INDEPENDENCE

I hope Summer 2024 is off to a good start.  I wish you and your family a Happy 4^th of July – the day the Continental Congress approved the Declaration of Independence.

Our founders were skeptical of concentrated power. They knew concentrated power set against its citizens could be a crushing force. So they devised a system with checks and balances, eventually writing a Constitution enumerating our rights. Our system is imperfect, but its foundation is fundamentally good and all of us play a role ensuring it continues to evolve into something better for the common well-being.

All of us at Bernardi Securities and Bernardi Asset Management have much to be thankful for. We are thankful for the many individuals, organizations, and communities that rely on our team to help them along. We are appreciative of the continued confidence of so many. On behalf of the entire Bernardi team, I thank you for allowing us to help you.

GENESIS

This is a milestone year for our firm.

On October 1, 2024 we celebrate our 40th year in business. 

Entrepreneurial values, paired with a primary focus of serving our clients well, were the essence of our beginning. We were ambitious entrepreneurs looking to build a successful organization. We wanted to help people and organizations plan and improve their futures by investing in the bond market. And we wanted to help communities raise capital for affordable and needed infrastructure projects. 

These elements remain at the core of our corporate ethos.

We opened our doors in November 1984. There were 3 or 4 of us the first few months. Our office was located across from Chicago City Hall where Mayor Harold Washington presided.

Our capital base was $275,000.00 supplemented by an American National Bank & Trust Company credit line. We financed our inventory from these two sources.

Tumultuous and innovative forces dominated 1984:

• the 10 year U.S. Treasury Bond yielded 11.55% at year-end
• Apple’s Macintosh went on sale for $2,500.00
• Continental Illinois National Bank & Trust Company, the nation’s seventh largest bank by deposits, failed
• NASA’s Space Shuttle Discovery departed on its maiden voyage
• U.S. Treasury public debt totaled $1.6 trillion, the year’s budget deficit was $175 billion

An uncertain feeling pervaded and the risks of starting a business, a municipal bond firm no less, were substantial.

Fortunately, we had a resolute and intrepid leader in firm founder, Ed Bernardi. It was his idea to:

• form a specialty firm excelling in the municipal bond marketplace
• focus on building trust with investors and issuers across the country while serving their needs
• assemble a young team comprised of hardworking, energetic individuals to accomplish our mission

Ed was our leader and mentor for many years. His leadership was masterful.  He set the tone establishing high standards for us to follow. Relying on his deep knowledge of the bond business, street smarts, and an innate common sensibility, he taught us the innumerable lessons we needed to learn. 

In the process, the firm prospered and the young team he assembled matured. 

From the outset we were blessed with numerous, loyal, and faithfully supportive clients who relied on our expertise. This gave us a huge advantage.

To this day this dynamic exists. There are many factors creating this force, but I believe the specialized nature of our firm model helps foster these deep and loyal client relationships.

Thank you. The Bernardi team is forever grateful for this loyalty and confidence you place in us.

 

RAGIONE D’ESSERE (REASON TO EXIST)

Nearly 40 years later we remain:

• doggedly committed to serving bond investors and communities across the nation
• an independent, private firm excelling in the niche business of municipal bonds
• a vertically integrated organization that does not outsource its core competencies

At Bernardi we note: “Municipal bonds build America’s infrastructure”. 

We understand the role we play in this endeavor and how it has grown over the decades. For nearly forty years we have not strayed from serving municipal bond investors and issuers across the country. Our commitment has been consistent and unwavering as we’ve played a small part helping to build and improve America’s infrastructure.

As we begin our fourth decade our goal is to continue on this path with laser-like focus.

BERNARDI 2024

Today our service platform consists of:

• bond portfolio management
• new bond issue underwriting
• credit surveillance
• public finance services
• secondary market trading

Daily activities at the firm can be daunting, exciting, and humbling. Individuals and organizations across the country count on us to help them navigate a complicated and often volatile marketplace. The responsibilities we have to our clients are significant. We understand this and do our best to perform at the highest level at all times.

Our firm is blessed with talented employees. For nearly 40 years dozens of honest, diligent, smart, hardworking employees have helped our organization flourish. 

I read recently that on average an employee remains at a company for about 4 years. While the average tenure of my Bernardi colleagues is 15 years.  At a recent firmwide gathering I recognized employees who’ve served for 17 years or longer – I recognized 12 individuals, about 40% of the team.

Our team works collaboratively.  Everyone contributes and is expected to play a role improving the platform of services we offer. This dynamic helps effect needed changes and improves the client experience. We are a diverse group and the ability to work together is a real strength, one of the great successes of our firm. 

 

TORCH PASSING – A LONG AND WINDING ROAD

The 2024 Summer Olympic torch passing relay began on April 16th and ends July 26^th in Olympia, Greece.  The lighted torch will then sail to France and begin its French leg ending during the Opening Ceremony. It’s a long road to Paris.

