Late Year Yield Surge & 2025 Tax Reform

Happy holidays and Merry Christmas! We wish you a healthy and happy new year as we turn the page on 2024.

2024 ended as a subpar year for fixed income returns as coupon interest was offset by a late year surge in yields. The Bloomberg Municipal Bond Index[1] has returned 0.73% thus far year-to-date, after returning nearly 6.50% last year and averaging just below 3% since 2014. 2024’s flattish return is a reflection of the AAA rated 10-year municipal[2] moving from 2.26% at the beginning of the year to 3.14% today. It increased by 37 basis points in December, alone. Typically, a subpar year for bonds is followed by good performance the next year. In fact, since the Great Financial Crisis, the average return of the Bloomberg index is 8.45% following a sub 1% return in the prior year. This is in no way a prognostication for 2025, but portends well for future bond performance.

Chart Source: Bloomberg

The increase in yields this year is primarily a result of plateauing inflation, steady growth, and, therefore, the Federal Reserve is less willing to cut rates relative to prior expectations. Trump’s reelection is also cited as a factor causing weakness in bonds as of late, not dissimilar to his first election in 2016 when the 10-year treasury yield increased from 1.85% on election day to over 2.40% a month later. That post-election sell-off nearly wiped out all gains for the year, and munis finished up a paltry 0.25% in 2016. Bonds bounced back in 2017, recording a 5.45% gain, as long term bond yields ended the year slightly lower.[3]


The Fed’s Role in the Recent Selloff

Fed rate cuts are typically carried out in 0.25% (25 basis point) increments. At the last FOMC meeting the committee reduced its projection for rate cuts in 2025 from four (1.00%) to two (0.50%). It released this projection on the same day it cut the Fed Funds Rate to 4.50% from 4.75%. But because this cut was fully anticipated by the market and the pace of projected future cuts was not, rates increased during the trading day.

In fact, this has been the trend of yields since the first cut of the cycle on September 18th. Since then, the Fed has cut the short term Fed Funds rate by 100 basis points (1.00%) from 5.50% to 4.50%. During this time the longer-term 10-year treasury has moved higher to 4.55% from 3.70%.

This is an atypical relationship between the Fed Funds Rate and longer term rates at the beginning of rate cutting cycles. During the previous two cutting cycles (2019 and 2007), the 10-year was at a lower yield than where it started 100 days after the first cut.

Chart Source: Bloomberg

This unique divergence between the two rates is a historical anomaly and a result of inflation that has flatlined – and in some cases picked up pace – the last three months. PCE (the Fed’s preferred measure of inflation) printed at 2.40% year-over-year in November, which was up from 2.30% in October, but down from 2.70% the previous year. During the last cutting cycle (2019) inflation moved lower over the next three months following the first cut due to a slowing economy. Today’s level of inflation remains above the Fed’s 2% target which has raised the probability of less cuts than the market previously expected and has largely underpinned this yield surge as of late.

             

Tax Reform’s Risk to Ratios

The municipal market digested blockbuster supply in 2024 (nearly $500 billion) and is expected to face even more in 2025. The market was unphased by the increased supply. As we noted in our October commentary, muni/treasury ratios have remained stable through the end of the year as both investor demand and high coupon repayments vacuumed up supply. Though we would welcome higher ratios, greater than 5%-6% taxable equivalent yields[4] are readily available. This will keep ratios in check unless treasuries break into the 5% yield range or supply significantly surpasses last year.

On top of supply, congressional tax policy negotiations present headline risk to the market over the next year as key provisions from the Tax Cuts and Jobs Act (TCJA) of 2017 are set to expire Dec. 31, 2025. A further decrease in the corporate rate would lessen bank demand for municipals, incrementally pushing ratios higher for bank qualified bonds. It remains to be seen where individual income brackets will settle, but we would expect them to remain unchanged at the 2017 levels, with 37% being the top bracket. Should there be a change, the risk is to the downside which would also incrementally pressure ratios higher given a lower benefit from tax-exemption.

During every tax reform cycle, the threat of removing tax-exemption reemerges. This has been measured by the CBO to “cost” the Federal government $30-40 billion per year. Historically, as negotiations pick up, Congressional representatives hear from local leaders – mayors, treasurers, city administrators, superintendents, police commissioners – about the importance of preserving tax exemption as both an efficient and highly effective way to stimulate investment into local infrastructure. Historically, this resonates, and tax-exemption is preserved and, in many cases, broadened to other types of projects. The benefits of the exemption to local districts is immeasurable and far outweighs any CBO estimate, which has false assumptions in of itself.[5]

Over $500 billion alone was raised by local towns and districts this year to fund infrastructure and the total market size is over $4 trillion. Without tax-exemption these figures would be significantly less or, if not, the tax burden on constituents would be significantly more (given higher taxable borrowing yields). For a country that already has a massive infrastructure deficit, this would put us even further behind.

