Ratings Granularity Leads To Trading Opportunities In Municipal Bond Market
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John Lee is a Founding Member of 16th Amendment Advisors LLC and its affiliates. He is also the Founder of Quansoo-TPI LLC, a private equity firm. A former Director of Credit Suisse First Boston/Donaldson Lufkin & Jenrette in the mergers and acquisitions department, Mr. Lee has advised on more than $100 billion of M&A volume. He received a B.A. in history from Boston College and an MBA from Columbia University.
TWST: There has been increased scrutiny of the municipal bond market over the last couple of years. How has that impacted the market?
Mr. Lee: It's been significant. If you wind the clock back to pre-2008, somewhere between half and two-thirds of the new-issue munis came as AAA-rated securities because they were insured by monoline insurers like Ambac (ABK), MBIA (MBI), FGIC and FSA. The basic story was that if you were a municipality and Moody's gave you a rating of "A" for your debt, it would cost you less to purchase an insurance policy and sell the debt as a AAA. Thus the market was very generic with so many AAA-rated bonds available. Today the story is quite different without the monoline insurers wrapping bonds. As a result, municipalities are being forced to issue debt based on their own stand-alone ratings, which are often not AAA-rated. That means the product set out in the market has much more granularity and is less commoditized. Today you have a much greater degree of variability of ratings and trading spreads. The separation of the different ratings was sort of painful for people who thought they owned AAA-rated bonds, but who subsequently owned A-rated securities. The bonds declined in value to reflect their underlying rating. On the positive side, however, there are many more trading opportunities because of the granularity in the ratings.
TWST: You are currently experiencing a very strong performance. What are the main factors that have contributed to that?
Mr. Lee: We are managing three strategies. Over the last 12 months on a gross basis, our long relative value was up roughly 10.5%, our long performance was up 16% and our ultra performance was up 70%. We want to benchmark ourselves against an index of municipals. We tend to look at the Lipper indices, as they are a basket of mutual funds which can be replicated. By comparison, the Lipper indices were roughly plus-9% for the last 12 months. So in all of our strategies, we have outperformed. That is virtually entirely due to the taking advantage of access to bonds, the ability to make judgments on attractive bonds, buying bonds at the right prices, selling bonds at the right prices. It's trading and execution, plain and simple.
TWST: Your prior philosophy is that you actively trade the portfolio rather than using a buy-and-hold philosophy. Why?
Mr. Lee: Risk and return. As mentioned earlier, we believe that by active management, you are in fact reducing risk in the portfolio. By design, our portfolios are comprised of liquid bonds in liquid sectors. We tend to buy frequent municipal issuers who by definition regularly update their financials and meet with rating agencies for updated ratings. We are not a high-yield shop. By contrast, buy-and-hold investors tend to buy a lot of bonds which do not trade, and as a result, these bonds have little market following. The illiquidity premium can be very large. Also, these issuers are not necessarily frequent issuers, so their disclosure can be stale. The second reason is return. Contrary to popular opinion, there is alpha in munis. We have six years of a track record to demonstrate outperformance versus a long-only benchmark. By actively trading and staying in the liquid sectors, liquid structures, we can react to things much more quickly. We can pick up the five or 10 basis points of profits that may be available through an exchange of similar bonds.
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