Persistently low supply met with sturdy demand is keeping municipal yields at bay, even as Fed rate cut projections get kicked further and further out the calendar. The nature of the demand has created a tale of two municipalities along the yield curve with attractive long term rates (12-20 years), but relatively unattractive yields in the intermediate (2-11 years) portion of the curve. Therefore, it is a market that warrants patience and tactical implementation of cash. Fortunately, most ladders roll over into the longer portion. That said, patience is rewarded with attractive money market fund yields (~3.40% tax-exempt). But investors must understand these high yields on cash will be fleeting if the Fed starts cutting rates. We believe one should diversify exposure across the curve, aiming to lock in similar-to-higher rates as these money market funds currently provide.

Today’s market demand for municipals in the intermediate portion of the curve (2-11 years) is driven by passive fund investors and large managers forced to buy into low supply. These investors are passive in that they allocate in accordance with the benchmark and largely must buy what is currently on the shelf amongst the largest issuers. These strategies are driving ratios (the percentage of a muni yield to concurrent treasury yield) to historically low and irrational valuation levels, in our view.

 

What you are seeing in the chart above is 5 and 10-year muni ratios nearing their post COVID-era lows. This means munis are at historically “rich” valuations in this portion of the of the curve. However, the longer-end portion of the curve (grey line) has not tracked the intermediate portion to such low ratios, a break from recent historical correlations (see how all three lines basically tracked each other until the summer of 2022).

These 5 and 10-year benchmark rates[1] are overpriced when taking into account their taxable equivalent yield and alternative fixed income assets. The 5-year AAA Muni BVAL rate is 2.42% today, which is 55.76% of the 5-year treasury (4.34%) and equivalent to a taxable yield of 3.84% at the 37% bracket.[2]

Why would anyone (or product) buy a 3.84% taxable equivalent yield when you can purchase a similar maturity treasury at 4.34%? The answer lies within passive index funds and separate account strategies that mimic them. These products largely must buy what is stipulated by the benchmark. Given a low supply market, ample competition amongst funds and underwriters alike, and continued inflows into these products, this has created a feeding frenzy for bonds in this portion of the curve.

It is our opinion the longer end of the curve has not traded to irrational levels given the above mentioned products are simply not as active in this portion of the curve and due to inherent duration risk in longer bonds, as well.

We clearly live in a siloed market right now where supply and demand dynamics are driving price. Even if this price is unattractive relative to other high-grade fixed income.

 

Our Approach Given This Dynamic

  • Patient cash implementation
  • Let the ladders roll (In honor of National Ladder Safety month, of course)
  • Avoidance of benchmark names

Cash: Fortunately, investors are currently paid for patience as tax-exempt money market funds yield 3.25%-3.40%. These yields are relatively attractive to most intermediate maturity municipal yields (i.e. inverted curve) and taxable alternatives. The risk here lies in that the Fed is expected to cut short term rates, which will pull these floating yields down and also, potentially intermediate-to-long-term yields, as well. With new cash added to portfolios, therefore, we are gradually implementing across the yield curve at target average yields equal to money market fund yields. Essentially, we are aiming to lock in these high short term yields in a laddered portfolio.

Ladder: A historical benefit of the ladder and what our investors are experiencing today, is that we typically roll over matured proceeds at the longer-end (15-20-years) of the ladder. Given fair valuations and tax-exempt yields of 3.50%-4.00% (5.55%-6.34% taxable equivalent) in this portion of the curve, we find these bonds relatively attractive and are able to largely avoid the intermediate bonds unless directed otherwise.

Beware of benchmarks: Today’s municipal benchmarks are generally allocated to big names located geographically on the coasts (CA & NY). Given high state tax rates in NY and CA, it makes sense for instate residents to over allocate to instate bonds. However, for residents in the other forty-eight states, it generally does not.

Furthermore, big deals get big attention from the big fund/SMA providers. This often leads to small yields and small spreads for the issuers and investors alike. Especially in times of low supply.

For example, on Monday March 11th the State of Ohio (AAA rated) issued nearly $174,000,000 in bonds with the 5 and 10-year bonds yielding 2.45% and 2.48%, respectively.  Good for the State of Ohio to borrow at such low yields, but we avoid these types of bonds in our SMA portfolios and pity the investors who locked in taxable equivalent yields under 4%.

Instead, we are targeting tax-exempt yields of at least 2.90% in this portion of the curve. This equates to a taxable equivalent yield of 4.60% – a positive spread to the concurrent treasury.

 

As always, let us know if you have any questions about current market dynamics or your portfolio. Thank you for your confidence in our team and reading our market commentaries.

 

Sincerely,

Matt Bernardi
Senior Vice President
March 2024

 


[1] Benchmark yield source: Bloomberg BVAL Muni AAA Curve

[2] All taxable equivalent yields referenced hereafter assume a 37% tax bracket.

 

Here are two portfolio strategies we find attractive in today’s municipal market:

  • Tax loss swaps
  • Discount bonds[1] trading at relatively attractive yields

Tax Loss Swaps

Selling bonds is an infrequent exercise for most income-oriented investors. However, when bond losses present themselves on paper, it may make sense to capture them. Losses have arisen due to the significant increase in yields (leading to lower prices) over the past two years. Investors can use up to $3,000 in tax losses to offset regular income and use losses beyond this to offset capital gains. Losses can be carried forward, as well. Additionally, a tax loss swap may offer a benefit beyond tax considerations by allowing investors to buy higher cash flowing and longer maturity securities.

Do you have current or projected capital gains? If so, we recommend investors reach out to their Investment Specialist to inquire about tax loss swaps and our bond sale process. Our process is transparent, efficient, and enables broad market exposure to increase the number of potential bidders on the securities for sale. Selling bonds in today’s secondary market requires a high amount of patience and careful consideration of bid results.

 

Attractive Discount Bonds

Discount bonds – bonds trading under par ($100) – are readily available in today’s secondary market. A discount price is a consequence of a bond’s market yield trading higher than the coupon rate it was issued at. The coupon rate is a fixed level throughout the life of the bond.

To give a simplistic example of this relationship, if a bond was issued in 2021 with a 2% coupon at par ($100) that means it had a yield of 2% to maturity. However, today that bond is trading at a higher yield (more than 2%) regardless of its maturity – as our benchmark yields for 1, 5, 10, 30-year bonds are all over 2%.

Therefore, if you were to buy this bond from a seller, you would demand a price under par as your demanded return (above 3%) is a combination of the coupon (2%) plus discount (appreciation you capture when the bond matures at par).

