Municipal Bond Podcast 2Q14 (Transcript)

Marty Tourigny: Hi, this is Marty Tourigny. I'm one of the PMs here at GW&K. This is the Q2 Municipal Bonds Strategy Podcast. I'm going to take a few minutes to explain what happened during the quarter and then talk about strategy and how we see the market going forward.

What happened in Q2? Rates continued to decline. If you look at Treasury rates, five year rates were down 9 basis points, ten-year bonds were down 19 basis points, and 30 year Treasuries were down 20 basis points in yield. The longer you were, the better. This is a theme that we've seen throughout the year as the curve has bull flattened pretty significantly.

Again, this has proved the naysayers wrong. People keep predicting rates are going to rise, and instead rates keep coming down. In terms of the factors moving rates, it certainly wasn't the economy this quarter. The economy seemed to actually rebound pretty well from the first quarter.

Economic data was decent. Employment, consumer, housing all showing positive signs. But, this was trumped by a couple of things, one being the geopolitical risk that's been going on in Iraq and Ukraine. That's caused a bit of a flight to quality trade.

Then also concerns about Euro's own deflation pushed the ECB to cut rates. Rates across Europe declined over the course of the quarter, which made Treasuries relatively cheap. We saw some crossover investing, people looking at the value. Even though rates are low over here, they're even lower in Europe and that caused a bid on the Treasury side.

Looking at munis, they have performed even better than their Treasury counterparts. If you look at ten year munis, they were down 23 basis points versus the Treasury down 19. Then on the long end, munis were down 37 basis points versus only 20 on the Treasury side, so we even had a bigger flattening of the curve.

Usually munis underperform when the market rallies. The reason munis outperformed this period was a strong supply/demand technical environment. If you look at the supply side, the supply has been down year over year for basically the whole year. It was down pretty significantly in April and May.

In June, issuance actually ticked up a bit. That was the first month of year over year gains we actually saw. Then the market started to anticipate a drop off in supply that we see in the summer, so people started loading up on bonds to make sure they had some supply in their portfolios heading into the summer when we typically see a bond calendar slowdown.

On the demand side, fund flows were pretty strong. For year to date, we have inflows of about $5 billion into muni mutual funds. Of course, remember last year we had $60 billion in outflows, so there's a pretty big delta there, pretty big change in attitude in the muni market.

That's due to a couple things. One is the higher tax rates. People filing their taxes saw that their tax bill was even bigger than it has been because of the rate going up to 39.6%. Then, of course, on top of that you have the Obamacare surtax of 3.8%. So, investors were really seeing the value of their municipal bonds, which are exempt from both of those taxes.

We typically see a lot clients of tax selling in March and April to pay for their taxes out of their muni accounts and we didn't see that this year, and a big part of that was the change in tax rates. Then also, retail has begun to understand that the Fed can remove stimulus. That doesn't necessarily mean that rates are going to go up.

We always talk about how the Fed controls the short end, but intermediate and long-term rates have a mind of their own and are much more based on inflation expectations than what the Fed is doing. I think that retail started to understand that the Fed isn't necessarily going to cause the rates to go up and they can actually invest some of their cash that's been sitting on the sidelines for a while.

In terms of credits, we've seen a lot of the same credits continuing to fill the headlines in the muni world. Puerto Rico is one of those credits. The situation there continues to get worse. They recently passed legislation that is going to allow them to restructure some of the debt of their public corporations.

In Puerto Rico, they have no provisions for bankruptcy so this is an attempt to implement that and allow them to reduce their oversized debt load. The legislation applies to the electric authority, the water sewer authority, and highway trust bonds.

It's really not the GOs and the sales tax bonds at this point, but people are beginning to question whether their willingness to pay has decreased because of this. It certainly appears that way. The bonds had already been trading at distressed levels, but this recent legislation caused them to drop below 50 cents on the dollar in many cases.

The Puerto Rico situation continues to deteriorate. We don't think it's going to have a big market impact at this point. That should be limited. Most of the bonds are held in high yield funds and hedge funds at this point. It's out of retails hands, for the most part. But, we could see some selling on the edges.

