“The value of due diligence is greater now than it ever has been,” says J. Gibson Watson III, president of Prima Capital Holding, and the best money managers, he argues, “are focusing on investment quality to restore investor trust.”
We present seven of those best money management teams in the pages that follow, all of which are 2010 Separately Managed Account Managers of the Year. This is the sixth year that Investment Advisor and Prima Capital, the Denver-based firm that conducts due diligence on SMA managers, have joined together to choose the best SMA managers in multiple categories. What constitutes “best” for the committee that chooses the winners, which consists of Watson, Prima CIO Cliff Stanton and director of research Shane Calhoun, along with Wealth Manager Editor-in-Chief Kate McBride and this writer?
The committee starts with a quant approach, making sure each portfolio scores high marks in firm strength, resources devoted to the particular strategy, tax efficiency, and performance, compared to their benchmarks and their peers. Each portfolio must also be open to new investors and be widely available to advisors and their clients. The quant analysis (all data in the following profiles come from Prima’s Prima Guide online tool, with data as of 12/31/09) goes on for some time, but the discussion on the candidates–chosen by Prima’s analysts–ends with a quality discussion on the manager (or, usually, team), including their tenure and the ownership of the firm, whether they have skin in their own games, and what makes them unique in their process of stock or bond picking through different business and market cycles. The SMA Managers of the Year are not flashes in the pan who’ve been able to scrape together a good year or two: their processes and their human capital allow them to perform well, and consistently, year after year.
Being able to rise to the top is a particular accomplishment not simply because of the challenging markets of 2008-2009, but also because the SMA industry itself is in the midst of a “transition, a transformation,” argues Watson, as evidenced by the rise in particular of unified managed accounts. He says that assets in UMAs grew in 2009, despite a decline in overall assets in SMA accounts of about $20 billion, leaving about $540 billion in total SMA assets, following 2008′s ouflows of $36 billion, citing Cerulli and Money Management Institute data. The wirehouses still control the bulk of SMA money–about 70%, says Watson. In a higher-tax environment, which we may well see over the next few years, UMAs could also be more tax-efficient, suggests Watson.
“They must have clarity in their alpha thesis,” responds Watson to a question about the common traits of this year’s winners, with each showing “a demonstrable edge in their discipline.” Such an approach allows these managers to “add value, but always on a risk-adjusted basis” to their high-net-worth and ultra-high-net-worth clients’ portfolios, Watson says, and they must all show “consistency and repeatability.”
In the profiles of these sterling managers that follow, you’ll learn how the SMA Managers of the Year ply their trade; you can learn more in a series of Webinars that begin in April with these managers; consult InvestmentAdvisor.com for details.–James J. Green
[Editor's Note: The following profiles are extended versions of those that appeared in the print edition of Investment Advisor, April 2010]
Specialty Manager Award: Tradewinds Global Investors
Attractive valuation is a mandatory pre-requisite for Los Angeles-based Tradewinds Global Investors’ Global All-Cap portfolio, and the company dedicates a substantial portion of its due diligence efforts toward determining the value of stocks across the globe. But Tradewinds is also interested in getting to the heart of businesses with strong franchises and good forward growth prospectives, in trying to understand the risks they face, and how those risks will impact performance in the longer term.
“We like to understand the industry a company is in, get a handle on the supply and demand dynamics, and look at what’s happening at a sector level,” says Emily Alejos, equity analyst and portfolio manager at Tradewinds who manages the global ADR portfolio, which follows the same strategy as the all-cap and every other strategy in the firm. “We buy businesses rather than stocks, so we’re really not looking at how a company will do in the next few months: We go beyond the economic cycle and try to understand whether a particular business will do well over time.”
Once Alejos and the rest of the Tradewinds team have identified a company as being a “survivor” with a sustainable competitive advantage, they add its name to the one list of stocks that all the firm’s strategies–international as well as domestic, all-cap and small- to mid-cap and ADRs–use.
