My colleague Patty Healy discussed the muni sector’s credit scoring and status in her recent quarterly commentary. See https://www.cumber.com/q1-2018-municipal-credit/. Readers who missed her missive may want to take a look at it, as it recites lots of evidence of upgrades and downgrades in municipal credit and why they happened. Patty is an expert on municipal credit.
Let me address a market reaction to these credit changes and why that gives separately managed accounts an edge over certain mutual funds and passive muni portfolios. In the latter there are often a set of fairly rigid allocation limits. We know that edge is real from our observation of funds.
When a fund has an allocation method that is rigid, it must watch the weights of its holdings. Thus it may have an allocation to California and another to New Jersey and so forth. Now what happens in the marketplace when California gets a credit upgrade and New Jersey gets a credit downgrade? The market values of California bonds go up while the market values of New Jersey bonds go down.
For a separately managed account this credit shift doesn’t require an allocation change if there are no allocation constraints. The manager can adjust in anticipation and will quite likely use an advanced forecasting credit-scoring system to make those adjustments prior to the actual credit-rating changes. At Cumberland, we try to do that all the time. We want to be ahead of the tsunami.
The passive mutual fund faces a different situation. It is governed by the rules in its prospectus and must comply with them. If it is a state-specific fund, it has to continue to own the New Jersey bond whether it wants to or not. The same is true for a California state-specific fund.
But if it is a national fund, it may encounter a different problem. The fund’s holdings are imbalanced after the credit-rating changes. The New Jersey allocation is down in price while the California allocation is up. Thus the weighting scheme, which is required by the mutual fund’s specific rules, may be out of whack. The fund must make an adjustment, and that usually means the trader has to do something he doesn’t want to do. He has to reduce the position of his higher-rated California bonds because it is now overweight, and he has to increase the position in his lower-rated New Jersey bonds. Additionally, there are usually time limits that govern how long a trader has to make these changes.
Market agents like Cumberland know this and can therefore anticipate that certain bonds may become cheap while other bonds become more richly priced. These distortions affect the entire muni bond market but are not well understood by the retail bond buyer or by the passive-allocation community of family offices and consultants. The nuances are frequently missed. The distortions create market inefficiencies, which can then be seized upon by a separate account manager.
The evidence of these distortions is seen in muni pricing. Remember, this is a freely operating market. The price and yield of any single municipal bond that trades is a direct result of a market transaction between a buyer and a seller. That seller or buyer may be a separate account manager like Cumberland, or it may be an uninformed or unskilled individual, or it may be a passive family office. It makes no difference that the players are diverse or have different levels of skill: It is the price that reveals the market’s inefficiencies.
Here is a recent example: A very-high-quality housing finance agency bond came to market with a yield above 4%. The bond was secured by a block of mortgages, and most of the collateral had the direct or contingent guarantee of the federal government. At the same time the new issue was coming to market, the US Treasury 30-year bond was trading at about 3%. The housing agency bond became available when the market was experiencing reallocations, so that meant that its pricing was a second-order derivative of the reallocation of other bonds.
Why was the housing bond in excess of 4% tax-free versus the 3% taxable Treasury? On the face of it, this makes no sense at all. But when the muni market is distorted, the ripples of those distortions impact many bonds, and such opportunities to present themselves to those prepared to seize them. At Cumberland we bought the 4% plus tax-free housing bond for our clients. We avoided the 3% long-term US Treasury bond. Note that the actual credit exposure taken by our client was about the same.
Patty has explained the dynamics of muni credit in her quarterly piece. All we want to add to her excellent commentary is that there are market dynamics that allow an active separate account manager to seize opportunities. The bottom line is the same: Dig deep in the weeds and understand the credit and the dynamics of its market pricing. Thorough research works to your advantage.