Tax Exempt Fixed Income Strategy
The municipal bond market enters the second half of 2007 with signs of encouragement. The Fed has acknowledged that inflation is improving while most municipalities benefited from a long period of economic expansion. In addition, as shown, the increase in tax-free bond yields this year provides an opportunity to lock in good coupon income, especially for clients who rely on cash flow from tax-free income payments.
During the past several years and as interest rates moved higher, we invested heavily in above market coupon securities for several reasons. As you are aware, the total return from municipal investments is a combination of coupon payments, the reinvesting of those flows and security price adjustments. During this period of rising interest rates, Oakwood stressed the importance of the cash flow component of return to offset any security price erosion. This above market cash generation was then reinvested into the marketplace, if available, as yields moved higher. This process further enhanced portfolio values. Furthermore, as we experienced in April and May, the price levels on many lower coupon “market discount” bonds fell below the “de minimis” threshold (a cutoff point that changes the tax-exempt status of a municipal bond’s accretion to a partial taxable status) and, as a result, we have seen values drop more quickly. We were able to avoid this by holding only above market premium securities.
Now that we are forecasting a decline in yields, albeit unevenly, we see an opportunity to both lengthen the overall maturity and lower the coupon structure in client portfolios. This will shift our focus away from high income generation to a combination of income and market appreciation.
There are many issues facing investors. One of them is the US Supreme Court case of Davis versus Kentucky. The basis of the argument in the case rests on a State’s right to tax out-of-state income on municipal bonds. Simply stated, currently, if a state resident purchases a tax-free bond from any other state, it is taxed at the state of residence tax rate. If this is disallowed, we would expect those states that do not have a state income tax to benefit. We are constantly monitoring the status of this case, and feel it will not prevail, as precedent has given states their autonomy on decisions such as these. However, we hold a vigilant eye to the opportunity to introduce non-California bonds in client portfolios, pending the ruling. We believe that as this case approaches its hearing date, highly taxed states, such as California, may underperform more tax-friendly states. Our strategy is based upon our ability to capture enough yield to pay California taxes.
Similar to our taxable portfolios, we are pleased that we are able to preserve capital during this very difficult interest rate environment. As outlined in the most previous edition of the Oakwood Outlook, we embarked on a program to extend shorter municipal holdings in favor of 10+ year maturities. However, recently we halted that effort as municipal versus taxable yield ratios tightened to unattractive levels. Now that long maturity yields have readjusted, we have returned to this program. It is now our goal to extend average portfolio durations to 5.25, up from less than 4.5. We are paying particular attention to the current weakness in housing throughout the country. A drop in home values and defaults can easily alter expected tax revenues and spending plans of local municipalities. Most investors view municipal bonds as a safe haven. It is true that municipal bonds are among the safest of all investment classes; however, it is vital to scrutinize all investment choices on their ability to preserve capital, meet future interest obligations and provide liquidity, if needed. As an active bond manager, we view each factor as a potential investment opportunity or risk reduction measure.