In many cases, the names that make the cut are under-appreciated by the market at large, Alejos says. “Maybe they’ve disappointed on a quarterly basis or have relatively low earnings compared to their peer group. But being contrarians, we know that the market is punishing these companies for a particular reason, and we try and get beyond that to understand whether or not it’s a good business in the long-term.”
Wal-Mart and Whole Foods are two classic examples of this approach. The market loved both companies when they were going through a period of great growth, Alejos says, and as such, they probably got overvalued, and then subsequently disappointed because investors had set their expectations so high. Tradewinds bought both stocks when they were at their lows, knowing that “we were buying best-in-class franchises at a point in time when they were unloved,” Alejos says. Both companies have since bounced back very nicely.
Tradewinds also places an emphasis on company management, particularly what management has done in the past with respect to capital allocation, acquisitions, and stock buybacks. A management team’s track record at growing a business organically, and whether that has added value over time, is very important, Alejos says.
In the aftermath of the financial crisis that began in 2008, more and more stocks became appealing from a valuation perspective. The Tradewinds team had much to choose from, particularly in the emerging markets, where names such as Brazilian oil refiner Petrobras and India’s ICICI Bank were trading at distressed levels. These and other stocks Tradewinds purchased in 2008 performed very well in 2009.
“It was tough to figure things out in 2008, but we stuck to our guns and we remained fully invested when many people were in cash,” Alejos said.
The universe of stocks that Tradewinds chooses from includes companies whose capitalizations typically range from $100 million and above. The firm’s investment strategy is typically benchmarked to the MSCI All Country World Index, and its portfolios are broken down such that position weightings are no greater than 5% at cost; industry allocations are less than 25% and sector weightings are less than 30%. Tradewinds weights countries excluding-U.S. at less than 35%, and has a 25% exposure to emerging markets.
The company follows a strictly discipline approach that also takes into account a broad range of fundamental valuation metrics such as price-to-cash flow, price-to-book, price-to-earnings, and liquidation/replacement value. Tradewinds’ portfolios are generally diversified across 40 to 85 companies representing strong risk/return characteristics.
Tradewinds Global Investors is an affiliate of Nuveen and manages $2 billion in its Global All-Cap Strategy, which is available via major national broker/dealer platforms such as MorganStanley, UBS, and Wells Fargo Advisors, as well as through several of Tradewinds’ partners serving independent investment advisors.
Specialty Manager Award: Forward Uniplan
Common stock, preferred shares, REITs or MLPs? Or why not all of them at the same time and in the same vehicle?
That’s what Rick Imperiale, principal and founder of Union Grove, Wisconsin-based Uniplan Advisors offers clients who are interested in all four asset classes and who are keen to get the best of the spread differential between them.
“We decided to do this because we saw that people were always comparing them when deciding where to put their equity money,” says Imperiale who, with the support of a team of research analysts and traders, manages Forward Uniplan’s $60 million High Income Total Return (HITR) portfolio (Forward Uniplan is one of a number of financial companies owned or controlled by Imperiale or Uniplan Advisors, through which various products are managed). “Most people compare common stocks, MLPs, and preferred stocks with REITs, so we thought we’d be simplifying life for everyone if we put all four together in one packet and added some intrinsic value for a financial advisor.”
Combing these four into a single portfolio is the fruit of the decades of experience Imperiale has in credit analysis and in assessing the relative value between different yield opportunities. He believes in strong quantitative research, combined with exhaustive bottom-up fundamental analysis, to build a portfolio with lower risk than the benchmark but that offers stronger returns during a market cycle. Imperiale has been managing portfolios since 1984, starting out with fixed income and then moving into equities, and he believes that while common stocks, preferred stocks, REITs, and MLPs get cheap and expensive relative to each other over time, eventually they equalize.
Meanwhile, taking advantage of the spread differential between the four investment vehicles continues to be a winning strategy. Imperiale tracks this spread on a weekly basis, and if all categories are within one standard deviation of each other, he weights them at 25% each in the portfolio. “Once we get beyond one standard deviation, we migrate money from one category to another,” he says.
