Tax Exempt Fixed Income Strategy
The municipal bond market is following the performance trend of taxable fixed income securities, as market conditions improve dramatically from a July setback. As a result, the year-to-date municipal bond returns are in positive territory, just as they are for the taxable markets. We are especially pleased with these results as municipal bonds typically underperform their taxable counterparts during periods of market rally. Contrary to historical precedent, the supply of new municipal securities entering the marketplace is somewhat scant. However, investors continue to feel a sense of comfort in this lower risk asset class. This is especially true as the economy struggles to establish solid growth and as inflation remains subdued.
Looking forward, we expect that municipal bonds will continue to follow the tendency of taxable markets. As a result, we believe the same factors affecting taxable bonds will prevail with tax-free bonds. This includes future economic direction combined with job trends and the impact of recent tax cuts on consumer spending patterns. We will also continue to monitor the direction of oil prices because of its influence on industrial growth, automobile sales, discretionary spending patterns and the prices paid for all goods and services.
As pointed out in the taxable strategy section, a concern to be closely watched is the recent upward trend in commodity prices. As stated previously, economic activity is not the catalyst to higher interest rates; inflation is. Fortunately, with the exception of a recent rise in commodity prices, there has been little evidence to support higher inflation. In fact, fears of deflation continue to support the Federal Reserve’s position to maintain a low interest rate policy.
Meanwhile, we continue to enhance portfolio yield by seeking out select callable bonds, primarily in the intermediate maturity area, with the expectation that most of these bonds will be called away early. In this low yielding climate, the added yield from this strategy versus similar maturity non-callable bonds is a welcome addition to total return. To protect the portfolio against a possibility that these securities could extend to their final stated maturity, we emphasize an above market high coupon structure and select only issues with a very narrow separation between their shorter call dates and their final stated maturity. To validate our return expectations, we perform a return study whereby we view the return behavior of our choices under a variety of interest rate scenarios.
Our past decision to purchase non-California bonds in California resident portfolios, for diversification purposes and an after tax yield advantage, was a good one. The out-of-state bonds have outperformed in-state bonds as yield levels compress and are on parity with California municipalities. This strategy will continue to provide us with an opportunity to swap back to California, with a minimal loss of yield and an after-tax advantage. We began this process several months ago as high quality investment candidates surfaced.
For the balance of the year, we will continue to manage portfolios using a very disciplined selection process. We will adhere to our high quality standards, which include avoidance of all general obligations of the State of California, until there is clear proof of fiscal discipline, sustained economic growth and the potential for quality improvement. In addition, we seek small return advantages by swapping existing bonds in favor of alternatives, which we believe will add value. This includes the select selling of very short, low yielding positions, in favor of intermediate bonds that provide modest yield increases. We urge investors to remain patient with their asset allocations and resist the confusion caused from conflicting daily market commentary or speculative forecasts. Similar to our taxable strategy, municipal bonds are set to generate positive returns for the fourth straight year and should continue to provide investors with an attractive alternative to other asset classes.
