Talking to Robert DiMella of MacKay Shields

June 17, 2014

I had a chat with Robert DiMella, a senior managing director of fixed income manager MacKay Shields. DiMella brought MacKay Shields to New York Life in 2009 with $400 million of assets under management. He now manages close to $10 billion there. Retail investors typically buy and hold municipal bonds, but mutual fund managers like DiMella get paid to move from overvalued to undervalued bonds and take advantage of market mispricings. I had a peek into his operation.

Choosing bonds is about the underlying strength of the issuer. DiMella’s group references but does not rely on credit ratings. DiMella thinks that there is too much fear of rate increases and, like Blackrock fund managers, he does not think they are likely.

There may be value in more credit-sensitive parts of the market, like non-investment-grade high-yield bonds. The wide risk premiums seen in high yield are not legitimate, according to DiMella, who thinks they come from fears generated by Detroit and Puerto Rico. Investors are less willing to buy high-yield bonds because they are not comfortable with the risk. “Don’t take duration risk, take credit risk,” said DiMella. Translation: buy lower-quality bonds, but not long-dated bonds.

DiMella had sold all Puerto Rico bonds out of his portfolios by April, 2012. He sold bonds at $108 that he can now buy at $62. He questioned the credit ratings of Puerto Rico sales-tax based COFINA bonds, because they are not higher quality than Puerto Rico’s general obligation bonds. He believes that Puerto Rico will restructure PREPA, highway and appropriated debt bonds. DiMella’s team urged their clients not to buy the new Puerto Rico general obligation bonds that were issued in March because everyone wanted to quickly flip them for profit, which is what happened.

The reduction of committed capital from dealer banks could be a problem for trading liquidity. The model for decades has been that dealers with a lot of capital buy bonds when their clients need to sell, and hold these bonds in their inventories until different customers purchase them, which could take weeks. In 2007, bank dealers had $320 billion of trading capital. That shrunk to $50 billion at the beginning of 2013 and fell again to about $20 billion at the end of 2013. The cushion that dealers had provided for fixed income trading has evaporated. This makes trading for DiMella and other mutual fund managers difficult.

Some market commentators have alleged that troubling headlines about Detroit and Puerto Rico have caused the big sell-off, but DiMella said that it was the May 2013 comments of Federal Reserve Chairman Ben Bernanke about the future of interest rates. In that turbulent trading environment, dealers were unable to buy bonds and store them in inventory. Dealers were acting more like agents than principals. Rather than taking all the bonds that mutual funds were selling, dealers were scrambling to find buyers and had to drive prices down to do it. This was the death knell for muniland trading liquidity.

Last summer’s sell-off was a bonanza for DiMella and his clients. He told me that he “couldn’t bring in enough cash to buy as many good securities as were being offered.” DiMella’s team worked closely with their clients to give them confidence to buy into the sell-off while many others were fleeing the market. Some of the larger fund complexes were either overweight Puerto Rico bonds or highly levered and became stressed. Municipal exchange traded funds also had some challenging liquidity problems during the sell-off.

Last summer municipal interest rates shot up 2 to 3 percent, while U.S. Treasuries only went up 1 percent. That period created a big boost in assets for DiMella’s team.

DiMella says that investors shouldn’t worry about interest rates. A lot would need to happen for the benchmark 10-year U.S. Treasury to go back to 4.5 percent. That would require a stronger multi-year recovery. Most financial leverage is now at the sovereign level. This leverage is a drag on economic activity. Governments are diverting more of their cash flows to service debt rather than provide social services, constraining the role governments typically play in stimulating economic activity.

It is likely that muniland will refocus on bond insurance and investors will recognize the value, said DiMella. He believes that insurers deliver liquidity for issuers. There value is being proven in Detroit right now, as insurers are stepping up to make unlimited tax general obligation (UTGO) bondholders whole, though the city will only pay 74 cents on the dollar.

DiMella rode Illinois bonds to a profit when he bought them last summer at 180 basis points over AAA and sold them at 110 basis points. He believes that the market will start feeling more positive about Chicago and that the city does not have Detroit-size problems. Chicago has an expense problem, not a revenue problem. Chicago bonds are appropriate for some portfolios, though they are higher risk than many other city bonds, said DiMella.

New Jersey has some “structural” issues, said DiMella, and he was not surprised by recent downgrades to the state. Governor Chris Christie is trying to resolve problems, but it will take a long time to fix the state. DiMella is underweight New Jersey bonds because they are trading too rich. It is a wealthy state with demand for the bonds from local investors who want to shelter their taxes, which pushes down the yield on those bonds.

Further:

Bloomberg: Tom Keene interviews Robert DiMella

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