3Q 2020 — Tax-Free Fixed Income

Jamie Mullen
Senior Portfolio Manager
Neal DeBonte
Portfolio Manager

Comfortably Numb?

The Bloomberg Barclays Municipal Bond 5-year Index turned in a 1.32% return for the quarter ending 9/30/2020. Nearly all of the quarter’s performance can be traced back to the period of 7/1 to the peak on 8/10, with the index up 1.51%. After a small retracement, the markets basically traded sideways for the balance of the quarter.

While one could celebrate the returns for the quarter overall, performance through mid-August is nothing new. Seasonal patterns leave the market flush with cash, taxes have been recently paid, leaving the populace wanting to shelter more of their hard-earned money, and new issues are slower coming in as bankers, underwriters and the market in general enjoys what’s left of summer. 2020’s performance was enhanced by the bounce from the March/April liquidity crunch at the onset of COVID. More interesting is the performance following 8/10 in each of the last 5 years:

The Bloomberg Barclays Municipal Bond 5-year Index (8/10-10/1 performance)

2020 -0.17
2019 -0.94
2018 -0.55
2017 -0.24
2016 -0.34
2015 0.5
2014 0.42
Source: Bloomberg as of 10/1/2020

2020’s tail end went dormant. The traditional municipal ides of fall: when investable cash dries up, deals accelerate, the weather chills as does the traditional muni demand model. In five of the seven periods above, the market experienced losses. This effect becomes magnified with the institutionalization of the market. With so many following similar protocols, the market falls into a numbing slumber… Hello? Hello? Hello? Is there anyone out there?

Just nod if you can hear me…

The market did steepen in the 3 to 30-year measure by approximately 11 basis points, with the overall market experiencing the strongest gains 3 to 7 years. What was once a paltry 0.29 yield in 3 years currently stands at around 0.16. Munis out-steepened Treasuries by 4 bps and it was all front end loaded. Is there anyone home?

Yes, plenty are home and doing what they usually do in times of uncertainty—running to the earlier maturities. This demand took the front end on a wild ride if we use ratios to Treasuries as a surrogate to measure muni demand.

In the 3-year tranche, the yield as a percentage of Treasuries went from 150% on July 1st, to 56% on August 11th to 101% to close the quarter. I believe ratios would be even lower if not for the level of absolute yields. 16 basis points of yield is, well, just 16 basis points of yield. Talk about numb… the move in muni yields in 10 years was a whopping 1 basis point, and 30 years only moved 2! Complacency in a market should always be suspect, as should outsized moves, both of which were displayed in the most recent quarter. Drifting markets tend to drift lower, so it will be interesting to see how the coming weeks behave.

Well I can ease your pain, get you on your feet again…

The move lower in yields overall was driven by economic data, a supportive broader fixed income market, and a multi-year low in market volatility. But remember, the ides of fall are upon us… and the market is abuzz with fear of outsized supply concerns, political uncertainty and a coming election, and a general malaise in activity at these levels.

By many measures, the argument can be made that the front end is overbought. But the wave of supply as broadly quoted is missing one vital piece of information… Relax, I’ll need some information first… and that information is that 30% of the third quarter supply came as taxable municipal debt. If one considers AMT tax paper, that number grows to 35%.

Any severe price depreciation in the coming quarter may be nominal, as “real” munis, the triple tax-exempt ones, are not experiencing the massive growth the pundits would lead us to believe. To that point, the closing week’s supply in California was 90% taxable— 90%! That does hurt an investor in a high tax state that is seeking to protect themselves from taxes. Remember the complacency we referenced earlier in the longer end of the curve? At least the complacency is reflected in more appealing relative value to Treasuries, as 10 years currently stand at 125%. That ratio alone is an indicator of value versus the front end. Further, the lack of steepness in the curve was finally cured this quarter, by the exact move in the front end we are referencing.

