The market experienced a large range of optimism and uncertainty over the past few months. The prominent theme continues to be the convergence of optimism with a harsh reality that the U.S. economy may not be on the cusp of an era of notably higher economic growth. The outcome remains to be seen with investors tuned to upcoming reports and actionable efforts from Washington which may support or deflate sentiment levels. Additional sources of uncertainty are mounting geopolitical concerns and an increasing likelihood that fiscal spending and tax reform may not impact the U.S. economy in 2017. A healthy level of skepticism about economic growth has recently been demonstrated by the bond market. The treasury yield curve flattened in the first quarter with the Fed raising fed funds 25 bps combined with 10 and 30 year U.S. treasury rates declining. High grade corporate bond issuance in the 1st quarter was high with issuers taking advantage of investors’ appetite for high grade paper. Municipal bond rates steadily declined as investors added holdings and municipal rates tracked somewhat closely to treasury rates.
Uncertainty creates opportunity for those with long-term money to invest. This uncertainty combined with choppiness in U.S. interest rates created an excellent 4 month period to extract value from the secondary bond market. Whenever market participants act on uncertainty by stepping away from the bond market, we become better positioned to identify compelling values. Given the municipal market is dominated by individual investors who often make emotionally-based decisions, market uncertainty can become quite pronounced, serving as a very helpful tool for long-term buyers of bonds with cash and coupon income to invest.
Municipal bond portfolios have performed well given their attractive coupon income combined with pricing improvement from declining municipal bond rates. These are two sources of portfolio returns we discussed in our last commentary. The municipal bond yield curve steepened before the March 15th Fed rate hike, providing an attractive opportunity to invest portfolio cash flows and new monies into higher yields (Bloomberg). Positive fundamental improvements include pension funding levels increasing with stock valuations, a very low national unemployment rate, and property prices remain steady-to-up, maintaining property tax bases.
Municipal bonds remain stellar relative values within the investment grade fixed income universe, particularly portfolios that average AA credit ratings with income streams of over 4% for exempt bonds and 5% for taxable municipal bonds. We are finding 2.5% to 3.5% exempt yields for A-AA rated municipal bonds issued by quality municipalities (e.g. GOs and Essential Service Revenue bonds across the country). When you do the tax math, this equates to 4%-6% tax equivalent yields for high bracket investors. These 4%-6% TEYs provide material yield pick-up compared to other investment grade fixed income and we do not see any comparable levels except in the high yield market. The 10 year treasury, before federal taxes, yields 2.33%, leaving most investors with less than 2% yield combined with an 8.00 duration. The 30 year treasury yields 2.98% before taxes and comes with much longer duration (Bloomberg). Investment grade intermediate corporate bonds yield about 3%, as do MBS, again pre-tax. One needs to buy high yield corporate bonds to approach the 4%-6% TEY’s we are finding in the high quality municipal bond market. High quality municipal bonds are backed by excellent repayment streams: ad valorem property taxes, essential service revenue streams for water, power, and transportation, as well as highly-regarded universities and hospitals, most dating back decades and some centuries. The combinations of coupon income, yield, creditworthiness, and duration are excellent - one just has to know which structures are well-positioned for this interest rate environment.
The goal of high coupon municipal bond portfolios with intermediate durations is typically income. Investors can enjoy 4-5% income streams with an average of AA ratings and durations in the 3.50 – 5.00 range. This portfolio positioning provides investors with attractive income, lower duration than traditional intermediate term bond funds, and potentially a real return given reasonable 2% long-term inflation expectations. A portfolio such as this is what we consider an “all weather portfolio.” It doesn’t take excessive risk nor is it excessively cautious. This is how we believe investors can earn the bulk of the municipal bond market’s yield and income. In our opinion, the goals of investors’ bond portfolios are exactly this: income and preservation of principal. We see our clients tracking well with these goals.
Greg Lavine, CFA, CFP®
Past Performance is not indicative of future results.
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Gregory Lavine, CFA, CFP®, Vice President Fixed Income Investments
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