Pam Hunter's Vista Tax Free Income Fund has been a stellar performer among general municipal bond funds on a three- and five-year basis, ranking second and first, respectively, according to Lipper Analytical Services Inc. But in 1994 -- or, as Hunter calls it, the "year from hell" -- it has been a different story.
The $95 million fund was off 7.23% for the 12 months ended Oct. 31, ranking a distant 137th out of 177 funds in its group. What happened? About four Federal Reserve tightenings too many, Hunter says.
Early in the year, Hunter figured about two credit tightenings by the central bank would be enough to slow the economy and flatten the yield curve. As a result, the fund's duration -- a rough measurement of a portfolio's sensitivity to changes in interest rates -- was about nine years in the first quarter. "I think probably our duration was longer than some of the other funds," said Hunter.
In a recent interview with senior editor William Goodwin, she discussed her investment strategy for 1995. Here are some excerpts.
Q: How are you positioned now?
A: We're barbelled. We're looking for inside of a couple of years if we can get high-coupon, short-call bonds -- that's the short part of our barbell. And then out in the 15- to 22-year range for the longer part of the barbell.
We feel that the curve will flatten much more significantly from here on out in municipals than it will in Treasuries -- it already has in Treasuries -- so we don't really like the intermediate sector right now. We're also trying to avoid par bonds or discounts in the intermediate sector, so the barbell makes sense there.
One of the more recent deals that we've been involved in were some Cleveland Powers; they were 7s due 11/15/24 on the longer end. Conversely, we bought a shorter, higher-yielding piece that matures, I think, in 2003 that has a 1995 call and a 9%-plus coupon.
Q: How far out in the future do you expect to follow your barbell strategy?
A: Until we see the muni curve flatten significantly.
Q: What's the average maturity and duration of your portfolio right now?
A: Our duration is about 8.75 years right now and the average maturity is probably about 17 years, maybe 18.
Q: Does that reflect your view on where you see rates going over the next six to 12 months?
A: Yes, it does, but it's more where we see the value in this market at this point, as opposed to where we think we're going to be in 12 months. We try to actively manage the portfolio, so the positioning we have now might not be the positioning we have 12 months from now. But we see this barbell as the best value in the market at this point. The long end of the barbell, for instance, was done because munis at greater than 87% of Treasuries, we think, are a real buy. So we're thinking in terms of relative values as opposed to just a pure interest-rate call.
Q: You're not looking to change your present duration or average maturity?
A: Not over the near term. We think it probably is going to be a pretty good month and a half for munis, and that's why our duration is a little bit longer now. If we see economic numbers come in strong, obviously we'll maintain a higher cash position, or start to weight it more on the shorter end of that barbell.
Q: Earlier in the year, you were buying very high-quality paper to increase the liquidity of your portfolio in the event of shareholder redemptions. Did the redemptions materialize to the extent you had feared?
A: We have had redemptions, but not an amount that really would hurt us.
Q: In light of that, have you readjusted your investment strategy in terms of the credit quality of the fund?
A: We want to be a high-quality fund. We believe the types of bonds we have in our portfolio are what our shareholders want. What we have done recently is to put more lower-quality bonds in there -- A-rated revenue bonds -- primarily because we saw value in them again.
What had happened was that quality spreads had compressed fairly dramatically over the past couple of years, and recently they started to widen out again. So we felt this was a time to move.
Q: What have you been buying?
A: We're starting to look at New York paper again. We were out of it for a while when we saw the numbers on new supply. We try to buy the bonds when there is not a lot of supply out there, or anticipated supply. We knew there was going to be a $4 billion-plus New York calendar. That's not when we want to buy. But prior to that we had bought New York appropriated debt in the A-rated category. We've been looking at resource recovery -- it's a sector that has been beaten up quite severely. There were a couple of bonds we bought in there. We did our homework on them; we liked the story on them.
Q: What's your mix of revenue versus general obligation bonds?
A: On the long end, we like revenue bonds. With the absence of tremendous refinancing activity, we think that long revenue bonds are going to be one of the outperformers in 1995. That's really what we're looking at on the long end of the barbell.
On the shorter end of the curve, we are still buying some of the higher-quality GOs that tend to maintain some stability, particularly in the high-tax states. One other sector that we really like would be the prerefunded sector out to 2001, 2002. They had become very, very rich relative to Treasuries. They were down to about 71% or 72%. Now, they're back up to about 77% to 78%. So we like that sector as well. And that's kind of the shorter end of the barbell.
Q: At one point this year you held a lot of hospital bonds. Do you still like that sector?
A: We haven't been that heavy on hospitals probably over the past five months. And again, that was because quality spreads had compressed. We see them widening out again, so we are taking another look at the hospital sector now, with the widening of quality spreads.
Q: Any other sectors that you like right now?
A: We still like the long power sector. In New York, in particular, if we see that a tax cut is imminent, we probably would get into more essential-service revenue bonds, like water and sewer bonds. Waters and sewers have always been a very high-performing sector for us -- they're one of my favorites. They tend to uphold their value and have very good marketability.
Q: What about geographic preferences?