Just the basic facts, can you show me where it hurts…

Well, if you are residing in New Jersey, higher taxes will hurt, especially for those in the top bracket as it will be increased to 10.75%. This just when the state also announced $5.4 billion (yes, billion) in borrowing to meet shortfalls. The Governor did make brief mention of perhaps borrowing from the MLF facility, administered by the Federal Reserve for municipal borrowers.

Tapping that facility this past quarter was New York’s MTA, as traditional issuance proved price-prohibitive for them. While we are discussing NY, the fourth quarter is usually outsized in issuance for city and state-level agencies, and this year will not be different as NYC is on pace to issue over $1 billion, DASNY will issue $2.5B in mixed taxable and exempt, and the TFA has about $500 million on tap. All are names that can cheapen the New York market while at the same time making differentiating credits in NY dearer.

There’ll be no more, AHHH! But you may feel a little sick…

So, we leave the third quarter behind— a roller coaster of ratios, increased credit fears and an intense focus on new issue supply, or lack thereof, depending how it’s measured. We also leave behind an extended period of rate stagnation, as liquidity became tighter and price fluctuations narrowed. All of these factors lead to a cautious entry into the fourth quarter.

I caught a fleeting glimpse, out of the corner of my eye…of some of the factors that may help ease these coming headwinds. In reviewing data since 2014, it’s interesting to note that in the 5-year maturity tranche, the benchmark 7-year rate fell 7 times and went up 7 times. Its ratio to Treasuries fell 3 times, but went higher 11 times. Further out, the curve the 15-year maturity moved lower 10 times and higher only 4. Its ratio shrunk 9 times and increased 5. So, while there is perceived safety in the front end, history shows that may not always be the case. Moving forward, we will stay our course and continue to purchase bonds that meet our credit requirements, including, but not limited to: tax-backed school districts including those with recourse to state aid, regional school districts and colleges with solid financials and stout endowments; revenue backed bonds with a performance history; and essential service bonds in identifiable municipalities.

We have reduced our holding of credits that have been under pressure financially as well as those that face headline risk. To that end, we have reduced our exposure in Healthcare as spreads for the last year have pointed to underperformance and have a higher risk of widening. As new deals begin to come with longer maturities and 2031 calls, we feel the “roll-down” effect in our position of bonds with calls ranging from 2026 to 2029 will appreciate as their term rolls down at the new year. Further, buying callable bonds in lieu of solely buying bullet maturities allows us to lock in better percentages of Treasuries while still managing duration. Considering estimates show that only 10% of callable bonds, or less, ever make it to maturity, we believe it is an attractive option to lock in better yield.

We have not become comfortably numb.

The views expressed are those of the author(s) and do not necessarily reflect the views of Clark Capital Management Group. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. There is no guarantee of the future performance of any Clark Capital investments portfolio. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation, recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies. For educational use only. This information is not intended to serve as investment advice. This material is not intended to be relied upon as a forecast or research. The investment or strategy discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial circumstances. Past performance does not guarantee future results.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in market value of an investment), credit, payment, call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase)
The Bloomberg Barclays 5 Year Municipal Bond Index is a capitalization weighted bond index created by Bloomberg Barclays intended to be representative of major municipal bonds of all quality ratings with an average maturity of approximately five years.
The Bloomberg Barclays Municipal AAA Index is the AAA component of the Bloomberg Barclays U.S. Municipal Bond Index
The Bloomberg Barclays U.S. Municipal Index covers the USD-denominated long-term tax exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and prerefunded bonds.
The Bloomberg Barclays US Intermediate Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by US and non-US industrial, utility and financial issuers that have between 1 and up to, but not including, 10 years to maturity.
The Bloomberg Barclays US Treasury: 10-Year Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury with 10 years to maturity.
Municipal securities can be affected by adverse tax, legislative or political changes and the financial conditions of the issuers of the municipal securities.
Municipal bonds can be significantly affected by political and economic changes, including inflation, as well as uncertainties in the municipal market related to taxation, legislative changes, or the rights or municipal security holders. Municipal bonds have varying levels of sensitivity to changes in interest rates. Interest rate risk is generally lower for shorter-term municipal bonds and higher for long term municipal bonds.
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