Michael Sullivan: Hi everybody, this is Mike Sullivan at GW&K. This is the fourth quarter 2013 update for our Municipal Bond Strategy. I'm going to take about 10 minutes today to talk about what happened during the quarter. I'll also discuss what happened during 2013, and then I'll touch upon our strategy and our outlook for 2014.
Taking a quick look at the fourth quarter in terms of yield movements, Treasury yields moved significantly higher. Strong economic data, stronger than expected employment numbers, manufacturing and consumer confidence numbers caused yields to rise during November and the early part of December. And of course we had the announcement of the Fed taper in the latter part of December.
By the end of the quarter, Treasury yields moved about 30 to 40 basis points across the curve. Munis outperformed Treasuries, particularly at the short end of the curve, where we saw 5-year muni yields actually decline eight basis points. We saw 10-year yields back up about 23 basis points, and 30-year yields backed up only about eight basis points.
The net result for the quarter in munis was that pretty much the entire part of the curve had positive performance, with the exception of the Barclay's 10-Year Index, which was down 0.1%.
For the year, we saw munis significantly outperform Treasuries at the front end of the curve. Five-year triple-A munis only rose 40 basis points, whereas the 5-year Treasury increased about 102 basis points for the year.
At the very long end of the curve, munis underperformed Treasuries. The 30-year triple-A muni yield rose 136 basis points, and that compares to the 30-year Treasury yield moving up about 102 basis points.
To the degree that there was demand in the muni market throughout the year, it was pretty heavily concentrated at the front end of the curve. Municipal participants really didn't want to be allocating dollars to the long end of the curve during 2013.
The net result is the 5-year part of the curve was up about 80 basis points for the year. The 10-year part of the curve was down about 2.2%. In the long end, the Barclay's Long Index was down about 6%.
From a thematic standpoint, there are several key themes that persisted throughout the year. First and foremost, Treasury volatility impacting municipal market volatility. We all know that the Treasury market was extremely volatile, particularly in the latter half of the year. Most of that was driven by the Fed tapering conversation. That volatility again trickled over into the muni market.
I just referenced it a second ago, but the second key theme was an aversion to duration in the muni market. Muni investors simply didn't want to be allocating dollars to the long end of the curve, and that's why you saw the 30-year part of the curve significantly underperform the long end of the Treasury market.
The third key theme that we saw throughout the year was persistent outflows from muni mutual funds. We saw about $67 billion in outflows. That's a record outflow for a year and the largest outflow going back since Libor began tracking that number back in 1992. There was significant pressure on the market from a fund outflow standpoint.
What helped in the market to some degree was a lack of issuance. Issuance declined about 11% for the year. We saw about $330 billion of issuance in 2013, compared to about $370 billion in 2012. That decline in supply was largely driven by a decline in refunding activity. Simply put: as yields moved higher in the back half of the year, it just didn't make as much sense for municipalities to bring refunding deals to the market.
Finally, the last theme that we paid attention to throughout the year, and this certainly impacted the market, were lingering credit concerns and negative headline risk as it pertained specifically to Detroit and the bankruptcy proceedings there. As well as significant stress in Puerto Rico credits beginning in September and carrying through to the end of the year.
Those two credit stories combined most likely contributed to the outflows from the muni mutual funds. We would argue that the primary reason why you saw such significant outflows was the Treasury market volatility. As a secondary effect, certainly the overhang, the credit concerns, probably contributed to that negative sentiment.
Turning to our strategy, and quickly touching on performance, we had a very strong year on a relative performance basis. We also had a strong fourth quarter. Throughout the year, the key reason for the outperformance was our shorter duration relative to the index. We ended the year with a duration of about 6.3 years, compared to a duration on the Barclays 10-Year Index of about 6.7 years. In a rising rate environment, that certainly helped on a relative standpoint.
Our lack of exposure to Puerto Rico debt also helped from a contribution standpoint. Puerto Rico was down about 5% during the fourth quarter and down about 20% for the year. We have zero exposure to Puerto Rico, and again that contributed to our outperformance.
From an activity and positioning standpoint, throughout the year we methodically extended the duration of our portfolio even though we were shorter duration than the index. The duration began the year at about 5.6 years. We started the year with an elevated cash balance, up around 8%. As the first quarter moved along, we put that cash back to work, bringing duration up to about 5.9 years.