Imperiale says the process of migration is a slow one, however, and is designed to be strategic rather than tactical. The one hard constraint on the portfolio is that it must always have at least a 10% weighting in each asset class, “which means you will never have 70% in any one category,” Imperiale says.
Beyond this, Imperiale tries to keep the portfolio diversified by industry and by sector, employing all the usual portfolio management procedures. However, the focus–particularly with respect to REITs–is maximizing on current yield as opposed to total returns, he says, and income generation is the fund’s primary mandate. So if REITs are currently yielding 4%, “we’d ideally be looking for those that are yielding more than 4%,” he says.
Imperiale makes sure to choose only top quality REITs, made up of properties in the best locations, and with high caliber management teams capable of taking advantage of the supply and demand dynamics in the industry.
When it comes to choosing dividend-paying stocks, Imperiale uses the Altman Z-Score method (formulated by Edward Altman in the 1960s) to find companies that are relatively cheap compared to where they have been in the past, but have positive fundamentals as evidenced by improving credit scores over a four- to six-quarter period. He employs similar scoring and evaluating systems for master limited partnerships and preferred stock.
At present, the High Income Total Return Portfolio has a 43% weighting in common stocks; an 8% exposure to MLPs; a 23% exposure to REITs; and 26% of the portfolio is invested in other assets such as convertible bonds and preferred stock.
Uniplan’s HITR portfolio is available on both Smith Barney’s and UBS’s managed accounts platform, as well as through Schwab. The product is available in two versions, Imperiale says, one that comes with close-ended MLP funds instead of MLPs, (since endowments and other ERISA accounts cannot own MLPs), and another that comes with MLPs. Imperiale says he is also in talks about offering the High Income Total Returns portfolio as a mutual fund.
Large Cap Award: Atalanta Sosnoff
New York-based Atalanta Sosnoff Capital focuses all its efforts and resources on managing a single product. “We just do one thing and we do it to the best of our ability,” says Craig Steinberg, the firm’s president.
That “thing” entails investing in large cap companies that have above average growth rates through a disciplined, three-step process, the most important part of which is assessing their potential for “earnings acceleration.”
“The rationale behind earnings acceleration is that there is a very strong correlation between growth rates and valuation, so companies with high growth rates are rewarded with multiple expansion,” Steinberg says. “We identify companies where we anticipate the growth rate of earnings looking forward a year or two to be higher than looking backwards.”
A company’s ability to multiply its earnings in the future are not only a consequence of its business model and process: Changes in industry dynamics, movements in supply and demand, new product expansion, and other factors also contribute to earnings acceleration, Steinberg says. Take Apple Inc. (AAPL), for instance: Atalanta Sosnoff first bought the stock in 2005 as the iPod’s popularity was starting to soar. “But the management of Apple, through almost continual product innovation, has taken things much further than we originally expected, so today, Apple is still a 5% weighting in the portfolio and we still see plenty of upside to it,” Steinberg says.
He also gives the example of specialty pharmaceutical company Celgene (CELG), which introduced a new cancer drug that was so popular on an industry-wide basis that it resulted in an explosion of the company’s earnings power.
Once Atalanta Sosnoff has crunched the numbers, read the research, and identified a company that fits the earnings acceleration bill, it will validate that knowledge independently in a security analysis process, partly by building its own earnings model. Finally, the firm values the stock in order to decide whether the earnings acceleration is discounted or not vis-?-vis the stock price.
The continued monitoring of earnings acceleration is the cornerstone of portfolio management for Atalanta Sosnoff.
“If we buy a company because we expect it to gain market share and then we see it’s losing market share, our philosophy is that that stock should be sold to stay true to the model of earnings acceleration,” Steinberg says. “We have been doing this through the years and it has enabled us to avoid having torpedo stocks that would otherwise have undermined the entire portfolio.”
