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.

2022 is off to a volatile start in global financial markets as the Fed begins the process of tightening monetary policy. Yields have risen – especially at the front end of the yield curve, thereby flattening the curve. Today the average AA rated 2-year and 10-year municipal bond yields 0.97% (1.53% TEY) and 1.66% (2.63% TEY)1, respectively. This is up from 0.26% and 1.18% at the start of the year. The 10-year muni is now at the same level it was on January 1st, 20202, prior to the COVID outbreak. Yield ratios (municipal yields as a percent of treasuries) have moved higher as muni bond mutual funds recently experienced the largest weekly outflow ($1.4 billion) since April 2020.3 The 10-year AAA muni is currently at a ratio of 85%, which is up from 67% on Thanksgiving and now back to historical averages. As we noted in End of Easy and its Implications for the Municipal Bond Market, higher levels of volatility can be expected as the elephant (the Fed) leaves the room. That said, we expect municipals to remain a bastion of relative stability.

Investor anxiety and today’s market volatility is underpinned by the fear that inflation and higher rates (induced by the Fed) will slow the economy. The Fed’s wind down of bond buying and communications about rate hikes, has mostly impacted the front end of the yield curve.

Source: Bloomberg, MMD; TEY calculated at 37% bracket

The market is now pricing in five rate hikes this year alone, projecting the Fed Funds rate will settle somewhere between 1.25% and 1.50%. At the start of the year, the market was pricing in only three rate hikes. One Wall Street analyst is calling for seven hikes, or one at each scheduled Fed meeting through the rest of this year.

Long term yields have not moved higher at the same pace as short term rates. The reason for this is two parted. For one, short term rates are heavily influenced by Federal Reserve policy and recent Fed communications have indicated higher short term rates in the near future (a la rates hikes noted above). Secondly and alternatively, long term rates are more of a reflection of the market’s view on long term growth and inflation. A 10-year treasury is a projection of where the market believes short term rates will be in 10-years, or roughly 1.77% today. That is not significantly higher than the 2-year treasury, at 1.15%. Essentially the market is expecting an aggressive Fed in the short term (e.g. five rate hikes this year), but a Fed that has limited capacity to raise rates in the long term.

In fact, the difference (“spread”) between the 2-year and 10-year treasury is unusually low relative to past economic cycles. As you can see in the graph below, today’s yield curve never was as steep when compared to the post-recession periods of 2009-2010, 2001-2002, and 1991-1992.4

Today’s flat yield curve shape looks eerily similar to the early 1980s during Chairman Volker’s inflation-crushing run as Fed chairman. The 2y/10y spread has averaged 0.93% since the COVID induced recession ended. This compares to a 0.83% average the 2 years following the end of the 1982 recession. Though yields back then were significantly higher (2-year at 10.87% and the 10-year at 11.61%) the yield curve is communicating the same message about projected growth, inflation, and likely yields.

For most of the 1980s the yield curve traded at these flat levels – until Chairman Greenspan started aggressively raising rates in early 1988 to further combat inflation. This flattened the yield curve as the Fed Funds rate was increase from 6.50% in March 1988 to 9.75% in summer 1989. This policy direction ultimately led to a recession in 1990.

During this hiking cycle the 10-year treasury started at 8.15%, and traded as high as 9.54%. It averaged 8.67% or only 52 basis points higher than its starting point. Today’s 10-year treasury started the hiking cycle5 at 1.45% and currently trades at 1.78%.

Similar to 1988, today’s curve structure leaves little room for Powell to raise rates before the curve inverts. The 2y10y curve inverted in December of 1988, only 9 months after Chairman Greenspan started increasing short term rates. Many market participants fear a flat-to-inverted curve (when short term rates are higher than long term rates). An inverted curve has preceded every recession over the past forty years. Many argue whether it’s a signal or source of the recession. In all likelihood it is a combination and, at the very least, an indicator of poor sentiment within the economy.

