May 15, 2022 | Cameron Parkhurst
Last week we published a short missive regarding historical performance of munis when the Fed has acted. This week, we want to take a closer look at the current market, as it can drive portfolio management decisions for you as an Advisor to your clients.
In a sentence, investment grade munis are cheap relative to most any other investment grade bonds right now. In fact, while munis averaged approximately 75% of comparable Treasuries over the last year (and many times some tax-free bonds falling towards 50-60% of Treasuries), that ratio has climbed dramatically this year, and this week hit 98% of Treasuries.
While the first third of 2022 was extremely challenging for fixed income, with many investment grade sectors down 10%+, many Advisors seem focused on what the Fed “is going to do”, rather than evaluating potential opportunities that have been created. We believe that we are looking at an opportunistic municipal market, with much of the rate move having been already priced in. Thus, there is opportunity for both tax loss selling and repositioning, as well as taking advantage of a cheap marketplace on the bid side when deploying new capital.
Municipal Valuations
With growing geopolitical concerns led by the Russia-Ukraine war, and with inflation seemingly accelerating, bond market volatility has generally increased. Although the municipal markets usually will have a more muted move than others, we still saw the rate on a 10-year AAA bond move from right at 1% to now almost 2.90% for new issues. From these levels, many secondary market bonds are now able to be bid in the high 3% level, meaning tax equivalent yields are above 5% in the highest of tax brackets. That’s very significant, as it is beginning to be additive when using historical financial planning models with a 4% bogey for fixed income.
All of this is coming at a time when we are seeing almost a 3:1 ratio of upgrades to downgrades by major ratings agencies, and with state tax collections growing in the 20-25% range on average. Additionally, there should be ongoing demand for municipals due to the thought that investors will deal with higher taxes in the future.
As for the supply/demand side of things, there is imbalance. Supply has waned, as municipalities will now be forced to issue debt at much less attractive levels than even 6 months ago. This also applies to calling/refunding existing bonds. There is much less incentive to refinance debt now that the curve is significantly higher. Demand is also lower, and its degradation during the bond sell off has outpaced supply, with outflows being historically high. This has helped to provide significantly cheaper bond prices, and thus future opportunity. It seems as if the retail investor is just beginning to focus on the opportunity at hand:
How to Capitalize on Municipal Bond Opportunity?
We are having almost daily discussions with RIAs regarding what to do in the current environment. The crux of our thesis is that we believe that we have seen a fairly massive move in rates. This move could be ahead of historical norms, dependent on one’s outlook of the inflation picture. We have not seen it yet but expect inflation to roll over. Some of this could be Fed induced, depending on how aggressive they get with rate hikes.
Even though this sell off has been painful, it has been orderly. Outside of a day or two, the market has not become sloppy, as it did during the financial crisis and also during the early stages of COVID-19 onset. Even with the order in the market, we have seen the worst price action in munis in essentially 50 years. With such a dramatic move, much of the price movement, even for those in the camp that the Fed may take stronger action than not, seems baked in here. Also, due to COVID stress testing, we have been forced to take another look at sub asset classes that prove their worth during times of stress, even recession.
Thus, our overall recommendation is to not be fearful of this market. More importantly, it is to focus on areas that have historically proven themselves to stand up in tough times. If the Fed is strong in their tightening, some market participants think that there could be a recession on the horizon. This would lead us to focus on a few different items regarding portfolio management.
First, a high-quality approach will rule the day. The focus will be on essential service revenue bonds, on teaching institutions, on certain strong sales tax revenue bonds, and on larger general obligation issues, etc. (and avoiding lesser quality credits).
Second, we should maintain our short-intermediate term approach, but not be scared to take on duration here. The yield curve is begging investment in the 2 to 5-year spot right now, as the municipals have some normal slope in yields, but not much. We agree that we should park some money in this shorter-term area and let it slowly mature. However, what if we do enter a slowdown and rates then fall? Having some duration in the portfolio during that time could pay dividends in the form of price appreciation. Thus, we continue to keep our laddered approach from 2-15 years primarily. For those Advisers in the camp that they expect an overtightening Fed, we don’t mind having some high-quality bonds out even further as a bit of a barbell (in order to capitalize on any future slowdown that may occur).
Third, to utilize the bid side of the market. Although this sell-off has been orderly, we have had the opportunity to pick up cheaper bonds for our Advisor clients by having the latitude to bid bonds, work our capitalized inventory, and oftentimes come out ahead of the electronic platforms with this strategy. It requires a lot more work on our end but can pay good dividends in the form of portfolio yield enhancement at the end of the day.
Fourth, evaluate tax loss selling of existing positions. This has been a seldomly used strategy in recent years (as rates retreated and bottomed), but can be rewarding in times of major market moves like we have just seen. By tax loss selling, making portfolio adjustments, and reinvesting in comparable names at higher yields, we will ultimately add to both potential portfolio economic yield and income. During this process, we can also evaluate duration and make any important fine tuning as necessary.
Lastly, evaluate a client’s tax bracket. With the recent cheapness of tax-free municipals over and above Treasuries and some other taxable bonds, it can be value additive to circle back and re-evaluate a client’s tax situation. There are many cases right now where we might even opt to buy a tax-free bond inside of a 15% Federal bracket. Depending on where we are investing across the yield curve, we are always going to be evaluating relative value and whether taxable bonds versus tax-free issues make the most sense for any particular client/household.
As you can see by reading the above, the portfolio construction process becomes more of an art than a science, all considered. Thus, we want to be your partner in this process, and help during these times that we see as potentially opportunistic. Please do not hesitate to leverage us for any of your analysis or fixed income portfolio needs. We are always just a short phone call or email away.
Thanks,
Your PeachCap Fixed Income Team
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