What keeps tax-exempt yields relatively low for municipalities are the trillions of dollars individual investors keep invested in the market in order to secure principal and maximize after-tax income. The exemption has fostered a diverse capital market ecosystem composed of mutual funds, ETFs, separate accounts, electronic trading networks, broker-dealers, and advisors. These components enable the nexus that moves capital from investors seeking tax-exempt income to local projects that need low-cost financing.

Because projects are financed in a decentralized fashion by investors, the pricing mechanism is market-based and measured in yield. Yields are in large part derived by an obligor’s credit worthiness which is a measurement of how well they spend your tax dollars. Better management means lower yields, which means lower taxes and/or better local infrastructure and services for constituents. This aspect of the market keeps a lid on “bridges-to-nowhere” as dollars need to be paid for by the local population and local leaders’ reputation is on the line.

This decentralized, market-based feedback loop is enabled by tax-exemption with no federally centralized party dictating how or to whom capital should be allocated for local projects. The two most important inputs for if a project gets off the ground are need and ability to pay, rather than some sort of political connection or special interest group securing funds for a project.

Without tax-exemption, local taxes would be forced to increase, projects paired back, and the solicitation of funds from the central government greatly increased. With the latter, local control and, therefore, efficiency declines. Projects would be decided and financed less based on local input and fiscal judiciousness, and more on who has power in D.C. Not only is this a less efficient allocation of tax dollars but it also reduces community involvement, the bedrock of our federal republic.

If credit health is any indication of how well this market works, notice that 32 states are rated by Moody’s at Aa1 or better, which is equal to or better than the U.S. government! Only two states (Illinois and New Jersey) are rated below Aa3, demonstrating fiscal mismanagement is an infrequent bug, not a feature, in this market.

The benefits of tax-exemption cannot just be measured in dollars alone and we expect its importance to be highlighted and preserved throughout the tax negotiation process.

Thank you for your confidence in our team during 2024 and we look forward to working with you in 2025!

 

Sincerely,

 

Matt Bernardi

Sr. Vice President

 

 

[1] Source: Bloomberg (LMBITR Index) as of 12/30/2024; Bloomberg Municipal Bond Index Total Return; duration 6.33, Time to Mty: 13.57

[2] BVAL Muni AAA

[3] Source: Bloomberg

[4] Assuming a 37% bracket

[5] For example, the CBO estimates that every dollar invested in tax-exempt securities would be reallocated to taxable securities/strategies.

Disclosures: All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur. Past performance is no guarantee of future returns. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy will be profitable.

Muni Market Update: Fairly Valued with a Hefty Supply Backdrop

Municipal tax-exempt yields maintain fair overall valuations amidst a significant pick-up in supply throughout the year. The 10-year muni/treasury ratio is 69% vs. a 5-year average of 71%.[1] As of early September, total muni supply is up 38% year-over-year.[2] As we enter the final quarter, the pace of new supply should escalate further potentially pressuring ratios higher. Therefore, we think this fall could present opportunities to capture relative value in municipals should supply remain ample and the economy avoid a major slowdown. That said, investors remain awash in cash and any outsized move in municipal yields likely will be met with increased demand, bringing ratios back in check.

Source: SIFMA, September 2024

Greater supply is a welcome dynamic for a market which has essentially flatlined around $4 trillion total outstanding the past 15 years. This is during a timeframe where GDP has nearly doubled[3], money supply is up 250%[4], and treasury debt outstanding has moved from $8.8 trillion to over $27 trillion.[5] During this time, municipalities have generally not embarked on a debt-laden spending spree in effort to right size balance sheets post Great Financial Crisis. Furthermore, federal pandemic stimulus stuffed state coffers allowing some municipalities the ability to pay down debt. Entering 2024, rainy day fund balances are at record levels[6], pandemic aid is over, average pension funding is increasing, while our country has a pronounced infrastructure deficit…this means time is ripe for municipal issuance to pick up its pace for the foreseeable future.