 

Attractive Municipal Yield Ratios (Valuations)

In the current environment we are finding attractive valuations within tax-exempt and taxable municipal bonds. The 10yr ratio (10yr muni/10yr treasury) currently trades at 85%. This is above the pre-COVID level of 75%, and up from a low of 53% in early 2021.  We expect this ratio to trade between 70-80% and believe a move significantly higher is a buy signal for municipals vis-à-vis other high grade fixed income.

A stable level of the ratio is expected given an excellent credit backdrop for your average municipality, ongoing federal stimulus, and high demand for tax-exempt securities from investors. As nominal rates move higher, we expect demand from investors to increase further, supporting present day ratios.

An additional technical factor we see supporting current ratios is a muted supply outlook. If rates move higher, refinancing bond issues will become more difficult. This will reduce new issue supply and support present ratios, possibly even pushing them lower. Supply estimates for the market are in the $425-500 billion range for 2022, following $475 billion last year. We would not be surprised to see a similar-to-lower level than that for 2022.

****

With a balance sheet of nearly $9 trillion – 25% of the overall treasury and mortgage bond market outstanding – the Fed must toe a very fine line through the balance of the year in calming inflation and market volatility alike. If the late 1980s are a guide, the Fed only has limited room to tighten before flattening the curve and inducing a recession.

Please call us to review or discuss your portfolio positioning. Now may be a great time to reconsider the role municipal bonds play in your overall asset allocation, given that yields and ratios for the market have moved higher and trade at relatively attractive levels.

 

Sincerely,

Matt Bernardi
Vice President
February 2022

 

 


[1]TEY is the taxable equivalent yield calculated at the 37% bracket

[2] Cases of COVID-19 were first reported in late-December 2019 in Wuhan, China.

[3] Source: Week ending January 26th;  Lipper US Fund Flows

[4] The COVID induced recession of 2020 – which was the quickest recession on record – officially lasted from February 2020 to April 2020. Source: National Bureau of Economic Research

[5] Mid-December, or when the market started pricing an early 2022 hike

of serving Investors, Issuers, and the Municipal Bond Market 

 

THANK YOU. We wish you and your family a healthy and prosperous 2022 and offer our profound “thank you” for your continued confidence in the Bernardi team. We greatly appreciate the opportunity to help you, your family, organization, community, and constituents.

September 30, 2021 marked the close of our 37th year.

It was another successful and prosperous year for our clients and, therefore, the entire Bernardi Securities team. A highlight for us was our relocation over Memorial Day weekend into our beautiful, new headquarters located in Northfield, Illinois.

 

MUNICIPAL BONDS BUILD AMERICA’S INFRASTRUCTURE

The municipal bond market has existed for more than 100 years. It is dynamic, developing, and efficient.

And it fundamentally affects how our economy runs and the quality of life in our communities. For the past thirty-seven years we have focused our expertise and efforts on the municipal bond market. Thousands of communities across the country have allowed us to help them raise low cost capital for infrastructure projects their constituents want, need, and can afford.

For nearly four decades, our investors have provided billions of dollars in capital for infrastructure projects across the nation. Projects such as updating existing school facilities, building new schools, town halls, county courthouses, libraries, airports, and recreation facilities. Investors have helped local, county, and state governments fix their roads, bridges, update water and sewer plants, park district and many other facilities.

For the past thirty-seven years individual investors, community banks, family offices, investment advisers, corporations and many other entities have sought our expertise to help invest their capital in quality, public purpose infrastructure projects across our nation.

Since our inception we have relentlessly focused our efforts to help ensure municipal bonds continue to build America’s infrastructure – playing our part at improving lives along the way.

We are gratified to serve in our role and thankful to all who give us the opportunity. We are merely one cog in the machine, but always strive to do our best for those who rely on us.

I thank our loyal clients – both investors and communities across the country – who rely on our team to help navigate the complicated, nuanced municipal bond market.

 

COVID CONCERNS CONTINUE

In many respects, March 2020 seems a long way off in the rear view mirror and yet Covid protocols remain in place everywhere around us. Our organization continues to successfully adapt our operating policies and procedures. It has been difficult at times, no doubt. But we continue to learn new ways to successfully operate our business serving our clients – without missing a beat.

