Municipal fund managers, still reeling from Detroit's bankruptcy, the surge in Puerto Rico yields and a midyear sell-off that was the worst in a quarter-century, are getting their portfolios ready for the next expected hurdle - another spike in interest rates.

They're turning to shorter durations, high-quality or alternative coupon structures - or a combination of these strategies - to protect their holdings from volatility prompted by expectations that the Fed will begin tapering its $85 billion-a-month economic stimulus program in the first quarter.

Jeffery Elswick, director of fixed income at Frost Investment Advisors in San Antonio, says he's overweighting his Frost Municipal Bond Fund with six- to seven-year paper, while adding floating-rate securities to the fund's fixed-rate holdings to boost price stability.

"Now is not the time to take a fair amount of risk," he says. "If there are any changing monetary policies, that will bring unattractive returns, and I can't tell you the amount of folks I speak to that say, 'We basically want to be the first ones out in the case of a sell-off.'"

Patrick Early, chief municipal analyst at Wells Fargo Advisors in St. Louis, is recommending fixed-rate securities with high credit quality and liquidity, as well as focusing on the short- to intermediate-maturity range, which he believes will provide a defense against potentially rising rates in the aftermath of tapering.

Elswick, who manages $1.5 billion in municipal bond assets, says he is preparing for a rising-rate scenario by using floating-rate bonds and avoiding investments longer than 10 years, which helps keep the average maturity of his municipal fund lower than the benchmark Barclays Municipal Bond Index.

Elswick says his strategy of adding floating-rate securities has been more difficult given their scarcity in the municipal market, but he hopes to be aggressive and increase his ownership to at least 10%. He says the securities help deliver stronger price stability as rates rise versus fixed-rate bonds and make his fund more defensive given the Fed's expected moves.

"Unlike a traditional fixed rate, these have low duration or low interest rate risk because their coupons are resetting with however the overall market is changing," Elswick says. "As rates rise, our portfolio will not lose as much value as it would if we owned all fixed-rate securities."

Focus on Quality & Durations

Like his peers, David Litvack, managing director and head of tax-exempt research at U.S. Trust, Bank of America Private Wealth Management, is limiting rate risk by boosting the quality of clients' portfolios and targeting durations to be shorter than the industry benchmarks. In his view, portfolio posture is important as potential volatility looms.

"Shorter duration bonds protect the values of our clients' holdings because they are relatively insensitive to increases in rates," says Litvack, who oversees research and investment strategy for U.S. Trust's high-net-worth investors with separately managed accounts.

He is taking advantage of the relative value of municipal bonds - in spite of the expectations for tapering - and other challenges he says are "disconcerting" investors, such as "isolated cases of defaults and bankruptcies, and escalating unfunded pension and other post-employment benefit liabilities."

"We believe that, generally speaking, credit conditions for states and local governments are starting to improve as the overall economy continues to grow," Litvack says. He favors the general obligation, essential service and infrastructure bonds of "well-managed issuers with sound finances, stable economies and manageable debt levels." He is cautious about widening credit spreads as a result of the risks of certain issuers with "poor regional economies, structurally imbalanced operations and high debt, pension and other long-term obligations." Although he has no exposure to Detroit, Elswick is concerned with how the severity of losses to the large universe of bond holders will affect the overall market.

Aftermath of Whitney Call

Mitigating credit and interest rate risk is also a key strategy at Wells Fargo Advisors, according to Early and municipal analyst Dorian Jamison. The firm is curtailing exposure to the long end of the municipal yield curve due to its vulnerability to price weakness in a rising-rate climate. At the same time, the firm is increasing exposure to short-to-intermediate tax-exempt bonds with high liquidity and credit quality. Like others, Early will also watch troubled markets, such as Detroit, Jefferson County, Ala., and Puerto Rico.

Yet overall, Early says, investors are less vulnerable to investment risk than they were a few years ago in the aftermath of Wall Street expert Meredith Whitney's predictions for widespread municipal bankruptcies and defaults.

"The market has become resistant to 'the sky is falling' concerns," Early says. "People are more savvy about who is involved in the municipal market and who is coming in from the sides making big proclamations."

Christine Albano is a reporter at The Bond Buyer.

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