This should pressure ratios (the yield of a muni relative to treasury) higher, providing higher relative yields which favors income oriented investors. Currently the 10-year muni/treasury ratio is 69%, near its average since 2021. Prior to the financial crisis, from 2000 to 2007 it averaged 86%.[7]

This means the average 10-year municipal had a higher yield relative to the 10-year treasury from 2000-2007 than it has since 2021. A variety of inputs effect this ratio including the supply of bonds, the Federal tax code, the perceived credit health of municipalities, and the resulting demand dynamics for municipal bonds themselves.

At this point in time, given a favorable macro backdrop (as the Fed cuts rates /disinflation continues) and sturdy demand from investors, any outsized move higher in ratios has been largely kept in check by investor demand. Demand has been underpinned by investors seeking high nominal and after-tax-adjusted yield, which remain available even as the market prices in over 200 basis points (2%) of rate cuts through 2026.[8] Looking further out, as baby boomers continue to roll into their retirement years – and likely increase their fixed income allocation – this may provide an offsetting demand dynamic to digest higher levels of supply.

Furthermore, money market fund balances just recently reached an all-time high at $6.76 trillion.[9] Investor appetite therefore is plentiful, and should ratios become overly disconnected, we’d expect a quick recovery as investors seek value.

 

The chart above displays YTD municipal bond issuance in orange, which has significantly outpaced the prior 5-years of issuance. As we enter the last quarter of the year, historical seasonality trends point to an increasing pace of supply. Source: Bloomberg, September 2024.

 

Current Yield

As the Fed cuts short term rates, we expect increased demand for intermediate-to-long duration bonds as cash moves off the sidelines away from deteriorating short term rates. The Fed currently is signaling an aim for a ~3% Fed Funds Rate (down from 5% today) to be reached over the next 2 years.[10]

Regardless of what the future might hold for supply and demand dynamics, we believe today’s relative and outright yield levels remain attractive for municipal bond investors. Tax-exempt yields of 3.00%-4.00% for a portfolio with a max maturity under 15-years are still attainable. At the top income tax bracket, these yields are equivalent to taxable rates of 4.76%-6.34%. Today’s 10-year treasury yields under 3.80% while it has averaged 3.25% since the year 2000.[11]

 

Sincerely,

Matt Bernardi
Sr. Vice President

 

[1] Source: Bloomberg BVAL AAA Muni Yield % of Treasury 10-Year. To calculate the ratio you divide the municipal yield by the concurrent treasury maturity yield.

[2] https://finance.yahoo.com/news/muni-debt-sales-set-surge-180737417.html

[3] Source: https://fred.stlouisfed.org/series/GDP

[4] Source: https://fred.stlouisfed.org/series/M2SL

[5] Source: SIFMA

[6] “With an estimated aggregate $155.7 billion in savings at the end of fiscal 2024, states could run government operations on rainy day funds alone for a median of 48.1 days, equal to 13.2% of spending—a record high. The strength of state rainy day funds remained approximately 66% greater than in fiscal 2019, just before the pandemic-induced recession started in February 2020.” Source The Pew Charitable Trusts, Prioritize Reserves as Fiscal Flexibility Declines, September 19, 2024 https://www.pewtrusts.org/en/research-and-analysis/articles/2024/09/19/states-prioritize-reserves-as-fiscal-flexibility-declines?rsrv_hbar_data_picker=rdfd&rsrv_line_data_picker=tbd

[7] Source: Bloomberg BVAL AAA Muni Yield % of Treasury 10-Year (MUNSMT10 Index)

[8] Source: Fed Fund Futures, Bloomberg WIRP screen

[9] Source: https://cranedata.com/archives/all-articles/10499/

[10] Source: https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20240918.pdf

[11] Source: Bloomberg, September 26, 2024

 

 

Disclosures: All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur. Past performance is no guarantee of future returns. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy will be profitable.

Cash vs. Bonds

With money market fund rates of 5% taxable and over 3.25% tax-exempt (5.15% TEY1), maintaining high cash balances is enticing. However, this is not an attractive long term investment strategy and will be a temporary mirage once rate cuts commence. In this piece we review various micro and macro factors that argue for employing an intermediate term laddered portfolio as a bond portfolio strategy instead of parking funds in the money market.

These factors include (in order from the macro to micro):

  • Restrictive monetary policy
  • A “soft-landing” proxy as insight into future bond returns
  • Historical returns of cash vs. bonds
  • Muni yield-to-worst perspective since the Great Financial Crisis
  • Relative yield across the curve
  • Notion behind the “ladder” portfolio concept

 

Is the Fed Restrictive?

