Ticker Symbols

VMPAX (Class A) VMPIX (Class B) DHICX (Class C) VMPYX (Adm) STRIX (Inst)

Investment Advisor

Wells Fargo Funds Management LLC


Subadvisor

Wells Capital Management Inc.

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Total Return Approach to Muni Bond Investing

Oct 12, 2015

Wells Fargo Advantage Strategic Municipal Bond Fund

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Q: What is the history of the fund?

We took over management of the fund in 2010 and it was one of the first funds on the municipal side to have a strategic portfolio. Now, there are half a dozen or more, but there is little consistency in terms of what “strategic muni” means. In general, a strategic muni portfolio gives price protection in a rising interest rate environment and provides broader flexibility within the asset class.

Our team’s assets under management (AUM) have grown from $4 billion in 2010 to about $40 billion today. Our team has 28 people: nine portfolio managers, 16 credit analysts, and three traders.

Q: How has the fund evolved since 2010 when it was taken over by the current management?

Under the prior manager, the fund had more flexibility in its prospectus. For example, the fund had no duration parameters and it could fully invest in high yield. At that time, the fund’s securities had a very short duration, meaning low sensitivity to interest rate risk, two- to three-year portfolio, with a fairly high average credit quality of AA rated bonds. 

We set target duration between 3–3¼ years and will go plus or minus 60% of that. If we are bearish on the market, the shortest duration it will ever be is 1¼ years. If we are extremely bullish, the longest it will ever be is close to 5½–6 years.

We also reined in the limits on high yield. If we are extremely bullish, the most we will ever have in high yield is 35% and kept the lower boundary at zero. While we never want the portfolio to get extremely overaggressive from a credit perspective, we would like to have plenty of flexibility to utilize high yield when we feel it is attractive. 

We wanted the flexibility to implement our strategy more aggressively than we would in some of our other funds. At the same time we also wanted to give investors time to get acclimated from what was, pre-2010, a fund that was one step up from cash, to what would become a strategic muni portfolio.

Ultimately, we wanted a product to take duration risk and credit risk but within prudent yet well-defined parameters. What we really wanted was a product that gave us flexibility to add long-term alpha for our shareholders. 

Q: How are muni bonds different from corporate bonds and what kind of investment opportunities are available to investors?

The income generated by a municipal bond is generally not subject to federal taxes (whether state taxes apply varies by state). Just like any other fixed-income asset class, it should be a core in most people’s portfolio. 

There are basically two types of municipal bonds: general obligation (GO) bonds and revenue bonds. GOs are backed by a state’s or a municipality’s full-fledged taxing authority. Revenue bonds are secured by a specific revenue source, and cover a variety of sectors: essential services revenue bonds include water and sewer; in transportation, there are toll roads; not-for-profit hospitals and multistate healthcare companies; and not-for-profit universities are some of the thousands of issuers in the tax-exempt space.

Traditionally, people have wanted to own GOs because they are backed by a taxing authority and, historically, have had lower default rates and higher recovery rates relative to revenue bonds. The world is changing though—look at Detroit, San Bernardino, or Puerto Rico. People are reevaluating whether GOs are the safest asset class. If you have no tax base, it doesn’t matter that you have unlimited taxing authority. 

Revenue bonds historically have had higher income levels but were lower rated in the marketplace, with higher default rates and lower recovery rates relative to GOs. However, more and more people are saying, “I’d rather own an essential service revenue bond because I can evaluate its revenue source, and I’m not subject to a political environment.” Investors are increasingly looking at a willingness to pay, rather than an ability to pay.

Unlike the corporate bond market, the muni bond space is very broad-based. We think credit research can add a lot of value in the marketplace.

Q: What is your investment philosophy?

We are relative value investors. We want a good balance between maximizing total return, yet still generating a nice level of tax-exempt income. Total return is what protects investors in a rising rate environment, as well as from a bad credit decision. 

Our relative value approach means we want to buy securities that represent the best relative value in our portfolio. Let us look, for example, at a bond rated BBB and another rated AA. While the AA credit is a better and safer credit, we analyze whether you will be getting paid enough to take the risk of buying the BBB in your portfolio.

This relative value approach permeates our entire team of analysts, portfolio managers, and traders. An analyst’s job is twofold. First, they assign an internal rating to each and every credit we buy. Then, they offer an opinion on whether the credit is stable, neutral, or declining. For most fund families that is 100% of what analysts do. The ones that add alpha—like ours—are those where the analyst overlays his credit opinion by asking where it is trading in the marketplace and whether it represents good relative value.