Low rates during COVID provided many 2.00-3.50% coupon bonds which now trade under par, at a discount. This vintage of bonds is generally avoided by the market for three reasons:

  1. Lower coupon bonds have lower cash flows and, therefore, a higher duration. This structure leads to a security that can demonstrate higher volatility, which many buyers aim to avoid during portfolio construction.
  2. The discount is taxed at one’s income tax rate or the capital gains tax rate if it falls within the de minimus threshold[2]
  3. Due to #2, municipal bonds demonstrate a higher level of negative convexity[3] due to tax ramifications on discount prices. Furthering the avoidance of many buyers for discount bonds.

The features of discount bonds noted above leads them to trade relatively cheap (higher yield) than “fuller” (4-6%) coupon bonds. And in many ways, the attractiveness of tax loss sales has led to a hefty supply of discount bonds, without significant demand for the structure.

This all results in higher than average yields to buyers and we believe an attractive structure to take advantage of for a portion of your municipal portfolio. For investors that file at a 35% (one notch below the top, 37%) or lower tax bracket, this structure becomes even more attractive.

Don’t hesitate to reach out to your Investment Specialist or Portfolio Manager to inquire about tax loss swaps or discount bonds. We hope everyone had a wonderful Thanksgiving and the holiday season if off to a great start!

 

Sincerely,

Matt Bernardi
Senior Vice President, Investment Specialist


[1] A discount bond is a security trading below par ($100)

[2] The allowable market discount under the de minimis rule is 0.250 per year. If a market discount amounts to less than 0.25 per year, the investor is required to pay the applicable capital gains rate on the accrued discount.

[3] Negative convexity is when a bond’s duration increases as yield increases. This means that as rates increase the loss in value on the bond will increase at a greater pace than the potential increase should rates have fallen. Essentially bonds with negative convexity have greater potential downside than upside as it pertains to on paper performance.

Yields moved up precipitously during the month of September as the AAA rated 10-year municipal has moved from 2.85% on August 31st to 3.52%[1] today. 3.52% is equivalent to a taxable rate of 5.58% calculated at the 37% bracket. This bond selloff (higher yields) has pulled the 10-year treasury to 4.84% as of this morning after a great jobs report. This is its highest level since 2007 – pre Great Financial Crisis. The underpinning of the selloff is the i.) market’s “higher-for-longer” forecast of Federal Reserve policy ii.) a resilient economy in the face of significant rate hikes over the past year and a half and iii.) a potential supply/demand imbalance for treasuries.

The latter point echoes the 1990s and James Carville’s famous remark: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” Or an even further back historical reverberation would be Henry Kaufman’s warnings in the 1970s and 80s. Kaufman, then chief economist at Salomon Brothers, earned the nickname “Dr. Doom” after his various warnings about government policy.

 

 

10-year municipal yield moves to a 10-year high (source: Bloomberg)

 

 

 

 

 

 

10-year treasury yield surpassing pre-financial crisis highs (source: Bloomberg)

 

 

 

 

 

1990’s Redux  

Fueled by concerns about federal government spending, the “Bond Vigilantes” of the 1990s caused severe volatility in the treasury market. The 10-year rose from a 5.16% yield in October 1993 to over 8% by the end of 1994. And it was a double-edge sword of fiscal and monetary policy pressure for the bond market, as the Fed raised rates from 3% to 5.50% in 1994 alone.

Alternatively, today’s most recent selloff is not accompanied by Fed Funds rate hikes, as they have not raised since July and the market’s expectations for them raising again has barely budged.[2]

Such volatility based on fiscal concern in a developed country’s debt market is not unique in more recent times. Britain experienced a similar episode in the fall of 2022. When large tax cuts, paired with new spending plans, were announced to Parliament, the pound fell significantly in value and their government debt shot up in yield. This led to the abrupt resignation of the newly elected Prime Minister, Liz Truss after only six weeks in office and a rethinking of the country’s fiscal plan.

Fitch’s August 1st downgrade of its rating on U.S. debt helped fuel the market’s fire.[3] But what underpins the potential supply/demand imbalance is a variety of variables including high-to-increasing debts and deficits, the Federal Reserve balance sheet runoff (Quantitative Tightening), and a continued decrease in Chinese treasury holdings.

This dynamic also had a self-fulling aspect to it, as government borrowing costs rise so does the cost to service debt, thereby increasing the supply of debt. Lather, rinse, repeat and the vicious loop continues.

Typically, investors need only to focus on growth, inflation, and resulting Fed policy to give context to bond yields. However, the emergence of a fiscal variable in explaining yields is emerging as a major focal point.

 

Our Approach to Current Market Dynamics

Broadly, choppy markets like today are typically an excellent long term buying opportunity. Furthermore, taxable equivalent yields of 6-7% now readily available are historically high nominal rates.

The lagging impact of monetary policy, paired with a decreasing money supply, should continue to reign in inflation and, therefore, today’s restrictive monetary policy from the Fed. One interpretation of restrictive or “tight” monetary policy is when the Fed Funds Rate (5.33% today) is above headline CPI and/or core CPI. These recently printed at 3.7% and 4.3%, respectively. However, the Fed Funds Rate did not move above headline CPI until this past April. Therefore, it could be argued we were in stimulative monetary policy territory until then – a full three years after the COVID crisis.

Through the late summer of this year, we favored the front (1-2 years) and long-end (12-20 years) of one’s ladder to capture relatively high rates and underweight the “belly” (3-10 years) of the yield curve, which we found overvalued.

Money market funds paying 4% tax-exempt are certainly attractive, but – as new cash or maturities become available – we think targeting the intermediate portion of the yield curve at 3.80%-4% and long term, targeting 4-4.50%, is attractive for long term returns. For the more income-oriented investors – where duration risk is secondary to maximizing yield – we would overweight the latter rungs of a ladder.

A 4.50% tax-exempt yield is equivalent to a 7.14% taxable return. Over the last 30 years, the S&P has returned 7.70% annually without reinvestment of dividends and 9.68% if reinvested.[4]

An investment grade municipal portfolio at such yields not only offers a locked in yield but also significant protection from a credit perspective. Should a “soft landing” ensue, credit is certainly less important than duration risk, but during any sort of economic turbulence, a high level of credit safety is vital as part of your overall asset allocation.

 

Don’t hesitate to reach out to your Investment Specialist or Portfolio Manager with any questions about the market or your portfolio.

 

Sincerely,

Matt Bernardi

Sr. Vice President

 


[1] Source: Bloomberg AAA rated BVAL Yield Curve, 10-year

[2] According to Fed Funds futures, there is a 25% chance they will raise rates in November. This is up (insignificantly) from 11% on August 31st.

[3] Moody’s remains the only major rating agency with a Aaa rating on U.S. sovereign debt.

[4] Source: Bloomberg

  • Moody’s “Corporate Default Rate to Breach Historical Levels”
  • Three of four of the largest U.S. bank failures have occurred in the past two months
  • Capital One: “Credit Card Delinquencies Test Multi-Year Highs as Job Market Faces ‘Material’ Worsening.
  • Powell: Monetary Policy Trying to Reach and Stay at Sufficiently Restrictive Stance to Bring Inflation Down –WSJ

The headlines above demonstrate that investors need greater focus on the credit health of their fixed income investments in this phase of the economic cycle.

