Municipal managers and strategists, still reeling from Detroit's bankruptcy, the surge in Puerto Rico yields, and a mid-year sell-off that was the worst in a quarter century, are getting their portfolios ready for the next expected hurdle as 2014 approaches 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 Federal Reserve Board will begin tapering of its $85 billion-a-month economic stimulus program in the first quarter.
Jeffrey Elswick, director of fixed income at Frost Investment Advisors in San Antonio, said he is 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 said. "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,' and that sentiment is really taking hold out there."
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 the Fed tapering.
The highly-anticipated move was originally expected at its September meeting, but the Fed surprised the market by postponing its plans to scale back its monthly stimulus due to insufficient evidence of economic data to support the effort.
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 late June, rates catapulted nearly 60 basis points over three trading sessions, following positive economic news and an announcement from Fed Chairman Ben Bernanke that hinted at tapering.
Besides June's historic sell-off, investors experienced other market turbulence in 2013, ranging from apprehension over the debt ceiling deadline, the government shutdown, and the possible elimination of municipals' tax-exemption. In addition, municipal mutual funds have reported 22 consecutive weeks of outflows.
Elswick, who manages $1.5 billion in municipal bond assets, said 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.
"The rally in September and October has been nice, but at some point the sell-off will commence again and the sentiment out there is they want to be the first ones out, not the second ones out," he said.
Elswick said 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 up to at least 10%.
He said the securities help deliver stronger price stability as rates rise versus fixed-rate bonds, and, as a result, makes his fund more defensive given the Fed's stimulus reduction plan.
"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 said. "As rates rise, our portfolio will not lose as much value as it would if we owned all fixed-rate securities."
Although he believes the municipal market will remain range-bound for the remainder of 2013, Elswick continues to plan ahead for the expectations of higher rates.
"We think the market in general is headed into year-end in a situation where it will take a wait-and-see approach with respect to policy with the Federal Reserve and economic data," he said.
As the first quarter nears, however, he said he will have growing concerns over how quickly rates could rise in a post-tapering market.
"Closer to the summer of next year and into 2014 rates could start moving up as the Fed talks about removing QE once again," Elswick said. "We think, at this point, they are not going to start tapering their bond purchases until at least the second meeting in March," he added.
At U.S. Trust, Litvack said 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," explained the municipal veteran, who oversees research and investment strategy for U.S. Trusts' 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 that he says are "disconcerting" investors, such as "isolated cases of defaults and bankruptcies, and escalating unfunded pension and other post-employment benefit liabilities."
"At the current pricing levels, we believe tax-exempt municipal bonds represent one of the more attractive fixed income sectors," Litvack said.
"We believe that, generally speaking, credit conditions for states and local governments are starting to improve as the overall economy continues to grow," he continued. Litvack favors the general obligation, essential service, and infrastructure bonds of "well-managed issuers with sound finances, stable economies, and manageable debt levels."
However, all of the managers said they are highly concerned about the market's reaction to larger implications from overall credit weakness - especially Detroit and Puerto Rico, which have constantly been under the market's microscope in recent months.
Litvack is cautious about widening credit spreads as a result of the headline risks of certain issuers with "poor regional economies, structurally imbalanced operations, and high debt, pension, and other long-term obligations."
Elswick is monitoring the financial situations of Puerto Rico and Detroit.
"One thing we are watching closely is the events of Puerto Rico and whether the situation has worsened," he said. "Weaker credits have already begun to come under pressure, and to the extent Puerto Rico can't issue new bonds, that could be a catalyst for risk premiums to start to increase across the board," Elswick added.
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.
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, which manages more than $100 billion in individually held assets, 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, such as GO and essential service securities, with high liquidity and credit quality of A or better.
"It's those types of issues that continue to unceremoniously get through some of the pitfalls that could occur in the market," Early said.
Jamison recommends taking advantage of the yield curve "roll down" as a result of the steepness of the intermediate range where the slope between two and 10 years was 261 basis points as of Sept. 5 a two-year high according to MMD and Thomson Reuters data.
Even though the curve has flattened by approximately 25 basis points to 213 as of Oct. 28 as a result of the Fed's decision to delay its tapering initiative and concerns over the debt ceiling deadline, Early said there is still value to be gained from the roll down strategy.
He said investors can gain approximately 85% of the 30-year yield by only investing out to 15 years. On Wednesday, the benchmark triple-A scale in 2028 yielded a 3.29%, while the 30-year ended at a 4.11%, according to MMD.
According to ASG Municipal Research, the intermediate range is still 36 basis points steeper than the 12-month average of 177 basis points.
Like others, Early will also be keeping watch on major headlines from troubled credits such as Detroit, Puerto Rico, and Jefferson County, Ala. as the year comes to a close. The county will sell $1.7 billion of sewer warrants to retail investors on Nov. 18 a day before the official pricing of its crucial bankruptcy exit financing.
"There is always the potential that changes in what investors had been expecting from certain credits can create more of a news item toward year end," he said. "If the [Detroit] emergency manager [Kevyn Orr] finds a way to impair creditors in a way we haven't seen and if we saw a fundamental change other than how we expected credits to work that could have an impact in the market," he explained.
But, overall Early said investors are less vulnerable to headline 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' kind of concerns," Early said. "People have gotten more savvy about who is involved in the municipal market and who is coming in from the sides making big proclamations."
Christine Albano is an investing reporter for The Bond Buyer.