Q: What is your investment strategy in the municipal marketplace?

We have built our process around the unique nature of the municipal marketplace both from an investment and investor standpoint. The largest investors in the muni market are direct retail investors, who like the tax exemption and buy individual bonds for their personal portfolios. Because their investment style is different from traditional intuitional investors, their influence creates opportunities in the marketplace. 

In 2003–2004, we implemented a proprietary risk model on all of our portfolios, putting parameters around what sort of duration bets we can make relative to our index or our peer group. The model shows what magnitude of credit positions we can take overweights or underweights to the portfolio. It also gives us enough flexibility that we can add alpha but protects investors if we make a bad decision. 

The key drivers are duration mismatches and credit positions. As you go down in credit quality, our position sizes get smaller and smaller. A BBB-rated muni will not be over 1.5% of the portfolio. A BB-rated muni won’t be over 0.5%, while single B and below won’t be greater than three-tenths of a percent of our portfolio.

It comes back to looking mathematically at what have been historic default and recovery rates. If you do a two or three standard-deviation event, how’s that going to affect performance? 

We now apply corporate default statistics to the muni market and we also do a complete look through to the underlying credit in addition to researching any bond enhancement. We used to allow slightly higher position sizes if a mono-line insurer wrapped the bond, but now we look to the underlying credit when we are diversifying our portfolio.

Q: What is your research process and how do you look for opportunities?

It’s really a team approach, but it starts off top down, then it gets more bottom up. We start with a macro discussion among all portfolio managers—tactical managers, high-yield managers, and treasury agency people—throughout the organization. We meet regularly to talk about the level and direction of rates. We also have periodic meetings that focus on our longer-term strategic outlook, and others that focus on specific sectors.

The most important thing we discuss is relative value across different asset classes. Currently, because of what we see going on in the broader fixed-income marketplace, we are much more cautious from a credit perspective. This affects how we set strategies for muni bonds.

We then take that into weekly muni-only strategy meetings. One of our firm’s economists joins us to discuss the economy and its outlook. We talk about how we want to be positioned in our muni portfolios and we look at duration position per sector, credit quality, and security selection. 

Then we go back to our desks and implement that strategy in the portfolios that we manage. It is truly a team approach. We all have dedicated portfolios that we take the lead on, but if you see a bond in the marketplace that works well for yourself, you may also think it works well for another manager’s portfolio.

The bottom-up side to our approach begins with our credit meetings. Every week the new issues calendar serves as the source of discussion. All of the portfolio managers get the calendar from the head of research and note the deals we are potentially interested in. These are in turn distributed to credit analysts, who prepare bullet points on each credit. 

The managers will then agree or disagree to finalize a credit opinion. This often generates discussions around sectors of the municipal bond market where we can talk about our weightings within those sectors and what relative value looks like. 

Q: Can you give examples of credit opportunities that played out positively?

California Local School Districts are local GOs and a great example of how we approach the world. California tends to lead the nation in economic recovery, but it also tends to lead during economic downturns. As the financial situation started to look quite ugly in 2009, many people did not want to own any California bonds.

When the economy started to turn around and grew more in 2010, California was levered on the upside. We got positive on the California credit in February 2010. Our analysts upgraded the credit and have been continuously upgrading it—we went from BBB+ to AA- over a period of 4 years. The ratings agencies were slower to do so, but I believe they are now all at AA- as well.

Our thesis started with, “We should own California GOs,” because those are the biggest and most liquid. In other words, those will benefit most quickly. But after we saw spread tightening there, we thought that if the economy continued to do well and the state rebuilt its balance sheet, eventually it would trickle down into the local municipalities. 

So, the question became, “Which local GOs do we want to own?” We really liked the school district sector for a couple of reasons. First, it is obviously an essential service. The state is committed to it. Funding levels can move around, but it is rare that anybody ever defaults on a school district debt. 

Second, school district debts were also backed by property tax levies in the State of California. That had been challenged in a court case in which a school district was shut down and the local constituents continued to get taxed until the debt was paid off. We felt there was a court precedent where it gave you, as an investor, a secured revenue pledge on those actual property taxes to pay off debt, even in the worst case that a school was closed. 

