of the yield curve, his intermediate strategy offers protection from potentially-higher interest rates, which, he said, could be "the new normal" over the long-term.
"Long-term munis, those above 17 years, offered little extra yield in exchange for their generally higher sensitivity to rising interest rates - only 0.57% of additional yield from 17 to 30 years," Colby wrote in his municipal blog last Tuesday when the shutdown began.
The ITM fund performed better than the Van Eck's own short and long indexes, he pointed out. It is a market value-weighted index designed to replicate the price movements of medium duration bonds with a nominal maturity of six to 17 years.
The Market Vectors Short Muni Index posted a 3.51% total return, while the Market Vectors Long Muni Index posted 5.62% over five years, as of Sept. 30, according to Van Eck data.
Likewise, the benchmark that ITM tracks the Barclays AMT-Free Intermediate Continuous Municipal Index posted a 5.20% net asset value total return, which was higher than the 4.74% posted by the Barclays AMT-Free Long Continuous Municipal Index, and the 3.60% by the Barclays AMT-Free Short Continuous Municipal Index, according to the data.
The analysts agreed that market fear could lead to more opportunity in other areas especially the longer the political tumult exists and the market reaction to their eventual outcomes.
It is widely believed that the U.S. will lift the debt cap and overcome the latest political tug-of-war without risking a downgrade as it did during debt ceiling debates in 2011. Still, Larkin said he will be cautious as he looks for potential investments in the coming weeks.
"If there were lower prices on traditional state GO debt that could be attributable to irrational fear or a rating agency report discussing economic dependence at the state level, I would welcome those investing opportunities," Larkin said.
At the same time, he said he would be wary of debt structures that are dependent on discretionary, direct federal subsidization, like Section 8 housing projects. "Military housing projects without firm legal contracts for occupancy should already be suspect," he said.
Colby said if investors shy away from the market due to perceived impact from the Congressional deliberations they could be overlooking "meaningful income on a taxable equivalent basis" in the intermediate range.
"There are uncertainties, but given the uncertainties that do exist and have existed over some time we are making a case to consider this type of allocation in terms of muni bond exposure," he said of the intermediate range. "If the Federal Reserve continues on its present course, and with the policy of QE still on the table and tapering pushed off until sometime next year, investors are losing an opportunity to secure some tax-free income."
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