To say that the first half of the year was painful for investors would be a considerable understatement, with very few hiding places to be found, and with the typical safety of government bonds disappearing.
As the calendar turned to the second half of the year, there was a palpable sense of hope across the market that the worst may be behind us and the markets, as a whole, could expect to see some stability through the remainder of the year. What we know all too well, however, is that hope is never a strategy, and we need to continue to be on our toes for the volatility that does not seem to be receding.
Even with the market focus clearly shifting from inflation to growth in recent weeks, there is still a teetering between full-blown recession fears, with capitulation toward that idea on one side, to still fresh wounds from ripping inflation on another, to ever-changing language by central banks that a recession isn’t yet inevitable on the back of some still strong economic data prints. As a result, it is not unusual these days to still see 15-20 bps somersaults in global bond rates in a matter of minutes. While there are indications that the worst may be behind us from an inflationary standpoint, at least as far as the likelihood of yields spiking another 200 bps, the overall volatility and liquidity constraints appear to be sticking around.
With the combination of higher global rates, increased corporate issuance, and less international demand, the lower-rate picture today versus the peaks seen in mid-June is not leading to lower bond volatility, shown here by the BofA MOVE Index, which came dangerously close to March 2020 high over the first week of July.
Source: Bloomberg.
While tax-free municipals are in a strong summer seasonal period with maturities far outpacing new issue supply, there is still a hesitancy to chase a rally that feels shaky ahead of a Fed that has made it clear of their desires to hike at least another 75 bps this month, with more to follow, forcing a struggling ECB to match suit and take rates higher themselves. The whipsaw movement of market expectations for policy rates has been dizzyingn—with the 2-year Treasury riding a wave from a 2.53% to close out May up to a 3.50% in mid-June, down to a 2.83% again in early July, while now riding the choppy waters along a 3.20%—which makes discounting risk factors for high duration securities very difficult. However, the Fed has made it clear that they wish to move into restrictive territory, so here is where we stand now, with an implied policy rate of 3.55% by year end.
“There are countless unknowns in the world right now, but to use the wave analogy from above with a mindful mantra: while you cannot stop the waves, you can learn to surf them. We continue to feel that the best way to ride the waves of this volatility is within a municipal strategy that is specifically geared toward your client’s needs, mandates, time horizons, and risk tolerances, where they are not left up to the psychological swings of retail mutual funds and ETFs. The continued interest rate risk, potential credit implications of an economic slowdown, and varying liquidity dislocations all tend to further favor selective investment approaches and the selection of individual bonds for individual clients.”
Source: Bloomberg.
Until secondary bids-wanted and mutual fund outflows abate, we believe there will continue to be value found in the municipal market. Looking at Bloomberg’s MBWDPAR Index, it is clear that, regardless of new issue calendar, the secondary supply in our market is staying well above average, with the 200 DMA at $1.009 bln, 100 DMA at $1.388 bln, and 50 DMA at $1.391 bln. For comparison, the period from January 1, 2019, through and including the spring 2020 COVID dislocation all averaged around $550 million.
Source: Bloomberg.
With all that being said, after our defensive posture for much of the last couple of years, we are now more willing to be a bit more opportunistically-aggressive in our desire to extend duration where possible, as the principle of convexity has already reared its head, leading to much more severe pain in the move away from near-zero, than if any further move continues now higher from a 3% (10-year UST at time of this publication).
We have touched on this previously, but the notion of “income” being back in “fixed income” is one we feel many market participants can no longer ignore and could lead to a more “normal” correlation between risk assets and the safety of fixed income. The multi-year mantra of “TINA,” there is no alternative to equities, is facing not only the threat of an economic slowdown, but now the argument that bond yields look attractive, with the percentage of S&P 500 members carrying a dividend yield higher than the 10-year US Treasury rate at the lowest since 2007.
And with the relative steepness of the municipal curve versus that of the Treasury curve, we believe taxable equivalent yields of tax-exempts beyond the 2-year tenor maintain their historical relative value attractiveness.
Source: Municipal Market Tate, US Treasury, APA. Taxable equivalent yield (TEY) assumes the highest current federal rate of 37% + the 3.8% net investment income tax, from which tax-free income is exempt.
If we look back over the last few years, the most consequential macro events have been ones that were not a thought just a couple of months prior. Using The Economist, a well-respected publication, as an example—their 2020 Year Ahead Outlook had no mention of COVID, while their 2022 Year Ahead Outlook had no mention of the Russian/Ukraine war. And who could ever forget the now infamous cover stories from The Economist and Bloomberg Businessweek that ran in 2019 asking if inflation was dead….whoopsies.
This is not to pick on these two publications (as there certainly is an argument that long-term deflationary trends are still intact), nor to say that we knew any differently…the point is that nobody truly has any idea what will happen a few days from now, much less, a few months from now.
There are countless unknowns in the world right now, but to use the wave analogy from above with a mindful mantra: while you cannot stop the waves, you can learn to surf them. We continue to feel that the best way to ride the waves of this volatility is within a municipal strategy that is specifically geared toward your client’s needs, mandates, time horizons, and risk tolerances, where they are not left up to the psychological swings of retail mutual funds and ETFs. The continued interest rate risk, potential credit implications of an economic slowdown, and varying liquidity dislocations all tend to further favor selective investment approaches and the selection of individual bonds for individual clients.
Strategy Overview Report
As of June, 30 2022
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