We tactically extended the duration June and July. We took about 5% of the portfolio and moved it out the curve, and that brought the duration out to about 6.3 years where we basically stayed at through the latter half of the year. Throughout the year we also focused on selling our 5-year holdings again. That's where the strongest bid was in the market. We took those holdings and basically rolled them out to the 9-12 year part of the curve.
One thing I do want to mention though from a positioning standpoint is we still have about 40% of our portfolio positioned shorter than our benchmark. Call it 5-7 year munis. While we don't necessarily like being in that part of the curve, we recognize the need to be there. These bonds act as a nice stabilizing force. They help keep the duration of the portfolio in, and they also serve as nice, dry powder if rates were to continue to move higher here in 2014.
Turning to our outlook for the year, I think the macro picture will certainly continue to dominate here. Specifically, what I'm referring to is basically the Fed's transition from its quantitative easing program towards its forward rate guidance from a monetary policy standpoint.
When the Fed announced the taper in December, they basically indicated that they'll gradually wind down the purchasing program. But also importantly, they're going to keep the Fed funds rate basically at zero provided that inflation remains below 2%. And they'll keep it at zero, even as the unemployment rate pushes below 6.5%.
The market certainly feels like it's on board with that as we ended the year and that's essentially what gave the Fed the ability to announce the tapering. At some point, and whether it's the first part of the year, or later, it will be important to see how the Fed responds to a testing of that type of language.
The second source of potential volatility in the market could come from Puerto Rico. Puerto Rico will probably come to market with a deal at some point during the first quarter, possibly at some point in mid to late February. Puerto Rico is on negative watch at Moody's and at Fitch, and they've basically said, "Prove to us that you can access the market; prove it to us that you can get a deal done." That could be a source of volatility and it'll be interesting to see if Puerto Rico can get that deal done and at what levels they'll have to pay on their debt to get it done.
Finally, tax reform is always on the table in the municipal market. To the degree that the conversation returns to ratcheting back the municipal tax exemption that could certainly add some volatility in 2014. Although we think that's a lot less likely than the first two that I mentioned.
Focusing on the positives, and focusing on what's the case for munis in 2014, I think first and foremost, we'd point out that we're no longer at historical lows from a yield standpoint. The 10-year triple-A muni yield has moved about 130 basis points off of its low back in November of 2012, and it moved 100 basis points higher last year.
At 2.77% on the 10-year triple-A, we're about 20 basis points higher than the 5-year average. If you look at it on a 10-year basis, we're still about 35 basis points lower than the 10-year average, but we're certainly not that far away from that level. There's been a big adjustment here, and we think that that leaves us in a much better position in 2014.
Second, the yield curve is very steep. The 5-10 year spread is out at just over 150 basis points currently, and that's not too far away from its all-time steepest levels, which was back in 2010.
What this means to us is by moving out into the 10-year part of the curve, you're picking up a significant amount of carry, or just absolute yield, by being out there. You're also positioning yourself well to capture potential return from bond roll.
You combine that with the fact that the 5-year muni is trading so rich right now relative to Treasuries, and that's where the bid is in the market, we're happy to consider selling 5-year bonds, and buying 10-year bonds at this point in time.
Finally, if you just look at it from a tax standpoint, the marginal tax rate is 39.6%, and then you add to that the Medicare surcharge of 3.8%, that comes to 43.4%. That's your top marginal tax bracket and that's an elevated level.
When you look at munis on a taxable-equivalent yield, taking into consideration that tax level, you take a 2.77 % 10-year triple-A muni, you gross that up and you're looking at a 4.9% taxable equivalent yield. You compare that to just over 3% on a 10-year Treasury, you're picking up almost 200 basis points on a taxable equivalent basis in the 10-year part of the curve, compared to Treasuries. We think that's pretty compelling.
That's going to wrap it up for our call today. We recognize that 2013 was a challenging year for the muni market, and to the degree that you have any lingering questions about the market, the way it behaved, about our strategy, or our thoughts on 2014, please do not hesitate to give us a call. Thank you.
This represents the views and opinions of GW&K Investment Management and does not constitute investment advice, nor should it be considered predictive of any future market performance. Data is from what we believe to be reliable sources, but it cannot be guaranteed. Opinions expressed are subject to change. Past performance is not indicative of future results.