Abracadabra

Inflation dominated the landscape again in Q2 2024 as investors fixated on every macroeconomic indicator and every word from the Federal Reserve (Fed). Once again, interest rates bounced around with the ebbs and flows of the data and rhetoric. Breaking the spell of inflation has remained much more difficult than the Fed initially hoped. We expect market volatility to remain elevated as we progress on an uncertain path to an eventual easing of monetary policy. Investor sentiment reflected this uncertainty as early-quarter pessimism abruptly swung to optimism by quarter-end. We stayed focused and took advantage of market volatility by steadily adding new opportunities, many of which featured non-standard bond structures.

Market volatility was again driven by changing Fed policy expectations. After looking for six to seven rate cuts at the beginning of the year, investors now only see two cuts, one before the presidential election and one after. Strong labor and housing markets, accommodative financial conditions, and large federal fiscal deficits have benefited the economy, but present strong resistance to the Fed’s inflation fight. Core inflation has risen an annualized 3% to 4% for the last six months. Super-core inflation, which measures price changes in core services excluding housing, was up more than 5% over the same period. These are not the typical preconditions for a pivot to easier monetary policy, but the Fed can always pull a rabbit out of its hat. Tighter monetary policy has not had the bite that policy makers expected, and many are now questioning the restrictiveness of the Fed’s stance.

Although elevated, municipal yield volatility declined to well-below 2022 and 2023 levels, which were the most volatile back-to-back years in decades. Just like the dynamic in taxable corporate bonds, credit-sensitive municipals strongly outperformed. Whereas Aaa-rated General Obligation (GO) bond yields fluctuated widely, premiums for lower-rated paper consistently narrowed. Simply put, the weaker the credit, the better the performance. We have experienced market conditions like this before and they are typically challenging for us. Indiscriminate buying tends to reward the less deserving and drives strong competition for new issues. Broad credit fundamentals remain healthy, with most states and local governments still sitting atop large, post-pandemic reserves. Revenue bonds have also performed well, buoyed by the strong economic growth. This sound foundation has helped low-rated credit spreads to approach their record tight levels. We will never buy a bond without a sufficient margin of safety,¹ and today’s credit spreads provide slimmer margins than they had for the past couple of years.

We are proud of our first half performance, generating a return of 0.72%, outperforming the index by 135 bps.² Generating a positive return in the face of an interest rate sell-off is a testament to the strong portfolio income and security selection results. We are also proud we beat the index despite such a small exposure to BBB credit, which tightened by roughly 45 bps since the start of the year. We continue to scratch our heads as other investors continue to pile into risky credits. We prefer alternatives to traditional credit to achieve similar yields with less risk.

The first half of 2024 provided plenty of investment opportunities, assisted by record supply. Strong issuance was driven by several factors including tighter credit spreads, the increased cost of construction after multiple years of high inflation, and a desire to tap markets before the election. Lastly, several large issuers invoked “extraordinary redemption provisions” (ERP) on their outstanding taxable Build America Bonds (BABs). ERPs give the bond issuer the right to call back the bonds at par if certain “extraordinary” conditions are met. Keep in mind, the word “extraordinary” is open to interpretation, making them difficult to analyze. Upon calling their BABs, these municipalities issued new tax-exempt bonds. Los Angeles Unified School District was the largest deal at $2.6 billion. From an investment perspective, we try to avoid premium bonds with par-priced ERPs. While we are grateful for the rebound in supply, we note that issuance was very concentrated, with a record number of billion-dollar new deals. We frequently source opportunities from the niche corners of the municipal market, rather than from larger, more generic GO bonds.

Over the past years, strong technical factors, underpinned by low supply, have helped support valuations in the municipal market. During May, outsized issuance volume in the second quarter helped to drive the municipal market’s worst two-week period of performance since the onset of COVID-19. The change was most notable in the intermediate portion of the curve, which has been inverted for 18 months due to heavy retail demand. By quarter end, intermediate maturity yields increased by 20 bps to 45 bps, while the rest of the curve experienced more muted increases. We have consciously de-emphasized the area of the deepest inversion and expect to maintain this positioning. The sell-off quickly reversed as the continued pace of strong fund flows helped to absorb much of the new issuance, driving a rally in June. We strive to avoid being influenced by the Presto Chango of investor sentiment. This year, like in the past, periods of volatility are often accompanied by attractive opportunities.

During the quarter we purchased a wide array of opportunities across a range of sectors and structures, most of which fall out of the scope of retail investor preferences. We added two prepaid gas transactions, a floater backed by J.P. Morgan and a put bond backed by RBC with yield spreads of about 100 bps. Prepaid gas deals typically contain two elements retail investors seek to avoid: non-standard coupon structures, and corporate credit risk. Prepaid deals also contain several ERPs which must be thoroughly assessed. Other corporate-backed bond purchases for the quarter include puts from Intel and Duke Energy. We are grateful for the assistance we receive from our corporate analysts. This is a nice benefit of us all sitting together.

We also added bonds from two toll systems, a floater from E-470 in Colorado, and a zero-coupon bond from the Pennsylvania Turnpike Commission (PTC). The pandemic reinforced our assessment of toll road bond durability. That period presented a stress test that none of us fathomed before 2020. Both toll systems were able to offset lower traffic volume by reducing expenditures, delaying capital spending, or raising toll rates. Finally, housing planned amortization class (PACs) bonds continue to offer the best risk-adjusted value in the municipal market and played a large role in our activity. We purchased housing PACs across several states at spreads around 140 bps.

In good times and bad, we try to stay steady. We do not bet on what we do not know. We have a lot of tools and analytics at our disposal, but not a crystal ball to see the future movements of interest rates, economic releases, election outcomes, or Fed utterances. We stick with what we can analyze – credit, valuation, and portfolio construction. In other words, we spend our time evaluating rather than predicting. This approach helps us stay focused in the face of the noise and distractions of swings in investor sentiment. It is anyone’s guess what the future holds, but we will be prepared. Not magic, but good old-fashioned analysis.