Because inflation remains above the Fed’s 2% target, monetary policy will remain restrictive for longer, placing further pressure on the economy.[1] Investors’ concern about duration risk (maturity length) should pivot to the increasing threat of credit and default risk. Warren Buffett famously quipped “Only when the tide goes out do you learn who has been swimming naked.” The Fed has been the force causing the tide to ebb and by draining liquidity from the system, its actions are further generating pressure on the economy.

At this point, acute pressure within the economy has been sector and company specific. For example, certain banks have fallen victim to interest rate risk within their fixed income portfolios and clearly failed to properly manage this risk. Today’s much higher rates (compared to 1-3 years ago) caused paper losses within bank fixed income portfolios. Many banks can avoid realizing these losses because their deposit base is stable.

However, due to a concentrated deposit base and then substantial depositor flight, Silicon Valley Bank, Signature Bank, and, most recently, First Republic failed. These failures are primarily a reflection of a rate shock rather than a credit shock. These recent failures compel us to ask two questions: could this be the next phase of the economic cycle and is the market underappreciating this possibility?


Interest Rate Risk Within Municipal Portfolios:

Interest rate risk is mitigated in part by the ladder structure – as there will always be coupon interest and short term maturities coming due for reinvestment or to meet unforeseen cash needs. Furthermore, high coupons[2] are a way to lower duration and protect against inflation risk by boosting portfolio cash flow. That said, we believe the market is generally overpaying (low yield offered) for coupons 5% and above. We believe 3.50-4.50% coupons offer a sweet spot of high cash flow and an attractive yield.

 


Currently, the market is inadequately focused on credit risk as demonstrated by:

  • Corporate credit default swap levels – These are a measure of credit risk within corporate bonds. The higher the spread, the more credit risk the market attributes to buying a corporate bond. These spreads are below 2022 and 2018 highs. The latter was the last time there was a significant probability of a recession pre-COVID.
  • 10-year municipal ratio – The 10-year municipal yield divided by the 10-year treasury yield is below historical averages. This ratio typically moves higher and above historical averages during times of market stress and concern over credit fundamentals within the municipal universe.

The muni market’s quiescence is somewhat understandable, given state cash reserves are at record levels. This provides a massive buffer to weather a downturn. But should growth slow or remain muted for an extended period, the large levels of reserves will deteriorate. As an example, the State of California’s projected deficit has increased by over $10 billion since January alone, now projected to be $32 billion in total. At this point, the state will primarily cut expenses in order to bridge the gap and only pull $450 million from reserves.

This demonstrates the immense budget flexibility states have in order to address shortfalls. It is also a reason the municipal credit cycle tends to lag the general economy as municipalities can “kick the can” for an extended period. Even though the Great Financial Crisis was the hair that broke Detroit’s fiscal back, the city did not file for bankruptcy until 2013.

Corporate issuer credit health is more sensitive and tighter correlated to the economy versus your average municipal obligor. Moody’s Investors Service recently noted it expects US corporate default rates to climb. Moody’s projects the US speculative-grade default rate rising to 5.6% a year from now, breaching the historical long-term average of 4.7%. It cited lower rated issuers coming under pressure from higher interest rates, slower economic growth, and limited market liquidity.

Some municipalities are dealing with budget shortfalls and lack substantial rainy day funds to help cushion forthcoming cutbacks. Many entities relied heavily on Federal largesse through the American Rescue Plan Act (ARPA) to bridge their finances, and now will likely need to organically address deficits and structural imbalance. For example, New York City is expecting a potential $4 billion deficit this year. And the State of Illinois recently revised down its revenue projection from $51.4 billion to $50.7 billion.

According to a recent Route Fifty article[3]:

Almost all the states with income taxes that have reported April receipts—including Alabama, Arkansas, Idaho, Iowa, Kansas, Missouri and Montana—have seen revenue declines. West Virginia is the only exception, reporting a 4% year over year increase in total April general fund revenues.

This apparent path forward to tighter budgets and reduced Federal support, means portfolios should avoid:

  1. Fiscally imbalanced issuers with large, fixed costs (pensions, OPEB, debt service)
  2. Fiscally unprepared issuers with low unrestricted cash balances
  3. Bond issues with high levels of sensitivity or concentration to economic growth.
  4. Urban environments (with the fiscal characteristics of item i. or ii. immediately above), which are suffering from lower foot traffic, higher crime, and deteriorating commercial real estate values.

Our portfolio management strategy continues to target essential purpose and essential revenue bond issues from small-to-medium size issuers that have either fiscal flexibility and/or lower fixed costs. In many of these cases, these types of issuers do not face the same type of secular pressure that working-from home, deteriorating commercial property prices, and crime are causing for many larger, urban creditors.

 

Hiking in May, Cutting in July

The rate hike cycle has been exceptionally severe in both pace of change and change itself (5% increase in rates in just over 400 days). The Fed recently hiked to 5.25% on May 3rd. And the market’s current lack of concern over credit conditions is primarily predicated on a Fed “pivot” to lower rates and easier monetary policy in the near future.

The market is anticipating a 33% chance of a rate cut (from 5.25% to 5.00%) during the Fed’s July 26th meeting. The view is that a deteriorating economy and inflation will cause an abrupt change in Fed policy from hiking in May to cutting in July, and beyond.

The impact of rate hikes is known to have a lagging impact on the economy. The Fed acknowledged this in their recent FOMC statement:

the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation…

Their recent decision to “pause” rate hikes is based on them wanting to surveil the lagging impact of their policies and that it likely will slow inflation from today’s still high levels.

 

Yield Curve & Where We See Value

The municipal yield curve has been fluctuating between a J and nearly U shape given high short term rates (induced by the Fed) and upward sloping longer terms yields. The positively sloped municipal curve is unlike the inverted treasury yield curve where shorter maturities generally yield more than longer ones:

Treasury Tenor Yield
3-month 5.18%
1-year 4.77%
2-year 4.00%
3-year 3.67%
5-year 3.46%
10-year 3.49%
30-year 3.83%

Ultra Short Strategies: At the very front end of the yield curve, we find bank certificates of deposit (~5%), treasury bills (~5%), and tax-exempt municipals (~3%) attractive.

Tax-exempt money market funds have been a great cash placeholder and have fluctuated in yield anywhere from 2.50-4.00%(tax-exempt) over the past month. These are floating rate funds composed of variable rate obligations backed by investment grade municipal issuers with average maturities measured in days.

