PM Corner: In conversation with the Tax Aware Strategies Team
Portfolio managers Rick Taormina, Curtis White and Josh Brunner discuss the state of the municipal market and opportunities in a short end that has significantly repriced to higher yields this year.
What is the advantage of an ultra-short municipal bond fund in a rising interest rate environment?
Ultra-short strategies maintain a duration of less than one year across market cycles. The flexible duration provides a pickup in incremental yield as we step out beyond cash. When the Federal Reserve (Fed) is raising rates, that pickup can be meaningful. In the Treasury market, for example, four-week bills yield 3.32% while two-year notes yield substantially more at 4.45%. The municipal market has a similar slope given that municipals typically trade as a percentage of Treasuries. In addition, municipal investors can allocate to variable rate demand notes (VRDNs), which are reset daily or weekly and have a put at par; this can help reduce volatility by providing principal preservation and liquidity.
Can I use an ultra-short bond fund as a cash alternative?
In this environment especially, clients may want to examine the cash bucket and define an acceptable level of volatility from this portion of the portfolio. It may make sense to segment the cash allocation, first making sure that there are enough funds in bank deposits or money market funds to cover any immediate expenses or commitments over the next nine months. Most true ultra-short funds, may be appropriate for investors with an expected investment horizon of nine months or more; an allocation to a higher-yielding ultra-short strategy can help add incremental yield to a cash allocation.
As we move into year-end, what do the technicals and fundamentals look like in the municipal market?
Municipal fundamentals are in solid shape. Although there are some headwinds from higher inflation and moderating economic growth, credit fundamentals should remain stable well into 2023 given the strength of municipal balance sheets. As the Fed tries to engineer a slowdown, we expect states to continue the same fiscal discipline and conservative budgeting they demonstrated during the COVID-19 pandemic and, if necessary, draw on the record rainy day funds they’ve accumulated. We are being more careful in some sectors – health care, education, and continuing care – that face longer-term issues.
The technicals are a little more challenging. We’ve already seen record and persistent outflows this year from mutual funds. On the other hand, with state and local government entities flush with cash, and upcoming election uncertainty, supply has been lighter than expected. The spike in Treasury rates and higher market volatility has produced interesting opportunities in a market that finally offers some attractive yields.
How much further do you expect the federal funds rate to rise and how will that affect the strategy’s yield through the end of the year and into 2023?
In our view, although the Fed is still likely to raise interest rates further, we are closer to the end of the rate hiking cycle than the beginning. The Fed raised rates 75bps on September 22, 2022 and made it very clear that strong economic data and persistently high inflation may require it to continue aggressively raising rates and tightening financial conditions. The Fed projected a 4.40% fed funds rate at the end of 2022 and a terminal rate of 4.60% in 2023. That translates to approximately another 75bps hike in November and 50bps in December. The very short end of the curve will adjust accordingly: Our Global Fixed Income, Currency and Commodities (GFICC) team’s year-end estimate for two-year Treasury bonds is 4.50% to 4.88% from the current yield of 4.45%.
The strategy’s significant short-term exposure – almost 45% in cash, VRDNs and bonds that mature by year-end – will drive yields higher as the Fed moves up rates. Given our current rate forecast, we estimate that the Securities Industry and Financial Markets Association (SIFMA) yield will reset to about 3% by year-end, up from the current yield of 2.37%. This should translate to an attractive increase in overall portfolio yields.
How are you positioned today and what areas of the municipal market do you think are the most attractive in the short end?
We have been cautious over the course of this year, keeping our duration in a range of 0.5-0.7 years, well inside the one-year maximum duration, and keeping an allocation of 20%-40% in readily available liquidity, including VRDNs. The allocation to VRDNs allows us to increase yield in the portfolio as the Fed raises rates without any principal at risk. The allocation also serves as shock absorber, contributing to a much smoother ride for investors in times of volatility. We also look to add value by being a liquidity provider in volatile markets, stepping in to set levels that we think will sustain their value. We continually look for high quality rated notes, as well as non-rated notes from investment grade issuers with acceptable internal ratings, that are priced with a significant yield concession. We are also opportunistic: We aggressively bid odd lots when the spread is 20-30bps over round lots and look for cheaper new issues.
We have stayed short but will likely extend duration once we think the Fed is coming to the end of its hiking cycle and rates have peaked. As a guidepost, we want to see inflation below the fed funds rate on an annualized basis. Historically, the Fed stops hiking when the policy rate is above inflation. At that point we would expect a slower economy would result in a stabilization in short rates, which is when we want to add duration. As always, the state of Fed policy and market conditions will impact our duration, credit and allocation to VRDNs.
We continue to comb the market for credit opportunities but acknowledge the Fed’s intention is to slow the economy. That’s a fundamental change. As a result, we are scrubbing existing holdings to make sure that we want to continue owning them as the cycle evolves. As we look across the market, we finally see some very interesting opportunities, including a yield cushion to offset any incremental increase in rates.
Investments in asset-backed, mortgage-related and mortgage-backed securities are subject to certain risks including prepayment and call risks, resulting in an unexpected capital loss and/or a decrease in the amount of dividends and yield. During periods of difficult credit markets, significant changes in interest rates or deteriorating economic conditions, such securities may decline in value, face valuation difficulties, become more volatile and/or become illiquid.
The risk of a municipal obligation generally depends on the financial and credit status of the issuer. Changes in a municipality's financial health may make it difficult for the municipality to make interest and principal payments when due. Under some circumstances, municipal obligations might not pay interest unless the state legislature or municipality authorizes money for that purpose. Municipal obligations may be more susceptible to downgrades or defaults during recessions or similar periods of economic stress.