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 8^th, 2022

[5] Source: Moody’s

[6] On January 1^st, 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, 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 4^th and June 15^th).
• 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.

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.

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.

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

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 9^th, 2021

Municipal bonds are known for their credit preservation characteristics (and certainly have proved their worth during today’s crisis), but another less known attribute of the asset class is their ability to mitigate duration.¹ Duration is one of the primary measures of risk for a bond portfolio and certainly a focal point for today’s portfolio managers. According to our regression analysis, over the past 10 years (as of 12/31/2020), the correlation between tax-exempt municipals and taxable treasuries was high at roughly 88%, but municipals displayed lower volatility. 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%.

Furthermore, municipal yields are less correlated relative to corporates which have displayed a 0.97% correlation over this 10-year period vis-à-vis treasuries. For every 100 basis point increase in the 10-year treasury yield, the 10-year corporate increased 0.94%.

One-year data for the analysis above is not included due to the unusual market dynamics of 2020 when correlations broke down. Municipals displayed a 35% correlation with treasuries last year due to the sharp but brief sell-off experienced in March. The correlation with treasuries soon returned in April and thereafter, as investor worries over credit calmed, and liquidity resumed for money market and mutual fund products. This proved to be, and we acted on, a great buying opportunity for SMA strategies.

Certainly, as the “risk-free-rate” (treasury yields) goes, as will municipals over the long term. But according to the data above the volatility is lower for municipals relative to both treasuries and corporates. Hence, municipals should play a role in investor’s high grade fixed income allocation as both a credit and durational hedge. Given the stable to improving credit backdrop for the market and the potential for higher individual and corporate tax rates, we believe municipal valuations are well supported. Furthermore, should supply remain muted, this provides an additional positive input for the market’s technical environment.

How to defend a bond portfolio in a rising rate environment

Given the above, we believe municipals should play a primary role for high income and high-net-worth investors in the current environment. Within the municipal sector, we believe there are three ways to mitigate a bond portfolio’s sensitivity to rising interest rates:

1. Target higher – but not too high – coupon bonds: in the current environment we are targeting 3-4% coupon bonds. 5% couponed, “kicker bonds” are attractive as well, though the callability on these is high, so the yield-to-call must offer quite a spread. 3-4% coupon bonds will trade with lower volatility in a rising rate environment relative to a ~2% coupon bond.
2. Ladder Structure – the ladder does two important things in relation to duration. It i) diversifies portfolios across the yield curve and ii) enables ongoing cash flow for reinvestment. Both qualities prevent over or underinvesting in particular areas of the ever-changing yield curve.
3. Target non-benchmark issues – Bernardi Asset Management composite portfolios are centered on non-benchmark, smaller to medium-sized issuers. During volatile markets, like we experienced in March, retail fund flows tend to exacerbate performance of the large ETFs and mutual funds, which passively track the benchmark. These funds are forced to sell these benchmark names en masse, further exacerbating their performance and volatility. We believe that a Sharpe Ratio² analysis demonstrates not only the greater return potential of allocating away from the benchmark, but also a lower portfolio volatility as well:

Source: Morningstar

The results above show that our Tactical Ladder and High Income strategy composites outperform the comparable benchmark from a risk adjusted perspective as defined by the Sharpe Ratio. Additionally, they should be considered in the overall asset allocation conversation as way to differentiate from passive strategies, reduce portfolio volatility, and add value over the long term for investor’s “mattress money” portfolio allocation.

Please contact your Investment Specialist for information about our Municipal Bond SMA strategies.

[1] Duration can be used interchangeably as both the weighted average time until repayment and as the percentage change in price of a bond based on the change in interest rates. The measurements are often nearly the same, but different conceptually. Both provide an indication of how sensitive a portfolio is to a change in market interest rates. The higher the duration, the higher sensitivity a portfolio will have to interest rate changes.

[2] Sharpe Ratio calculation: Return of portfolio minus Risk-free rate divided by the standard deviation of the portfolio.

[3] Standard deviation is a measure of the amount of variation or dispersion of a set of values. A low standard deviation indicates that the values tend to be close to the mean of the set, while a high standard deviation indicates that the values are spread out over a wider range.