Tax Exempt Fixed Income Strategy
The municipal bond market continues to surprise most market forecasters as the Fed’s action to nudge up short term rates is met with concerns of a waning economy. Through the first nine months of 2004, even conservative intermediate tax-exempt strategies captured returns of around 2.5%, translating into a taxable equivalent yield of 3.9%. This is well above the skeptics’ predictions who forecasted negative returns accompanied by significantly higher interest rates.
We did not share the skeptics’ viewpoint and instead interpreted the shift in Fed policy as an effective tool to fight inflation and build confidence in the markets. In fact, during the quarter, we reversed our somewhat defensive stance that restricted the purchase of longer securities and the general shortening of portfolios triggered by the passage of time. As a result, we extended our duration target to 5.25, from 4.50. This is modestly longer than the Merrill Lynch 3 to 7 Year Municipal Bond Index, whose duration stands at 4.25.
One measure to determine the relative attractiveness of tax-exempt bonds versus taxable Treasuries is the yield ratio. We perform this calculation on various maturity areas throughout the yield curve. As shown in the following chart, based on a one-year comparison, the yield ratios in the five-year area at 78% and long area at 95% are attractive. In fact, we like a combination of these two maturity areas as an alternative to the 10-year area which is less attractive on a risk-adjusted and historical basis.
Recent hurricanes hammered Florida and surrounding states, leaving behind devastation and significant hardship. However, municipal bond investors should take comfort that there is ample governmental support behind the rebuilding process. Historically, there have been few ratings downgrades to municipalities as this assistance flows in. After a review of client holdings, we see little impact on their market value and no deterioration in their Aa and Aaa bond ratings.
We have always favored general obligation versus revenue debt support, unless the debt service payments flow directly from a specific revenue source (i.e. toll road fees or direct user charges). Additionally, general obligation bonds usually have better access to federal and state assistance programs with a greater flexibility to levy taxes for any anticipated shortfall. Further validation that these storms have had little impact on bond values is the unchanged yield relationship on Florida debt compared to other non-affected areas of the country.
As pointed out in the Taxable Fixed Income Strategy, higher oil prices create a dilemma for the Fed. The Fed understands that raising interest rates in the face of rising oil prices can hurt the economy, however, if they do not respond, inflation may become a greater problem. We believe their decision to focus on inflation in the face of a waning economy is the correct course of action that will ultimately lead to economic stability and continued low inflation. For the balance of the year, we will use periods of market pullback as an opportunity to make new purchases or reinvest coupon payments at attractive yield levels. As always, we continue to emphasize buying only the highest quality investments to obtain maximum liquidity and performance potential and remain ready to change our current investment structure if market conditions change.
