Tax Exempt Fixed Income - Strategy
As we enter the second quarter, municipal bonds continue to generate good positive results, even as price volatility has picked up recently. This increased volatility can be partially attributed to the municipal market’s reaction to events occurring in the stock market. During periods when stock prices rally, municipal prices move modestly lower; conversely, when stock markets are under pressure, municipal prices advance. Since there have been many days of common stock price weakness this year, overall municipal values continue higher as yields decline. A reasonable explanation for this inverse connection may be that declining stock prices signal further economic weakness which municipal investors would read as a need for additional Fed ease. Rising stock prices imply that a better economy is ahead and portends a possible end to this round of Fed ease.
While this pattern should continue, other factors could affect the near term direction of tax exempt securities as well. First of all, the large balances in money market mutual funds represent an important future source of demand for municipal securities as these investors, at some point, will leave the short term money market for more permanent investments. Second, even though available yields are now lower, on a tax-adjusted basis, the municipal sector continues to provide good return potential versus inflation forecasts. Third and most importantly, for balanced accounts, tax-free investments should continue to play a vital role in reducing risk and preserving capital for the high net worth investor.
Finally, in terms of individual security choices, we are carefully monitoring economic conditions throughout the country to assess how the slowing economy impacts municipal credit quality. As an example, in California, more so than in other states, projected revenues may be more vulnerable to an economic slowing due to the state’s large exposure to technology-based companies which are struggling to resume their growth. At the same time, California’s state surpluses are being used to pay for an energy shortfall and consumers are also forced to use more of their discretionary income to pay for the rate increases recently approved.
By the same token, other state and local municipalities throughout the country are not immune to the economic slowdown or to higher energy costs. They should expect a reduction in tax collections as well. In anticipation, municipalities will need to adjust their budgets by reducing expenditures, as sales, corporate or property tax revenues slow. If the economic slowdown is prolonged or if budgetary action is not taken, deficits could emerge and credit quality would deteriorate.
As a precaution, in California portfolios, we have pared back our positions in non-insured State obligations, thereby increasing cash positions. Furthermore, as a prerequisite to new purchases for all clients, we demand credit enhancement or collateral backing. We are pleased to note that last year’s strategy to invest California portfolios in out-of-state securities has generated an excellent increment of additional return. We also avoided paying unusually high prices as municipal bond shortages prevailed. Currently, we are reviewing the available security choices within California for a possible reversal of that decision and a move back into California tax frees.
Currently, we find value in the 3 to 9 year maturity areas where investors would have to earn well over 6% on taxable securities to achieve a comparable after tax return. Furthermore, because the yield curve is only somewhat positive beyond 10 years, we will avoid long maturity purchases for now. We expect a steeper yield curve to emerge as the benefits of an easier monetary policy begin to fuel economic growth and cause the performance of these longer term municipal investments to lag that of the shorter maturities. We will retain this conservative stance until our expectation is met. At that time, we would again consider longer maturities.
