Tax Exempt Fixed Income Strategy
As with the taxable bond market, tax exempt bond inves-tors are looking forward to an end of Fed tightening. Most market forecasters expect further rate increases to last only into the second half of this year. This forecast seems reasonable as economic growth appears to have peaked and the latest reporting on job growth indicates a slowdown. What seems surprising is the market’s ability to absorb a heavy supply of new issues in the face of rising interest rates. It appears that the higher yield levels are attracting investors. They too must sense a limit to the Fed tightening.
The demand for tax-free securities has been particularly strong in the 5 to 10 year maturity areas, where on a taxable equivalent basis investors can capture 5% to 6% yields. However, year to date, long maturity tax-free bonds were the stellar performers, easily outperforming both short and intermediate maturities. In fact, the 30-year municipal area generated modestly positive total returns for the quarter, as the yield ratio of municipal securities to equivalent maturity Treasuries fell from around 95% to just over 90%.
During the quarter, we continued a program that involved adding to holdings beyond 10 years. This process has been deliberately slow and tedious as a result of our rigid selection standards. As an example, we are demanding a coupon structure of 5% or higher and a minimum of 10 years call protection. We believe this is necessary in the event that long-term interest rates become more volatile. Even though less demanding structures can perform well in a stable rate environment, they typically under-perform when the markets are in a rally mode. Unfortunately, during periods of market rally, securities with a shorter call date have limited growth potential. Conversely, during periods of a market pullback, price levels on low coupon structures fall faster than their higher coupon counterparts.
For California specific clients, we continue to avoid non-insured California issues on a state level basis. We understand the benefits that an improving economy has on tax receipts and applaud Governor Schwarzenegger’s efforts to deal with inefficiencies and waste within the state. However, an additional 15 basis points of yield seems too little for the added risk an investor must accept to own non-insured issues. Instead, we will continue to demand high quality stand-alone and insurance-backed issues, wherever possible. In fact, we have effectively used high quality 10 years and longer California bonds in non-California client portfolios. The historic yield differential of 20 to 25 basis points for in state versus out of state residents has disappeared, except in the shorter maturity areas where general market issues make sense. This anomaly sets the stage for California to outperform as yield relationships return to normal.
Once again, municipal bonds play an important role in investment diversification and risk control. There appears to be an enormous amount of money poised to enter this market, as flows into money market funds continue to swell. As interest rates move higher, the switch from money markets funds to permanent bonds becomes compelling. Just as we correctly predicted last year’s positive returns, we believe 2005 will provide a repeat performance.
