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By Nadia Papagiannis, CFA | 01-31-2012 12:00 AM

Plenty of Tailwinds for Muni-Bond Investors

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?

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