Tax Exempt Fixed Income - Strategy
During these past two years, tax-free bonds continued to provide investors with generous positive returns and acted as an excellent complement to other asset choices. We believe the upcoming environment, as well, is favorable and represents opportunity. However, as interest rates reach historic low levels and as the economy continues to struggle, we must also approach the upcoming period with caution.
On both a state and local level, there is a growing imbalance between budgeted outlays and projected tax revenues owing to the weak economy. Furthermore, the allocation of State funds to the local governments may be derailed. As an example, one third of all states are now cutting spending for education, health care and other programs as a spate of job cuts grows. Even lottery proceeds, which account for as much as 5 percent of states’ budgets are declining for the first time in years. This strain is forcing governments to divert funds to those programs once dependent on lottery proceeds at the expense of local governments. In Pennsylvania, budget deficits are becoming a reality, while Kansas is showing fiscal restraint by announcing drastic spending cuts in anticipation of weak revenue growth. In Tennessee, there is even discussion about a state income tax. Furthermore, California remains on alert for another downgrade as the State’s two largest electric utilities, Pacific Gas and Electric and Edison International’s Southern California Edison, are insolvent. To subsidize this, California had hoped to sell $12.5 billion in bonds last June to replenish coffers; however, regulatory snares are pushing the sales out.
As mentioned, these types of problems are widespread throughout the country with a clear message that credit quality is deteriorating. As a result, we are looking more closely at the underlying rating on each municipality, prior to any new purchases. After a recent review of existing holdings, we feel we are well positioned to endure any prolonged economic slowdown. We continue to emphasize high quality and demand a AA minimum rating on all new purchases, independent of any insurance enhancement. For California clients, we have eliminated all non-insured State holdings and will avoid any new purchases of uninsured issues, regardless of credit backing.
On the positive side of the markets, cash in tax free money market funds is running at record levels with yields falling well below 2%. As reality hits investors, they will seek greater yields and move to longer investments. Even now, residents in highly taxed specialty states are experiencing a scarcity of high quality bonds, especially in the 3 to 7 year maturity areas. We anticipated this development and have already invested heavily in intermediate maturity bonds. In fact, most Oakwood municipal bond clients hold over 50% of their assets in this area. For the balance of the year, we will focus our attention on general market securities, as an alternative to expensive in-state choices. This will continue to bolster portfolio diversification and yield, net of state tax considerations.
The weak economy is certainly altering the budget plans of most municipalities. However, unlike the widespread damage to the private sector caused by the combination of the recent disaster and earnings weakness, municipal sectors are not affected as much. Because of this, investors view the municipal market as a safe haven. Even after factoring in recent yield spread widening throughout most corporate bond sectors, municipal bonds still offer competitive yields on a taxable equivalent basis and with less event risk.
As pointed out in our taxable bond comment, at some point, longer maturity investments may come under pressure as the stock market begins to improve and inflation hawks view the Fed actions as overly aggressive. Owing to the rate connection of tax exempt bonds to taxable counterparts, we are limiting positions beyond 10 years to 15%.
This year should be a very good year for municipal investors. However, we believe we are entering a transition period that may be marked by increased price volatility. We will continue to emphasize quality in portfolios using only call-protected holdings with maximum liquidity. The markets are unforgiving to those who hold deteriorating credits or structures riddled with redemption provisions. We remain prepared and confident that tax-free bonds will continue to play an important role in risk reduction while still providing a favorable return over inflation.