Stocks are also sold when they reach their price target. Atalanta Sosnoff had, for example, invested successfully in Brazilian metals and mining company Vale (formerly known as Companhia Vale do Rio Doce), a leading iron ore exporter, and Freeport McMoRan (FCX), the world’s largest producer of copper, on the premise that high demand from emerging markets–China in particular–accelerated both their revenues and earnings growth. Atalanta Sosnoff sold both stocks earlier this year, Steinberg says, because they reached their price target and also because the demand for both iron ore and copper is likely to slow down if the Chinese authorities decide to rein in the Chinese economy.
Atalanta Sosnoff manages a total of $10 billion in separate accounts for institutions and individuals, 85% of which is invested in large-cap stocks. Typically, the firm owns about 40 to 50 stocks in the large cap equity portfolio, and unless a client issues special directives, or has unique tax considerations, all individual accounts are managed in the same way.
Steinberg believes that an investment in a particular stock only has meaning if it is given a significant weighting in the portfolio. The firm has a 3% to 5% allocation to all its holdings, he says, and these are not necessarily stocks that figure in the benchmark Russell 1000 index.
“We don’t own a stock simply because it’s part of the index; to perform slightly better than the index, one needs to be willing to be significantly different from the index,” he says.
All four senior portfolio managers at Atalanta Sosnoff–Steinberg, Atalanta’s founder Martin Sosnoff, Robert Ruland, and John McMullan– work as a team and they are all equity holders in the firm. Recently, though, New York-based financial firm Evercore Partners purchased a stake in Atalanta Sosnoff, a move that Steinberg and his colleagues are excited about. “Adding the experienced and talented partner that is Evercore will supplement our business development efforts and allow us money managers to continue focusing on stocks,” Steinberg says.
Large Cap Award: C.S. Mckee
There are two key elements to Pittsburgh-based C.S. McKee’s approach to the large-cap equity space that, according to Lloyd Stamy, senior VP and member of the executive committee of the firm, have not only distinguished it from its peers, but have also allowed the firm to take advantage of some of the best opportunities in the market and avoid some of the greatest pitfalls that got the better of many others in the business.
First, C.S. McKee–which manages $3.7 billion in large cap value equity–essentially performs a Wall Street buyout valuation by measuring a company’s enterprise value to its EBITDA, which entails taking the company’s total value compared to its real earnings divided by its five-year forward growth rate.
“This is one of the key elements of our valuation model,” says Stamy. “We place the highest value on measuring enterprise value to EBITDA, and although it often works better in the small-cap space where there is more M&A activity, it still gives us a stripped-down value of a company whose assets we can buy at a discount to their earning capacity.”
One recent example where this approach worked well for C.S. McKee is Burlington Northern Railroad, a company whose shares as per the enterprise value to EBITDA valuation seemed significantly undervalued to the firm. Billionaire investor Warren Buffett subsequently bought Burlington Northern out, sending the share price soaring, and proving that “our Wall Street buyout evaluation worked,” Stamy says.
C.S. McKee also runs a risk assessment model on the companies it selects for its portfolio, which takes into account such features as bond spreads, bond ratings, and pension funding, among others. Applying this model saved C.S. McKee from a number of dangerous situations, not least the calamities that were Enron and General Motors.
“The risk assessment model has kept us out of jeopardy in many instances,” Stamy says. “We have had plenty of stocks that ranked very high in the fundamental model but had a terrible score in risk, and that kept us away from them.”
C.S. McKee’s benchmark index is the Russell 1000 but the firm uses it more as a rough guide and prefers to “let the market tell us where the opportunities are,” Stamy says. ExxonMobil, for instance, has the greatest weighting in the Russell 1000, but C.S. McKee doesn’t own any XOM because it has found better value in companies like Chevron, Apache, and Conoco-Phillips. Similarly, the firm has been underweight financials (one of the top five sectors in the Russell 1000) since 2006 and continues to be, even though it has felt the pinch, as financials have been performing well since the market nadir last March. However, unlike many other investors, C.S. McKee is not interested in getting into financials despite the returns it may be offering because it believes the sector is only going to face more trouble.