Two main drivers of money supply (along with bank lending) are monetary and fiscal policy. Today fiscal policy is highly stimulative given our budget deficit is expected to reach nearly $2 trillion this year alone, up from the CBO’s prior projection of $1.5 trillion. This increases the money supply, which increases inflationary pressures. The Fed has been combating high levels of inflation by i.) raising short-term rates (via the Fed Funds rate and the interest rate on reserve balances) and ii.) reducing their balance sheet of treasury and mortgage-backed securities. Both these levers typically translate into reducing the rate of loan and money supply growth, thereby reducing inflation.

The crux of this monetary and fiscal policy dance (battle) is which is having a greater impact on the economy? If tight Fed policy is more than offsetting the stimulative fiscal policy, then both growth and inflation will slow.

At the moment, the market and most economists think it’s a net weight, hence the first rate cut is expected to occur at the September 18th meeting, with 2-3 cuts total this year. One indication of restrictive Fed policy is that the Fed Funds rate (5.50%) is well above CPI (3.00%). If this trend continues – inflation moving lower – intermediate rates should remain at current levels or move lower in concert.

How this impacts money market funds: Cash and money market yields are highly correlated with Federal Reserve rate setting policy. As the Fed cut/hike rates, money market fund yields decrease/increase in association to this policy.

 

Bond Returns During the Last “Soft-landing”

The Fed is aiming to orchestrate a “soft-landing” scenario which is an analogy to launching a rate hike cycle (in order to combat inflation) and then be able to land the vessel (i.e. economy) softly without damaging its contents (i.e. high unemployment) with rate cuts. The Fed has succeeded so far in avoiding a recession. The unemployment rate remains low at 4.10% while inflation is 2.6% YoY (PCE2) down from 5.6% in 2022. The Fed’s ultimate goal is in the low 2%s.3

The last time the Fed accomplished this was in 1994-1995 under Alan Greenspan. Bond return s over the next 1-year and 3-year period (from the last rate hike) were very good as inflation petered off and remained stably low.

How this impacts money market funds: This period was a double-edged sword for cash returns as 1) rates were cut so this decreased cash yields and 2) longer bond strategies had attractive total returns, leading to major opportunity cost for those in a cash strategy.

 

Historical Returns of Cash vs. Bonds

The chart largely speaks for itself. Investing in cash/short-term bills (Bloomberg US Treasury Bill Index, June 2024) as a long term strategy is relatively unattractive vs. intermediate term bonds (Bloomberg US Treasury 7-10 Year Index, June 2024).

A reason for this is that yield drives return, and historically speaking, intermediate-to-long duration bonds pay higher yields than shorter term bonds. Today’s yield curve of higher short term rates relative to long term is both a mirage and aberration as this dynamic typically does not last for an extended period.

How this impacts money market funds: Cash/short term strategies have outperformed the longer duration 7-10 Year Index most of the time since this rate hike cycle started. However, if short term rates drop, their potential return will fall in concert, and limited price appreciation will be realized given the short time to maturity. Allocating funds to a slightly higher duration should outperform a cash-based strategy over the long run.

 

Yields at Highs Since Great Financial Crisis

We are at the high point of yields since the financial crisis in 2008-2009. This period was characterized by low-to-stable levels of inflation/growth and easy monetary policy aiming to combat this. Certainly, the next 15-years could play out differently as global economic forces transform.

The Bloomberg Muni Bond Benchmark has a 13.5 year average maturity and yield to worst of 3.59% (July 24th, 2024). This equates to a taxable equivalent yield of 5.69% at the 37% bracket and 5.27% at the 32% bracket. Both these yields are mostly higher than cash yields. This presents an opportunity to lock-in high yields for an extended period of time.

How this impacts money market funds: You can avoid the “cash-trap” of currently high floating rates by locking in intermediate-to-long yields at similar-to-higher levels in today’s market.

 

Relative Yield Offered by Municipal Bonds

The municipal yield curves continues to maintain its “J” shape. In that the front end of the curve (1 to 10 years) is inverted with short term rates higher than the longer portion of this segment. But as you move to the ~13-30 year portion of the curve, yields increase with significant steepness relative to the treasury bond market.

Across the curve we are aiming to lock in a yield to worst of 3.40%, which is like buying a 5.39% taxable bond at the 37% bracket.

5.39% is higher than any point of the treasury curve. So, in essence, implementing a laddered municipal portfolio today both maximizes yield and diversifies interest rate risk.

