Kotok On Muni Outperformance (Premium)

April 14, 2014

Utilities also attractive to CIO of Cumberland Advisors.

David Kotok is the chairman and chief investment officer of Cumberland Advisors, a registered investment advisory firm based in Sarasota, Fla. Cumberland offers several fixed-income, equity and balanced portfolios, with its equity portfolios constructed using solely ETFs. He is a frequent guest on various financial television networks, and is quoted regularity in the financial press. Kotok has authored two books, including From Bear to Bull with ETFs.

Kotok recently sat down with ETF.com to give us the latest on municipal bonds and where he sees opportunities in the muni market roughly nine months after Detroit’s bankruptcy. He also discusses the importance of being selective in emerging markets investing, and reveals his favorite sector plays at the moment.

 

[Excerpted]


ETF.com: After Detroit's bankruptcy in July 2013, you were one of the few bulls on municipal bonds. Since last fall, munis have performed exceptionally well. What are your thoughts on munis at present?

David Kotok: The influences of troubled issuers and the impact of the troubled issuers are waning. That's why munis have been outperforming. Detroit is being resolved, albeit slowly. California cities’ problems are being resolved. Slowly, we can begin to estimate what the damage will be.

We now have a better handle on Puerto Rico. Not out of the woods yet, but Puerto Rico did, at a very high cost, achieve financing to get it through the next year or two. Of all the names mentioned, Puerto Rico is the most important one.


Why? Almost 400 mutual funds hold Puerto Rico debt. Puerto Rico is a junk credit. When it was acquired by those funds, it was an investment-grade credit. So they may not have to sell, but they have great difficulty buying. So we have a situation in which there's an overhang of Puerto Rico debt. It's identified, but it still exists.


You take a holding that is that ubiquitous and it pressures a portion of the muni market, and it takes time for that market to adjust. The market in munis has adjusted in the front and intermediate section of the curve. Short-term and intermediate-term munis have restored their tax arbitrage, meaning they yield less than comparative government securities or Treasury securities.


In the long end of the muni market today, the highest-grade tax-free credit trades at a yield over 100 percent of the 30-year Treasury bond. That has been the case for almost 5 1/2 years. So the longer end of the muni market is still cheap, and relatively cheap compared to governments that are at a federal level. I think munis are still a bargain.

 

ETF.com: For investors looking to invest in munis through ETFs, is it best to target investment-grade, high-yield or a broad-based approach?

Kotok: While we have extensive ETF strategies in our firm, we do not use ETFs for the municipal bond market. We reject them. Instead, we do separately managed accounts. We do our own analysis of the issuer's credit. And we do selective bond purchases and do not use the ETF.

So for the purposes of an ETF discussion, I'm anti-ETF when it comes to bonds. I can do better for clients in a tailor-made portfolio and not use an ETF for munis. I don't use mutual funds either. I do individually selected bonds in those managed accounts.


There's one, which is in the Build America Bond taxable government securities space. Those taxable fixed-income securities tend to price in tier off the tax-free sector. There's logic behind that, because the issuers often are the same.


Take the New Jersey Turnpike. There's a tax-free bond and there's a taxable bond. The taxable bond will trade with a higher yield than the tax-free bond. So if the tax-free bond is cheap, the taxable bond tends to be cheap as well.


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