For years, investors eagerly pursued high returns by shouldering risk, with little fear — or experience — that those text-book “risks” would turn into real-life losses. “Risk” started to seem less risky.
No more. Investors now understand the potential costs of high rates of return and the importance of managing risk. Today, they are keeping more cash on hand and investing more conservatively. As the economy shows early — if unsteady — signs of growth, however, some investors are coming out of hiding — 19% of Northern Trust’s clients indicate they plan to divert their cash reserves to other investments in the next year, according to a Northern Trust client satisfaction survey conducted in the first quarter of 2010. These investors may not all be returning to the aggressive portfolios they might have held in 2008, but more of them are taking small steps, such as converting their cash holdings to relatively lower-risk investment vehicles such as Northern Trust’s fixed-income municipal bond funds.
This could potentially be a good move, according to Tim McGregor, Northern Trust’s director of municipal fixed income. He believes that Northern Trust’s funds have the potential to yield competitive returns in the municipal bond market because he thinks that Northern Trust’s investments in those markets carry manageable risk.
McGregor explains that Northern Trust’s investment strategy “should work well in the municipal space because we believe that the municipal bond market is incredibly inefficient. By capitalizing on those inefficiencies, we strive to add value on a day-to-day basis while staying away from a big bet on credit or a big bet on the direction of interest rates.”
Here are several core tenets of Northern Trust’s investment strategy in the fixed-income municipal bond market:
Exploit the inefficiencies
The inefficiencies McGregor mentions both relate to volume, as there are many bond issuers and many types of investors, so the sheer volume makes the market difficult to master for an individual investor. For a financial institution such as Northern Trust, however, it is manageable because of the manpower and expertise of a staff of professionals. For instance, there are more than 50,000 issuers of municipal bonds, which means there’s a lot of proprietary credit research and price discovery necessary to find what are believed to be the best deals — something Northern Trust attempts to do by exhaustively scanning the market. Also, by examining which investor categories — retail investors, institutional investors, hedge funds, etc. — are active in the muni market at a particular time, Northern Trust’s municipal bond experts strive to identify over- and under-valued areas and then pursue the “sweet spots” along the yield curve and maturity spectrum in an effort to create the most value for clients. McGregor adds that certain bond markets are seasonal, based on issuance patterns and maturity windows, which helps to allow Northern Trust to gain a competitive advantage by buying at the right time.
Avoid excessive credit risk
Credit issues are front and center in the municipal bond market right now, as many municipalities struggle to balance their budgets. Northern Trust’s fixed-income municipal bond funds take a conservative approach to credit, aiming to carry more assets rated AAA and AA than their benchmarks and most peers, and historically eschewing municipal bond insurance in favor of the underlying credit, even when such insurance was popular. Though McGregor isn’t worried about municipalities going bankrupt, he makes sure Northern Trust’s bond investments have credit qualities that Northern Trust believes are most likely to pay.
“Our view is that credit risk lies much more with smaller, project-specific revenue bonds, which essentially don’t stand on their own from an economic standpoint because they require annual appropriation [as opposed to an automatic payout],” McGregor says. “You wonder how essential these projects [such as stadiums, convention centers or parking facilities] are when budgets get tight, because they rely on discretionary funds to pay. And the truth is, every city, state and county government has fewer discretionary funds than a few years ago because of the nature of the economy.”
Instead, McGregor focuses on bonds backed by a municipality’s general revenue — sales and income taxes, etc. — and that are designed to automatically pay the bondholders.
“An unlimited-tax, general-obligation bondholder is near the top of the list, constitutionally, in terms of where a municipality’s general fund monies go,” he says. “That’s comforting. It’s when you’re near the bottom of the list that it’s worrisome, when you’re relying on discretionary dollars. We make sure to purchase bonds with taxing power behind them and bonds with solid, dedicated revenue streams.”
Manage interest-rate risk wisely
Of course, all investments bear some risk, and Northern Trust’s fixed-income municipal bond team prefers to take on interest-rate risk, rather than credit risk. Interest rates are near historic lows, and while Northern Trust doesn’t think the bond market is in danger of suffering from a “bubble” effect, McGregor is preparing for rates to slowly rise. (Bond prices generally fall when interest rates rise, and vice versa.) McGregor says this shouldn’t pose a threat to investors as long as fund managers keep their hands on the rudder.
For example, investors who anticipate a rate increase can shorten the maturity term of bonds in their portfolios and the types of funds in which they invest. And in the municipal market, especially, rate hikes don’t affect all bonds uniformly. If the Federal Reserve raised rates, for example, McGregor says that short-term municipal bond prices would be affected more than their intermediate and long-term counterparts.
“As an active manager, you can work through the process [of rate increases],” McGregor says. “That’s where proper maturity positioning on different parts of the yield curve becomes very important.”
Like most asset classes, the municipal bond market suffered in 2008, and prices dropped dramatically. McGregor says the market is still feeling the effects, which is good news for investors currently looking to buy muni bonds.
“Frankly, the value is still there, left over from the severe problems of 2008,” he says. “Investors looking [at municipal bonds] today may stand to potentially benefit from the market’s problems two years ago.”
All investments carry risk, and municipal bonds are no different, even though they fall at the conservative end of the risk-reward continuum. But particularly for investors whose alternative is to hold onto their cash, Northern Trust’s well-managed, fixed-income municipal bond funds may offer an attractive investment opportunity.
Bond Risk: Bond funds will tend to experience smaller fluctuations in value than stock funds. However, investors in any bond fund should anticipate fluctuations in price, especially for longer-term issues and in environments of rising interest rates.
Tax-Free/AMT Risk: Tax-exempt funds’ income may be subject to certain state and local taxes and, depending on your tax status, the federal alternative minimum tax.
Please carefully read the prospectus and summary prospectus and consider the investment objectives, risks, charges and expenses of Northern Funds before investing. Call 800-595-9111 to obtain a prospectus and summary prospectus, which contain this and other information about the funds.
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