Despite fears this year that the US municipal bond market would suffer large-scale defaults it’s held up well. Last December, banking analyst Meredith Whitney predicted hundreds of billions of dollars of defaults. So far, however, there’s only been USD2.8billion in defaults, reported the Financial Times last week.
Performance in the market has been surprisingly strong. A triple-A rated 30-year US muni bond with a five per cent coupon yielded 5.12 per cent mid-January according to Municipal Market Advisors – since then, prices have risen and the yield has dropped to 3.7 per cent. As a tax-free investment for US investors, muni bonds are a good diversifier, particularly with US treasuries at record low yields.
Municipal bonds remain a very niche space. Few outside of the US really know much about these instruments, let alone invest in them. But one hedge fund manager, Concordia Advisors LLP, is trying to change the perception of the muni market. The firm has been running a municipal relative value strategy since 2003 and currently has USD300million in AUM.
“It’s an absolute return fund for both taxable and tax-exempt investors, US and overseas. It would fit into the category of any fixed income relative value fund that’s trying to generate total returns, not just current tax-exempt income,” explains CEO Basil Williams (pictured) from the firm’s New York office. “That to me is the first misconception of the muni market. If I speak to people about it everyone says ‘well that’s for US taxpayers, it’s a US-centric product’. In fact, this is a space that anyone investing in fixed income arbitrage, fixed income relative value, should look at.”
Given that it’s a relative value strategy, Concordia looks to exploit inefficiencies, which have increased in the muni market since the wrapping institutions left and the market has opened out. The strategy trades spread relationships and looks to profit from the volatility in those relationships. Typically, these relationships are between tax-exempt muni bonds and taxable alternatives – corporate bonds, treasuries. For example, Concordia might buy 30-year muni bonds and hedge them with 30-year treasuries or corporates.
“When treasury yields move, muni bonds yields will almost always move in the same direction but less so. Depending on where you think interest rates will go, you have the opportunity to make returns,” explains Matt Fabian, senior analyst for Municipal Market Advisors, who provide independent research on municipal bonds.
So far, the fund has returned high single digit returns this year. “It’s been a good year for the strategy. I would say our municipal performance is in the top quartile of fixed income relative value funds,” notes Williams.
Fabian says it’s a good time to generate alpha but that it depends on your exit strategy: “It’s very easy to overstate the liquidity in US munis. Entry and exit points can be very sloppy. The liquidity conditions can be interrupted by things you could never predict or model: negative news stories, some kind of technical move, discussions of tax reform in the US Congress. It’s a difficult investment strategy to do in scale.”
As Concordia’s portfolio is actively traded, the number of bonds it holds fluctuates throughout the year depending on how relationships play out. In a risk-on climate the portfolio might hold 20 to 40 different names but only a few, if indeed any, in a risk-off climate.
“We want to own relative value when it’s cheap, and be out of the market when we think it’s rich,” says Williams.
For investors trying to build a diversified portfolio of absolute return strategies ideally what they’re for are those that offer, in theory, uncorrelated drivers of return. Many of the drivers of returns in the muni market are unique to those of other fixed income relative value strategies. “The muni market is predominantly a retail rather than institutional market. What drives those retail flows is a different mindset to what drives institutional flows,” says Williams.
He admits the risk appetite for munis is a bit nuanced: munis might cheapen because people are concerned with risk, or equally because they’re concerned with risk. “Investors’ risk tolerances are shifting almost on a monthly basis: I want risk, I don’t want risk. What you’re seeing in the muni market is a limited amount of risk capital at play. Accordingly, the noise in relative value relationships has increased,” notes Williams.
This is because of the high level of absolute rate volatility in the US and the questionable outlook for municipal credit and fiscal health of municipalities.
Fabian makes the point that muni bonds are not as homogenous as they once were. “There’s more idiosyncratic pricing in the market: State of Virginia bonds are 3.5 per cent but State of Illinois bonds are north of 5 per cent.”
According to Lipper, investors had pulled USD50million out of muni bond mutual funds through June 2011, suggesting they weren’t overly enamoured with these instruments. But Williams is quick to emphasise that money flows both ways and that’s what helps create opportunities.
He states: “When you invest in a strategy like this you’re gaining selective exposure to relative value relationships in the muni market. You’re taking advantage of them when they’re cheap and, if we do our job right, you’re not investing in them when they’re rich.”
Fabian points out that the bigger the hedge fund is, the better relationship it tends to have with the major dealers (JP Morgan, Bank of America etc). He notes that there’s a tremendous reliance on the top dealers for liquidity in the muni market, adding: “In a crisis, the bigger hedge funds are better positioned and are going to have better access to liquidity.”
The challenge for Concordia and others is to convince investors that munis are a good portfolio diversifier. Pre-2008 there were a number of funds pursuing more of a carry-based strategy and got burned in 2007 and 2008. This put a black cloud over the muni space and caused investors to shy away. Concordia hopes to change that.
“One of our biggest investors is not American. Some major European pension funds have an interest in the strategy but most investors in Europe have limited knowledge of this market. The challenge here is one of education, helping investors understand the opportunity set,” comments Michael Bruntisfield from Concordia’s London office.
“Although sporadic there’s always been some level of international interest in US municipals,” notes Fabian.
At a time when there are plenty of other challenges facing institutional investors, dedicating time and resources to understanding unknown asset classes is probably not high on the agenda. But in terms of offering uncorrelated returns, munis are an interesting choice.
“This is an enormous, liquid and inefficient market place – it’s an ideal forum for hedge fund investing,” adds Bruntisfield.
Williams thinks that the challenges muni bond issuers will face going forward present the “early seeds of opportunity for credit-related alpha in the space. Over the last 12 months we’ve started to see that shift.”
