April 13, 2023 | Cameron Parkhurst
Spring is upon us!
It’s hard to believe that we are entering Q2 for the 2023 calendar year. Spring is normally an exciting chapter of each year. Children are in the last few months of school and are getting excited about the prospects of summer. Adults are doing spring cleaning around the house and are taking inventory of items that may be used less in order to create room for new objectives for the year. For us fixed income traders and managers, it is also a time to be doing spring cleaning of our own portfolios in a literal sense.
We are in the process of conducting global portfolio reviews for many of our Advisor clients and we believe it is quite a good time to be doing so. In conversations with financial planners, safety of principal has come back to the forefront in discussions. Obviously, many are concerned about the Silicon Valley Bank, Signature Bank, Credit Suisse/UBS situations, and thus are asking questions about the credit worthiness and overall positioning of their portfolios. Many are asking how broadly any further contagion could expand across the banking sector and how strong of a flight to quality we may see in bonds. Thus, we will take some time in this commentary to directly address the municipal sector and why we feel very comfortable with its historical credit quality parameters and minimal default rates compared to other fixed income sub-asset classes.
We will also take a few moments to weigh in on the other primary leading questions that we have heard from RIAs. Most are obviously concerned about lingering inflation, the employment picture remaining strong and how these two forces are helping to guide the Fed. As a corollary, some are also inquiring as to how high we believe the FOMC could take Fed funds, and what impact a higher than forecasted Fed Funds rate could have on the overall economy throughout 2023 and 2024.
So, first, a historical look at munis from a safety of principal standpoint.
We have shown similar charts in the past, but this is one of the easiest to read. It shows historical default rates of munis (lime green) relative to corporates (dark green), across the credit curve. One can clearly see a couple of important characteristics. First, for A and better credit quality munis, the historical default rate over the last 50+ years has been virtually 0% for munis and 1% for corporates. Even when adding in BAA securities to cover all of investment grade ratings, municipals have an average default rate of only 29.5 basis points (0.295%) across the entire investment grade landscape. As the chart shows, BAA corporates default three times more often than BAA munis, albeit both default rates are low. Additionally, BAA corporates comprise almost 50% of the corporate landscape, while they only amount to 6% of overall muni issuance. Munis typically hold higher ratings because of strength in the ability of municipalities to draw on reserves, change tax rates, cut spending and use other avenues to pay off debt over time.
Even if we broaden our look across high yield fixed income, one can clearly see that the historical default rate of munis is far less than that of corporates. Across the quality spectrum, munis have shined from a safety of principal perspective. This is a major reason why we support having a high allocation to either tax-exempt or taxable municipals depending on account type and tax situation of your client.
Furthermore, looking at general credit fundamentals, municipal balance sheets are very strong right now. While each micro-economy is different than the next, with a broad brush we are looking at a favorable foundation for most local municipalities. Tax bases are high, most local governments have filled coffers including accepted recovery funds and many have high reserve fund balances. These are important points when evaluating the strength of muni bonds currently, especially with the expectation that we may enter an economic slowdown and recession in late 2023 or 2024.
On a recent institutional advisor fixed income conference call by Alliance Bernstein, we saw an interesting poll question. The results from RIA and registered rep participants are below:
With most Advisors being concerned about credit deterioration, we feel that discussing the above is very important. If you are one that has concerns about portfolio credit, and how it might hold up in an economic slowdown, you should be able to breathe easy in knowing that we look at 50-years of default rate history above (including growth periods and recessions), and that municipalities are coming into any potential slowdown from a foundation of financial strength in this cycle.
We have seen anecdotal newswire postings regarding the strength of state balance sheets as well. One example is the state of Illinois. For many years, some RIA clients have had a mandate to avoid IL bonds altogether. While we often disagreed with this from an overall investment point of view, in many cases it made sense when overlaying financial planning goals and expectations. As we continued to favor a high-quality approach, some RIAs opted for this route, as there were other options out there that would involve fewer discussions between an Advisor and their less investment savvy clients. Thus, we went along with some mandates to avoid IL. We are now pushing back in most cases, as IL seems to be a good turnaround story. We have seen positive momentum in IL state bonds due to credit upgrades by both S&P and Moody’s, along with better-than-expected state revenues. With positive news has come yield spread compression, benefiting bond holders who did purchase IL in years past.
We are also having discussions about the inverted yield curve, the Fed and their rate hike initiative. Dialogue typically revolves around the probability of future recession and how any slowdown may impact bond portfolios. There are obviously many moving parts to this discussion. We will unpack them here.
