Municipal Bond Commentary
The Allure of Munis

Unprecedented developments are having a dramatic im-pact on all bond yields. In the taxable market, investors are taking losses in their corporate and mortgaged-backed holdings and shifting to the safety of U.S. Treasury securities. The frantic dumping of supply is cratering prices, raising yields, and driving spreads to historic levels. The municipal bond market has also been selling off, but to a lesser degree than corporates, due to general fear and, in many cases, to meet equity market margin calls. Much of the selling is matched by solid investor demand. In fact, as 10-year Treasury yields dropped to 3.60%, comparable 10-year high-quality municipal bonds currently yield well over 4.00% before consideration of the tax benefit. As many municipalities postpone new deals due to the general market pandemonium, secondary markets reflect a continuing imbalance favoring tax-free bonds.

Navigating this environment
Market dislocations reflected in unprecedented volatility are creating a noticeably wider gap between the bid and offer side of municipals. This reinforces our requirement to utilize multiple sources to determine the proper price prior to making new purchases or sales.

Owning the best of the best
Oakwood’s policy is to own only very high-quality bonds regardless of insurance backing. In the current environment where insurers’ viability is questionable, this strategy is working well for us. It improves liquidity and helps close any potential gap that might exist between valuations on portfolio statements and the actual sell order into the market.

Monitoring fiscal health of states
For the balance of the year we aim to maintain our current portfolio duration target of less than 5.25 years. Despite the natural temptation to extend maturities to achieve higher yields, the economy’s shakiness brings with it legitimate concerns that municipalities may suffer a significant decline in tax collections. We will surely see this in California. We have embarked on a state-by-state study to identify those that continue to operate in the black. This will guide our future purchases.

The buffering effect of munis
The market’s focus remains on Capitol Hill, credit markets, and the banking sector. With so many unprecedented events contributing to uncertainty, we think it wise to stay flexible and not draw any firm conclusions. Oakwood’s municipal bond strategy provides an excellent alternative to riskier investment choices. While overall performance in client portfolios year to date remains essentially unchanged, our approach, specifically designed to protect on the downside, is proving invaluable during troubled times.

Tax-free bonds remain an excellent alternative or complement to stocks. For investors in a maximum tax bracket, the 10-year municipal bond yielding 4% equates to a taxable equivalent yield of 6.15%. This results in the potential to generate returns similar to stocks with less downside risk. Even government-backed pre-refunded bonds trade at levels higher than Treasuries, without an adjustment for taxes. We would not be surprised to see more and more institutions adding municipal bonds to their taxable portfolios. At some point, the relationship between these two asset classes will return to an historic norm. When this occurs, investors will be rewarded with additional principal appreciation from tax-free bonds. The chart shows current tax-free yield levels and their taxable equivalents.