Watch Your Muni Bonds Portfolio – Not The Fed by Terrance T. Hults, AllianceBernstein

When will the Federal Reserve start hiking rates? Many muni investors have been busy debating this question. We think they’d be better off making sure their portfolios are prepared.

At some point, the Fed will take action by raising short-term interest rates. The exact timing has been argued about at length. In our view, a better use of time for most investors is reviewing, and if necessary adjusting, their municipal bond portfolios to make sure they’re well-positioned regardless of the Fed’s actions.

Here are a few thoughts on how to assess your bond portfolio:

Avoid too much duration. Duration is a measure of how much a bond portfolio’s price will change if rates rise. In other words, how sensitive is it to interest-rate changes? If duration is too high, it could take years for the portfolio’s increased yield to make up for the price loss if rates rise. We think most municipal investors should consider a portfolio duration of between four and six years.

Limit long “callable” bonds. The majority of muni bonds with maturities over 10 years can be redeemed, or called back, by the issuer before maturity. Municipalities often redeem bonds when interest rates are lower than when the bond was originally issued—that’s true now for many long-term bonds.

Duration is largely determined by how long a bond is expected to remain outstanding. Since the market expects most long-maturity bonds to be called before they mature, these long-maturities show relatively short durations. But if interest rates rise, your long-maturity bonds will suddenly exhibit much longer durations, because the bond is less likely to be called. This is why investors need to check their exposure to long bonds, even if their portfolios show low durations. We’ve written about this danger before. With the exception of high-coupon, high-yielding bonds, we don’t think investors should own many long-term bonds.

Don’t be caught too short. Just as it’s important to avoid having too many long-maturity bonds, investors should avoid being too overweight short-term bonds. Over the last few years, investors who worried about rising rates tilted their allocations heavily to very short-maturity bonds. But these maturities are tied closely to Fed rate moves, and investors would immediately see more volatility when rates rise. In our view, bonds in the seven-to-nine-year range provide a good compensation in terms of extra yield plus the benefit of “roll.” Roll is the tendency of a bond’s value to rise over time.

Beware of leverage. We’ve been in a near-ideal environment for leverage in the bond market. Borrowing rates are tied to very short-term rates, and these have been near zero. But as rates rise, borrowing costs will increase, and high-yield strategies that rely heavily on borrowing will likely see pressure on their income.

Manage exposure to credit risk. The last few years have been very good to muni high-yield investors. A select few issuers, such as Puerto Rico and Detroit, had sizable problems, but the vast majority of municipalities weathered the Great Recession pretty well, and lower-credit-quality bonds outperformed other sectors. But make sure your high-yield muni strategy doesn’t try to generate high yields in today’s relatively low-yield environment by taking too much credit risk with too many small, lower-rated or unrated bonds. Be especially wary of concentration in volatile sectors like tobacco—and issuers such as Puerto Rico.

Assess your liquidity. When bond yields respond to the Fed’s actions, it may help to reposition a muni portfolio by selling lower-yielding bonds and buying higher-yielding bonds—either to improve income or realize tax losses. But only investors with enough liquid holdings—bonds that can readily be sold at market prices—can take advantage.

A portfolio shouldn’t be too concentrated in bonds from relatively small issues that have traded infrequently since they were first issued. Trading smaller issues can cost more, and higher transaction costs eat into yield. Make sure your muni strategy also invests in and can trade larger issues, which can result in more favorable pricing.

To sum things up, take the time now to ensure your portfolio is positioned to take advantage of the market environment when interest rates begin to rise. Use the portfolio checklist as a guide as you work toward easing your downside risk while preserving your portfolio’s return and income.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

Terry Hults is a Portfolio Manager, Municipal Investments at AllianceBernstein.

Watch Your Muni Bonds Portfolio - Not The Fed