Municipal Bond Podcast 3Q14 (Transcript)

Martin Tourigny: Hi, this is Marty Tourigny. I'm one of the portfolio managers here at GW&K. This is the "Q3 Muni Bond Strategy" podcast.

I'm going to take a minute to explain what happened during the quarter, and then I'm going to move on to strategy and performance, and then finish up with our outlook heading into year-end.

What happened during the third quarter? Munis continued to perform extremely well. We had the third straight quarter of declining rates. ten-year munis were down 9 basis points. That brings the year-to-date rate decline down 64 basis points. Using the Barclays 10-Year Index as a proxy, it's up over 7% now, so a pretty good year. All this in a year when most of the pundits were sure that rates were going to rise. This has certainly been a cautionary tale for anyone who is trying to predict rate movements, or even sitting in cash on the sidelines waiting for the right moment to invest.

What have been the causes of this big rally in muni bonds? The primary reason has been the strong Treasury market. The Treasury market was down another four basis points for the quarter, and now 54 basis points year to date. There's a number of factors at work here, most importantly the slowing global economy. The IMF just lowered their forecast for global growth to 3.3%. That's almost half a percent lower than six months ago. Also, there appears to be very little inflation at work worldwide. That's also a product of that slower growth. This has led to lower bond yields in Europe. The 10-year yield in Germany is less than 1%. If you look at Treasuries, at well over 2% here in the U.S., they've looked relatively attractive. That's meant a pretty strong global bid for our Treasuries. In addition, we've had plenty of global unrest, from Ukraine, to Gaza, to Syria, to Iraq, to Hong Kong, and potential for Ebola to spread in the U.S. have all meant a steady flight to quality bid for Treasuries, also.

On the muni side we performed particularly well, even outperforming Treasuries for both the quarter and the year. That is not typical. We usually will underperform in a strong rally. The reason for the muni outperformance has been mostly supply and demand driven. Supply has been very weak all year. It's down 11% year-over-year. If you look at the third quarter in isolation, that was the lowest level in 13 years. You combine that with some pretty strong demand and there's been a couple of factors there, one being very consistent positive fund flows. Now we're totalling about $13 billion year-to-date in those fund flows. If you remember, last year we had about $60 billion in outflows, so a shift there in sentiment from munis.

Also, we've had some pretty strong coupon immaturity redemptions. That's typical of the summer months. Usually July and August have big redemptions. That money gets reinvested back into the muni market, so there was plenty of cash on the sidelines looking for a place to invest.

Those factors together led to a supply and demand imbalance. You could really see that in the new issue market. The deals that did come to market saw voracious demand, were typically many times over subscribed, and in some cases 10 to 15 times oversubscribed. The higher yielding names got that really strong demand, but even the higher quality names received strong demand. All this allowed dealers to lower their yields during the sale period. When these bonds were free to trade, in most cases, they traded in even lower yields.

What was our strategy in this environment? We really tried to take advantage of that strong bid in the third quarter. We looked to sell out of some of our weaker names that were still trading at what we felt was relatively rich. We targeted some of our state GOs that had poorly funded pension systems and/or high debt levels. That included Pennsylvania state, Kansas state, and Connecticut state GOs. All three of those have pension funding levels of less than 60%. Connecticut, in particular, was less than 50%. We're going to see some new accounting standards that are going to be implemented in the next few years. They're going to force states to report even lower levels, based on lower discount rates, particularly for those that have higher unfunded liabilities. That could be eye-opening for some of the states and for some investors in the market. We could see some spread widening for those states. We figured this was an opportune time to sell, as the market was not really pricing in any downside risk for these names, really just basing the strong bid on the fact that they're state GOs. With no supply around, there tends to be very little differentiation between credits. Almost all of the names have been trading pretty tight, so we were OK with selling some of those names before any such spread widening. In general, we've been really OK with upgrading our credit quality as spreads have really tightened all year.

From a curve perspective, we continue to sell our five-year bonds that have moved down the curve from the six-year bucket. Inside of five years is the period of a bond's life when that premium really starts to decline quickly as it approaches par, so we try to get out of that five-year paper before that depreciation happens. As an active manager you really are responsible for capturing those premiums before they go away, so that's what we've been focused on. In addition, if you look at the relative value metrics for the five-year part of the curve, it certainly appears a bit overvalued in here. Using muni yields over Treasury yields as a proxy, currently we're in the five-year part of the curve. That's in the mid-60s as a ratio. If you look at historical averages, that's more like 81%, well through historical averages. Meanwhile, if you look at the 10-year part of the curve and out further, those ratios are modestly cheap versus historical averages. We were able to sell these five-year bonds at yields of around 1%. We moved those bonds out to the curve, into the 8-13 year part of the curve. The curve is really still historically steep there, so we picked up some nice yield and the benefit of the stronger bond roll that's out there. We executed this trade mostly during September where there were a couple of weeks of particularly strong supply, and we had multiple deals of over a billion to take advantage of. Our timing was pretty good in that way.

In terms of performance, we slightly underperformed the Barclays 10-Year Index for the third quarter. It's been the same attribution themes for the quarter and the year. Our shorter than benchmark maturities were a modest drag with the 10-year really severely outperforming the 5-year part of the curve on a year-to-date basis. If you look at 10-year yields, they're down 64 bps, and the 5-year is only down 17 bps. To the extent that you owned anything shorter than 10 years, it was a negative for performance. We tend to be underweight BBB and single-A names and with spreads tightening, our high quality bias was a modest negative. We're modestly overweight in longer maturities. Those were our best performers as the yield curve flattened.

Moving on to outlook, performance certainly has been great, but what should you expect for the rest of the year? We think the muni market could be tested a little in here. Those positive technicals that we've seen in the third quarter could weaken a bit. Coupon immaturity redemptions that were strong all summer are not as robust in the fall. Also, we could see a little bit of a pick up in issuance. That is typical this time of year, but we feel like any supply-induced backup is likely to be modest.

If you look at the states, they're still focused on balancing their budgets and solving the issues with their long-term liabilities, i.e. pensions and healthcare benefits. Large-scale capital projects that are the ones that really create issuance are certainly not a priority right now. Austerity still rules the day. Rather, the likely path is probably a modest uptick in issuance as states try to deal with some deferment maintenance and repair needs. In terms of larger scale volatility, rates up or down will likely come from the Treasury market. That's certainly difficult to predict, as this year is evidence of. Even there, if asked our opinion, we don't expect a big backup in rates. Inflation does appear to be well contained, and that relative value trade versus those low European yields is certainly strong.

The front end of the curve will probably continue to move a little bit higher as the Fed prepares for its exit. The long end is much more focused on the low inflation and slowing global economy, so more flattening is probably in order. When it comes down to it, we really know we need to be prepared for anything. That's why we have a very flexible portfolio. We are really well positioned for any backup in rates. We'd certainly welcome it. We have about 40% of our portfolio shorter than benchmark maturities, so all of that is essentially dry powder which we'll use to sell and redeploy. If rates rise, we'll sell those bonds that will likely perform pretty well, and move them out into bonds that have cheapened up. That volatility that could happen always tends to create an opportunity to add value, and we certainly would look forward to that.

With that said, this concludes the muni podcast, and we look forward to speaking with 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.