Tax Exempt Fixed Income Strategy
The municipal bond market showed modest improvement over the quarter, as cash generation from coupon flows accounted for most of the performance gains. Compared to this period last year, new bond issuance is strong as municipalities use this low interest rate environment to shore up weak balance sheets. While the demand for the added supply is robust, there is a certain amount of “rate shock” as investors move to the sidelines or switch to the equity markets.
For California residents, even modest positive performance is quite commendable, considering the huge State deficit financing scheduled to start in June. In fact, during the quarter, California actually outperformed many other states. This, however, may change as the State floods the market with the biggest ($15 billion) municipal bond deal ever, easily eclipsing the recent $10 billion deal in Illinois. The deal is already beginning to affect the supply/demand balance of municipal bonds throughout the country at the same time other state and local governments are tapping the municipal bond markets for their own needs.
Although the California situation may continue to draw money away from other states, the extra pressure placed on the municipal market should be manageable. One widely used measure to identify attractive maturity areas is the yield relationship of tax-free bonds to their taxable counterparts. Historically, a yield relationship of 80% for intermediate bonds and 90% for bonds maturing beyond 10 years is attractive. Because we are even more demanding, we are able to find high quality intermediate bonds with a yield relationship of 85%, and longer maturity bonds with a yield relationship of 95%.
Looking forward, we believe interest rates are likely to move modestly higher. As pointed out in the Taxable Fixed Income Strategy, low yield levels have factored in an ideal climate of moderate economic growth and subdued inflation, and even small market disappointments can exaggerate price volatility. However, a rebound in yields should begin to attract investors again.
Meanwhile, we are allowing the average maturity in client accounts to shorten through the passage of time. Furthermore, despite the inherent tendency to “chase yield” by extending bond positions to higher yielding longer-term fixed income investments, we maintain only limited representation beyond 10 years. To keep accounts from becoming too short, we are able to take advantage of the steep yield curve through the select selling of shorter holdings, in favor of six- to eight-year investments, for generous yield gains of +100 basis points or more. California clients receive an additional tax benefit as previously purchased out-of-state bonds are shifted back to in-state municipalities and are modestly extended.
Continuing our investment posture, our above-market coupon preference is designed to generate high cash flow and protect against a rising interest rate event. Regardless of the ultimate outcome, we will continue to use daily market changes to identify other attractive areas of investment. For national accounts, under consideration are states like Florida, where yields have adjusted upward in response to a reduction in the intangible tax on residents. Also, pre-refunded and escrowed to maturity bonds that normally offer lower comparable yields due to their government collateral support are now trading at comparable levels to other sector choices. Finally, we believe the key to success in this uncertain environment is market discipline and patience, a quality that Oakwood is well known for.