The overall goal of the large cap strategy and for all C.S. McKee’s strategies is getting quality by finding companies that are undervalued and have growth potential. This means that the large-cap portfolio may not perform so well in periods where the market is driven by technicals rather than fundamentals, Stamy says.
At C.S. McKee, everyone is a generalist, Stamy says, and the firm’s five portfolio managers are also analysts who “break up the world” into sectors.
“Our technology sector manager is in charge of that sector for both the large-cap product and the international product; the auto guy isn’t only following GM and Ford, but also Hyundai,” he says. “Each manager follows a large sector and when they unearth an idea, they bring it to the table and a discussion follows.”
C.S. McKee, which was founded in 1931, has been an employee-owned firm since 2001, where compensation is based on performance and none of the portfolio managers is eligible for bonuses until all clients are “in the money,” Stamy says.
“We don’t just beat the benchmark here: The hurdle is higher and the benchmark must be exceeded by the prevailing fee that clients pay for the mandate before any compensation is awarded,” he says. “The fact that we are a 100% employee-owned firm, that everyone from the president to the receptionist is an owner, changes culture and behavior for the better, because there is nothing more motivating in life than owning a piece of where you work.”
Small Cap Equity Award: GW Capital
At GW Capital, a boutique investment firm based in Bellevue, Washington, the same investment team manages a small-cap equity portfolio and a medium-grade bond portfolio, leveraging research and knowledge from both the equity and bond markets to gain what the managers say is a unique perspective into both worlds that ultimately works to their advantage, and their SMA clients.
“Using fixed income research gives us an insight into areas of the marketplace and valuations that managers focusing solely on equities might not have,” says Scott Mullet, who, like his partners and co-portfolio managers Guy Watanabe and Tom Parkhurst, has a background in bonds. “Following a more holistic approach means that we come across ideas that are good for one or the other, for equity or fixed income, and even both.”
He cites the example of Sallie Mae, whose debt and equity both figured in GW Capital’s portfolios. Spreads on Sallie Mae bonds, which had greatly widened at the end of 2008 amid uncertainty surrounding the direction of student loans under a new president, began to tighten in 2009 as investors once again became comfortable with the company’s risk profile, and this prompted the GW Capital team to perform an analysis of Sallie Mae stock.
“We saw that the stock was greatly undervalued even though people were getting more comfortable on the bond side, and this prompted us to go in,” Mullet says.
That was the right thing to do: Convinced of their value, GW Capital bought Sallie Mae shares for under $5 and they subsequently traded up to around $12.
Evidently, GW Capital’s equity strategy is not based solely on what’s happening in the bond market. The company also has a unique approach to investing in small-cap stocks, Mullet says, the most important part of which is that it maintains a focused portfolio of between 30 and 35 names, 60% of which are selected through a “thematic” investment process.
“We may say thematically that we want to overweight the utilities sector, and to give more conviction to this theme, we add different catalysts, such as demographics, changes in the regulatory environment, a shift in companies’ business models, or even business model shifts within an industry,” Mullet says.
The remaining 40% of the portfolio is selected through a straight bottom-up analysis, and here, GW Capital looks for companies that are attractive on a valuation basis and trading low on a relative basis both compared to their peers and to where they may have traded historically in various market cycles.
“What we’ll do is apply a metric that we feel is most appropriate for that company–enterprise value over EBITDA, price-to-earnings ratios or any other–depending on what type of company it is,” Mullet says. “We are trying to identify companies where there is potential for growth, where there is a catalyst coming, and we will propel that valuation up to its peak level.”
Currently, GW Capital is de-emphasizing its allocation toward the consumer discretionary sector, based on its view that U.S. consumers have changed their buying habits as a result of the recession to what they need rather than what they want. Consumer discretionary stocks proved to be the best performers in the small-cap universe last year, but even though GW Capital had already cut back its exposure, the firm still did well because it was overweight in the energy sector and had some very strong performers in the healthcare space, Mullet says. GW Capital is still overweight in energy and materials companies, and is looking to expand in the industrials sector.
