Tue, 31 Jan 2012
Improving municipal-bond market fundamentals and the potential for rising marginal tax rates should power investor interest in muni bonds in the coming years, says Cedar Ridge's Guy Benstead.
Nadia Papagiannis: Hello. My name is Nadia Papagiannis. I'm the director of alternative fund research here at Morningstar, and today, I have with me Guy Benstead, portfolio manager of Forward Credit Analysis Long/Short, ticker symbol FLSRX.
Guy, thank you for being here with us today.
Guy Benstead: Thank you, Nadia. Glad to be here.
Papagiannis: So Guy, your fund is in this new non-traditional-bond category, and this is a category that we launched in October of 2011 to basically make a home for funds that can either go short on the credit spectrum or short on the interest-rate spectrum. But within that group of about 30 or 35 funds, it's a motley crew; there are a lot of differences. A lot of these funds are unconstrained bond funds. Can you explain how your fund might be different than an unconstrained bond fund?
Benstead: Sure. I think our investment mandate is very flexible. So, it's a good group to compare us to. We've run a traditional hedge fund before launching the 40 Act fund. So, we have a number of years of experience running on long/short credit strategies.
One of the big differentiating factors for us is we use municipal bonds as a core asset class, and that's a relatively novel approach to doing credit-risk analysis in that market. We've been doing it for quite some time. We're also very disciplined about using the short book to hedge out both interest-rate risk and credit risk.
I think investors need to be cognizant of what the underlying strategies really are, and some unconstrained strategies may just be leveraged long credit that's with some short interest-rate exposure, which can be problematic in a flight-to-quality trade environment. We have been fairly successful and disciplined about being willing to go short on corporate credit risk as well as hedging out interest-rate risk using both short Treasuries and short corporates.
Papagiannis: So, that actually happened this year; a lot of the category underperformed as a result of being long credit and short Treasuries. Then the Treasury rally in the third quarter really hurt a lot of funds. So, can you explain how that is as almost a leveraged long credit bet?
Benstead: Sure. I think the interest-rate move environment in 2011 caught a lot of people by surprise. Our investment process starts with the top-down approach, and we entered 2011 actually a little more negative on the economy than many people. So, we were looking for ways to manage the portfolio exposures, to not be exposed to a potential flight-to-quality trade, and actually take advantage of it.
What we found is that flight-to-quality trades or risk-off trades manifest themselves in two very clear ways. One is bullish for U.S. Treasuries, and credit spreads widen. And so if a portfolio is really just long a lot of credit risk and short Treasuries, that's not going to be a very good environment. We witnessed that in 2008; we witnessed in 2010. We've witnessed it a number of times. And so our approach at the beginning of 2011 was we created a heavy corporate short weighting in the portfolio, and a heavy part of that was relative-value decision. We thought that that part of the market represented a fairly rich asset class, and conversely, municipal bonds had gone through a pretty heavy sell-off in late 2010 and early 2011. So, we really emphasized long positions in munis. And we found that the corporate short/muni long correlations were a better match than a Treasury short position, for example.
Papagiannis: In terms of the hedge for the munis?
Benstead: In terms of the hedge, right, and the volatility tended to match up better. So that cost us for about the first seven months of the year because they are more expensive to run those, and the corporate market did very well in that period. So being short that was a drag on performance.
Papagiannis: You're paying the coupon.
Benstead: We're paying the coupon, right. So a lot of that changed in the third and fourth quarter with the flight-to-quality trade that happened in August-September and then reversed itself in October.
Papagiannis: You mentioned that you invest a lot of your fund in municipals and also you can go long and short corporate credits. Can you kind of give your outlook right now for the corporate credit market and the municipal market?
Benstead: Sure. I think the corporate credit market right now is, I would say, fairly priced. There's not a lot of great opportunity there from our perspective to be either long or short. We're still cautious on the economic outlook. We are very concerned about the risk dynamics coming out of Europe. So we don't want be long a lot of credit risk here, but we also don't want to be short a lot either because if Europe does find a grand solution then the technicals for the corporate credit market are pretty good. The fundamentals are decent. So it's a bit of a no man's land for us, so our exposures there are very light.
For our outlook for municipals, we've thought this year would be a good year for municipals; it started off to be a great year so far. And so we're pleased with that performance. The muni market is a very seasonal market, and the supply/demand dynamics play a big part in that. We think that the fundamentals for the municipal market are in pretty good shape and seem to be on the mend. And the technical backdrop right now is there's a fair amount of money coming into that market. We think that investors are becoming more sensitive to the tax rates and their aftertax returns. And they have been during the past few years. That's playing into the demand side. And the supply is very low. So we think that at least for the first few months of the year or maybe into the second and third quarter, these supply/demand dynamics favor been long municipals over corporate credit.
Papagiannis: So you had mentioned that one of the drivers of your positive outlook on munis is investors being more tax-sensitive and maybe fearing some kind of tax increase in the future or just not really knowing what kind of tax bracket they might be in the future. So, how does your fund position? Are you looking for some kind of aftertax return or that just plays into how you favor the municipal sector as a whole?
Benstead: Right. We use municipals as a total-return vehicle. We view the market as where is the best opportunity for us to generate total returns. Now, we are bond managers, so when you have bonds in your portfolio, you are generating income. And we get the benefit by the fact that a lot of our securities pay their income as tax-exempt to taxable investors.
Now, we make no assumption whether our shareholders could take advantage of that or not. That's not the point. In fact, a lot of investors are in tax-deferred accounts, such as 401(k)s and all that, just looking at our strategy as a total-return strategy.
But I do think that there's a great deal of uncertainty in the marketplace now regarding tax policy. We obviously have the presidential election and congressional elections coming up in November, and I think that that election is going to be a referendum on tax policy in large way. The choices seem to be pretty stark. I think it could go either way, and so there's a lot of uncertainty, as you said.
Our outlook is that with the deficits that the country is facing, my base case is that marginal tax rates for high-income earners will increase, not go down. In that environment, tax-exempt income is going to be a preferred asset class. Now, whether they invest through our fund or just by bonds directly, I think that the asset class gets supported by changing tax policy going forward and by the prospect of general improved conditions in the fundamental characteristics and quality in the municipal market. So, again, we think that the pricing of taxes into income in the marketplace today is quite frankly just too cheap.
Papagiannis: At the moment, but it could get more expensive as more investors become aware of this tax efficiency.
Benstead: Sure. I think these markets tend to overreact. We certainly saw as the underpinnings of the municipal market went away, when bond insurance was basically eliminated from the marketplace in 2008 and 2009, we saw the asset class get oversold. We could very easily see an environment going forward in 2013, 2014 where municipals get overbought. And if they are too rich, we are not going to own them. We don't have to. We like them now. We think they are a cheap asset class. We have a differentiating capability given all my partners' backgrounds as municipal finance bankers and the like. It's a very inefficient market. So, from an active manager standpoint, it gives us a lot of arbitrage opportunities. So, we like it, but we are not beholden to it.
Papagiannis: Great. Thanks so much, Guy.
Benstead: Thank you, Nadia.