The first quarter of 2017 proved to be rather uneventful for the municipal bond market. This is actually good news. Contrary to some expectations, the market did not sell off and the seasonal pick-up in new municipal bond issuance did not materialize. Debt issuance was 11% below last year’s first quarter volume, which helped market performance. The Bloomberg Barclays Municipal Bond Index has returned 1.58% year-to-date, as of March 31.
Buyers have shown a preference for short- and intermediate-maturity securities, which has led to lower interest rates and rising prices along this segment of the yield curve. Long-term interest rates experienced minimal change during the quarter. Tax-exempts have been able to extend their late-year price gains through early 2017.
SMC FIM maintains that it is advisable for fixed income investors to stay invested. Failure to maintain a fully invested portfolio posture can be costly. This rule holds true even if interest rates increase. The following hypothetical example illustrates this point.
Note: The simulated examples herein are for informational purposes only and are not necessarily indicative of actual or future results. Simulation returns would be reduced by transaction costs, expenses and our management fees which will be borne by client accounts, which in aggregate may be expensive. There are inherent limitations in simulated results, particularly the fact that such results do not represent actual trading and that they may not reflect the impact that material economic and market factors might have had on the adviser's decision-making if the adviser were actually managing clients' accounts. It should not be assumed that any of the securities transactions or holdings discussed was or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. Additional information regarding SMC FIM’s fees is included in Part 2A of its Form ADV.
The chart above summarizes SMC FIM’s analysis quantifying how much tax-exempt income an investor with a five-year horizon foregoes by not committing to be fully invested in the bond market over the entire period. In this example, the investor sacrifices $3,500 of tax-exempt income by attempting to "time the market." If interest rates increase over the course of one year, the lost income cannot be recouped, as detailed below. The loss of income diminishes investment performance.
The graph below highlights the two investment options. An investor with $1 million to invest and a five-year time period can purchase a municipal bond today at a yield of 1.55%, based on the current yield curve (green). Alternatively, the investor can wait until the following year, when the yield curve shifts higher (blue) due to a 50 basis point interest rate increase, and then purchase a four-year bond at a yield of 1.85%. (Bear in mind that by waiting one year until 2018 to invest, the investor only picks up 35 basis points of additional income due to the yield curve shift.)
The chart below illustrates the cumulative annual income payments under both investment options. By choosing the second option, the investor has lost income. This choice translates into sub-optimal investment performance over the five-year investment timeframe. Choosing to remain uninvested for the first year, by withholding the $1 million from the market, was disadvantageous. Despite eventually investing in the second year at a higher yield, following the interest rate upswing, the investor never recovered the foregone first year loss of coupon income. Waiting to invest cost the investor $3,500. Investing before the interest rate increase would have been the correct financial decision.
SMC FIM’s analysis supports the need to maintain a fully-invested municipal bond investment posture; market timing can be a sub-optimal investment strategy. In our opinion, selective yield curve positioning, duration management and security selection should be the key considerations in optimizing portfolio performance. These factors are more critical in determining performance than market timing and should be considered.
The information provided in this commentary is not intended to be a complete summary of all available data. Certain information contained herein has been obtained from published sources and/or prepared by sources outside SMC Fixed Income Management ("SMC FIM"), a division of Spring Mountain Capital, LP, and certain information contained herein may not be updated through the date hereof. While such sources are believed to be reliable, no representations are made as to the accuracy or completeness thereof by SMC FIM or any of its affiliates, directors, officers, employees, partners, members or shareholders, and none of the former assumes any responsibility for the accuracy or completeness of such information. Nothing contained herein shall be relied upon as a promise or representation as to past or future performance.
This commentary is neither an offer to sell nor a solicitation of an offer to purchase securities, any other investments or any other product sponsored or advised by SMC FIM, nor does it constitute an offer or a solicitation to otherwise provide investment advisory services. Such an offer or solicitation may be made only by the relevant documents for the relevant investment vehicle and/or investment program. This commentary is not, and may not be used as, a recommendation of any security, investment program or vehicle. There is no assurance that any securities discussed herein will remain in a client's account at the time you receive this commentary or that securities sold have not been repurchased. The securities discussed do not represent the client's entire portfolio and in the aggregate may represent only a small percentage of the client's portfolio holdings. It should not be assumed that any of the securities transactions or holdings discussed was or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein.
Statements contained in this commentary that are not historic facts are based on current expectations, estimates, projections, opinions and beliefs of SMC FIM. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon. Unless specified, any views reflected herein are those of SMC FIM and are subject to change without notice. SMC FIM is not under any obligation to update or keep current the information contained herein.
This commentary does not take into account any particular investor's investment objectives or tolerance for risk. The information contained in this commentary is presented solely with respect to the date of its preparation, or as of such earlier date specified in it, and may be changed or updated at any time without notice to any of the recipients of it (whether or not some other recipients receive changes or updates to the information in it).
No assurances can be made that any aims, assumptions, expectations, and/or objectives described in this commentary will be realized. None of SMC FIM or any of its affiliates, directors, officers, employees, partners, members or shareholders shall be liable for any errors in the information, beliefs, and/or opinions included in this commentary or for the consequences of relying on such information, beliefs, or opinions.
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