Tactical Ladder: the benchmark municipal yield curve in 2-10 year maturities is quite rich (low yield/ratios) in our opinion. Unless we can capture a 3% yield to worst, we tend to favor parking funds in the money market fund and opportunistically invest. 10-20-year bonds yield 3.50-4.00% are very attractive in our opinion.

A 4.00% tax-exempt yield is equivalent to 6.34% taxable. We deem this not only a great return to lock-in within the municipal universe, but relatively attractive to many other asset classes as well.

 

In Summary

Given the reality of inflation above its 2% target, the Fed is likely committed to a tight monetary policy for longer inducing further economic weakness. Given this scenario we believe the market is overestimating duration risk to portfolios and underestimating the credit risk and the health of their fixed income holdings. Therefore, it is time to allocate to high-grade credits.

Resulting higher municipal ratios – during a period of lower or muted growth – will be welcomed. This is traditionally a great buying opportunity for investors.

Thank you for your confidence in our team and please reach out to your Investment Specialist or Portfolio Manager with any questions you may have.

 

Sincerely,

Matt Bernardi
Vice President
May 2023

 

 

 

 


[1] The last consumer price index (CPI) report was released on May 10th and printed at 4.9% year-over-year.

[2] A bond’s coupon is the annual cash flow you receive based on the par amount purchased. A bond’s yield, however, takes into account the price you pay and is the true return on the bond if held to maturity/call. A 4% coupon bond purchased at par ($100) has a 4% yield. A 4% coupon bond purchased above/below par has a lower/higher yield than the coupon given the premium/discount paid and returned value on maturity ($100).

[3] https://www.route-fifty.com/finance/2023/05/amid-economic-uncertainty-april-state-tax-revenues-decline/386307/

 

The Fed on Wednesday raised its target range for the Fed Funds Rate by 50 basis points (0.50%) to 4.25%-4.50%. The Fed Funds Rate (FFR) most directly impacts short term treasury rates, while bonds 5-years and beyond are primarily priced based on market forces and the expectations for future growth, inflation, and resulting Fed policy.

A 4.50% top end of the FFR is the highest level since 2004 and has risen at a much quicker pace compared to the previous four hiking cycles. This year, the Fed has raised rates the same amount (4.25%) as it did in 2004-2006, but in 1/3rd the amount of time.

Source: NBER & Bloomberg

This steep pace of rate hikes (orange line in graph above) reflects the high and persistent levels of inflation the Fed is trying to combat. Higher short term rates (caused by the Fed) raise borrowing costs for consumers and can reduce bank liquidity, thereby reducing loan availability. This all reduces demand and, potentially, the levels of inflation.

We are seeing significant signs of weakness in the economy largely caused by the rate hikes:

    • The Leading Economic Indicators Index1 turned negative in June and has proceeded to move lower over the past three months.
    • The U.S. treasury yield curve is massively inverted as the 2-year yield recently exceeded the 10-year yield by 80 basis points (0.80%), a level not seen since 1980. Every recession of the past 60 years has been preceded by yield curve inversion,
    • Building permits issued have fallen to August 2020 levels, a time when we were in the early innings of the COVID economic recovery.
    • US Manufacturing PMI – a sentiment survey amongst domestic manufacturers – dipped into recessionary territory in November and is at a level not seen since the summer of 2020 (the height of the COVID economic turmoil).

The Fed is now seemingly in a precarious position of continuing to combat high levels of current2 inflation but potentially overtightening (raising rates too high, too fast) which could lead to ugly economic outcomes and further deterioration in financial markets.  In this case, credit risk will move to the forefront within investors’ asset allocation and, specifically, fixed income portfolios.

Return of and on Principal

Unless the Fed can effectively engineer a “soft landing” (characterized by a rate hiking cycle + no recession), credit and default risk will materialize within investor portfolios. The most fiscally imbalanced (unprofitable, historical deficits), levered (highest amount of per capita debt) or economically cyclical (where revenues are sensitive to the general economic climate) types of issuers carry the highest credit/default risk.

Your traditional, high-grade municipal does not fit into these categories. A recent NASBO3 report noted that:

    • 49 states reported fiscal 2022 general fund revenue collections exceeded enacted budget forecasts, with collections in the aggregate exceeding original projections by 20.5 percent.
    • Rainy day fund balances continued to grow in fiscal 2022 after increasing 58 percent in fiscal 2021, and the median balance as a share of general fund spending is projected to be 11.9 percent in fiscal 2023.

Therefore, we believe this sector offers significant levels of safety and a high probability of the return of your principal.

Low historical default rates for municipals, as judged by Moody’s Analytics are a retrospective reflection of our belief. (See chart to the right).

Source: Moody’s Analytics

We believe the sturdiness of municipal credit health and their ability to adjust to poor economic environments, remains in effect. Rainy day fund balances are at decade highs. And the flexibility municipalities have in raising revenue or cutting expenses is an inherent credit strength. We saw this on display during the height of the economic crisis in spring/summer of 2020.

Revenues paid to municipalities are prioritized by payers given the important underlying purposes they serve such as property taxes, electric, water, or sewer utilities. These are staple living conditions and the types of revenues that back the bonds we target.

The risk of either overtightening (Fed raising rates unnecessarily high) or sticky inflation (therefore, even higher rates) will both cause further economic deterioration. The latter case (sticky inflation) may lead us to a late 1970s, early 1980s environment of stagflation. According to the National Bureau of Economic Research, the US was in a recession twenty two of the thirty six months from 1980 to 1982.4

 

Where We See Value

Cash Alternatives & Short Term Strategies: For 1-2 year maturities, we are targeting a minimum of 3% tax-exempt. We are also finding readily available value in certificates of deposit, US agency, and treasury bonds.

    • The money market funds we utilize (where the holdings have an average maturity of 30-60 days) are currently yielding 2.80% tax-exempt and up to 3.70% taxable. A 2.80% tax-exempt yield is equivalent to a 4.44% taxable yield at the 37% bracket.

Source: Bloomberg, MMD, Bernardi Trading Desk Monday December 19, 2022

High short term rates within fixed income products are pressuring banks to raise CD rates to retain deposits. In our opinion, these higher CD rates are attractive for short term funds.

Traditional Fixed Income Strategy: Municipal yields remain nominally and relatively attractive across the bulk of the yield curve. Yields range from 3-4% tax-exempt, or 4.76%-6.34% taxable equivalent (37% bracket). Intermediate maturity ratios (the value of a municipal yield divided by the concurrent treasury) appear to be properly valued as the 10yr ratio is 72% vs. a 2-year average of 75%. The 10-year average pre-COVID, however, is in the high 80s, so a slight readjusted higher could be in store. This does not necessarily mean municipal yields are destined for higher levels (treasury yields could fall, while municipals stagnate to bring the ratio back to historical norms).