A: We like the Southwest. We like Texas a lot. In the Midwest, we like Ohio and Michigan. The Northeast is coming back more slowly than the rest of the country, as is California, but we do see some bright lights. And Southeastern credits are always very solid. In fact, during adverse [market] conditions, if you can get your hands on a Georgia or South Carolina on the shorter end, they hang in there like a rock. There's always huge demand for them. So we've actually used them as a hedge, even in the seven- to 10-year range, as almost a chsh equivalent.
Q: Why do you like Texas?
A: From an economic standpoint, Texas has come back beautifully. They've diversified their economy. Also, what we try to do is pattern what's going to happen going forward as far as issuance versus redemptions. And we think Texas is one of the states where you'll see probably more bonds called next year than you will see issued.
Q: What areas are you avoiding in terms of geographic region and sector?
A: Really none from a geographic standpoint, because even if a state is in a lot of trouble, there usually are opportunities. For example, even when Louisiana and Massachusetts were having problems, there were bonds to buy that performed very well. We might look toward the insured sector there. No matter how poor or what type of budgetary problems the state is undergoing, there are always opportunities in some sector.
In terms of revenue bonds, we're shying away from airline bonds. We've never really been big users of them. We're looking at the same factors that are influencing the equity markets.
Q: Have muni prices in general bottomed out?
A: I think we have had a near-term bottom, and rebounded from that bottom. We're going to see a tremendous amount of bonds called next year and we don't see new issuance very different than it is this year, and possibly even lower. We're also looking probably at $94 billion of bonds being called just in the first few months of next year. Additionally, Jan. 1 is one of the biggest coupon payment dates, and we think at these very, very attractive yields, it's going to be enough to attract investors back into the market.
So I think that certainly we have had at least a near-term bottom in prices. What could change that is if the economic numbers continue stronger and the Fed continues to tighten. But I think ultimately the curve will flatten and you're going to see a lot more upside from a yield standpoint on the short end than the long end. I personally think it's a great opportunity.
Q: Do you see some of the retail interest in individual municipal bonds spilling over into the bond funds?
A: Yes, absolutely. We have balanced portfolio managers who have some munis in their accounts, and if you look at those accounts, something like 25% of their portfolios are maturing just between January and March 15. So I think there will be follow-through definitely to the mutual funds.
Q: So, on the one hand, muni fund investors have been bailing out of the funds this year and buying individual issues, but on the other hand, you're anticipating that holders of maturing individual issues will migrate to the funds?
A: Yes. I think once the yields begin to catch up on the mutual fund side, you could see more money coming in to mutual funds. I just think there's more of a longer-term trend toward investing in mutual funds.
Q: Is this a good time to be buying discount bonds?
A: I think the strategy from a relative value standpoint makes sense, because there's about a 15-basis-point differential aftertax between bonds that are inside the de minimis band and outside the de minimis. What we've been trying to do is actually buy bonds that are just outside the de minimis and sell them when they're just inside the de minimis. But you have to be pretty convinced on the market that yields are going to start to come down fairly soon in order for that strategy to work.
Q: Are you convinced of that?
A: Not over the near term.
Q: So you're hanging back a little bit?
A: Yes. I'm not going into the 4 1/2% coupons, I'm not going into the 5% coupons right now. My bottom would probably be 5 3/4, and I still like that 6%. It's still a significant discount from where we are now. You're talking about a good 100-basis-point discount. And it certainly gives you a higher current income than at 5%. Five percent is a pretty big bet. But I can understand the strategy of buying them. From a relative-value strategy, it makes a lot of sense.
Q: Would you touch par bonds right now?
A: No, the better bet is a mix of premium debt and discount bonds. Par bonds can be particularly dangerous right now, especially in the intermediate and shorter part of the curve.
Q: There's a lot of speculation that Congress will kill the de minimis rule next year.
A: I hope they do, because it's an absolute nightmare from an accounting standpoint. There has been a tremendous amount of confusion about it in the muni industry.
Q: What about a cut in the capital gains tax -- how would that affect the muni market?
A: I think some of the municipal bond funds that don't have a total-return slant probably would begin to. There would be much more incentive to take that strategy, when they don't have to pay as much in capital gains.
Q: The supply-demand picture looks pretty favorable for the muni market in 1995, but supply was way down this year, too, and it didn't seem to do the market much good. Are you confident 1995 will be better?
A: I think that there was a different dynamic present in 1994. First of all, we knew the Fed was going to increase interest rates. I don't think anyone really felt that rates would rise as substantially, or if they did, they were in the minority. And that's a factor that's not present in 1995. Yields have risen dramatically this year, but that's not going to be the case next year. We've got to be close to the top of the range.
Q: So the benefits of a favorable supply-demand balance should kick in next year?
A: Absolutely. And I think we're starting to see the effects now. We're poised for some real outperformance in municipals, and I think that's what's drawing in all these nontraditional muni investors.
Q: Any derivatives in your portfolio?
A: Zero.
Q: When did you clear the decks?
A: Very early this year -- January pretty much. We didn't have many, probably 2 or 3% of the portfolio. We were not expecting derivatives to underperform to this extent, but what we felt was the curve was going to flatten. We had that outlook back in January. And in a flattening curve environment, you don't want to be in inverse floaters.
Q: Under what conditions would you use them again?
A: If we saw the curve begin to steepen again from short rates falling, we might begin to take a look at them. They've been beaten up dramatically. At some point they deserve a look-see, but I don't think it's yet. And I don't think it's in the foreseeable future.
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