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Investing Podcast recorded on March 6, 2015

Portfolio Positioning

Podcast Transcript

Welcome to the Breckinridge podcast. This is Ariana Jackson and joining me today I have Matt Buscone. So Matt thanks for being with us today.

Good to be back Ariana.

So in light of the recent interest rate volatility, we thought it would be a good time to review our portfolio positioning, and this podcast will touch on duration, yield curve positioning, drivers of interest rates, asset allocation, and sector allocation for both the tax-exempt and taxable strategies. So Matt, let's start with our duration targets on the tax-exempt side. Where are we versus the indices that our intermediate strategy is benched to?

So, most of the Intermediate-Term Tax-Exempt portfolios are benched to either the Barclay's 1-10 Year Blend or the Barclay's 5 Year Index. As of month end, the Barclay's 5 has an option adjusted duration of around 3.85 years, while the 1-10 Year Blend is slightly longer, just less than a 4 at a 3.98. Our current target on the Intermediate-Term portfolio is about 4.15 years, so it is a little bit longer than the indices, but really only about 5% longer so you could argue whether it is neutral to slightly long. We would say it is just long of the indices at the moment.

Okay, and is there any particular reason?

The first reason is those tax-exempt indices have gotten much shorter over the past year as interest rates have fallen. Both those indices have a number of bonds that are priced at shorter call dates. As interest rates have fallen, they price at the shorter call, and the duration has gotten much shorter. We tend not to chase the index too much in terms of its duration, so we have kept our target a little bit longer. The second is the valuation that we see. Right now, tax-exempt municipals in the 10-year area of the curve are very attractive when measured versus government bonds. If you use the AAA 10-year bond as a reference point, that ratio is between 100% to 104% over the past three months, that 104% ratio representing the cheapest level that we have seen in the past year. In terms of yield pickup, if you move from a 5-year bond to a 10-year bond right now, you are picking up just over 80 basis points of incremental yield, and that is right about its average for the last three months so we are a little bit longer because we see a little bit better valuations in that 10-year area of the curve.

Got it. So while we like the 10-year area of the curve, there is also a need to offset the longer duration of those bonds. What's the positioning like across the rest of the yield curve?

So we like to look at our portfolios across three different duration buckets. We have a short, intermediate, and long. The short bucket has bonds with option-adjusted durations of between 0 to 3 years, the middle bucket has bonds with option-adjusted durations of 4 to 6, and the longer bucket those with 6 to 11-year option-adjusted durations. So what we like to do is sort of reflect our curve view by increasing or decreasing the weightings of those different buckets. Right now, we have a weighting of just about 40% to the short bucket, 30% in the middle, and 30% in the long bucket. At Breckinridge, we don't like to make large duration bets one way or the other so what we want to do is balance that out and look to where we see better relative values on the curve. So as I mentioned, we like that longer part of the curve so we’ve got a 30% weighting there, but in order to offset that longer duration, we have a higher amount in that shorter bucket.

Sure. So obviously, the biggest driver of returns on both the tax-exempt and taxable strategies is the direction of interest rates. What can drive treasury rates higher or lower, and just start off with higher.

Sure. So the bearish case for treasury is the strength of the US economy over the past year and the potential for the Fed to begin raising interest rates at some point this year. Employment growth has been very strong, and while GDP growth has been solid but not quite spectacular, we have got an improving economy, so the bond bears would say that this is not an environment that warrants a 0% Fed funds rate. Stronger growth in the Fed entering a tightening cycle could lead to higher treasury rates and a steeper curve, that would warrant being somewhat shorter on the interest rate curve.

Right. And what's the bullish scenario for bonds?

So, despite the improvement that we have seen in the labor market, we have seen very little evidence of a pickup in wages, and that has not led to any of a pickup in underlying inflation, both core PCE and CPI are running well below the Feds' target of 2% for an extended period of time now, and away from the US, there has been very slow economic growth and close to outright deflation in several European countries. Those factors have combined to push many European sovereign yields to extremely low levels. That makes US rates look more attractive and you combine that with a stronger dollar, and it keeps adding money to the US side of the equation, so there are reasons that rates could stay lower.

Definitely. So what factors are unique to municipals that impact yield levels?

