Avoiding the Crowds - Extra Yield Without Extra Credit Risk

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The Fund invests principally in municipal securities. The value of municipal securities may be affected by uncertainties in the municipal market related to legislation or litigation involving the taxation of municipal securities or the rights of municipal securities holders in the event of a default or bankruptcy. If a security’s structure fails to function as intended, the security could become taxable or decline in value. Additionally, issuers of municipal obligations may not be able to make timely payments because of general economic downturns or increased governmental costs. 

The Fund will not invest 25% or more of its total assets in any one municipal revenue sector relating to bonds backed by revenues from similar types of projects (such as those relating to higher education, healthcare, housing, airports or utilities) or with other similar economic, business, or political characteristics. However, as the Fund’s exposure to such similar projects increases, the Fund will also become more sensitive to adverse economic, business or political developments relevant to these projects.

Rob McClure is a Registered Representative of ALPS Distributors, Inc. 

ALPS Advisors, Inc. is the investment adviser to the Fund and Brown Brothers Harriman & Co. is the investment sub-adviser to the Fund. ALPS Advisors, Inc., ALPS Distributors, Inc. and ALPS Portfolio Solutions Distributor, Inc., affiliated entities, are unaffiliated with Brown Brothers Harriman & Co. 

ALPS Portfolio Solutions Distributor, Inc. is the distributor for the Fund.

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SPEAKER_01 0:14

Hello everyone, I'm Chris Proctor, Director of Fixed Income at Alps Funds. Welcome to Avoiding the Crowds, our MuniBond podcast series with Greg Steyr, head of municipal fixed income at Brown Brothers Harriman and portfolio manager for the Alps Intermediate MuniBond ETF, Ticker MNBB. Welcome back, Greg. It's nice to see you so quickly again after our last podcast. On today's episode, I wanted to walk through your strategy, in particular, your approach to generating strong risk-adjusted returns. Every manager out there claims to have a unique strategy, but you can actually back that claim up. Okay, you recently published a chart which read extra yield without extra credit risk. Can you walk us through what that means?

SPEAKER_00 1:03

Thanks, Chris. Great to be back. Extra yield without extra credit risk goes to the heart of risk-adjusted returns. There are three basic ways to generate extra yield in bond portfolios. You can move down in credit, you can go long duration, you could sell volatility through callable bonds. In Munis, we're fortunate to have a fourth option, which is investing in bonds with off-the-run structures. These bonds have formed the core of our portfolios for a long time and have played a central role in our consistently strong risk-adjusted returns. We always strive to avoid the crowds, and these bonds help us do just that.

SPEAKER_01 1:44

Help me put this together, Greg. What crowds are you avoiding?

SPEAKER_00 1:50

Remember, the Muni market is dominated by household investors who have very specific preferences, such as for current income, high-rated general obligation debt from within their state of residence, and bonds that are easy to understand. We place valuations above these preferences, and by doing so, we can find more attractively priced opportunities that provide greater yield than they should. What does this look like in practice? This means holding large exposures of bonds that households aren't comfortable with. These opportunities form a strong foundation for us and they allow us to enhance portfolio yields without sacrificing our high credit profile.

SPEAKER_01 2:34

Is this strategy dependent on market conditions? In other words, does it work just as well in a rally as it does in a sell-off?

SPEAKER_00 2:45

Household preferences are fairly stable, and so are the range of opportunities we're here to talk about. What isn't stable about households is their sentiment, which is often disconnected from valuations. One of our team's mottos is don't go with the flow. In other words, we seek to avoid getting caught up in the vagaries of investor sentiment. Taking advantage of these swings is important, as is focusing on niche areas of the muni market. This is basically what our clients pay us to do. Thanks, Greg.

SPEAKER_01 3:16

Can you give us some examples of how these niche areas enhance yield without sacrificing credit quality?

SPEAKER_00 3:24

Sure. For example, we find we get paid more by buying zero coupon school district bonds instead of their coupon-bearing counterparts. The underlying credits are exactly the same, but because households have a strong preference for current income, the zeros will yield more. The same can be said for floating rate notes. Households often avoid floaters because of their complexity, which helps make them more attractive for us.

SPEAKER_01 3:53

But are these portfolios difficult to manage? I mean, zero coupon bonds would be very long in duration, and they don't provide any income reinvestment opportunities.

SPEAKER_00 4:06

I think like everything in life, you need balance. Zero coupon bonds tend to have higher interest rate risk, but if we simultaneously hold floating rate notes, which have durations near zero, we could achieve balance. You can think of zeros and floaters like peanut butter and jelly. It's a perfect pairing as long as you don't have a food allergy.