The pandemic has taught us much about the facets of society and life, its fragility but also our resiliency in dealing with stress and loss. I tend to gravitate to the first line of Hemingway’s passage from A Farewell to Arms (rather than the balance of the excerpt, which is not published here):

The world breaks everyone and afterward many are strong at the broken places.”

The resiliency of the municipal market has been on full display the past two years, and it has emerged from the crisis a much stronger animal. Largely speaking, most state and local governments quickly reacted and adjusted to the crisis, financially and procedurally so they could continue to govern and provide services in an uncertain and unsafe environment. Traditional revenues that secure bond investors mostly held steady (there were notable exceptions in certain sectors and geographies) and expenses were managed tremendously well, in our view. Federal support was unparalleled helping calm a volatile situation during the initial crisis stage of the pandemic. As important as it initially proved to be, our current analysis points to much of it being largely unnecessary for the average type of credit we invest in. This is a testament to the steady reliability of the municipal bond market as the “mattress money” portion of investment portfolios.  On a very positive note, much of the federal money will now serve as a boon for local economies and municipal credit as a whole.

 

YES, THE FED IS STILL BUYING BONDS

In the coming years we will learn the level of resilience and reliance of the economy to recent Congressional and Federal Reserve stimulus.

Source: Bloomberg

The Fed has begun the process of tapering – reducing the amount of treasury bond and mortgage backed securities it buys each month – and it has indicated this round of quantitative easing will culminate in March/April of next year. Some predict a rate hike around that time and possibly 1-2 more over the course of the year.

The Fed’s latest projections1 anticipate a long term Fed Funds Rate of 2.50%. This compares to 0.00-0.25% today and a dubious 10-year treasury of 1.48%. With high levels of debt and – potentially – society’s dependency on low rates, is the market doubting the targeted future Fed Funds Rate of 2.50%? Many are wondering just how high yields can march before causing economic harm, overall.

What we do have confidence in transpiring during the coming year are higher levels of equity and fixed income market volatility given the removal of a huge provider of daily liquidity. Bank of America’s MOVE Index – which measures bond market volatility – has been moving higher over the course of this year and is nearing a 5-year (excluding the COVID crisis) high. On December 3rd, the CBOE Volatility Index (VIX), a popular measure of stock market volatility, hit its highest level since January 2020 and the S&P 500 Index moved more than 1% for five straight sessions, the longest streak since November 2020. As the Fed begins to taper, financial market volatility will continue.2

We view volatility as an opportunity for our investors and it is an environment we welcome following years of muted bond market volatility. Our clients’ municipal exposure will act as the ballast of their portfolio should equity volatility persist. We have seen this dynamic play out time and time again over the years. The most recent example during the March 2020 COVID sell off.  Additionally, the laddered portfolio structure, coupled with owning non-benchmark securities, has proven a successful strategy to insulate bond portfolios against market volatility. The latter are relatively immune from mutual fund induced sell-offs and typically offer higher yields at the time of purchase due to their small-to-mid-size issuances.

This strategy and security selection has worked very well for 37-years, and we expect 2022 to play out similarly.

We thank you again for your confidence in our team and wish everyone a happy, healthy, and resilient new year!

Sincerely,

 

Ronald P. Bernardi

December 30, 2021

 


[1] Source: https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20211215.pdf

[2] Source: Bloomberg

As the Fed publicly discusses it is nearing the end of its emergency approach to the pandemic and begins scaling back its pace of securities purchases, we thought it would be a good time to review the current status of the municipal market and potential outcomes for the 4th quarter.

Municipal yields – and bond yields in general – have stagnated since the early spring even though economic growth is robust and inflation readings are high. The market has largely looked through these metrics, as many believe this dynamic will be short-lived. What underpins this stance is the view that growth and inflation metrics are simply boosted by fleeting catalysts such as supply chain bottlenecks and one-time federal stimulus measures. The immense presence of the Fed’s growing balance sheet has served as further support for current market yields, as well.