“We are also finding that with the credit markets stabilizing, we are more positive on financials, and so we’ve been shifting our focus toward this sector while paring back a bit on healthcare REITs, to which we were heavily oriented in the past,” Mullet says.
GW Capital manages about $690 million in its small-cap strategy (all of that is in separate accounts, institutional as well as individual), which is available on Smith Barney and Key Bank platforms. GW Capital is actually planning to close the product to new investors when it hits the $850 million to $900 million mark.
“This is not a product that we can keep growing,” Mullet notes, “and we had actually closed it in 2006. We reopened in the downturn.”
International Award: Thornburg Investment Management
Lewis Kaufman, managing director at Santa Fe-based Thornburg Investment Management and co-portfolio manager of the Thornburg International ADR portfolio, has always been passionate about stocks, and he’s found no better place to indulge that passion than in the stock pickers’ paradise that is Thornburg.
“Wherever you think there’s value, Thornburg gives you the ability to uncover it,” Kaufman says. “That kind of flexibility attracts people who are passionate about the stock market, and when you allow people to indulge their passion, you have a great deal of success.”
Kaufman, together with managing director and co-portfolio manager Wendy Trevisani and a small, tight-knit team of analysts and investment professionals are constantly combing the globe in search of companies whose shares promise good returns at a good price. They sort these stocks into three categories: basic value (companies with low PE multiples); consistent earners (firms with steady revenue streams and cashflow); and emerging franchises (fast growth companies in the early phase of their development).
“We’re all global generalists, and everyone from portfolio managers to analysts cover companies on a global basis, across sectors and industries,” Kaufman says. “This means that when I travel to, let’s say, Brazil, I can see 30 companies in a week. Maybe I won’t buy them right away but when the markets get bad, I know where we can look.”
If there is one prevailing characteristic that all stocks in the International ADR portfolio must have, though, it is the precedence of operating leverage over financial leverage. This is the core of the qualitative aspect that the Thornburg team looks for in all its holdings. Moreover, sticking to that philosophy in the investment process not only has helped the firm stave off the worst of the financial downturn, Kaufman says, but also enabled it to identify winners like Indian IT player Infosys and Brazil’s Banco Itau, both of which remained strong growth stories despite the crisis.
Companies that have the ability to self-fund and that can generate capital organically are the only companies that can make the grade for Thornburg. The firm favors names like the highly successful Swedish clothing business H&M (one of the portfolio’s top holdings), which consistently generates cash flow through which it can self-fund its business expansion. H&M is able to open new retail outlets at a time when other companies in the same sector are struggling, and because it is not financially leveraged, H&M can not only hold up in a poor economy but it also has the potential to do well when things start to improve, Kaufman says.
“Our portfolio construction is bottom-up and we are trying to create a product that can protect in a downmarket and perform in an upmarket,” he says. “A company’s cyclical recovery is very important to us.”
In the aftermath of the crisis, when so many stocks–particularly in the banking and insurance sectors–became very cheap, assessing the extent to which companies are financially leveraged has become even more important, even if it is not always so easy to do. But while the crisis has thrown up many more good investment opportunities, companies that Thornburg already held in the International ADR portfolio, such as Walmart de Mexico (Walmex), have also been able to get ahead of the game. Walmex’s main competitors were pretty much put out of business as a result of their financial and economic woes, Kaufman says, so “Walmex was able to focus on new store growth and invest more aggressively. All of a sudden, we had a company that went into a good competitive position and became a high growth company with free cashflow, so we went from having a small exposure to Walmex to having a larger one.”
Looking ahead, Kaufman believes that emerging markets offer the greatest opportunities for the International portfolio (currently, EMs make up about 20% of the holdings). But the overall outlook for ADRs is positive, not least because of the adoption in 2008 by the SEC of final rules regarding the exemption from registration for certain foreign private issuers, which improved their access to the U.S. capital markets and resulted in many more ADR issues from such entities as Hong Kong Clearing and Exchange Limited (the Hong Kong stock exchange) and luxury goods company Louis Vuitton Moet Hennessy. Thornburg invested in these and will be looking at more issues as they come online.