First, the yield curve is currently highly inverted. Inversion is a very unstable rate environment and is atypical. Strong inversion is a very telling recession indicator. The current Treasury curve, via Bloomberg, is seen below (green line) relative to June of 2022:
With inversion having a near perfect track record of prognosticating recessions, and with the Fed taking a stance of being aggressive to rein in inflation, we believe that the probability of a hard landing is increasing significantly. With this, obvious questions come up regarding positioning of bond portfolios.
There are also numerous pieces of anecdotal evidence showing economic deterioration, including bank lending standards tightening and money supply contraction.
We often discuss our love affair with long term charts. These historical views, with a long-term track record, tell a compelling story. If we look above, we have never seen tighter bank lending standards outside of recession. Similarly, below, one can easily see the money supply contraction. Many see this as an economic warning sign, and M2 has never fallen this fast.
So, what happens when we enter recession? We saw in the charts above that defaults in investment grade muni bonds are indeed rare. However, one can expect waves of downgrades as any economy slows. With that, it is our job to have a focus on security selection and in biasing our portfolios towards those sub-asset classes which will have the ability to withstand a temporarily faltering economy. Thus, our focus continues to be on the higher credit quality areas of the municipal investment landscape.
Our focus includes general obligation bonds (backed by taxing authority), school districts and charter schools, essential service revenue bonds (water/power/sewer/etc.), larger transportation hubs/toll roads, larger university systems/medical teaching institutions, some quality housing bonds (especially if at a discount or close to par), affordable housing bonds, among other sectors. We also favor bonds that include protective covenants such as state aid, school funding programs, muni insurance, pre-refunding/escrow provisions (Treasury backed). These are all areas that are seen as the highest quality components inside of an already strong muni landscape.
Secondly, we do not want to be afraid of duration in this market environment. Although rate volatility is up, and we are seeing weekly swings in the benchmark 10-Year Treasury, we continue to see the general rate landscape as attractive for the long-term bond investor. We have tested the 4% 10-Year Treasury level a few times and that seems to be a well-defined ceiling in this cycle. Additionally, we continue to have the food fight between the inflation numbers and then other variables causing short-term (and seemingly panicked) flights to quality (and thus lower rates). In these times, we have been retesting a 3.30% floor quite frequently, followed by retracements back to 3.60% 10-Year.
While we believe that we could see 4% on the 10-Year again in this cycle, that level seems to be an aggressive buying opportunity. 3.40% and higher is also attractive for the buy and hold bond investor, as we fully expect lower rates should we enter a strong economic slowdown or recession. Keep in mind that most of what we
buy in portfolios on the taxable side is high-quality spread product. So, in many cases when the Treasury is in the mid to high 3%’s, we are getting taxable yields in the mid to high 4% level, and in many cases above 5%. If we were betting people, we would be positioned for lower rates vs. higher as we move towards the end of 2023 and into 2024, with the Fed winding down their rate hiking campaign, with the strong likelihood of recession, and with many analysts believing that rate cuts are on the horizon.
Coming out of a recessionary environment, we also expect the yield curve to resume its typical positive slope while rates fall. Thus, there could be reinvestment risk for those piling money into the short-term area of the inverted curve.
Should rates fall, bonds with higher duration will exhibit larger price appreciation than those shorter-term vehicles where rate movements have less impact. This is why we advocate for playing both sides of the fence through well-diversified bond ladders (geographically, across sub-asset classes, credit, etc.).
Inside of a laddered approach, we can have some exposure to the front end of the curve which is currently rewarding investment. However, we also will have maturities structured systematically across the yield curve and will have consistent maturing principal. Thus, maturing principal will be reinvested each year back into the ladder where it makes sense based on the economic environment and curve shape. During times when rates are higher, one will reinvest back into the portfolio and raise the economic yield expectation. During times when we see lower rates, systematic portfolio reinvestment will be at lower yields (but still higher than 2021 levels) and held intermediate term bonds will experience price appreciation on paper.
The key to these portfolios involves the high-quality approach (to avoid economy-based volatility), squeezing out incremental yield (by utilizing the bid side of the market and in buying odd lots), and making marginal duration adjustments as it makes sense based on the rate cycle.
With the likelihood of recession rising, and with a strong feeling that the Fed is closing in on the end of its rate hiking campaign, we want to make ourselves available to each Advisor client. We feel that it is a very prudent time to conduct global and household portfolio reviews for credit, duration and many other parameters. The goal is to be well-prepared and in front of what we see coming as we close out this year. We believe that we will have good opportunity to add safety of principal and participate in currently attractive yields. We also feel that this is a great time for you to be contacting prospective clients and using bond portfolio analysis and conversation to grow your AUM. We can be instrumental in helping you with your endeavors on that front as well. Please don’t hesitate to reach out and to leverage our expertise to help your firm grow.
Your PeachCap Fixed Income Team
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