Source: Bloomberg & MMD Monday December 19, 2022

As you can see in the chart nearby, municipal taxable equivalent yields (red line) are generally more attractive than treasury and even corporate yields. Even though the latter sector, has much higher historical default rates and sensitivity to economic weakness.

The front end of the yield curve (<3 years) is a bit murkier and a toss-up day to day on what asset class makes the most sense, yield-wise. As noted above, we are targeting tax-exempt yields of 3% for short bonds (4.76% taxable equivalent at 37%), otherwise CDs, treasuries, US agency bonds make more sense.

 

 

******

In summary, we think investors need to be cognizant of the high potential for further economic weakness and, therefore, credit risk within their portfolios. We hope for the proverbial soft landing, but hope is not a good investment strategy.

Should we move on to a rockier economic climate, the best defense will be a good defense and we believe municipals are fiscally well positioned for that objective.

If further market dislocation ensues, we also believe investors are best positioned in the separately managed account (SMA) to hold those municipal assets. In addition to the benefits of customization, the SMA enables transparency and control of your assets. Control is vital in haywire markets, and something fund products oftentimes lack.

Please reach out to your investment specialist or portfolio manager if you would like to discuss your portfolio and its underlying credit health.

 

Thank you for your confidence in our team and have a wonderful holiday season!

 

Happy Holidays,

Matt Bernardi
Vice President

 


[1] The LEI is calculated by The Conference Board, a non-governmental organization. The value of the index is computed from ten key economic variables, such as jobless claims, building permits, and money supply. These variables have historically turned downward before a recession and upward before an expansion.

[2] For example, the real estate component of CPI is a bit of a lagging indicator reflecting current “spot” rental rates, even though there are many indications that rent levels appear to be moderating, or even decreasing.

[3] National Association of State Budget Officers, The Fiscal Survey of States, Fall 2022: https://higherlogicdownload.s3.amazonaws.com/NASBO/9d2d2db1-c943-4f1b-b750-0fca152d64c2/UploadedImages/Fiscal%20Survey/NASBO_Fall_2022_Fiscal_Survey_of_States_S.pdf

[4] https://www.nber.org/research/data/us-business-cycle-expansions-and-contractions

 

The market rout of 2022 has left few asset classes unscathed. The S&P 500 is down 22.51% through 9/23. While bonds have not been immune given the Fed’s 180 degree policy turn from late 2021 and persistent inflationary pressures. The 2-year treasury’s steep rise is a sharp representation of how quickly the Fed transformed from dovish to hawkish.

The Bloomberg Global-Aggregate Bond Index[1] is down 19.30% through 9/23. Municipals have held up relatively well as the Bloomberg Municipal Bond Index[2] is down 11.28% YTD. High yield and higher duration municipal strategies have fared worse given positioning in longer maturities, lower credit, or the use of leverage.

Now is an opportune time to take advantage of tax loss swaps and, potentially, swap into a separately managed account strategy away from fixed income mutual funds and ETFs. This likely will reduce your clients’ tax burden and enhance their municipal bond investment vehicle.

Bernardi Asset Management separate account strategy composites have fared relatively well this year. The Tactical Ladder Municipal Composite (15-year ladder) was down 6.45% through 6/30, while the High Income Municipal Composite (minimum yield target) was down 7.74% through 6/30. For comparison’s sake, the Bloomberg Muni Index was down 8.98% through 6/30.

 

Last 4 Hiking Cycles 2-Year Yield Change Days
Dec 2021 – Sept 2022 3.54% 282
Sept. 2016 – Dec 2018 1.92% 825
April 2004 – June 2006 3.53% 820
April 1999 – May 2000 1.90% 412

 

A separate account municipal bond portfolio enables:

  • Control of assets – when to buy, sell, and take advantage of tax losses (or not at all)
  • Transparency of holdings – when the portfolio cash flows and oncoming maturities
  • Customization – geographic concentration, sector, and credit allocation

 

The separate account portfolio benefits significantly from these three facets, especially in environments like today. A separate account employing a hold-to-maturity strategy, experiences losses “on paper.”

Losses are not realized unless you want to lock them in. Over time, given successful credit selection, bonds will mature at par and our ladders roll forward into higher yields. The simplicity of this investment vehicle and strategy reduces volatility and the potential for losses.

That said, tax loss swaps are an excellent strategy to reduce one’s overall tax burden and add long term value to the portfolio. Furthermore, you can kill two birds (dove and a hawk) with swapping into a customized separate account strategy.

 

Please reach out to your Investment Specialist or Portfolio Manager if you have any questions about your portfolio or our approach to municipal bond portfolio management.

 

 


[1] Source: Bloomberg, LEGATRUU Index

[2] Source: Bloomberg, LMBITR Index

 

****

Bernardi Asset Management, LLC (BAM) claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. BAM has been independently verified for the periods 01/01/2013 through 12/31/2020. The verification report(s) are available upon request. A firm that claims compliance with the GIPS standards must establish policies and procedures for complying with all the applicable requirements of the GIPS standards. Verification provides assurance on whether the firm’s policies and procedures related to composite, as well as the calculation, presentation, and distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firmwide basis. Verification does not provide assurance on the accuracy of any specific performance report. Bernardi Asset Management, LLC (“BAM”) is a registered investment adviser with United States Securities and Exchange Commission in accordance with the Investment Advisers Act of 1940. BAM began managing assets in February 2000. The firm’s list of composite descriptions is available upon request. Results are based on fully discretionary accounts under management, including those accounts no longer with the firm. Past performance is not indicative of future results.

The U.S. Dollar is the currency used to express performance. Returns are presented net of fees and include the reinvestment of all income. Net returns are reduced by all actual fees and transaction costs incurred. The annual composite dispersion presented is an asset-weighted standard deviation calculated for the accounts in the composite the entire year using net returns. Policies for valuing investments, calculating performance, and creating GIPS Reports are available upon request. The investment management fee schedule for the composite is 0.40% for accounts $2 million or smaller, 0.35% for accounts between $2-5 million,0.30% for accounts between $5-10 million, 0.25% for accounts between $10-15 million, and 0.20% for accounts over $15 million. Actual investment advisory fees incurred by clients may vary. GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.