Thornburg manages $3.4 billion in the International ADR strategy; all in separate accounts. The product is distributed via all the major wirehouse programs as well as on high net-worth and ultra high-net-worth platforms.
Tax-Free Fixed Income Award: Breckinridge Capital Advisors
Peter Coffin, president and founder of Boston-based Breckinridge Capital Advisors and co-manager of its Enhanced Tax Free Income portfolio, has reassuring words for those who may be nervous about the municipal bond market. Yes, things don’t look great in many states and towns, he says, and credit quality and interest rate risk are certainly issues to ponder. But the good news is that the overwhelming number of municipalities actually have very manageable debt loads and are highly unlikely to default on their payments.
“States and local governments are having a tough time balancing their budgets, but they value their access to the capital markets and they understand that their obligation to service their debt doesn’t go away,” he says.
That said, though, it is imperative that investors in the muni market do their research properly, now more than ever before. Breckinridge–which manages about $11.5 billion in tax-free municipal bonds–has never slacked in this area: The firm has a skilled research staff to which it continues to add and it prioritizes investing in the best available technology to aid in the research effort. Breckinridge also invests exclusively in high-quality paper, and this, Coffin says, has ensured its leading position in the municipal universe.
“With careful analysis we can buy muni bonds of excellent quality that offer a little extra yield and perform quite well,” he says.
Coffin and his team are able to discover those credits because they are totally plugged into the muni world. Breckinridge prides itself on the broad network of dealers (over 100) with which it deals–a network that is fundamental to leadership and performance, Coffin says, because it is the only way to access the best of what’s available in the muni market.
“The good stuff always goes first, so to get the good stuff, you have to talk to as many dealers as possible,” he says.
Being so well connected to the municipal bond universe and placing such a strict emphasis on research allows Breckinridge to stay ahead of the curve when it comes to good deals. Last year, for example, the firm bought District of Columbia Income Tax Secured Revenue Bonds at a spread of about 42 basis point of the triple-A scale in the 10-year maturity range. In early March, the same issuer priced at the tighter spread of 32 basis points.
Within the high quality muni universe, Coffin looks for both general obligation and revenue bonds that have a monopolistic quality: exclusive franchises such as utilities and toll roads that don’t face much competition. When it comes to investing in states or cities, the firm’s main focus is debt levels and making sure debt service requirements don’t account for more than 10% of a municipality’s budget.
Surprisingly, even in these troubled times, the debt service levels of most states and municipalities, including California, a state rife with problems, are about at that level.
“Debt service is about 7% of California’s budget and there is good constitutional protection for bondholders,” Coffin says. “We also think we’re being well paid for taking on California’s volatility.”
But Coffin is most excited about a new and growing segment of the municipal bond universe: Taxable munis, which started coming to market in a trickle last year but quickly gained momentum. When municipalities issue taxable bonds, they get 35% of their interest cost paid to them by the federal government. Such issues are becoming more popular with both issuers and investors, Coffin says, and it’s quite likely that the Build America bonds program, introduced on a temporary basis as part of the Obama Administration stimulus package, will become permanent at the end of this year, thereby resulting in more issues.
Breckinridge currently manages about $550 million in taxable municipal bonds and Coffin is looking to grow that exposure as more issues come to market. He will be looking for the same attributes he looks for in tax-free bonds, and taking maturities into account. He passed over a recent taxable Build America issue from San Antonio Electric and Gas, for example, because its 2041 maturity was too long.
“Zero to three years is our dry powder,” Coffin says. “If interest rates do rise, then those bonds, which we overweight, roll off and we can reinvest and earn at a higher rate. But if interest rates don’t rise or if they go lower, then we have longer, eight to 12-year maturities, which we also overweight and which will preserve the income stream and earn over time.”
The Enhanced Tax Free Income product is distributed through Schwab, Fidelity, Pershing, and a range of other RIA custodians. Coffin founded Breckinridge in 1993.