Finding Value In Long-Dated Muni ETFs

August 04, 2014

A bit of duration in the muni market may be just what the doctor ordered.

Interest-rate hikes are just around the corner, and one investor is taking a long-dated view on muni bonds to shore up his portfolio while keeping a short leash on the corporate and sovereign debt space.

Brian Lockhart, chief investment officer at Colorado Springs, Colo.-based Peak Capital Management, a $125 million ETF strategist shop, spoke recently to staff writer Hung Tran about his take on the muni-bond space. Lockhart, who has built up an existing position in the PowerShares National Muni Portfolio (PZA | C-49), talked why his view on the flagging Puerto Rico muni bond market is one reason he did so. What fund have you recently added to your portfolio?

Brian Lockhart: In terms of a very recent purchase, as well as kind of a significant holding in our fund, that addition would be the PowerShares National Muni Portfolio (PZA | C-49). We initially took that position in January, and we just added to it. Why did you buy PZA in January?

Lockhart: One reason is we felt that the value in the muni-bond space was probably the most compelling part of the fixed-income universe from a valuation standpoint, and we continue to believe that today. So we believe the risk-adjusted yields on muni bonds are very favorable compared to the rest of the fixed-income universe. Why did you choose PZA over something like the iShares National AMT-Free Muni Bond ETF (MUB | B-75)?

Lockhart: The reason we rotated from MUB into PZA and why we just added to that position is a core conviction we have that the short end of the yield curve will continue to steepen in 2014, but that the long end of the curve will flatten.

And with that expectation, we would view long-dated munis to outperform shorter-dated munis on a relative performance standpoint. So with the rest of our portfolio, we’re essentially shortening duration in the corporate and sovereign debt space. But specific to munis, we’ve been trying to move out on the yield curve to longer duration.

When you compare PZA with MUB, nearly 80 percent of PZA’s portfolio has maturities 20 years and out. In fact, almost 30 percent of the fund has durations that are 25 years and longer, but only 15 percent for MUB. So, in line with our research, PZA is a good fit for us because we want to be longer duration in the muni space. So this is a long-term hold for your firm?

Lockhart: Yes. Just looking at some of the holdings for PZA, I see Puerto Rico munis are in the fund’s portfolio. Any reservations on your part in terms of headline risk?

Lockhart: It was a conversation we had with the portfolio manager before we took the position, knowing they had exposure to Puerto Rico. Frankly, we believe that’s part of some of the pricing value that we’ve gotten in that.

We were very comfortable with the due diligence they had done on the Puerto Rico holdings, and felt confident that that didn’t represent a threat to the portfolio. What’s your outlook for Puerto Rico’s muni debt?

Lockhart: Puerto Rico’s muni debt problems started in 2006 when existing federal tax breaks for corporate income expired and were not renewed. This caused a recession for Puerto Rico’s economy as an exodus of companies and people left the Commonwealth. The recession has remained for virtually eight years.

Many changes have been made in Puerto Rico’s governance in an attempt to get the Commonwealth back on firm financial footing. Changes include pension reform, tax reform, an expanded sales tax, and a debt restructuring law passed in June 2014.

In February 2014, ratings agencies downgraded Puerto Rico debt below investment grade. Also, measures to cut spending and increase revenue have been effective, and as of July 2014, the deficit was lower than expected.

It is going to be very difficult for the Commonwealth to issue new debt, as it would be virtually impossible for the debt to be insured. But the existing insured debt does not appear to us to be in jeopardy on the basis of the financial strength of the underlying insurers. What sort of advice do you have for retail fixed-income investors?

Lockhart: Probably our best advice for retail investors, first and foremost, is to know what they hold. A lot of retail investors who buy ETFs fail to really understand what’s in the underlying holdings.

So just like you brought up the issue with Puerto Rico bonds, if investors haven’t done due diligence on the specific bonds that they’re holding, whether or not they’re insured, they can be buying far more risk than what they’re being compensated for in terms of yield.

Another good example in the fixed-income space would be the AdvisorShares Peritus High Yield ETF (HYLD | C). When you buy HYLD, obviously you’re expecting that that’s going to be a high-yield bond ETF, and yet they have significant exposure to things like master limited partnerships.

But we’re not necessarily suggesting that that’s a bad thing if they make sense in an ETF to own not only high-yield bonds, but to also own some MLPs. I also believe they have a small amount of exposure to preferred stocks so they’re capturing income anywhere their analysts believe it makes sense.

So don’t trust the ticker symbol or the ETF’s description, but really dig in—figure out what’s being held within that ETF. And without doing so, I just believe that there’s no way to evaluate the relationship between the yield or the return you’re expecting and the level of risk that you’re taking. You mentioned high yield and MLPs, but what other subsectors of the fixed-income market do you think retail investors should currently think about incorporating into their portfolios, given your first-quarter 2015 time horizon for interest-rate hikes?

Lockhart: First, obviously, with a rising-rate environment, we would suggest people be in short duration. We really believe that it’s increasingly necessary to move outside of the domestic fixed-income universe. Also, while we expect the dollar to continue to strengthen—which could make things difficult for some of the emerging market economies—we believe developed-world sovereign debt is actually attractive right now.

So we believe that not only is the Fed serving as a backstop against a severe slowdown in the economy, but that the Bank of England, the European Central Bank and the Bank of Japan equally will serve as backstops against a sharp decline in the economy.

And so, we would look both to developed-world corporate as well as sovereign debt as places where the risk/return relationship may be more favorable than it is domestically.



Brian Lockhart is chief investment officer at Colorado Springs, Colo.-based Peak Capital Management, a $125 million ETF strategist that was founded in 1994.



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