The muni market is still very much driven by supply/demand factors. If you look at last year, throughout the first half of the year, we had very low levels of new issue supply and people were chasing munis, so that was really driving down ratios and making munis more expensive. So far this year, we have had an extremely heavy new issue calendar which is unusual for the first couple of years. We have seen almost $60 billion worth of supply the first two months of the year, and oftentimes when you get a heavier new issue calendar, that can lead to higher yields on munis, both from an absolute level and also more attractive valuations and that's the case that we saw during the month of February. On the demand side, while there's been strong support for mutual funds so far this year, there has been just over $7 billion worth of inflow so far, and that could change if interest rates begin to back up and we start to see fund flows turn negative. That sort of sets up a negative feedback loop where you see rates rise, you see outflows from mutual funds, people start selling, it sort of reinforces itself, so still a very retail-driven market, and those supply/demand dynamics can often impact rate levels pretty substantially.

So, shifting our attention to sectors…on the tax-exempt side, what sectors do we like and dislike, and you can start off with the positives.

Sure, so overall, our outlook for municipal credit still remains positive, and we continue to overweight local GOs that are generally voter approved bonds for schools and other projects that enjoy strong community support. In addition to essential service revenue bonds like water and sewer bonds, the improving economy has led to increased revenues that supported sales tax bonds and other tax backed bonds. We have also added selectively the highly rated hospitals and select university credits as well.

What about the flip side, are there any sectors we don't particularly like?

Yeah, appropriation backed debt is an area that we have been allocating to less than normal, and we are being more selective than usual with the ones that we do continue to buy. There have been a couple of recent examples of where an issuer has had the ability to pay back their debt, but they lack the willingness to do so due to the non-essential nature of the project. And so while muni credit has been improving for several years, appropriation backed debt that isn’t viewed as essential may be more vulnerable the next time we go through an economic downturn.

Right. So let's switch gears and discuss our Intermediate Taxable Strategy. These portfolios are usually benched to the Gov/Credit Intermediate Index…where does Breckinridge stand versus that index?

So we are currently neutral versus that index, if you look at the Gov/Credit Intermediate, it was about a 382 right at the end of February, our portfolios are not far away from that number. And while we believe that interest rates will rise gradually over time, as we mentioned before, there are a number of factors that may keep rates lower for a longer period of time, that makes it difficult to get very defensive with regard to duration, hence our neutral stance.

Right. So what are the weightings for the duration ranges on the taxable side?

So the biggest difference between the two indices is the Gov/Credit Intermediate is much shorter then we talked about the Intermediate—the tax-exempt intermediate index—and so that shorter duration target means different strategy positioning. So the shorter bucket on the taxable side has a weighting of about 48% to that short bucket, the middle has 30, and the long only has 22, so the biggest difference being that reduced piece on the long end being moved to the front end of that short bucket. And within that shorter bucket, we’re overweight the 1-year bond and we hold less in 2 to 3-year bonds versus the index as we believe that this part of the curve will be hit a little bit harder if and when the Fed starts to hike rates.

Right. And what's the asset mix on the taxable side?

Our current targets are 40% corporate bonds, 35% in taxable munis, and 25% in government bonds. We have reduced the corporate target by 10% over the past year by adding 5% to taxable munis and 5% to government bonds. We continue to use treasuries in the portfolio mainly to help manage duration and for liquidity purposes.

So you mentioned a reduction in corporates. What was the impetus behind that?

So we decided to reduce the overweight to corporates at two different times during the year. First was when valuations on investment grade corporate spreads were at their tightest level since the financial crisis, and the second reason is that while we are still constructive on corporate credit overall, we believe that the corporate credit cycle is moving into its later stages with event risk in leveraging activity on the rise that led us to a little more caution.

Now, what sectors do we like and dislike on the corporate side?

We continue to like US banks. They have done a very good job rebuilding their capital and their liquidity post financial crisis, and their asset quality is the strongest level it has been in a number of years. We also favor consumer cyclical sectors which should benefit from the sharp fall in oil prices as consumer demand picks up. And lastly, we like high quality utilities based on their regulated capital structure and essential service nature.

And are there any sectors we are wary of?

Yeah, we are somewhat more cautious on energy due to the sharp decline in oil prices we have seen over the last several months, which is going to pressure their credit metrics moving forward. And we are also wary of some credits in the food and beverage sector, mostly due to potential event risk since the sector is facing weak revenue growth and some margin pressure, that typically leads to consolidation and usually shareholder actions that are less bondholder friendly.

Got it. Thank you, Matt. We hope that you in the field have found this informative and we look forward to you joining us again next week.


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