APPENDIX – HIGH INCOME MUNICIPAL COMPOSITE

Year

End

Total Firm Assets (millions) Composite Assets

(USD) (millions)

Number of Accounts Annual Performance Results Composite (net of fees) Bloomberg Barclays Municipal Bond 15-Year (12-17) Index Dispersion Composite 3-yr

St Dev

Benchmark

3-yr

St Dev

2021 229.11 15.76 6 0.91% 1.91% 0.27% 2.88% 4.86%
2020 196.85 15.63 ≤5 5.20% 6.32% N/A2 3.39% 4.90%
2019 176.40 15.06 ≤5 6.75% 8.90% N/A2 2.83% 3.08%
2018 176.47 8.64 ≤5 0.43% 1.38% N/A2 4.21% 4.31%
2017 159.10 6.98 ≤5 5.45% 6.94% N/A2 3.80% 4.21%
2016 142.96 6.22 ≤5 -0.43% 0.34% N/A2 3.86% 4.33%
2015 138.14 4.48 ≤5 3.78% 4.00% N/A2 3.10% 4.23%
2014 115.62 1.68 ≤5 9.60% 11.73% N/A2 N/A1 N/A1
2013 114.63 1.49 ≤5 -1.07% -3.32% N/A2 N/A1 N/A1

N/A1 – The three-year annualized standard deviation measures the variability of the composite and the benchmark returns over the preceding 36-month period using net returns. The three-year annualized standard deviation is not presented due to less than 36 months of composite and benchmark data.

N/A2 – There are an insufficient number of portfolios for the entire year to calculate composite dispersion.

High Income Municipal Composite is comprised of fully discretionary, separately managed account (SMA) portfolios. Composite portfolios hold individual bonds, primarily consisting of investment grade issues, which seek high income through higher duration portfolios and for comparison purposes is measured against the Bloomberg Barclays Municipal Bond 15-Year (12-17) Index. The Bloomberg Barclays Municipal Bond 15-Year (12-17) Index is an unmanaged index of municipal bonds traded in the U.S. with maturities ranging from 12-17 years. The composite was created January 01, 2013. The composite inception date is January 01, 2013. The minimum account size for inclusion in the composite is $250,000.

APPENDIX – TACTICAL LADDER MUNICIPAL COMPOSITE

Year

End

Total Firm Assets (millions) Composite Assets

(USD) (millions)

Number of Accounts Annual Performance Results Composite (net of fees) Bloomberg Barclays Muni Short/Int (1-10) Index Dispersion Composite 3-yr

St Dev

Benchmark

3-yr

St Dev

2021 229.11 84.73 28 0.54% 0.43% 0.39% 2.23% 2.58%
2020 196.85 65.51 19 4.36% 3.97% 0.38% 2.20% 2.60%
2019 176.40 42.37 16 4.79% 5.23% 0.28% 1.63% 1.78%
2018 176.48 54.00 17 1.32% 1.69% 0.20% 2.04% 2.31%
2017 159.10 54.52 18 2.58% 3.03% 0.33% 1.92% 2.30%
2016 142.96 52.76 18 0.07% -0.15% 0.33% 1.91% 2.19%
2015 138.14 44.75 15 2.02% 2.20% 0.26% 1.76% 1.89%
2014 115.62 50.22 16 3.75% 3.85% 0.75% N/A1 N/A1
2013 114.63 56.74 15 -0.14% 0.02% 0.39% N/A1 N/A1

N/A1 – The three-year annualized standard deviation measures the variability of the composite and the benchmark returns over the preceding 36-month period using net returns. The three-year annualized standard deviation is not presented due to less than 36 months of composite and benchmark data.

Tactical Ladder Municipal Composite is comprised fully discretionary, separately managed account (SMA) portfolios. The composite contains portfolios holding mostly tax-free municipal bonds and for comparison purposes is measured against the Bloomberg Barclays Municipal Short/Intermediate (1-10) Index. The Bloomberg Barclays Municipal Short/Intermediate (1-10) Index is a market-value-weighted index that includes investment grade tax-exempt bonds with maturities of one to ten years. The composite was created January 01, 2013. The composite inception date is January 01, 2013. The minimum account size for inclusion in the composite is $250,000. An incorrect amount was previously used for number of account (2019 & 2020). These errors were due to a change in software provider for the firm’s performance reporting and composite management.

 

The first half of 2022 is one of the few market environments in recent history where all major asset classes suffered. The Novel Investor blog’s Asset Class Returns captures this nicely noting “cash” outperformed with a +0.2% return. “HG Bonds” (high-grade bonds) came in an uninspiring second place at negative 10.4%, while the S&P 500 was down 20.57% through this period. Returns have improved since this data was posted as stocks have rallied and bond yields have generally decreased, thereby increasing prices. However, the economy is giving us mixed messages about its underlying health, while inflation pressures persist. The latter causes the Federal Reserve to remain aggressive in its tightening policies by increasing short term rates and further reducing its almost $9 trillion balance sheet. Overall, this creates a very complicated investing environment and a highly uncertain future.

Municipals have not been immune from this volatility, but they have relatively outperformed.[1] Interest rates have increased drastically since the end of 2021 as the Fed turned a 180 after being caught on its backfoot with high inflation. Given the bond market’s sell-off earlier in the year, we are able to invest in a market that offers:

    • High tax-exempt rates vs. recent history
    • High tax-exempt rates vs. alternative high-grade fixed income

In terms of historical yields: The average AA rated 10-year municipal yields roughly 2.50% tax-exempt[2], which is equivalent to investing in a 3.96% taxable bond at the 37% bracket. This rate topped out at 3% in mid-May, which was a 10-year high. We are still capturing 3% from time-to-time in this portion of the yield curve.

The future path of rates from here, as noted above, is highly uncertain. The recent decrease in yields is a function of an economy that is showing signs of weakness and other forward looking metrics that point to a slowdown, such as a slowing rate of money supply growth.

Source: Bloomberg

From a relative valuation and return perspective: due to their tax-exempt nature, taxable equivalent yields[3] for municipals are attractive for a majority of the yield curve compared to treasury and corporate bonds as depicted by the chart below. Municipals benefit from their yield curve structure, which remains positively sloped. Unlike the treasury curve which has a negative 2y10y ratio (i.e. inverted) as the 2-year treasury currently yields 3.25% vs. 2.79% for the 10-year. This spread of negative 0.46% is the lowest since the early 1980s. Every recession the past 60 years has been preceded by an inverted yield curve.

Source: Bloomberg

Moody’s recently noted that “strong fiscal governance positions States to withstand high inflation, possible recession.”[4] This confirms our stance that your average state and municipality is well positioned to address continued economic deterioration. Generally, corporate bonds do not offer the same level of principal preservation due to more economically sensitive underlying sources of revenue. This leads to higher credit volatility and historical default rates. AAA and AA rated municipal yields have 60-year historical default rates of 0% and 0.02%, respectively.[5] The relative default risk of high-grade municipals versus treasury bonds is de minimus, as well. Of course, theoretically in a worst-case scenario, the U.S. Treasury could always print more money to pay bondholders. This is an instrument of governance municipalities do not have.

Source: Bloomberg

Another indication that municipal yields are attractive, is the difference between the AAA rated 10-year municipal yield and the S&P 500 dividend yield recently reached a level (1.20%) not seen since the Great Financial Crisis in 2009. According to Bloomberg, the 10-year AAA municipal yields 2.21%, while the S&P 500’s estimated dividend yield is 1.57%. The difference of 0.64% is above the 10-year average of negative 0.03%.