Municipal yields have trended sideways since mid-summer. The market has experienced robust demand as many investors rebalance out of the equity market following another year of outsized gains. Muted new issue supply, coupled with expectations for higher tax rates, has swelled demand, as well.

 

Valuation Outlook

At the moment, the ratio of AAA rated 10-year municipal bond yields (0.94%) relative to the taxable 10-year treasury bond yield (1.32%) sits around 71%. This compares to a pre-COVID crisis level average of 83%. So relative to pre-crisis levels, today’s municipal yields are lower vis-à-vis treasuries. Given the current backdrop mentioned above and very strong underlying credit fundamentals for the majority of state and local governments, we expect the ratio to remain in 70-80% range through year-end.

During the previous Fed tightening cycle, municipal valuations tightened. There were certainly bouts of volatility, but over 6 years the 10-year ratio moved lower from 105% in May of 2013 (when the Taper Tantrum began) to 72% in the period right before the COVID-19 outbreak. During this time, the Fed hiked short-term rates from 0.25% to 2.50% and reduced its balance sheet by $700 billion from its height.[1]

Though valuations may be tight from past history, ample spread is still available across the yield curve for smaller-to-medium sized issuers. For income-oriented investors, we believe portfolios should be overweight these types of solid quality issuers within a separate account structure.

 

Credit Outlook

Credit security (i.e. principal preservation) is a primary reason for investing in municipals and we forecast continued stability in this metric through the end of the year. That said, due to ongoing concerns about COVID-19, tax revenues may continue to be pressured within certain issuers that are dependent on tourism, urban commercial property, and urban transit. Alternatively, suburban and many non-metro credits will continue to benefit from the millennial generation’s march to the suburbs and their demand for larger housing footprints. These locales will also continue to derive benefits from families working in hybrid work-from-home environments.

 

Duration Outlook

Duration positioning within the fixed income market – and likely most assets classes in general – will be a very important aspect of portfolio construction over the next 6-12 months. We seek to protect portfolios from excessive duration risk through the ladder maturity structure. This strategy diversifies portfolios across the yield curve while maintaining a conservative average maturity. Additionally, it establishes a level of discipline to stay invested and helps us avoid the mistake of attempting to time the next cycle.

Investors should also take heart in the typical relationship of municipal bond yields to treasury yields, in that they tend not to move in lockstep. Our regression analysis showed that for every 100 basis point (1.00%) increase in the 10-year treasury yield, the mean increase in the 10-year municipal yield was 0.82%, which means municipals are less volatile when compared to treasury bonds.

****

As we enter the 4th quarter of 2021, the Fed’s role continues as the main ingredient in market fluctuations. Overall, we remain optimistic on municipal credit with the essential purpose and essential revenue sectors. We expect current valuations to hold in the current ranges of recent months, though the market could experience higher levels of volatility as the Fed begins stepping off the pedal of its easy monetary policies.

 

Matt Bernardi
Vice President
Bernardi Securities & Bernardi Asset Management

 


[1] Source: https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm

The two main ingredients determining long-term bonds yields are future growth and inflation expectations. Yields have dropped significantly the past number of months as investors have come around to the Fed’s view of high inflation as transitory and the expectation of muted long-term growth projections.

Over the past four months, the 10-year Treasury Note has moved from over 1.70% to under 1.35%. Average yields for 10-year AA rated municipals are 0.99% (taxable equivalent at the 37% bracket is 1.57%). The tax-exempt yield is roughly 75% of treasuries, which is a reasonable valuation relative to historical levels, current market fundamentals, and the potential for higher tax rates.

It is impossible to know if the market’s and Fed’s subdued view on growth and inflation will ultimately be correct. In terms of growth potential, debt (high) and demographics (older and low fertility rates) are major weights on the economy and support the view that long term growth will remain low relative to past experience. This view is corroborated by Japan’s experience and has played out in its domestic financial markets in two ways:

1. Low Yields: Japan’s 10-year treasury is 0.019% (nearly zero)

Click to zoom in on the graphic below. Reference the “Yld” column for Japan under Asia/Pacific. As you will see, negative yields are present in many European countries’ 10-year debt, as well.