Illinois also made some news this quarter. Basically during their budget process they failed to extend the tax hikes that they implemented during the financial crisis. That allowed them to balance their budget for the first time in a while. Now with the failure to pass those tax hikes, they had to implement quite a few onetime measures to get the budget to balance.

This could create some rating pressure on Illinois over the next six months. A lot of that was due to the election cycle. Legislators did not want to pass tax hikes while they were running for office. Post election we could see them actually pass the hikes then, but we'll have to see how that transpires.

Then, finally, Detroit continues to slog through their bankruptcy negotiations so that will be an ongoing theme. In terms of the product credit picture, it still appears to be strong. These stories are not indicative of the market. If you look at the revenues for the states, they are up 17 consecutive quarters now above pre-recession levels.

If you use California and New York as a proxy, California just got upgraded to AA3. This is their highest rating since 2002. If you look at New York, they got upgraded to AA1 in the quarter. That is their highest rating in over 40 years.

Both of these states went from huge deficits to surpluses over the last five years. Both have had surpluses of over two billion in this fiscal year. Things are certainly improving for most of the states. If you look at generic spreads, you can see the tightening there. A rated spreads year to date are in 18 basis points and BBB spreads are in 23 basis points. The credit picture overall is pretty strong.

In terms of strategy, just talking about these credit stories, we have avoided all of these: Detroit, Puerto Rico, Illinois. We've basically stuck to our knitting in terms of credit, which means high quality. The portfolio is all A rated names or better. We stick with essential service revenue bonds and state GOs that we like and approve and Illinois is not one of them.

We've found some value in A rated names, so we've participated in the tightening. In general we've stayed away from those weaker sectors in the muni market, being tobacco, land secured deals, Puerto Rico, gas, those types of bonds.

Then looking at the yield curve, our focus has been on maximizing the carry in this low volatility environment. The curve has flattened pretty significantly but is still steep historically. We view the sweet spot in the curve as that 6 to 13 year area.

If you look at our portfolio, over 90% is in that part of the curve. Basically once the bonds have been rolling out of that part of the curve, we've been selling them, moving them back out on the curve a little bit longer in that realm in order to take advantage of the return characteristics that are available there.

We've effectively maintained our duration throughout the year. The beauty here is that the best return characteristics are relatively short on the curve, so you don't really have to go that long to capture and maximize your return potential. That's what we've been doing.

We can also use these bonds, these shorter maturities, if rates rise. They are basically our dry powder in a rising rate environment. We can sell these and move these longer and take advantage of higher rates. If you look at our portfolio, about 40 percent of our bonds are shorter than the index that we can use in that type of environment.

We underperformed modestly in the second quarter. Our overweights of those shorter bonds that I talked about actually hurt us. The curve flattened significantly, ten year rates were down 23 basis points and five-year rates were only down 5 basis points. To the extent that you owned bonds in the shorter part of the curve, you were hurt relative to the index. Those bonds, like I said, are hedge versus rising rates, and we're comfortable with those. We've done pretty well relative to our competition that tends to be a little bit shorter.

In terms of outlook, Q3 we expect will be pretty strong for munis, all else being equal. This is typically a very good performance period. Issuance typically slows quite a bit, and demand is usually strong. That's because a disproportionate amount of coupon and maturities come in from existing munis and those get reinvested back in the market typically.

If you look at it in total, we expect redemptions to outpay supply by about $20 billion. That net negative supply is usually a pretty big positive for the muni market. If you look at July and August, these are typically two of the strongest months on the muni calendar because investors just fight for the limited amount of bonds that are available.

What could derail this? Obviously the Treasury market could move in either direction, and that would drag munis with it. We don't claim to know which way rates are going, and we're not in the prediction business.

The key for us is always to have a flexible portfolio so we're quick to react to the changes in rates, so we have bonds spread across the curve and we can use those bonds to redeploy in any interest rate environment.

We would actually look forward to rates rising. We could sell some of our shorter bonds and invest out longer. If rates should decline we may actually shorten up the duration of the portfolio. That's how we're looking at the market. This concludes this second quarter call. We'll see you next quarter.

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.