Investors Case

Our group found several articles discussing the challenge that investors are having obtaining the yields they desire in their bond portfolios, and the different ways they are attempting to solve the problem. The most obvious and widespread action being take seems to be shifting out of long dated Treasuries into shorter duration paper. This not only keeps the portfolio more liquid, but also helps avoid taking losses on the longer dated paper if rates rise. Another avenue being pursued is buying floating rate notes, particularly from municipalities. While the floating rate notes are a smaller market compared to the Treasury market, investors like the fact that these notes allow them to participate to the upside, should rates rise in the next several years. While this is a positive from the investor's point of view, we believe that the issuers are exposing themselves to interest rate risk going forward, which could greatly increase debt service costs in the coming years. Our recommendation would be to hedge these risks using interest rate futures.

Generating yield without undue risk presents challenge

The article "Generating Yield Without Undue Risk Presents Challenge", by Daisy Maxey, says that many financial advisors, faced with lingering low interest rates, are required to be more selective when choosing which bonds to purchase to bring higher yields to their clients. Advisors are worried that with rates so low, chasing yield is layering on too much risk of capital losses, while investors are complaining that bonds are not yielding as much as they once did, and clamoring for increased returns. As a result, advisers are shortening the duration of clients' portfolios and clearing low-yielding, core fixed-income holdings to diversify into more opportunistic offerings. Many firms have recently cut the duration of clients' Treasury portfolios to one to three years from seven to 10 years so that investors will suffer less damage if rates increase. Issues that were traditionally considered core fixed-income holdings, such as short and intermediate-term Treasurys, municipal and investment-grade corporate bonds, historically have occupied about one-third of fixed-income portfolios. Today they make up roughly 20%, a sign that market participants are searching for higher yields, while at the same time acknowledging that rates will likely begin to move higher in the next 12-24 months, according to some economists. Most of those assets were moved to equity and opportunistic fixed-income securities, primarily mortgage securities and emerging-market debt.

Are traditional Munis still attractive?

Compounding the seasonal weakness of munis around tax season, there were some troubling headlines for some high-profile municipal issuers. The Securities and Exchange Commission brought securities-fraud charges against Illinois for misleading bond investors about the extent of its pension-plan underfunding. California had to raise the yields it was offering on $2.1 billion in new state bonds amid lackluster institutional demand. Michigan appointed a bankruptcy lawyer to try to rescue Detroit from financial ruin, and Puerto Rico saw its credit rating cut again, to near-junk status, this time by Standard & Poor's, after Moody's did so in December 2012.

Muni funds have struggled recently. Among closed-end funds, the Nuveen Municipal Value fund (ticker: NUV) entered March at $10.46 and now trades for $9.96, down 5%. That's the fund's lowest price since last March, when the fund fetched $9.56. By May it had risen 6.6%, to $10.19. Looking at exchange-traded funds, or ETFs, Shares S&P National AMT-Free Muni Bond fund (MUB) registered a 2012 low of $107.50 on March 20 of last year, and subsequently rose by 3.4%, to $111.20 in early May. This year, it began March at $111.85, and was down 2.1%, to $109.79, marking its year-to-date low. "We expect this period of price volatility to endure in the coming weeks, as the April 15 tax-filing deadline approaches and new-issue supply remains robust," Morgan Stanley Smith Barney analysts wrote on Friday.

Even if investors are looking to boost muni returns by buying lower-rated bonds, they're not getting rewarded as much as they once were. This holds true across bond markets these days, as investors keep bidding up any high-yielding paper, with high-yield corporate bonds returning 2.57% year-to-date, compared with a 0.73% loss for their investment-grade counterparts. In the muni market, the high-yield sector has likewise been the best performer, returning 1.68% so far this year, according to S&P Dow Jones Indices, versus 0.11% for the high-grade sector. Along the way, the relative spread of high-yield over investment-grade munis has fallen to 2.65 percentage points, the smallest difference since 2008.

Investors' appetite for Interest Rate protection:

Borrowers have started to respond to investor demands for protection against rising interest rates by adding floating-rate tranches to their deals and issuing primarily shorter-dated maturities.

Bank of America and Capital One boosted their issues by US $1.5bn and US $250m respectively, by adding floating-rate tranches at the guidance stage. Citigroup jumped into the market on Friday to offer benchmark three-year fixed-rate notes. Comcast-guaranteed NBC Universal offered US $1.4bn of three- and five-year floaters with launch spreads that tightened from initial thoughts and priced as much as 5 basis points tighter than it's comparable. Satellite provider Intelsat added a US $500m five non-call two-year deal at the last minute to what ended up being a US $3.5bn trade that was double its initial size. Many funds have been preparing for rising interest rates for the past year, but bankers have seen a surge of demand as investors who are normally indifferent to floaters flood the market in search of paper.

"We have seen a material increase in new issuance as well as spread compression in floaters in the last few months as the buyer base has expanded beyond the traditional securities lending community," said Brendan Hanley, managing director in debt capital markets at Bank of America Merrill Lynch." Investors have increasingly demanded shorter-maturity fixed-rate notes, which do not sell off as much as bonds of seven years or more when