Overall, we felt it was a great security package. They were still trading at a wide spread because the local municipalities had not recovered yet. We made a large investment, buying both zero coupon bonds and coupon bonds within the sector. We focused primarily on the 10- to 25-year part of the curve, with the view that as things rolled down the yield curve, it would be helpful. 

Also, retail investors tend not to buy out beyond 20 years. We would get that added benefit—that if things improved, we could get a retail bid and that retail bid would be even stronger than an institutional bid.

That has played out well. If you look at the outperformance of California, and specifically, local GOs within the state of California, they have been one of the best places to have your money over the last five years. Now we are at a substantial underweight for the State of California and are starting to migrate into a lot of credits in Illinois.

Q: What types of credit would you avoid?

One credit we have not owned for some time is Puerto Rico. It was a large issuer in the muni market—it was an investment-grade rated credit—but our analysts have rated it as non-investment grade for 4–5 years. 

Our biggest issue with Puerto Rico is that they do not have the economic backdrop to support the debt levels they have. Their economy has continued to contract, even though the U.S. economy is in the fifth or sixth year of positive growth. Our view is that until they can turn around the economy, there really isn’t an investment story there. 

We feel you are not married to credit, and if your opinion changes, you must be willing to sell that credit and take a loss and move on. That sell discipline is very important. As soon as we think a credit no longer represents good relative value, we sell.

As an example, we just sold bonds in a coal warehousing and port deal in Louisiana. It allows coal to be loaded much closer to the Gulf of Mexico, and therefore makes it cheaper to transport it to the foreign countries. It is relatively new, efficient, with a global manager in charge. It is up and running and is working. However, we sold the bonds because of what is going on in the broader coal market—the impact of clean energy, the reduced margins within the coal sector, and spreads for coal companies in the broader taxable marketplace, which have underperformed dramatically.

These bonds are trading at the highest level they have ever had, or close to it. Spreads are tighter than where they were on new issues. Nonetheless, we felt if we could find a bid for these, we should sell them. We do not think they represent good relative value. The numbers look good right now, but if we continue to see pressure on the sector, and less use of coal from a U.S. or global perspective, it will obviously be a negative dynamic for this credit.

We sold it, took a capital gain and will move on. We make our own independent investment decisions.

Q: What is your portfolio construction strategy?

Our primary benchmark for the Strategic Muni Bond Fund is the Barclays 1-10 Year Short-to-Intermediate Municipal Bond Index. Because of the strategic nature of the portfolio we may take bigger bets on duration or on the credit risks than the benchmark.

When we think of the portfolio construction, we overweight or underweight sectors compared to the benchmark, taking into consideration the GO exposure and the revenue bond exposure in the index. Then, we further break down these two exposures at state levels and at various sector levels, such as toll roads, healthcare, school districts and others across each state. 

All of this flows through our risk system before we ultimately apply individual security level limits by credit ratings. For example, we limit AAA individual security at 4%, AA rated securities at 2.5%, BBB rated at 1.5%, corporate-issued BBB rated at 1%, and BB rated at 0.5%. Anything below BB is limited to 0.3% exposure. 

Our overweights and underweights are going to be based on our relative value based approach and our views on the individual sectors. 

Q: What does risk mean to you and how do you manage it?

Risk means a couple of things to us are there to define risks and help investors have an understanding of what kinds of risk t. First of all, how is our portfolio positioned relative to the benchmark? Obviously, benchmarks hey can expect.

We take this benchmark as a reference point, and with that we have the risk profile that accompanies it. Then, we take additional risks into account to make sure that we are more than adequately compensated. We generally do that through duration adjustments, sector allocation and weight adjustments for each kind of securities. 

Secondly, we measure risk on a duration-adjusted basis, not on an absolute holding basis. For example, the same municipal bond with a maturity of one year has a different risk profile from the 10-year bond. At times we may have two times the holding of a bond when compared to the benchmark, but when adjusted for duration that weight drops down to 1.2 times. 

To sum up, the duration-based risk and performance contribution relative to the benchmark is what primarily matters to us. 

Another measure of risk is volatility relative to the benchmark. Are you taking risk that may be more than the benchmark, and more importantly, are you compensated enough and are you able to generate excess performance relative to the benchmark? 

Sometimes you can have a fund that tracks closely with the benchmark but has an excess return of only 25 basis points or a fund that delivers 100 basis points of excess return but comes with nearly twice the volatility levels. That is what makes us consider performance on volatility adjusted basis too.
 

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