Tax Exempt Fixed Income Strategy
During this past quarter, the municipal bond market re-mained surprisingly stable, in the face of another three Fed interest rate hikes since June 30, 2005, and two very destructive hurricanes. It appears that investors are confident that the Fed will be successful in its efforts to fight inflation. However, there is much uncertainty surrounding the impact that the storms will have on the economy and the bond markets. For example, prior to the natural disasters, it was easier to monitor the direction of the economy. Economic indicators, including the unemployment rate and consumer confidence, were on a steady path of improvement. Now, market participants must decide the difference between short term disruptions and changes in longer term fundamentals. Complicating this issue is a lack of understanding as to how the Fed will handle monetary policy in the future. Therefore, until the picture becomes more clear, the municipal bond market should remain near current levels with day to day shifts in market sentiment.
At Oakwood, we have repeatedly emphasized the importance of an individual security’s underlying credit quality, independent of any supplemental insurance or credit support. While most analysts are in agreement that municipal insurance carriers will be able to handle interest payments in the event of defaults or cash flow disruptions, a financially strong municipality will retain both market value and liquidity. History shows that tax exempt municipalities are more likely to avoid bankruptcy and to endure hardship than are taxable corporations.
We also have encouraged all clients to diversify their fixed income investment choices. Heavy concentrations in a particular industry, sector or geographic area can expose portfolio holdings to regional mismanagement or natural disasters in an isolated region. We feel investors are not being properly compensated to take on more risk in these areas. Often, investors don’t even notice that they are creating imbalances that can leave them vulnerable.
The markets should continue to trade in a somewhat narrow range for the balance of the year. Furthermore, the supply of new municipal securities should be manageable while yield relationships between tax-free bonds and taxable bonds favor municipals. As shown in the following chart, we like the 10 to 15-year maturity area, where the yield differentials are approximately 90% of their equivalent US Treasury.
While the yield curve (comparison of short rates versus long rates) in the taxable market is completely flat, in the tax-exempt market, investors receive added yield for the added risk of investing in longer maturities. In fact, at present, a 15-year tax free bond yielding 4.20% has a taxable equivalent yield, based on the highest tax bracket, of around 6.45%. By comparison, a similar high quality taxable corporate bond yields 5.45%. For your review, we show current yield levels with taxable yield equivalents, throughout the maturity range.
It is important for investors to separate views based on short-term factors versus long-term trends. We believe the Fed will remain diligent and concerns over inflation should be resolved soon. Until the Fed calms these fears, returns will continue to be modest. We have been successful in protecting market value in client portfolios. Looking ahead, our goal remains to hold only the highest quality securities with maximum diversification. On a daily basis, we are making modest changes in portfolio structure, in advance of a more favorable market environment. In this process, it is essential that we avoid overpaying for new purchases during short periods of market rally and maintain maximum liquidity in order to take advantage of opportunities as they surface.
