Seeing the Forest Through the Trees

November 2016

Aftermath of surprise election outcome

  • Aftermath of surprise election outcome
  • Challenging environment through year-end
  • Trump election may not be a mandate
  • Investment opportunity?

In the aftermath of the unexpected presidential election outcome, the municipal market has experienced its worst monthly investment performance since October 2008, the onset of the financial crisis. The Bloomberg Barclays Municipal Bond Index dropped 3.73% in November and has erased its 2016 performance gains (year-to-date performance: -0.92%). While the Trump victory caught all financial markets by surprise, the tax-exempt sector ranked near the top of the most adversely impacted fixed income sectors.

Ambitious plans for personal and corporate tax reform, large-scale infrastructure spending, and healthcare overall portend bigger federal deficits, higher inflation, and more government debt issuance. While the prospects for these proposals have ignited a strong rally in stocks, bond markets are now anticipating the end of the easy Federal Reserve monetary policy which was undertaken to aid the post-recession economic recovery. Fiscal stimulus and tax cuts will likely be the tools to invigorate economic growth in the years ahead under the incoming Trump Administration. While potentially good for economic growth acceleration, consequences appear to be in store for bonds, according to the behavior of financial markets since Election Day. The long- anticipated December Federal Funds interest rate hike is now a foregone conclusion and will likely be an anticlimactic market event after this month's activity.

A dramatic shift in market technicals contributed to the comparatively worse performance of municipal bonds versus taxable securities. In last month's Commentary, we noted the fact that a record 54 consecutive weeks of cash inflows into tax-exempt bond mutual funds was broken in October. In the post-election aftermath, over $7 billion has been withdrawn from tax-exempt funds. Mutual fund portfolio managers have been aggressively selling bonds to meet mounting redemption requests. We believe this redemption activity has placed an added burden on the municipal marketplace as reflected in larger municipal price adjustments compared to other fixed income sectors. The weight of further bond fund liquidations might continue through year-end. Municipalities looking to market new bond deals before year-end will likely encounter buyer resistance and might have to offer greater price concessions to attract investors.

Furthermore, given the dramatic divergent price movements between stocks and bonds, more investors are now considering possible year-end bond tax-swapping to offset realized equity gains. SMC Fixed Income Management For Informational Purposes Only - Subject in all respects to the disclosures at the end hereof. There has been considerable debate over the likelihood that many of the promised economic plans and reforms will come to fruition. We believe the tax restructuring and infrastructure spending proposals are important considerations for the municipal market. Lower individual income tax rates could lead to an upward tax-free interest rate adjustment in order to maintain competitiveness with taxable alternatives. However, market analysis, based on historical tax data from the Tax Foundation and municipal yields levels from Thomson Reuters, indicates changes to the value of the tax exemption does not meaningfully impact the ratio of municipal to Treasury (taxable) yields.

Municipal bonds normally yield less than taxable alternatives because of their federal tax exemption. Tax-exempt securities now offer yields equal to 100% or more of comparable taxable securities. The graph below illustrates this "cheapness" compared to U.S. Treasuries; for the most part, tax-exempt yields (green line) are above U.S. Treasury yields all along the yield curve. Based on the current relationship between tax-exempt and taxable yields, the impact of potentially lower taxes on municipal securities should not be a significant concern.

Even before the Trump election victory, market consensus was anticipating higher interest rates. Rates have been slowing rising since July, and expectations for a Federal Reserve short-term rate hike before year-end has led to upward rate adjustments throughout the maturity spectrum. We believe much of anticipated 2017 bond market weakness has been channeled into the final weeks of 2016. Volatility has been absent for most of the past year. The past few weeks have been a stark reminder of financial market capriciousness. The new Administration and its ambitious plans will likely encounter some headwinds. Given the divisions within Congress and complexities of the legislative process, we are not convinced there is a mandate for radical change or that it will just happen without a fight. Financial markets have possibly over-reacted to an unexpected election outcome. We anticipate a return to more stable markets in the new year; however, heightened volatility could be a factor.

Experience and history argue for paying attention to market developments and taking advantage of market price adjustments. This is especially true after major shifts. SMC's investment strategy focuses on generating comparatively more coupon income relative to the benchmark index. We believe this strategy provides more of a performance cushion during periods of market unrest. The income produced from a portfolio of tax-free bonds continues to be paid as scheduled. The shifting valuation of a bond due to market interest rate changes does not impact the investment yield “booked” when originally purchased.

SMC's recommended investment strategy has been focused on constructing tax-exempt bond portfolios of higher coupon bonds (5%) concentrated in short and intermediate durations (defined by maturity or call date). In prior Commentaries we have highlighted the benefits of taking advantage of the municipal yield curve's steepness, the upward slope in additional investment yield available by extending maturity. Rising interest rates have resulted in a steeper slope.

The graph and chart above illustrate how much rising interest rates have impacted the municipal yield curve’s configuration. A much steeper curve configuration exists today compared to earlier this year when interest rates were near historical lows. The current shape suggests investors can possibly benefit by purchasing short-to-intermediate structured bonds and then “ride down” the yield curve as the bond ages and moves toward maturity. This strategy has the potential to work well in both rising and falling interest rate environments.

Disclosures

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).

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