Source: Bloomberg


2. Poor stock market returns:
Since the Japanese economy peaked in the 1980s their benchmark stock index (Nikkei) is still well below all-time highs.

Source: Bloomberg

Today’s high levels of fiscal and monetary policy stimulus, and low yields are supportive of high valuations for asset classes across the board, including real estate and the stock market. If you click the link, you’ll notice the Shiller PE Ratio is nearing an all-time high. This ratio was created by Yale economist Robert Shiller and graphs the price to earnings ratio based on average inflation-adjusted earnings from the previous 10 years.

Stocks currently benefit from low yields as:

  • Corporations can fund debt at low levels
  • They enhance relative valuations as: i.) the S&P dividend ratio seems attractive relative to bonds, thereby boosting stock prices and ii.) the P/E multiple of stocks can move higher as P/E ratio of bonds moves higher (price/yield)
  • Discounted cash flow models (a way to value stocks) price the current value of stocks higher when the discount rate (yield) is lower

As the Fed continues to push the pedal to the metal with easy money, this rising tide is lifting all boats (prices).


There are three potential pathways forward in terms of yields:

1. Should we move into a Japan-like scenario, bond prices will continue to benefit (stocks probably not so much). Disinflationary/deflationary economies are good for bond prices (and vice versa).

2. Should the market (and Fed) be wrong, and inflation is here to stay, we believe our laddered portfolios can weather the storm and, over time, take advantage of gradually increasing yields.

The inflationary environment of the late 1970s to mid-80’s took nearly 10-years for the cycle to play out. This is ample time for a laddered portfolio to naturally reorient itself at higher rate levels due to principal/coupon reinvestments.

That said – in all likelihood – the Fed learned its Volker-taught lesson of this time period. Therefore, it would not allow high levels of inflation to persist for such a long time and would quickly stamp this out through monetary tightening policies.

Source: Bloomberg

 

3. We stay at current levels:

Currently, municipal valuations are relatively attractive to other high-grade fixed income asset classes.

Below is a yield curve comparison depicting yields (from highest to lowest) for:

  • Taxable equivalent yield (37%) of a recent tax-exempt Bangor, WI Electric Utility Revenue issue: This is for example only and demonstrates the types of bonds we invest in for our clients. 
  • AA rated Corporate Benchmark (Bloomberg)
  • Taxable equivalent yield (37%) of the tax-exempt municipal benchmark (MMD)
  • Treasury yields
  • (Dotted) Tax-exempt municipal AA rated benchmark (MMD)

Munis remain attractive in yield and credit quality. A recent Moody’s Default Report[1] noted that:

  • There were no virus-related municipal bond defaults in 2020
  • Municipal ratings were resilient to virus-related pressures…while corporate ratings experienced more frequent rating downgrades
  • Municipal credits continue to remain highly rated

Diversification is key in this environment. Both in terms of asset classes and one’s bond portfolio maturity range. And relatively speaking, municipals remain a very attractive high-grade fixed income asset class when considering both yield and safety.

Relative to other asset classes, bonds will provide a safe-haven in a low inflation/deflationary environment and should not experience the same levels of volatility as stocks during uncertain/bad economic climates. Yields are low given the Fed’s activity in the market, though as I noted above, all asset classes are artificially stimulated given this activity.

If you have any questions regarding your portfolio or the market in general, don’t hesitate to reach out to your Investment Specialist or Portfolio Manager.

