Best Bets

The municipal sector has 90,000 potential issuers ranging from large states such as New York and California to a small fire district that needs to buy a truck every 20 years or so, according to Kotok. It’s more idiosyncratic than the corporate sector, and it requires a different understanding of a bond indenture. The analysis requires an investor’s ability to read and project the budgets of non-uniform governments around the country. Cumberland has five analysts and a 40-year history of doing this kind of work.

Kotok and his team can get 100 basis points above the 30-year Treasury, which yields around 2.8%, with relatively safe issues. For example, the firm owns a “AAA”-rated bond issued by Yale University, which, as Kotok notes proudly, is an older institution than the United States. Cumberland is happy lending the money of its clients to Yale over the U.S. government for the higher yield the university provides. In fact, so attractive are the deals on various munis that Kotok owns them in clients’ tax-advantaged accounts.

Of course, credit analysis and safety assessment carry the day for Cumberland. Kotok doesn’t like many issues from New Jersey and Illinois, “two poster children of unfunded long-lived liabilities in pension and health-care benefits,” as he puts it. Neither will he touch Puerto Rico unless the issues are insured and the senior and credit indentures properly structured.

Kotok notes, “I worry about appropriation bonds and moral obligation bonds, promises made by governments. We’ve seen Puerto Rico use that tool to default on a bond. We’ve seen [Illinois] not appropriate money and suffer a dramatic downgrade in a credit.”

Instead, when analyzing issues from dodgy states and territories, Kotok looks for solid revenue support. For example, the covenant on some New Jersey Turnpike bonds demands that tolls be raised to cover the bonds. Kotok finds these attractive, saying, “We like a central service revenue bond in first-lien position.” While the $15 cost for a driver to go from Delaware to the Lincoln Tunnel in New York City may be burdensome to a driver, it makes NJ Turnpike bonds attractive.

Additionally, some states have a strong constitutional structure protecting lenders. They include Utah, whose constitution demands that old money be paid off before new debt can be issued.

In terms of duration, Kotok isn’t afraid of portfolios for some clients that reach out to seven or eight years. However, he prefers a barbell strategy—owning shorter and longer-term bonds that average out to an intermediate-long duration—to owning bonds with actual intermediate durations. He thinks investors have bid up the intermediate part of the muni yield curve. So his barbell bet can amplify returns if the yield curve flattens and mute returns if it steepens.

Athena Lets Managers Navigate The Risk Sectors
Unlike O’Sullivan-Hale, David Lynch at the $6 billion firm Athena Capital Advisors in Lincoln, Mass., reports that his firm’s fixed-income portfolios tend to have a mixture of 80% in high quality municipal bonds and 20% in more opportunistic funds. The latter can be private equity funds through which Athena’s clients gain fixed-income exposure.

Athena is a manager of managers. Most of its clients are taxable investors, making the municipal bond exposure attractive as the anchor of their portfolios.

The firm operates with an awareness of a client’s home jurisdiction, but, as Lynch says, “We do believe there are opportunities around different areas. Our Puerto Rico exposure is through hedge funds and private equity. “

Athena’s core municipal accounts are higher-grade bonds. “We’re able to hold these municipal bonds in [separately managed accounts],” says Lynch, so they are not subject to the vagaries of fund flows.

Athena also owns some high-yield corporate bonds. Lynch says there’s no substitute for good credit work, and he’s willing to give some managers the ability to search for high-yield issues. “Good managers can find good bonds,” as he puts it. On a headline basis, the high-yield market will have bad days, and its problems could spread to other markets. But Athena can be patient through the volatility.

Athena also has exposure to non-agency mortgages through mutual funds. The firm isn’t underwriting real estate loans directly, but it’s using managers to get its clients exposure.

The duration for Athena’s core muni portfolio is around the four-year duration of the Barclays 1-10 Year Municipal Index.

Keeping The Safe Money Safe
All these advisors have reminded clients seeking yield that bonds are their safe money. And the clients, for their part, accept the situation.

Of course, it was easier to tolerate low bond yields when the stock market was roaring for six years through 2014. It remains to be seen, however, how long prodigious stock returns can cover for the lack of yield in the bond market, and whether the Fed’s rate “normalization” process bodes poorly for both stocks and bonds.

According to Janet Yellen’s late September statement, delivered at the time of this writing, she’d rather begin the tightening process gently before the end of the year than risk potential future inflation demanding a greater Fed response.

Indeed the Fed’s brake pedal is notoriously stronger than its gas pedal, and Yellen would clearly prefer to tap the former gently before it becomes necessary to apply more pressure.

Perhaps this latest statement from Yellen brings her closer to removing some of the uncertainty that Kotok has decried. Or perhaps it reflects an urgency indicating the Fed is losing control of the financial markets.