Tax Exempt Fixed Income

As we began the process of preparing client portfolios for the new year, we faced several challenges, the most obvious being how best to invest in a much lower interest rate environment. Just two years ago, tax-free bonds in the 5-year maturity area were yielding around 4.30%, approximately 1.70 percentage points higher than now. In fact, as shown in the following chart, yield declines occurred throughout all maturity areas.

Unfortunately, during this period, we have seen a disturbing trend toward deteriorating credit quality, as many municipalities have seen large surpluses turn into deficits. In preparation for these new challenges, we must determine whether prevailing yield levels offer investors enough return potential. We believe that they do; however, we must recognize that 2%, 3% and even 4.5% yields (depending on maturity preference) are not likely to generate the total return of the past two or three years, even if rates were to move still lower. Instead, we feel investors must begin to realign their return expectations to a more reasonable spread over prevailing inflation levels, which are currently at 1.5% to 2%. By adopting a conservative risk sensitive approach to investing, we believe investors will experience less volatility and portfolios are more likely to generate acceptable returns. Moreover, they will be able to guard their portfolio against the temptation of “chasing yield” by constantly extending their maturity structure in an attempt to maintain higher yield and/or by overweighting securities with numerous indenture provisions.

Our experience over the years has taught us that it is almost impossible to project the return outcome of investment choices, unless you are able to target and maintain a specific portfolio structure. For example, many tax-free bonds in the market place today have numerous call features attached to them. Unfortunately, as interest rates moved down, many have been retired prematurely, forcing investors to reinvest those higher yielding securities at a lower replacement yield. In addition, if rates move up from here, many of these same securities could face large losses, as the bond “extends” beyond the earlier call date, and is then valued to the much longer final maturity date. As a measure of protection, we prefer a blend of non-callable bonds and bonds with a narrow separation between a shorter call date and a final maturity. We believe that this is the best way to target specific maturity areas and better define future market risk. This will assure that each security receives maximum performance and market protection within a defined maturity area.

This year as in the past, we will strive to avoid controversial issuers and instead focus only on securities that have what we call “maximum investor appeal”. As an example, many hospitals and housing bonds have secondary insurance enhancements attached to their underlying credit ranking, making them Aaa rated. However, despite this presumed quality cushion, performance results continue to fall short of many other municipal sectors. This is especially true during periods of economic weakness, as investors shy away from any issuer that lacks a solid revenue source to back its coupon and maturity payments. Even though many of these bonds entice investors with higher yield, we instead prefer to invest only in bonds with maximum investor appeal and favorable liquidity characteristics.

With most states now experiencing significant budget shortfalls and deficits, many once premier Aa and Aaa rated states are now either on negative credit watch or have actually experienced downgrades. California, Washington, Wisconsin and North Carolina are a just a few that fell victim to recent or repeated downgrades. We feel that it is even more important to engage in diligent research efforts until the economy can demonstrate an ability to sustain solid growth.

In addition, we plan to limit our exposure to state level obligations, in favor of select cities and towns where budgets are more easily managed and adjusted. While it may seem almost impossible to avoid all of the negative effects of a weak economy, a careful scrutiny of security candidates can go a long way to preserving market value or maximizing return potential.

In general, municipal securities continue to be a bright spot for the new year. When compared to other investment choices, yield levels throughout most states are categorized as “cheap” or at least at their best cross-sector relationship in three years. Therefore, even if interest rates move somewhat higher in the months ahead, municipal securities should perform relatively well. Because of this, demand by individual investors should remain quite strong. As shown in this chart, although yields have come down over the past three years, investors are still rewarded to extend selectively out to ten years.

As you can see, available yields are still high enough to provide an after tax benefit above inflation, especially around the 10-year area. At present, municipal portfolios are fully diversified, both geographically and by issuer type. For highly taxed residents in states such as California we selectively use out-of-state bonds, as a complement to in-State selections. At this time, many states offer equal or greater yield, even after adjustment for the payment of state taxes. This strategy will provide another level of diversification and market protection. We continue to view tax-free bonds as a good investment choice for high tax bracket individuals. They should offer a reasonable return above inflation and a nice complement to other investment choices.