This yield difference is still lower than pre-financial crisis[6], but we would not expect this relationship to return any time soon. At the current pace of asset sales, it would take the Federal Reserve over 10-years to unravel the Quantitative Easing purchases since 2008.

This is certainly a paradigm we’d welcome as it would provide higher yields and a market equilibrium driven by investors, rather than central bankers. Should we be in the initial innings of this, you should expect your laddered, separate account portfolios will average in over time at these higher rates. Then again, our economy has become extremely dependent on such policies so the undoing of them will be accompanied by uncertainty which begets bouts of economic weakness and volatility.

Regardless, investing is a relative game and today’s municipal yields offer great value in of themselves and relative to other asset classes. We believe this, paired with underlying credit sturdiness, sets up municipals very well for the balance of the year. Should the Fed induce additional economic weakness, municipal revenues will remain stable and default rates low, in line with historical averages.

If you have any questions or would like to discuss your portfolio in more detail, please contact your Investment Specialist or Portfolio Manager.

 

Sincerely,

Matt Bernardi
August 2022

 

 


[1] The Bloomberg Municipal Bond Index (LMBITR Index) was down 8.98% through 6/30/2022

[2] Source: MMD

[3] Taxable equivalent yield is calculated by taking the tax-exempt yield and divide by (1 minus tax rate percentage)

[4] Moody’s Investors Service, Sector In-Depth: “Strong fiscal governance positions states to withstand high inflation, possible recession” August 8th, 2022

[5] Source: Moody’s

[6] On January 1st, 2008 the AAA muni yielded 3.74% while the S&P 500 dividend yield was 2.02% leading to a difference of 1.72%

Jerome Powell and his Federal Reserve colleagues have begun taking steps to put the income back in fixed income assets, leading to one of the worst bond market drawdowns in the past forty years.  Rates have spiked as the Fed has made a rapid about-face in its monetary policy approach.

Concurrently, municipal yields are up substantially and offer attractive yields when compared to alternative high-grade fixed income assets. Should the new Fed policy induce a recession, current yield levels of municipals offer significant value  in our view – and credit protection, since solid quality credits can weather a soft economy given  high cash balances, non-discretionary sources of revenue, and myriad expense cutting capabilities.

Our separately managed account (SMA) portfolios have held up relatively well in this environment – especially versus fund alternatives – and are poised to take advantage of higher yields as our laddered portfolios progress forward.

An important aspect of the SMA structure is that losses remain on paper and can be selectively realized should a portfolio have tax loss needs.[1] Alternatively, a fund may have to forcibly realize losses as outside investors sell.

Today’s average AA rated 10-year municipal yields 2.89% vs. 1.15% at the start of the year. The 10-year treasury (which is taxable) yields 2 basis points less at the time of this writing. If you are in the top four tax brackets (24%, 32%, 35%, 37%) buying the average AA rated muni is like buying a 3.80-4.58% taxable bond.

 

How We Got Here in Such Short Order

The spike higher in rates we have experienced this year is due to the Fed pulling a 180 degree turn in its approach to monetary policy. Just over a year ago, the Fed was projecting no interest rate increases until 2024.[2]

The Fed is now projecting and communicating:

  • An aggressive rate hiking cycle for the next 8 months (see red dotted line on chart below): The market is pricing 9 more hikes through year-end
  • A departure from the traditional 25 basis point (0.25%) rate hike increments: There is a high likelihood the Fed will raise rates by 50 basis points (0.50%) at each of the next two meetings (May 4th and June 15th)
  • A rapid decrease of the balance sheet, composed of $9 trillion of treasury bonds and mortgage-backed securities, as they aim to sell upwards of $95 billion per month starting in May.

We hope today’s yields stick and we are not in store for a 2018 repeat when the economy slowed before the Fed Funds Rate peaked at 2.50%. The chart below shows that the ISM Manufacturing Index[3] started deteriorating in the summer of 2018, shortly before the culmination of the hiking cycle in December 2018.

Figure 1 Source: Bloomberg

 

The projected path of the Fed Funds Rate through the end of this year matches the level reached in 2018. However, we are expected to get there at a much quicker pace.

We believe the laddered maturity structure, within a separate account is the best way to adapt to these volatile markets. According to our Sharpe Ratio Analysis – which measures risk-adjusted returns – our Tactical Ladder and the High Income strategies have outperformed the benchmarks as of late.

Bernardi Asset Management Composites vs. Benchmarks
As of 3/31/2022 3-Year Sharpe Standard Dev. Mod Duration
BAM Tactical Muni 0.15 2.95 3.99
Index: BBG Short/Int Muni 0.13 3.17 3.43
BAM High Income Muni 0.33 3.46 4.25
Index: BBG 15Yr Muni 0.25 5.71 5.86

The higher the Sharpe Ratio the better. It demonstrates either higher returns and/or a low standard deviation (level of volatility).

We attribute our attractive Sharpe Ratios and returns to a number of factors, including:

  • Ladder Maturity Structure: enables ongoing cash flows to reinvest at higher rates. It also keeps portfolio turnover relatively low compared to the “barbell” strategy.
  • Small-to-medium-sized issuers: these types of bonds provide two benefits:
    1. Higher yields given their smaller issue size/ lower market coverage
    2. Lack of presence in benchmarks and large mutual funds.
  • Allocation to high-grade credits: we target essential purpose and essential revenue bonds that have demonstrated sturdiness during economic downturns. See our Three Pillars of Credit Analysis
  • Allocation to higher yielding, out-of-favor states: we have low weightings to double-exempt (and often low yielding) states such as California and New York for non-CA/NY residents.
Top State Holdings 1 2 3 4 5
Ultra-Short Strategy IN MN NJ IA AZ
Short Term Strategy TX IN WI IA IL
Tactical Ladder Strategy TX IN WI MI IL
High Income Strategy TX MI IN IL KS

 

The above has enabled our Tactical Ladder, High Income, and taxable strategies to outperform their benchmark over a 1-year period.

*****

In summary, municipal yields are very attractive relative to recent history and especially other high-grade fixed income assets. The path of rates from here is unknown as we deal with an extremely uncertain future in terms of predicting the pace of inflation and growth. We believe it is best to diversify across the yield curve within the SMA structure.

Please reach out to your Investment Specialist or Portfolio Manager if you would like to discuss our approach and strategies in more detail.

 

Sincerely,

Matt Bernardi
Vice President

 


[1] Oftentimes a bond can be sold – tax loss captured – and replaced with a new similar maturity bond that pays higher levels of interest to offset the tax loss and add higher levels of income over the life of the bond.

[2] https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20210317.pdf

[3] The ISM Manufacturing Index is a monthly indicator of U.S. economic activity based on a survey of managers at more than 300 manufacturing firms. It is a key indicator of the state of the U.S. economy.

