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

 

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.

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.

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.

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

 

 

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[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.

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

 

 

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[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.

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

 

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

[2] Source: Bloomberg