Municipal Bond Podcast 3Q13 (Transcript)

Michael Sullivan: Hi, everybody, this is Mike Sullivan at GW&K. This is the third quarter 2013 update for our Municipal Bond Strategy. I'm going to take about 8 to 10 minutes today to review what happened during the quarter. I'll talk about our strategy and then our thoughts going forward.

Believe it or not, short- and intermediate-term municipal bonds posted positive returns in the third quarter, thanks to the strong September rally. For the quarter, 5-year munis were up about 87 basis points, and 10-year munis were up about 72 basis points. But at the longer end of the curve we continue to see weakness, and 30-year munis were down just over 2%.

Now, the rally in September essentially halted 4 months of weakness in the muni market. At the lowest point, year-to-date returns in the 10-year part of the curve were about -4.5%. Following the rally in September, returns were down about 2% on a year-to-date basis in the 10-year part of the curve.

Now, going back to the beginning of May, munis have been fighting negative sentiment from a number of different directions. First and foremost, munis have been battling simply the move higher in Treasury yields.

I think by now we're all pretty clear on what's been going on there. Clearly the Fed introducing the tapering conversation during May is what led to all the volatility in May, June, July and August.

By the first week of September, 10-year Treasury yields and 10-year muni yields have climbed up to about 3%, about a 140 basis point move off the lows. For the muni market, we had just witnessed one of the worst selloffs in 25 years. Pretty similar to what we saw during the post-Lehman bankruptcy period.

Now, the long end of the muni curve continues to feel the pain more significantly. During that same time period rates in the 30-year part of the curve rose about 160 basis points. Clearly on display there is an aversion to duration from your average municipal investor. But as we all know now, this move higher in rates reversed in September and really, the catalyst for the reversal early in the month was the weaker than expected employment report. Then later in the month, clearly, it was the Fed's decision not to taper its bond purchases.

Overall, for September, 10-year AAA munis rallied 40 basis points, and given this move, the yield was about 2 basis points lower for the quarter. Now, again, the long end didn't snap back quite as much, the 30-year AAA muni rallied 34 basis points in September. But it ended the quarter about 28 basis points higher. Year-to-date yields at the long end of the curve are about 130 basis point higher.

Now, also pressuring the muni market have been large outflows for muni mutual funds. You've heard us say this many times before. But typically, when the muni market gets volatile, we see large redemptions from muni mutual funds. Certainly this time is no different.

As of quarter-end, we've seen 19 consecutive weeks of outflows from muni mutual funds. June and July combined, we saw about $23 billion of outflows. Then in September, even with the strong rally, we saw about $4.5 billion of outflows. Year-to-date total outflows are about $39.5 billion.

Now, also putting pressure on the muni market is negative sentiment from a credit standpoint. Clearly, some of the weakness that we've seen over the last several months and some of the weakness that the market has experienced is due to negative headlines hitting the market.

In Detroit in July, we saw that Detroit officially filed for bankruptcy protection. We saw a super downgrade of Chicago by Moody's, that's a three notch downgrade from AA3 to A3. Then early in September, we saw Barron's run a real negative article on Puerto Rico pointing out some of its fiscal stresses. That's resulted in significant spread widening, significant weakness in Puerto Rico names. Year-to-date, Puerto Rico's off about 17%.

But even with all this negative sentiment from a credit standpoint, what we would point out is that fundamentals in the muni market continue to improve, state tax revenues continue to grow. We've seen 14 consecutive quarters of revenue increases. States have been replenishing their rainy day funds, Moody's improved their outlook on the states to stable from negative.

In our view, well, yes, there are some significant headlines and there are some credit pressures in the muni market that need to be monitored. From a big picture standpoint, states are heading the right direction.

All you need to do is look at spreads, look at the way spreads have behaved for confirmation of this view. If you look at credit spreads away from those high profile pockets of distress, you'll see that they've remained fairly stable across most of the market.

Clearly, the bottom line from our standpoint is, and again, this is something that we always talk about, you need to do your credit work in the municipal market. You need to know what you own, because there are pockets of weakness out there, and if you do your credit work, you'll be able to avoid those weaker areas.

All right, so that's an overview of where we've been over the last quarter. Now, I'll just take a quick look at where we are today and then wrap it up with our thoughts going forward.

Just a couple things to point out. Even with the rally in September, the municipal market is still cheap, particularly at the long end of the curve. During the selloff the muni/Treasury ratio in the 10-year part of the curve got as high as 106%. At the long end of the curve, it got as high as 120%.

Now, after the rally in September, the 10-year ratio declined to 97%. We'd argue that that's still cheap relative to history. The 30-year ratio declined to 112%, which is still very cheap compared to history.

Now, beyond that, let's not forget that year-to-date yields on 10-year munis are about 80 basis points higher and they're up over 100 basis points off of last November's lows. Same thing in the 15-year part of the curve. Yields in the 15-year AAA munis are up 112 basis points up for the year and 150 basis points since the lows of last November.

What this means is that the yield curve continues to be steep, it's steepened about 60 basis points year-to-date. That means that the curve continues to provide attractive carry and attractive role potential in a stable rate environment.

Now, turning to the strategy, from a strategy standpoint, from an activity standpoint, it was a fairly quiet quarter. If you remember back at the end of June, we did make a tactical move out of about 5% of our 5- and 6-year holdings, taking the proceeds from those sales and putting them out in a 10- to 15-year part of the curve.

As yields continue to climb, in July and in August, we continued this trade, but at a much more measured pace, basically continuing to sell 5- and 6-year bonds and continuing to buy into the weaker part of the market further out.

But overall, we continue to be fairly conservatively positioned, about 40% of our portfolios in 6- to 8-year bonds. Again, those bonds are there basically to be redeployed and to exploit higher interest rates if and when they arrive.

Now, from an outlook standpoint, in a way, the snap back in September was a bit of a double-edged sword, at least from our perspective. While in the short term, it's nice to see stability return to the market, there's definitely a part of us that would have preferred not to see the gains in September. Because, in return, we would have had the opportunity to keep buying bonds at higher yields.

You've heard us preach time and time again that the number one enemy for bond investors is reinvestment risk. That's getting caught reinvesting your coupon payments or your maturities or your proceeds from sales into a lower and lower interest rate environment.

That risk as rates move lower in September re-emerged. With the Fed postponing its decision to taper, it's clearly emphasizing its commitment to lower interest rates, not only at the short end of the curve, but also at the intermediate and the longer end in the curve.

Even if we see volatility pick up in the near term, it's difficult to see yields spike meaningfully from here. The Fed simply doesn't have the tolerance for that at this point in time.

From our standpoint, all of this points to needing to strike a delicate balance in the portfolio between guarding against lower rates while at the same time recognizing where we are in the interest rate cycle and recognizing that when economic growth begins to accelerate more rapidly, eventually there'll be a continued move upward in interest rates.

What does that mean for our strategy? What that means is from a duration standpoint, we're going to remain neutral relative to the benchmark. It means that we're going to maintain an allocation to shorter duration holdings that we'll be able to sell at a future point to lock in some higher yields. It means that we're going to continue to be biased towards higher quality credits. Finally, it means focusing on carry and roll that the steep yield curve continues to provide us with.

I'm going to wrap it up right there. Thank you for listening today. We appreciate it very much. If you have any questions going forward, please let us know. We'd be happy to chat. Thanks a lot.

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.