 

Sincerely,

Matt Bernardi
Vice President

 


[1] Moody’s Investors Service: US municipal bond defaults and recoveries, 1970-2020; July 9th, 2021

The past year and half presented many challenges, but also a multitude of silver-linings and learning experiences. Within the municipal bond market, the experience verified the sector’s overall creditworthy reputation and balance sheet sturdiness. Federal monetary and fiscal policy intervention certainly have helped, though most states projected balanced budgets prior to the latest round of direct fiscal aid.[1] Furthermore, prior to the sharp economic recovery – catalyzed by reopening, Federal aid, and loose monetary policy – most states and localities were dealing with the crisis in stride through job cuts, project delays, draws on cash reserves, debt refinancing, and other fiscal levers. This experience should be comforting to municipal bond investors as the asset class served its primary purpose of principal preservation – largely without extraordinary federal intervention.

Given the nature of the crisis, federal stimulus actions have been unprecedented. The Federal Reserve’s balance sheet now amounts to over $8 trillion, and we are expected to run a federal budget deficit of over $3 trillion for the second year in a row.  This intervention from D.C. has generally impacted the municipal market in two ways:

  • For the healthiest issuers and those best prepared for the crisis, it strengthened their balance sheets and underlying revenue sources to a level where many credits are better situated today than they were before the crisis.
  • It has temporarily bridged the gap for credits that are either i) structurally imbalanced (those that have high fixed costs; e.g. pensions) or those that ii) experienced significant revenue shortfalls as a result of the pandemic (e.g. NYC public transit). For many of these types of issuers, the day of reckoning has simply been delayed and medium-to-long-term credit pressures remain.

 

Present:

Source: SIFMA

Today’s municipal market is awash in cash, experiencing high levels of demand, and low levels of supply. Sound familiar? Demand is further catalyzed by potential higher tax rates and a very strong credit environment (noted above). In terms of the latter, forty-six states are rated AA- or higher by S&P, while twenty-five are rated AA+ or AAA, which is equal to or better than what S&P rates the US government. If treasury debt continues to mount, an argument could be made for owning municipals vis-à-vis treasuries, as a way to enhance credit.

This technical and fundamental backdrop should lead to a stable market environment for the time being and low muni/treasury ratio levels (low tax-free municipal yields relative to treasury yields). We believe value can be added to portfolios in two major ways:

  • Buying kicker bonds (bonds with a short call date and longer maturity) with 3-4% coupons. Coupons above 4% will likely be called, while coupons lower than 3% are subject to higher durations (i.e. volatility).
  • Smaller-to-medium sized issuers which do not have broad market coverage nor placement within benchmark indexes. Adding these types of issuers are a way diversify away from the average benchmark and enhance yield.

Additionally, for tax-advantaged accounts, taxable municipal bonds offer value relative to other high-grade fixed income and are a way to enhance yield.

 

Future:

Quiescent market dynamics could give way for two reasons:

  1. Change in Monetary Policy: Later this year the Federal Reserve will likely embark on a path of tighter monetary policy and begin the process of unwinding current levels of extraordinary monetary policy support. The first step will be purely rhetorical – not actually doing anything – through the discussion of tapering balance sheet purchases. Currently the Fed buys $120 billion of treasuries and mortgage back securities each month. Tapering these purchases (likely starting with mortgage bonds) will reduce the size of monthly purchases. The actual balance sheet will continue to grow through 2022.
  2. Infrastructure Bill: The sausage making process is running at full speed in DC today. As part of an infrastructure oriented bill or as separate legislation, Congress may reintroduce Build American Bonds 2.0, similar to the program rolled out during the last crisis. This would directly impact the taxable municipal market, and likely lead to higher supply and higher yields/spreads. Additionally, Congress may allow for municipalities to “advance refund” their debt. This is a refinancing mechanism currently unavailable to issues as a result of the tax reform in 2017. If it is reenabled, this will likely increase tax-exempt municipal supply.

In summary, the municipal bond market remains on solid footing and proved its primary portfolio construction purpose during the travails of 2020. The outlook is favorable as well, though a change in monetary policy may provide opportunities to add exposure and higher yields on resulting market volatility.

 

 

 


[1] The American Recovery Plan was signed into law on March 11, 2021 and allocated $350 billion to state, local, and tribal governments.