Municipal Bond Podcast 4Q14 Transcript

Chris Iovanna: Hello. This is Chris Iovanna and I am the Fixed Income Product Specialist here at GW&K, and this is the Q4 Municipal Bond Strategy podcast.

First, let's touch on what happened in the market. Overall, municipals continue to perform well with a fourth straight quarter of declining rates. Ten-year AAA GO rates finished at 2.04%, which was down 13 basis points for the quarter and 71 basis points for the year. Thirty-year rates finished at 2.86%, down 23 basis points for the quarter and 133 basis points for the year. If we use the Barclays 10-Year Muni Index as our proxy, the muni market was up 1.3% for the quarter, underperforming Treasuries, which returned 1.93%. For the year, munis gained 8.72%, which was ahead of the 5.05% increase in Treasuries. As has been the case recently, short-term bonds underperformed while long-term and lower-quality bonds outperformed. The Barclays 5-Year Index, representing the shorter side, posted a 0.09% gain for the quarter, and 3.19% gain for the year. On the other hand, the 20-Year Index was up 2.16% for the quarter, and 13.03% for the year. The Barclay's Baa Index posted a 2.33% quarter-to-date return and a 16.45% return for all of 2014.

All this in a year when most pundits were sure that rates were going to rise. It's been basically a cautionary tale for anyone who's been trying to predict rate movements or simply waiting in cash for the right moment to invest.

The primary reason for the solid municipal performance has been the strong Treasury market. For example, the yield on the 10-Year Treasury fell 86 basis points for the year and 32 basis points in Q4 alone. Also to note was the massive flattening of the Treasury curve, where short rates crept higher while intermediate and long rates fall.

Domestically the jobs market continued to improve with solid monthly growth and an unemployment rate down to 5.7%. GDP hit 5% for the third quarter, the highest since 2003. However, with growth and inflation still uncomfortably low in Europe and Japan, you saw global capital pour into U.S. government securities, basically looking for an alternative to the depressed yields available on high-quality overseas bonds. U.S. Treasuries have looked attractive to many sub-1% yields that you're seeing in the sovereign debt area.

Buying was also fueled by geopolitical tensions, the severe drop in oil prices, and concerns about a possible Ebola pandemic. The municipal markets are also driven by supply and demand, and in that regard for most of the year tax-exempt issuance was running well behind 2013's pace. But you saw a jump in fourth quarter supply, which caused munis to underperform Treasuries over the final three months of the year.

Demand remained strong in the face of the issuance pickup. The market saw positive fund flows every week of the quarter and new deals were oversubscribed and taken down easily. 2014 saw $21 billion in inflows compared to $60 billion in outflows for 2013. Definite improvement over last year.

Moving on to our strategy, in this environment we took advantage of strong bid and we looked to sell some of our weaker names that were trading relatively rich. Regarding credit, we upgraded quality toward the latter half of the year as investors chased yield in a declining rate environment. As spreads tightened during the year, the risk-reward profile changed, and that prompted us to shed risk that we believe will become more vulnerable to re-pricing as we go forward. This included the tax-backed debt of certain states, a number of fully valued hospitals, and the enterprise systems of weaker local governments that trade richer than their fundamentals.

In the fourth quarter we continued our selling of state GOs with poorly funded pension systems and/or high debt levels. This included Pennsylvania, Kansas, Connecticut -- all three with funding levels less than 60%. In Connecticut it's under 50%. There will be some new accounting standards that are going to be implemented within the next few years, and that's going to force states to report even lower funding levels based on lower discount rates. We thought it was an opportune time to sell. The market has not been pricing in any potential downsides to these names. We also continued to lighten on New Jersey and also some of our richer health care names.

Throughout the year our trading activity has been centered on selling 5-year maturities and reinvesting in 10-year bonds. With the yield curve historically steep through the majority of the year, these trades provided a pickup in carry from both higher yield and increased roll potential. The sales prices of the shorter maturities were still at substantial premiums, premiums that were set to drop sharply toward par as the bonds aged further.

Meanwhile the 10-year part of the curve performed particularly well in the bull flattening scenario. As rates declined over the course of the year, we allowed overall duration to drift modestly lower, and duration is in line with the benchmark. While any bonds shorter than the benchmark were a drag on performance in 2014, which I'll get to, we still have a healthy exposure to those types of positions. That serves as a hedge against rising interest rates heading into the new year.

Let's move on to performance. We modestly underperformed the Barclays 10-Year Muni Index for the quarter and for the year. The same attributions exist for the quarter as they do for the year where 40% of our bonds are in maturities shorter than the benchmark and that was a detractor.

Another negative was our underweight to A-rated bonds and our lack of exposure to BBBs. We have a higher-quality bias with this portfolio, and as we liquidated some of our lower-rated credits and upgraded our credits, we did that in a market where we saw spreads continuing to tighten. Our small cash allocation was a drag in the up municipal market. The main contributor to performance came from our longer maturities as the curve flattened.

Let's move on to our outlook. Looking ahead, markets are going to be focused on Fed policy and global growth, which the recent drop in oil prices is definitely a part of. We expect volatility to stay elevated and the fourth quarter definitely gave us a taste of that.

Municipals, we think, should offer a relative safe haven, and that's going to be helped by historically avoiding the sharp swings of the Treasury market. Credit fundamentals in the municipal bond space remain solid. Tax revenues have been on the upswing for five years, and states that have put austerity measures in place have modestly shrunk the level of municipal debt outstanding. We think that the dynamic is moving in the right direction.

You see that rainy day funds are on the raise, and states are also benefiting from the national recovery that's happening. That's trickling down to the individual states.

Technicals should be favorable as well. The fourth quarter jump in supply has changed over to the typically slow issuance months of January and February. We believe that good demand is going to help curtail any yield spikes, as we believe investors are waiting on the sidelines to buy in at more attractive levels.

Also yields versus Treasuries are historically cheap, particularly in the 10-year range and out longer. The 10-year muni to Treasury ratio finished the year at 94% and the 30-year at 104%, both above their historical averages and historically have been good times to put money to work in the municipal market.

As we look toward what may be a choppy 2015 for many markets, the steady income, tax-free income, domestic purchasing base and miniscule default rates should help reassure those looking for a portfolio anchor.

This concludes the Q4 2014 municipal podcast. Thank you for listening 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.