SPEAKER_01 4:27

Food allergies are serious, Greg. But I'm glad you guys aren't allergic to owning off-the-run bonds. What are some other structures that you would like to highlight?

SPEAKER_00 4:38

I know we spoke about housing and airport bonds on the last podcast, but I want to reiterate how much value these sectors have provided our clients over the last few years. One area we didn't talk about yet are delayed delivery bonds.

SPEAKER_01 4:51

Oh, yeah, thanks for the reminder, Greg. I would encourage our listeners to go back and check out that revenue bond podcast for more information on those topics you just mentioned. But now, can you tell us more about these delayed delivery bonds?

SPEAKER_00 5:07

Typically, municipal new issuance, new issue bonds settle in less than a month. Delayed delivery bonds usually settle in four to twelve months. Muni issuers are subject to a lot of rules about refinancing outstanding debt. Delayed delivery bonds help exploit a loophole around some of those restrictions and enable borrowers to take advantage of current rates.

SPEAKER_01 5:31

Interesting. What about this settlement structure is appealing to you?

SPEAKER_00 5:36

These bonds possess all the credit and interest rate risk of normal bonds, but they don't produce any income during the delay period. So in order to entice demand for these securities, issuers must offer a price discount. And another way you could think of that price discount is additional yield after settlement.

SPEAKER_01 5:57

How would you determine what you should get paid during this delayed delivery period?

SPEAKER_00 6:03

Math is sometimes treated as a proverbial four-letter word, but believe me, it's your friend, especially here. The basic question with delayed delivery bonds is whether the extra yield that the securities offer once they settle adequately compensates for the foregone income and accounting challenges during the delay period. The three most important variables are what you can earn on your cash, the slope of the yield curve, and the average credit spread of the issuer.

SPEAKER_01 6:32

Are these delayed delivery bonds common? Do they have a meaningful impact on the strategy?

SPEAKER_00 6:38

It depends a lot on market conditions, but even when they were most popular in 2021, delayed delivery bonds were only a sliver of total issuance. Last year we only participated in three deals. This year we've already participated in three deals. So issuance is picking up.

SPEAKER_01 6:59

I would imagine, though, that the downside to all these structures is that they are less liquid. Is that correct?

SPEAKER_00 7:05

To us, the most important factor in thinking about liquidity is quality. And this is a reason why we maintain such a high-quality profile. When we buy a bond, we need to be comfortable holding it to maturity. We also need to make sure that our portfolios carry adequate liquid reserves to protect our flexibility.

SPEAKER_01 7:25

The need to keep reserves instead of staying 100% invested. Do these reserves serve as a drag on return?

SPEAKER_00 7:33

Sometimes they do, but we view our reserves as integral to our strategy because they enable us to be nimble, which is really important during times of high volatility. And even within our reserves, we still find opportunities to enhance yield. We have the option of holding tax-exempt short-term notes, treasury bills, or even generic AAA rated intermediate securities. Our traders check every morning for the best source of value. So, Greg, how are you managing reserves in today's environment? There's a simple answer to this one: cash. Remember, the middle portion of the Muni yield curve has been inverted for some time now. Today's unusual because there's a yield advantage to holding cash. Effectively, you get paid to be patient. And this has a multiplier effect for our strategy, especially when it comes to those delayed delivery securities. There's been a lot of volatility in short-term tax exempt notes, so we've been actively moving between them and treasury bills, depending on which offers the hire after tax yield.

SPEAKER_01 8:36

I want to highlight the fact that your mutual fund is about to enjoy its 10-year anniversary. So, what have been some of the keys to your success?

SPEAKER_00 8:44

Thanks, Chris. I can't believe it's uh almost a whole decade has has passed now. Success has really depended on a few factors. First is avoiding the crowds. In other words, valuation trumps mainstream preferences. The second, as we've talked about, is not going with the flow. And this means taking advantage of swings and investor sentiment, not getting trapped by them. And last, we would say staying nimble and flexible to take advantage of volatile markets, especially like the conditions that we had in 2022. So it really all boils down to patience, creativity, and discipline. And I hope that helps.

SPEAKER_01 9:24

And congratulations on your outstanding long-term success. It's great to enjoy these same principles within our own Alps ETF ticker MNBD as well. So as a reminder, Greg Steyer is the portfolio manager of MNBD. We encourage you to check it out. You can learn more about this differentiated strategy and the Brown Brothers Harriman team at Alpsfunds.com. And thanks again, Greg, for your always insightful commentary. Have a great afternoon.