Municipal Bond Podcast 2Q13 (Transcript) 

Michael Sullivan: Hi, everybody. This is Mike Sullivan at GW&K. This is the second quarter 2013 update for our Municipal Bond Strategy. I'm going to take 10 minutes today to discuss activity in the market during the second quarter. I'll discuss changes we made in the portfolio, and then I'll wrap it up with our thoughts going forward.

Needless to say, it was a very difficult quarter, not only for municipal bonds, but for pretty much every part of the fixed income market. There was really no place to hide over the past couple of months, as rates across the fixed income universe reset higher as a result of improving economic data, and the increasing expectation that the Federal Reserve will begin tapering its QE program at some point later this year.

It felt like as the tapering conversation gained momentum, the markets became more volatile, because investors struggled to come to grips with the new reality that the Fed, at some point in the not too distant future, will no longer be the dominate purchaser of US Treasury debt.

For the quarter, 5 and 10-year Treasury yields rose just over 60 basis points and 30-year yields rose 40 basis points. The move came entirely in May and June as yields during April actually declined.

For example, if you look at the 10-year Treasury, yields actually rallied 20 basis points in April, but then sold off 50 basis points in May and then moved another 32 basis points higher in June, ending the quarter at 2.5%.

The situation was similar in the muni market, which experienced its worst quarter of performance since the end of 2010. Similar to the activity in the Treasury market, muni yields declined 20 to 25 basis points in April and then moved significantly higher in May and June.

The initial part of this selloff was pretty controlled, but as broad fears of Fed tapering picked up, volatility increased and retail investors, as they've been known to do, began to aggressively sell their muni mutual fund holdings. This forced selling led to large bid lists and very sloppy trading in the secondary market.

At the same time, underwriters started to postpone new issues, which also clouded price discovery. Nobody really had a good idea of where debt should be trading, which of course, can be a bit unsettling.

At the peak of volatility towards the end of June, we saw a three-day stretch where the 10-year AAA muni yield rose 52 basis points. That's the worst three-day period for the muni market in the last 25 years. But what's encouraging is that by the end of the quarter, the selling had calmed down and investors, who had been sitting on the sideline waiting for selling pressure to end, jumped into the market and were able to buy debt at yields that we haven't seen in a couple of years.

As a result, during the final three days of the quarter, 10 year rates rallied back 25 basis points, and importantly it felt like a sense of normalcy or a sense of calm had returned to the market.

Overall for the quarter, 5-year muni yields rose 56 basis points, 10-year yields rose 65 basis points to end at 2.56%, and 30-year yields rose 74 basis points. At 2.56%, the 10-year AAA muni bond ended the quarter 109 basis points higher than its all-time low, reached back in November of 2012.

From a performance perspective, given the move in yields, longer-duration munis were impacted the most, and the Barclays Long Index was down 4.4% for the quarter, while the 10-year Index was down 3.1%, and the 5-year Index was off 1.7%. For the first time in a while, lower quality underperformed higher quality, as we did see some spread widening as a result of volatility. The Barclays High Yield Muni Index, which has been a very strong performer over the last 18 to 24 months, lost about 4.1% for the quarter. As for our strategy, we performed pretty much in line with the Barclays 10-Year Index.

The question that everybody keeps asking us is, "What have you done with the strategy in light of all this volatility?" A common follow-up is, "Are you shortening duration, or are you raising cash?" The answer to those two follow-up questions is "No." We're not shortening duration, and we're not looking to raise cash. In fact, we're actually looking to do the opposite of that.

The longer answer, if you take a step back and look at how the strategy has evolved over the last few years, is that we've been methodically reducing the duration of this strategy since the duration hit its peak at over 7.5 years back in 2009. By the end of 2010, the duration was seven years. By the end of 2011, it was down to six years, and by the end of 2012, it was at 5.5 years.

At 5.5 years, that's the shortest this portfolio has been in over 10 years. Coming into this quarter, our duration was at 5.8 years. It was neutral with its benchmark. By the end of the second quarter, duration was pushed out to about 6.2 years.

Getting back to the original question, "What have we done in light of all of this volatility?" The answer is, "We did exactly what you'd expect us to do in this type of environment. We got active, and we modestly extended the duration of the portfolio."

Looking back, most of the activity in the strategy took place in June. It really peaked during the height of the selloff toward the end of the month.

In general, we purchased bonds maturing in 9, 10, and 11 years. Those purchases were partially funded from cash and also by selling five-year bonds that we've been holding on to precisely for this sort of opportunity.

Remember, from a portfolio positioning standpoint, at the beginning of the quarter, we held about 40% of our strategy in 5 to 7-year maturities. And we've always said that while we don't necessarily like the yield that we're earning on these bonds, we do like the fact that they are shorter in duration. We like the fact that they are liquid. We like the fact that they are defensive holdings that can be easily sold when we have the opportunity to lock in higher yields further out the curve.

Naturally, once we've answered the question about what we've done with this strategy, the next thing that people tend to ask is, "What are our thoughts on the market for the rest of the year?" Admittedly, that's a very difficult one to answer.

The bottom line is it's very difficult to know precisely where rates are going to go from here. It seems clear that the Fed has successfully injected uncertainty into the market with their comments about scaling back quantitative easing. In our view, the recent move higher in yields can almost be viewed like a down payment on future volatility. That down payment has just been coughed up during this most recent quarter and it will potentially lead to a more muted response when the Fed actually begins to slow or remove monetary stimulus. That's really just a fancy way of saying that tapering is probably already priced into the market or baked into the cake.

That said, it's likely that as we do approach policy removal, the market is going to definitely be more sensitive to economic releases, particularly ones that pertain to employment. It's going to be more sensitive to Fed speeches. It will also be more sensitive to economic and political developments globally.

We believe right now the market is in much better shape today than it was a month ago. Yields are higher. The curve is steeper. Munis have cheapened up relative to Treasuries. Credit fundamentals in the market remain strong and had nothing to do with the selloff that we saw over the past couple of months.

From our perspective, we're energized, and we're encouraged by the opportunity to take advantage of those higher yields. We're encouraged at the steeper curve that we can buy into. We're also encouraged by the cheapness of munis relative to Treasuries.

If rates move higher from here, it's likely that we'll modestly extend the portfolio again selling more of those bonds in that 5 to 7-year bucket. If rates stay the same, then we'll harvest the better carry and the better roll that we've established by moving slightly longer. If rates reverse course and start to move significantly lower from here, we may shorten the duration of the portfolio and lock in some nice capital appreciation.

Regardless of how events unfold, it's important to understand that we have a plan in place. We've built a flexible portfolio that can be adjusted appropriately to any market environment.

We believe that this sort of volatility is an opportunity that should be embraced and not feared. We believe that recent volatility is a perfect complement to our active style of municipal bond management.

I'm going to wrap this podcast up right here. If you have any questions or concerns about the market, about our strategy, about the Fed, really, about anything, please do not hesitate to give us a call.

We recognize that movements in the market like the one we've just been through can be unsettling, and it can be confusing. To the degree that we can help clarify anything about the markets, anything about the strategy, we are happy to do so.

Thank you very much for tuning in. I look forward to speaking with you soon.

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.