How this impacts money market funds: The 30-day average yield on your average tax-exempt money market fund is 3.25% or 5.15% taxable equivalent. Some may prefer the higher liquidity offered by this product vs. a 7-year municipal at a 3.40% yield. However, it is possible that a year from now the money market fund may have dropped by over 1% as the Fed cuts rates, while that 7-year bond is now a 6-year bond that you locked in at 3.40%. Furthermore, the bond will have realized price appreciation.

 

Notion Behind the “Ladder” Portfolio Concept

Ultimately, the aim is not necessarily to time the next phase of the rate cycle, but to diversify away from strategies that concentrate a large portion of a portfolio in any one part of the yield curve. Cash is a concentrated bet that yields will remain high or go higher. Certainly, this could happen and this strategy worked well during 2022 and parts of this year when rates increased dramatically.

However, as the Fed cuts rates and the yield curve normalizes, a “laddered” strategy is a higher duration strategy than a money market fund and one that diversifies across a large portion of the yield curve. This means it will i) lock in higher rates for longer and ii.) mitigate exposure to any one interest rate cycle. It is a bet on not making bets.

 

The pivotal input to defining the path of interest rates from here is how inflation plays out. And the defining input into bond portfolio performance from there will be duration. Should inflation continue to calm, higher duration portfolios will outshine lower duration allocations.

Cash has the utmost lowest duration risk on the yield curve.  This certainly comes with its benefits in its flexibility and liquidity. That said, from a bond investment strategy perspective, it is a concentrated bet on accelerating levels of inflation and/or tighter monetary policy (higher short term rates).

 

A ladder portfolio is a more diversified approach for your duration allocation. With both high nominal and relative rates offered by today’s market, we think it sets up very well for medium-to-long run performance.

Please reach out to your Portfolio Manager or Investment Specialist with any questions you may have as it pertains to portfolio positioning or the market in general.

 

Sincerely,

Matt Bernardi
Senior Vice President

 

[1] 30-day average yield of Federated Hermes Municipal Obligations Fund (Ticker: MOSXX); TEY = Taxable equivalent yield calculated at the 37% bracket.

[2] I use PCE as this is the Fed’s preferred measure of inflation. CPI is an alternative measure topped out at 9.1% in 2022 and last posted at 3.00%.

[3] Their explicit goal is 2%. But most believe if PCE prints in the mid-to-low 2%s, while continuing to demonstrate a trend lower in the “core” components, this will allow the Fed to begin cutting the Fed Funds Rate. PCE last printed at 2.6%.

Forty Years of Municipal Bonds – A Letter to Our Clients, Colleagues, and Friends

INDEPENDENCE

I hope Summer 2024 is off to a good start.  I wish you and your family a Happy 4th 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 26th 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 4th!

Sincerely,

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

Municipal Market Update| Pick Your Spots

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

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

 

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

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

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

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

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

 

Our Approach Given This Dynamic

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

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

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

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

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

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

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

 

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

 

Sincerely,

Matt Bernardi
Senior Vice President
March 2024

 

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

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

 

Two Strategies for Today’s Municipal Market

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

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

Tax Loss Swaps

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

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

 

Attractive Discount Bonds

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

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

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

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

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

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

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

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

 

Sincerely,

Matt Bernardi
Senior Vice President, Investment Specialist

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

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

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

Are the Bond Vigilantes Back?

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

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

 

 

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

 

 

 

 

 

 

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

 

 

 

 

 

1990’s Redux  

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

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

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

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

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

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

 

Our Approach to Current Market Dynamics

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

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

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

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

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

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

 

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

 

Sincerely,

Matt Bernardi

Sr. Vice President

 

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

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

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

[4] Source: Bloomberg

Market Anxiety From One D-Word to Another

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

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

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

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

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

Interest Rate Risk Within Municipal Portfolios:

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

 

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

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

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

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

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

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

According to a recent Route Fifty article[3]:

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

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

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

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

 

Hiking in May, Cutting in July

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

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

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

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

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

 

Yield Curve & Where We See Value

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

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

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

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

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

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

 

In Summary

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

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

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

 

Sincerely,

Matt Bernardi
Vice President
May 2023

 

 

 

 

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

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

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

 

Municipal Market Update: The Best Defense is a Good Defense

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

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

Source: NBER & Bloomberg

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

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

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

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

Return of and on Principal

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

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

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

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

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

Source: Moody’s Analytics

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

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

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

 

Where We See Value

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

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

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

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

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

Source: Bloomberg & MMD Monday December 19, 2022

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

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

 

 

******

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

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

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

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

 

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

 

Happy Holidays,

Matt Bernardi
Vice President

 

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

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

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

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