Jerome Powell and his Federal Reserve colleagues have begun taking steps to put the income back in fixed income assets, leading to one of the worst bond market drawdowns in the past forty years.  Rates have spiked as the Fed has made a rapid about-face in its monetary policy approach, as it aims to quell inflation, potentially at the expense of slowing the economy.

Concurrently, municipal yields are up substantially and offer attractive yields when compared to alternative high-grade fixed income assets. Should the new Fed policy induce a recession, current yield levels of municipals offer significant value in our view – and credit protection, since solid quality credits can weather a soft economy with high cash balances, non-discretionary sources of revenue, and myriad expense cutting capabilities.

Our separately managed account (SMA) portfolios have held up relatively well in this environment – especially versus fund alternatives – and are poised to take advantage of higher yields as our laddered portfolios progress forward.

An important aspect of the SMA structure is that losses remain on paper and can be selectively realized should a portfolio have tax loss needs.[1] Alternatively, a fund may have to forcibly realize losses as outside investors sell. This is a phenomenon that exacerbates declining valuations in the current market environment characterized by significant bond fund outflows.

Today’s average AA rated 10-year municipal yields 2.89% vs. 1.15% at the start of the year. The 10-year treasury (which is taxable) yields 2 basis points less at the time of this writing. If you are in the top four tax brackets (24%, 32%, 35%, 37%) buying the average AA rated muni is like buying a 3.80-4.58% taxable bond. There is similar value across the entire yield curve, and we are seeking yields 20-40 basis points (0.20-0.40%) higher in the types of issuers we target.

Potentially you can add incrementally more value the longer out you invest due to a steep muni curve and flat-to-inverted treasury yield curve.[2] Please note, longer term bonds carry additional risk including higher levels of volatility and increased credit risk.

 

How We Got Here in Such Short Order

The spike higher in rates we have experienced this year is due to the Fed pulling a 180 degree turn in its approach to monetary policy. Just over a year ago, the Fed was projecting no interest rate increases until 2024.[3]

The Fed is now projecting and communicating:

  • An aggressive rate hiking cycle for the next 8 months (see red dotted line on chart below): The market is pricing 9 more hikes through year-end, leading to a 2.50% FFR
  • A departure from the traditional 25 basis point (0.25%) rate hike increments: There is a high likelihood the Fed will raise rates by 50 basis points (0.50%) at each of the next two meetings (May 4th and June 15th).
  • A rapid decrease of the balance sheet, composed of $9 trillion of treasury bonds and mortgage-backed securities: The balance sheet has more than doubled from pre-COVID levels and they aim to sell upwards of $95 billion per month starting in May. A “normalized” balance sheet is in the $5.5-6 trillion range according to Ben Bernanke

We hope today’s yields stick and we are not in store for a 2018 repeat when the economy slowed before the Fed Funds Rate peaked at 2.50%. The chart below shows that the ISM Manufacturing Index[4] started deteriorating in the summer of 2018, shortly before the culmination of the hiking cycle in December 2018.

Figure 1 Source: Bloomberg

The projected path of the Fed Funds Rate through the end of this year matches the level reached in 2018. However, we are expected to get there at a much quicker pace.

We believe the laddered maturity structure, within a separate account is the best way to adapt to these volatile markets. We do not aim to predict if a repeat of 2018 or a 1994 “soft landing” is in store and believe the ladder can “average in” across either type of business cycle.

According to our Sharpe Ratio Analysis – which measures risk-adjusted returns – our Tactical Ladder and the High Income strategies have outperformed the benchmarks as of late.

Bernardi Asset Management Composites vs. Benchmarks
As of 3/31/2022 3-Year Sharpe Standard Dev. Mod Duration
BAM Tactical Muni 0.15 2.95 3.99
Index: BBG Short/Int Muni 0.13 3.17 3.43
BAM High Income Muni 0.33 3.46 4.25
Index: BBG 15Yr Muni 0.25 5.71 5.86

The higher the Sharpe Ratio the better. It demonstrates either higher returns and/or a low standard deviation (level of volatility). For your municipal allocation, these two outputs are vital as you want to both outperform the benchmark and preserve your wealth when the market goes against you, as it has the past quarter.

We attribute our attractive Sharpe Ratios and returns to a number of factors, including:

i.) Ladder Maturity Structure: this enables ongoing cash flows to reinvest at higher rates. It prevents portfolios from speculating on timing rates and when the next business cycle will turn. It also keeps portfolio turnover low compared to the “barbell” strategy.

ii.) Small-to-medium-sized issuers: these types of bonds provide two benefits:

  1. Higher yields given their smaller issue size and lower market coverage
  2. Lack of presence in benchmarks and large mutual funds.

iii.) Allocation to high-grade credits: we target essential purpose and essential revenue bonds that have demonstrated sturdiness during economic downturns. See our Three Pillars of Credit Analysis approach.

iv.) Allocation to higher yielding, out-of-favor states: we have low weightings to double-exempt (and often low yielding) states such as California and New York for non-CA/NY residents.

The above has enabled our Tactical Ladder, High Income, and taxable strategies to outperform their benchmarks over a 1-year period.

Top State Holdings 1 2 3 4 5
Ultra-Short Strategy IN MN NJ IA AZ
Short Term Strategy TX IN WI IA IL
Tactical Ladder Strategy TX IN WI MI IL
High Income Strategy TX MI IN IL KS


Yield Perspective

Municipal yields are significantly higher vs. early 2020 when the economy was slowing and before COVID broke out. Yields are at or near the 10-year peak reached in 2018 at the height of the Fed rate hike cycle.

The path of inflation and growth will determine the trajectory of rates from here, but there is no doubt municipals are set up relatively well for outperformance of the treasury and corporate bond market. Outperformance will be based on higher after-tax yields currently offered and a positive credit backdrop for your average municipality.

*****

In summary, municipal yields are very attractive relative to recent history and especially other high-grade fixed income assets. The path of rates from here is unknown as we deal with an extremely uncertain future in terms of predicting the pace of inflation and growth. We believe it is best to diversify across the yield curve within the SMA structure.

Please reach out to your Investment Specialist or Portfolio Manager if you would like to discuss our approach and strategies in more detail.

 

Sincerely,

Matt Bernardi
Vice President

 

 


[1] Oftentimes a bond can be sold – tax loss captured – and replaced with a new similar maturity bond that pays higher levels of interest to offset the tax loss and add higher levels of income over the life of the bond.

[2] When the yields investors earn on short-term bonds surpass those of long-term bonds.

[3] https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20210317.pdf

[4] The ISM Manufacturing Index is a monthly indicator of U.S. economic activity based on a survey of managers at more than 300 manufacturing firms. It is considered to be a key indicator of the state of the U.S. economy.