A torch passing has been occurring at our firm for nearly a decade. I extend a heartfelt thank you to the many individuals inside and outside the organization who have assisted in this process. The process is thoughtful, gradual, segmented and dynamic. It occurs daily and involves multiple firm leaders including several individuals who are the next generation of firm leadership. It’s a long and winding road with twists and turns, of course. But this process is progressing nicely and will continue in the coming years.

As part of this torch passing, two notable events recently occurred.

• Senior Principal and shareholder, Lou Lamberti, retired at the end of 2023.  He continues to serve on the Board of Directors.  Lou began his career at Bernardi on December 6, 1984. For thirty-nine years he served our clients leading the Trading and Underwriting department. Lou was one of our rocks – reliable, smart, steady, cool, classy, and honest. Over the years I have told this to many: if you want to succeed in this business with style and gravitas, look no further than Lou Lamberti.
• Senior Principal, shareholder, and Corporate Secretary, Michelle Landis, retired this past spring.  She continues to serve on the Board of Directors.  Michelle began her career at Bernardi on August 15, 1995.  She began in sales.  Over the years Michelle pivoted into new roles at my request taking on a variety of important management responsibilities requiring her precise and steady hand. Her responsibilities removed her from the limelight most often. But the work she accomplished helped ensure a positive experience for our clients and greatly contributed to the firm’s ongoing prosperity.

Both Lou and Michelle faithfully served our mission for decades. Together, we navigated through some rough seas including:

• Black Monday – October 19, 1987
• Great Bond Massacre – 1994
• Federal Reserve bailout of Long-Term Capital Management – September 1998
• Dot-com bubble burst – March 10, 2000
• 2008-2009 Financial Crisis
• COVID- 19 pandemic Market Crash – February/March 2020
• Federal Reserve Quantitative Tightening – 2022

We successfully dealt with a multitude of challenges and exciting endeavors and had a lot of fun along the way.  It was a remarkable journey with these two individuals.  And these words do not come close to conveying the depths of their contributions to our clients or my sense of gratitude for their efforts over the years.

 

THE PATH FORWARD – STAYING IN OUR LANE

I find myself looking to the years ahead as I imagine my father viewed the path forward in 1984. I remain involved in firm and client affairs, but the focus continues to shift appropriately as a team of younger leaders increasingly make key decisions.

These are exciting times for us – it’s energizing and exciting to experience this dynamism. We have a young and talented team. I sleep very well at night knowing the talent pool and dedication at this firm is robust. It’s this pool of talent that helps ensure our clients’ interests grow – which means the firm will expand, innovate and prosper in the coming years.

In many respects I liken the responsibility of running our organization to a jockey leading a Thoroughbred down the backstretch of a Triple Crown race:

• The stakes are high with many counting on you
• Time moves rapidly with many factors beyond your control
• You make dozens of decisions in rapid fire fashion without knowing the consequences until later
• The pressure is often intense

One key to our success at Bernardi – like the steed the jockey rides – we keep the blinders in place.  Of course, we glance left and right occasionally to size up the competition and the state of the world around us making needed adjustments.  But we quickly return our gaze straight ahead focused on the finish line where our mission goal awaits us. We move forward methodically, step by step, adhering to firm protocols and best practice methodologies. We rely on teamwork. We trust the training and work we’ve put in because those forces have successfully delivered us to this point.

We stay in our in our lane.

And I believe our clients recognize this as a strength, value it and appreciate the ways we help them.

THE IMPORTANCE OF A ROBUST MUNICIPAL BOND MARKET – TEAM BERNARDI ROLE

The municipal bond market in this country works well. And all of us, in communities across the country, benefit from its dynamic nature. Decisions are made locally by citizens closest to projects – public projects their constituents need, want and presumably can afford.  The central government is greatly removed from the decision making process.  And that fact has served all of our communities well. 

Municipal bonds finance the great majority of America’s public infrastructure: our schools, roads and highways, libraries, town halls, water towers, power plants, hospitals, airports, county courthouses, water and sanitation plants, flood control projects, electric grids, park district facilities and more. 

The issuance of municipal bonds dates back to the early 1880s and its origin coincides with the beginning of our nation’s rapid economic development. The Revenue Act of 1913 first codified exemption of interest on municipal bonds from federal income taxation.  This was a direct result of our federalist system structure and the separation of powers it engenders, including the ability of state governments to raise capital independent of the federal government. 

A multitude of recent studies confirm our nation’s public infrastructure needs upgrading. If we want to improve the infrastructure in this country in the coming decades, we will need a robust municipal bond market to finance much of it.

For nearly 40 years, our firm has played a part in this important headline of America’s story. We plan on continuing to contribute in the years ahead.

Thank you for your continued confidence in our team.  Happy 4^th!

Sincerely,

Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.

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

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[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.

• 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?

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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.

 

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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 3^rd. 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 26^th 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

 

 

 

 

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[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 1/3^rd the amount of time.

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).

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.

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).

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.

 

 

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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

 

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[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