Tax Exempt Fixed Income Strategy

Similar to the taxable bond markets, municipal bonds have entered a period of market stability after a long period of Federal Reserve interest rate tightening. In fact, on a tax adjusted basis, tax-free securities generated higher returns than their taxable counterparts. Because of this, yield ratios versus Treasuries are historically low. Therefore, investors must be careful not to pay too much for new purchases. As shown in the following graph, yield ratios are below our acceptable target range. As a result, we must continue to be diligent in our investment choices and careful to negotiate a fair price.

Furthermore, it is important now, more than ever, to continue to monitor the credit worthiness of existing holdings in client portfolios. During the past three years, in response to record tax collections and strong forward looking economic projections, many municipalities on both a state and local level ramped up spending plans. With home values now moderating or falling and defaults on the rise, those areas of the country that depend on high tax collections based on inflated home values will struggle to maintain their budget projections. Unfortunately, states, including California, have approved aggressive projects with an expectation that tax revenues will remain strong. As a result, credit rankings may fall and the liquidity of outstanding debt obligations will suffer. We will continue our intensive research efforts to validate the credit worthiness of our holdings.

Meanwhile, the growing supply of new municipal securities is being met with strong demand. Individuals have significant cash reserves as evidenced by large holdings in bank certificates of deposit and money market funds. Aging baby boomers continue to use municipal bonds as a shelter against taxes and as an alternative to riskier investment classes. With the Fed’s intense focus on inflation, it seems unlikely that yields will move much higher.

On a taxable equivalent basis, 13-year tax free bonds provide investors with yields approaching 6%. To take advantage of this, we have started to selectively extend shorter maturity holdings. Even though the Fed is unlikely to lower interest rates at this time, the benefits of their steadfast monetary policy should continue to benefit our clients. Through this, the key is patience. As you are aware, we have always stressed very strict quality standards which include a minimum strong single A underlying rating with insurance enhancement or double A without. In addition, we prefer those security choices with nationwide investor appeal. We believe the key to future success lies in high quality, maximum diversification, and sound liquidity.