Tax Exempt Fixed Income Strategy
Municipal bonds continue to reward investors with stellar returns. Even as interest rates reach levels not seen in over 40 years, there remains a huge demand for this asset class, especially in the wake of a weak stock market. However, unlike the taxable corporate bond market, where fears of credit deterioration have significantly impacted performance, credit scares seem far from the minds of most tax-free investors. We must remain mindful that many housing and hospital issues have now failed and 15 states are now on negative credit watch, with several states including California already experiencing downgrades. Unfortunately, many states’ expenditures are still growing and there seems to be a general lack of budget discipline, especially with 33 state governors up for election in November. Adding to the list of concerns is the growing number of underfunded state pension plans. Unfortunately, part of the solution for the states has been to reduce subsidies or shift the burden of various programs down to the local level. On the other hand, strong housing values continue to be a dependable property tax revenue source for cities and towns.
In light of these concerns, we continue to tighten our credit standards and seek more information or financial disclosure on each issue. As in the past, we require that all investments hold a minimum credit ranking of Aa. In fact, the vast majority of our positions are triple A rated with insurance. In addition, as interest rates hover at historic lows, we are avoiding many new deals that offer only low market level coupon structures. History has taught us that above market stated coupons provide a level of protection against the possibility of rising interest rates. This strategy is in sharp contrast to the huge demand from individual investors who prefer lower coupon or par bonds. Should interest rates rise at a later date, we fear the market value of these lower coupon bonds will fall well below “de minimis” thresholds (which could result in a portion of the return being taxed as ordinary income) wherein the security’s value would have to adjust even more to compensate new investors for taxable consequences. Independent of this consideration, newly issued bonds at this time are being priced at levels too expensive to attract our interest.
To improve the overall yield in client portfolios, we have begun to purchase callable type securities. Consistent with our taxable bond strategy, we are careful to only buy bonds with a high coupon structure and narrow separation between expected call dates and stated final maturity. Unlike the previously discussed newly issued bonds, we are able to capture higher yield and garner some market protection in the event interest rates rise.
As you are aware, there are endless debates from both economists and politicians on how to improve economic growth. While the new income tax rate adjustments provide some tax relief and disposable dollars for future consumption, they may create a loss of tax revenues to states, unless more growth translates into an increase in sales tax revenues. Under the new guideline, the top 38.6% federal income tax bracket in 2003 won’t kick in until taxable income exceeds $311,950 for joint filers. That is an increase from $307,050 in 2002. However, this incremental adjustment should not significantly alter the demand for tax-free securities or force yields to move higher.
Recently, the California Treasurer announced the planned launch of $11.95 billion bonds to pay back money the State borrowed from itself and others to purchase electricity for its residents. This bond program represents the largest such municipal bond transaction in the nation’s history. At Oakwood, we are likely to avoid these issues, owing to their unacceptable lower investment grade rating. In addition, with most California bonds now at abnormally low yield levels versus out of state counterparts, we plan to reverse our prior program of successfully swapping back to California. Once again, by now going out of state, we can capture more than enough yield to pay state taxes and further improve portfolio quality and diversification.
Please be aware that municipal bond issuers, unlike public companies, are not required to file quarterly financial statements. Recent reports suggest that 40 percent of issuers provide inadequate disclosure. We have responded by stepping up our internal research efforts. Furthermore, with yields at historic low levels, paying too much for trade execution can easily negate future returns. Institutional trade execution now more than ever is essential to the implementation of a well thought out investment plan. On balance, we continue to view tax-free bonds as a good investment choice for high tax bracket individuals, despite the potential for some further credit weakness. We feel our disciplined process and risk sensitive approach to managing portfolios will serve our clients well in achieving their investment objectives.
