Turning "Aggressively" Neutral

May 2016

Investors should stay the course

  • Municipal market records five consecutive monthly gains
  • Further interest rate declines in May
  • $100 billion of bonds mature this summer
  • More money chasing fewer tax-exempt securities
  • Investors should stay the course

Long-term municipal bond yields are still dropping. Despite the fact that market interest rates are at generational lows, investors are still allocating more of their investment dollars to the municipal asset class. U.S. investors are not the only ones buying; foreign investors from Europe and Asia have also been active purchasers of state and local government debt. While municipal yields remain historically low, they are very attractive versus global bond alternatives that carry lower or even negative yields.

The chart above illustrates the dramatic drop in municipal yields over the past year. 10-year municipal yields have fallen from a peak of 2.40% last June to 1.60% currently. Decreasing interest rates have enabled the municipal market to register performance gains every month so far in 2016, the first time this has happened since 1989, according to Merrill Lynch. The Barclays Municipal Bond Index added another 21 basis points (.21%) through May 27, bringing its year-to-date total return (income + price appreciation) to 2.63%, and one-year return to a surprising 6.07%. According to Barclays, the Municipal Bond Index performance has ranked near the top of all global bond indices over the past twelve months.

The municipal market’s ability to register gains during the past two months, typically a period of seasonal weakness, underscores the magnitude of resiliency. With the traditional tough stretch of the calendar behind it, the market can now look forward to a period of perhaps even stronger demand. Municipal investors will collect a wave of investible cash as many municipal securities mature over the summer months: $100 billion of bonds come due from June through August. Generally, the principal proceeds received are used to purchase new securities. Further supporting the municipal market from a technical perspective is the expectation that new debt issuance is likely to slow in the third quarter.

Owners of maturing tax-exempt securities might have fewer reinvestment options to choose from when their bonds come due. The relatively high yields and stability of the municipal asset class has left bond investors with few better yielding alternatives. For 33 consecutive weeks tax-exempt mutual funds have experienced net positive money inflows.

The combination of significant bond maturities occuring over the next few months and a steady inflow of money needing to be deployed in tax-exempt bonds should be sufficient to buoy the market. Lower borrowing costs are often an inducement for issuers to either refinance outstanding bonds or market new securities. For a variety of reasons, the municipal market should not be too concerned about a supply glut. Analysts are forecasting only a moderate amount of new bond deals in the weeks ahead.

Through the release of the minutes from its most recent interest rate meeting and member statements to the press, the Federal Reserve Open Market Committee (FOMC) has provided notice to the financial markets that investors should not remain too complacent by assuming further rate increases are not likely anytime soon. In fact, the FOMC would like investors to assume there is a good possibility of at least one short-term rate hike in the near future, maybe as soon as at its June meeting.

The fixed income markets have taken these words of warning to heart, as short-term rates have drifted a bit higher recently. SMC still maintains its more dovish view of the Fed’s future actions and rate hikes. At most, we can foresee only one 25 basis point rise in the overnight inter-bank lending rate this year. Interest rates in the United States are already significantly higher than elsewhere in other developed markets. Pushing rates higher would likely add to the strength of the U.S. dollar, which would be a further impediment to domestic trade and manufacturing. As was the case when the Fed instituted its intitial rate hike last December, stocks and commodities would probably suffer more than bonds. Economic growth and corporate earnings do not appear to be strong enough to weather much higher borrowing costs.

Given the confluence of events affecting the financial markets so far in 2016, we describe our municipal market posture as “aggressively” neutral. Annualizing municipal market perfomance based on the first five months’ returns would result in a 6% gain for the year. We think this is unlikely to occur, and we believe the second half of the year’s return will not match the first six months. We are not significantly altering our market view. However, in some instancces, we are adjusting duration to a slightly more defensive posture relative to the stratgey benchmark. The municipal asset class still offers a compelling investment opportunity when compared to most other global fixed income alternatives. Without strong evidence of significant global economic improvement, interest rates are unlikely to move appreciably higher. We think yields will remain near current levels.

Many market commentators have been discussing the shape of the municipal yield curve (difference in yield between the shortest and longest maturities) and future performance implications. Recent curve “flattening” is due to the greater decline in long-term yields rather than short-term yield movements. This happened for two reasons: first, is the significant amount of money flowing into long-maturity mutual funds. Secondly, the possibility of a short-term rate hike in the near future has caused short-term yields to drift higher recently.

As yield curve steepness is reduced, the additional yield compensation for extending maturity becomes less attractive. Furthermore, the relatively steep gradient of the curve in the intermediate maturity range (approximately 5-15 years) still holds; the best “rolldown” opportunity for future price appreciation lies within this optimal range.

Our strategy emphasizes maximizing current income by selecting bonds bearing higher coupons that are priced at a premium to face value. Income generation, rather than price appreciation, should be the main performance determinant through the balance of 2016. It is also important to control duration (interest rate risk) in the current environment just in case the declining yield trend reverses. Global economic growth and inflation fundamentals still suggest the continuation of a low interest rate environment going forward. In our view, the absence of a compelling economic growth story will limit interest rate movements. Given the strong technical posture of the market, municipals are likely to outperform taxable alternatives.

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).

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.

Neither this commentary, nor any of the contents hereof, may be reproduced or used for any other purpose, or transmitted or disclosed in whole or in part to any third parties, in each case without the prior written consent of SMC FIM.

Copyright © 2016 Spring Mountain Capital, LP. All rights reserved.