Tax Exempt Fixed Income Strategy
The municipal bond market finished the first quarter with mixed results. On the one hand, returns will reflect little change over the quarter. At first, these results may seem lackluster but, on the other hand, this reflects the market’s ability to preserve capital during these unsettling times. One factor hindering the markets is the existence of forecasters who continue to anticipate a quick resolution to the war, with the immediate result of a significant snapback in economic growth. Forecasters opine that such an immediate growth spurt would signal an end to the bull market in bond prices which we have enjoyed for many years. We also point out that many have been calling for an end to the bond rally for well over a year now. We believe that the U.S. economy faces many difficulties in the post war environment and that many opportunities will remain for bond investors to garner an excellent risk-adjusted return in fixed income securities.
We believe some upward adjustment in yields should be expected, especially after three years of declining interest rates and solid performance. Below is a chart showing the approximate change in yields since March 12.
Looking ahead, we see several benefits to this yield adjustment. We all know that highly taxed individuals utilize tax-free bonds to shelter against taxes. Furthermore, over time they should expect a certain amount of growth in their asset base. An essential ingredient to achieving this objective is the ongoing reinvestment of scheduled interest payments and maturities. Clients will benefit as these cash flows are reinvested at higher yield levels.
We have stated in the past that as yield levels moved to historic lows, we avoided the temptation to “chase yield” by extending to longer maturities in an attempt to maintain past yield levels. Such a strategy will lead to significant losses should interest rates move higher. We are pleased with our decision to stay conservative. In fact, higher yield levels now provide an opportunity to modestly extend for yield improvement while still maintaining a conservative posture. As an example, refer to the above chart, which shows that the five-year area had a yield of 2.25% on March 12. Currently, we can capture 2.65%, a yield gain of 40 basis points in the same maturity area. In fact, we can even improve the yield versus March 12, by shortening from 5 to 4 years. In summary, changing interest rates and yield levels can be used as an effective tool in the management of municipal bonds.
Another area that we find attractive involves the use of callable securities. However, we remain sensitive to the number of years separating a shorter call date from its final stated maturity. A narrow separation provides us with the ability to target and maintain a specific maturity area. In fact, should interest rates move higher, there is little extension risk. As an example, a 7-year callable bond with an 8-year final maturity can extend only 1 year in the event of higher rates. Therefore, with this approach, we can improve yield and control the exposure to interest rate changes. Finally, to add another layer of market protection from the possibility of extension risk, we favor above-market coupon securities.
While we remain committed to preserving market value, we also see a favorable climate for investing in municipal bonds. In fact, California tax-free bonds are currently yielding the same as out of state issuers. Over the years, we have observed that California bonds typically yield approximately 25 basis points less than comparable out of state bonds. We view this as an opportunity not only for California residents but also for general market clients regardless of residency. In fact, California clients receive higher relative yield, while all other clients who invest in California bonds should receive a future return benefit, as the 25 basis points yield spread returns.
In summary, while we have outlined a few of our techniques to control risk, these same strategies are designed to enhance returns and create the potential for market growth. We feel we are using the best combination of safety and opportunity strategies to face the environment ahead. As you are aware, we are active managers and stand ready to change portfolio structures quickly, as needed. In general, we believe municipal bonds are poised to outperform taxable securities in all interest rate climates in the upcoming period. We say this because tax-free yield levels versus taxable securities are not factoring in tax considerations. In fact, as outlined in the taxable comment, we may selectively use tax-exempt securities in our taxable portfolios. We believe other investors will see this opportunity and the demand for this asset class should grow.
