Last Week Another crazy week in a wild year. We spent the first three days of the week ratcheting up the odds of the potential of a faster Fed taper and earlier policy rate hikes, then we spent the da...
While 2020 started out as a difficult year for Municipal Bonds, those investors that were nimble and not ruled by fear, ended up having a good—if not a great—year. The spike in Municipal Yields during the first quarter ended up being a significant buying opportunity for individual bonds and structured products. After record cash outflows, investors poured back into the market with enough cash to meet the $470 Billion in new issuance and drive investment grade Municipal Yields back to relatively rich valuations compared to Treasuries. Spreads on high-yield bonds widened significantly and then narrowed quickly, but some fear remains in that sector based on COVID-19 uncertainty. Structured Municipal products, such as closed-end funds, which fell as much as 25% in the first quarter, rallied back strongly based on the discounts to net asset value as wide as 30% and Tax-Exempt yields close to 8.00%
2021 brings the expectations of continued strong demand for the Municipal market with the promise of higher taxes under a new administration. Fear in non-COVID-19-related investment-grade credits has receded significantly and the expansion of Municipal Bond insurance has made investors comfortable, while driving relative value to rich valuations. The credits, while rich, should outperform their taxable counterparts based on continued demand for tax-exempt income.
High-yield bonds, which rallied significantly for the last six months, are still exceptionally cheap relative to investment-grade Municipal Bonds and offer an attractive alternative to taxable fixed income securities based on tax equivalent yields. When investors consider the actual default rate in Municipals, they are even cheaper relative to taxable bonds on a risk-adjusted basis. Keep in mind that there is still uncertainty due to COVID-19 and I would expect downgrades and fear to persist in this sector—but fear and good analysis create strong buying opportunities.
Structured Municipal products such as closed-end funds still offer a strong buying opportunity even after rallying significantly from the lows. The 135 funds I closely monitor have an average tax-exempt yield of 4.35% and an average discount to net asset value of 5%. The top 25 yielding funds have an average tax-exempt yield of 5.20%, and trade at an average 6.5% discount to net asset value. On a tax-equivalent basis for the highest tax bracket, the yields range from 6.90% to 8.25%. In addition, with the Federal Reserve stating they have no intention to raise short-term rates anytime soon, leverage utilized in these funds is less of a concern and could be additive to performance going forward.
New bond issuance in 2021 is forecasted to be approximately $450 billion, which is lower than the $470 billion issued in 2020. 2021 will also have approximately $350 billion in bonds being called or maturing, resulting in only $100 billion in net new issuance. I believe new cash inflows will be sufficient to create a strong demand & supply imbalance supporting valuations throughout the year. Treasury issuance is expected to increase slightly for 2021, but skew more to long-dated securities, causing a scenario of potentially higher long-term interest rates. These two divergent issuance trends can help the Municipal markets outperform the Taxable markets in 2021.
Taking into account all the factors mentioned, the AlphaCentric Municipal Opportunities Fund is uniquely positioned to perform well in 2021 due to its overall strategy and ability to invest in relatively cheap segments of the Municipal market while adding alpha through its overlay in the Taxable Market. The AlphaCentric Municipal Opportunities Fund, managed by SWBC, is the first of its kind, open-end tax-exempt mutual fund with a true fixed-income hedge fund overlay. The Municipal bond portion of the fund consists of a non-constrained, opportunistic strategy that is structured to take advantage of the many inefficiencies that may arise in the Municipal bond market and related structured products. The hedge fund overlay will be managed independently by Mount Lucas Management, a hedge fund firm with a long track record of success. The overall strategy is designed to add alpha in both rising and falling interest rates. In an environment where investors are concerned about volatile interest rates, this fund is a ground-breaking product which can add a layer of protection to the portfolio not previously possible for non-qualified investors and offer qualified investors a low-cost alternative to portfolio protection.
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Roberto Roffo is a Managing Director and Lead Portfolio Manager for SWBC Investment Company. He has extensive experience in managing many types of funds and strategies and over his career has been part of teams that have been responsible for raising over $50 Billion in tax-exempt and taxable fixed income assets.