Yellen and Screamin’

To say that financial markets started the year on the wrong foot would be a gross understatement. By February 11, the S&P 500 had declined over 10%, the Russell 2000 had fallen nearly 16%, and crude oil had plummeted nearly 30%. In bond-land, conditions were poor as well. Investment-Grade and High Yield corporate bonds underperformed U.S. Treasuries by roughly 4% and 8%, respectively, as valuations moved to levels last seen in 2009. The Federal Reserve’s (Fed) preferred measure of market-implied inflation expectations reached new lows, below levels seen during the Financial Crisis. Our read: investors expected a recession, and arguably a deep one. Trading floors echoed with the noise of traders yelling for liquidity. U.S. Treasuries shined brightly with Municipal bonds following next — two safe havens from the storm.

Negative market sentiment reversed sharply following the mid-February lows. Screams of pain were replaced with cries of joy as markets recovered in dramatic fashion. Overall returns for the first three months of the year masked the breathtaking intra-quarter volatility. Hoping to assuage market fears, the Fed pivoted to a decidedly dovish posture with respect to the pace of future rate increases. In her public remarks during the quarter, Chairperson Yellen focused considerably on financial market conditions and global economic challenges. The year began with the Fed purportedly on track for four quarter-percent rate hikes. That plan all but vanished by March 31 as current market expectations call for only a single rate hike of 25 basis points (bps) by the end of the year.

The Fed’s statutory dual mandate calls for it to promote maximum employment and price stability. Past Chairs Greenspan, Bernanke, and now Yellen have approached their policy with a third, related objective to support financial markets. The Fed’s recent experiments with quantitative easing directly targeted financial asset appreciation and its economically-stimulative wealth affects. We are surprised that, after many years, the Fed has not tried to distance itself from the asymmetry with which it reacts to financial market volatility. It was not surprising that Chairperson Yellen almost immediately walked back the Fed’s December tightening plans given the rough way markets started the year.

Far from the nexus of market volatility, Municipal bonds generated strong returns for the quarter with the full market up 1.7%, and intermediate maturities not far behind at 1.2%. Amid relatively steady short-term and long-term rates, three- to fifteen-year maturity yields fell 20 bps for the quarter. Municipals have now generated positive returns for the last nine consecutive months, tied for the third longest winning streak over the past 35 years. The strong performance of credit-sensitive securities in Municipals stood in stark contrast to that in Taxable bonds, with lower-rated bonds outperforming. As a sector, Municipals were far less volatile than taxable Corporate bonds. Strong Municipal mutual fund inflows helped spur a widespread grab for yield. A lack of new issue supply, particularly early in the year, exaggerated this dynamic.

Account performance for the quarter finished near benchmarks. Our accounts generally benefited from their barbelled yield curve position as intermediate maturities outperformed short maturities; however, the cost of our modestly shorter-than-market duration provided an offset. With regard to security selection, we had the positive development of having two Auction-Rate Securities (ARS) called at par, Transmission Authority of Northern California and Brooklyn Union Gas. These bonds had been priced around $95 prior to their calls. In addition, our position in New Jersey Tobacco zero coupon bonds significantly outperformed. Offsetting these contributions was the underperformance of our floating-rate exposure, including our ARS. Our floaters remained out of favor as market expectations for future Fed tightening moved lower. Although our floaters benefited from higher short rates following the Fed’s December move, this extra income could not offset the quarter’s aggregate price declines.

Account activity was moderate. The purchases we would like to highlight were California School District zero coupon bonds. In general, these securities offered spreads of 60 to 80 bps in seven- to ten-year maturities. These spreads are roughly 50 bps greater than comparable maturity, coupon-bearing debt of similar credits. In today’s low yield environment, investors continue to prefer the cash flow of coupon-bearing debt rather than zeros. Last year in our Strategy Update “Back to School Bonds”, we highlighted the three primary ways that school district enhancement programs work: 1) via a state aid intercept such as in Pennsylvania for Philadelphia Schools; 2) via a state guarantee such as in Michigan for Detroit Schools; and 3) via the support of an asset pool such as in Texas via its Permanent Fund.

California has a unique program to enhance much of its school district and community college district unlimited tax general obligation (UTGO) debt. In California, school and community college districts employ a separate debt service levy that is not commingled with the district’s other funds. Collected by the county in which the district resides, the debt service levy is sent directly to an independent trustee for ultimate payment to bondholders. Last year, Governor Brown signed into law Senate Bill 222 which afforded school district UTGOs statutory lien treatment in California. With their statutory liens, school district UTGOs are considered secured obligations with their revenues unable to be diverted from their primary purpose, and not subject to an automatic stay in the case of bankruptcy. We find that California school district UTGOs offer strong credits and attractive yields.

On the credit front, we are happy to report that after a record 272 days, Pennsylvania finally adopted its fiscal 2016 budget. This provided much needed short-term relief to its schools. Unfortunately, the dysfunctional and uncompromising political process has permanently harmed the state’s various school district enhancement programs — at least in the eyes of Moody’s and Standard & Poor’s. At the end of last year, S&P withdrew their ratings for bonds backed by the state’s enhancement programs and Moody’s downgraded our Philadelphia School bonds to non-investment grade. Following these actions, our positions experienced a fair amount of volatility.

The ultimate backstop of Pennsylvania’s enhancement programs is the ability to intercept state aid for the benefit of bondholders. As we learned from the prolonged budget impasse, school aid can be withheld for an extended period of time despite the state’s constitutional mandate to support public education. We remain confident in the quality of the bonds we hold, but recognize that because of these rating actions, future access to capital markets and short-term bank lines will be more difficult for Pennsylvania school districts. Originally intended to ease access to capital, Pennsylvania’s school district enhancement programs cannot effectively fulfill their mission until the bonds they support have their ratings restored. This will likely require legislative reform and clarity on the source of interceptable school aid in the event of future delayed budgets. The state is already at work on this.

Another significant exposure for us is Detroit Public Schools (DPS). DPS has two types of debt outstanding: 1) Michigan’s Qualified School Bond Loan Fund (QSBLF) enhanced bonds — the ones we own; and 2) State Aid enhanced bonds — the ones we do not own. QSBLF bonds feature an ultimate guarantee by the State of Michigan. Importantly, and in contrast to our Philadelphia school bonds, QSBLF bonds are not prone to political gridlock and do not require legislative approvals for payment. They represent one of the strongest school district enhancement programs.

As of this writing, the State of Michigan is close to passing legislation to restructure DPS. The state’s plan revolves around splitting DPS into two parts. One part would exist solely to service its debt including our Michigan-backed bonds, while the second part would be responsible for educating children and would receive future allotments of state aid. While our holdings are safe, Michigan’s plan could potentially place DPS’ state aid enhanced bonds at risk. Given the precipitous enrollment declines in Detroit, we have never been comfortable with their state aid backed bonds as aid is allocated on a per-pupil basis.

While the broader investment world was stormy, Municipal bonds remained calm and tranquil. As value-driven investors, we prefer a little wind and rain. We see storm clouds building from distress in Puerto Rico, the struggles of the City of Chicago and its schools, revenue shortfalls in energy-boom states, and the relentless growth of pension obligations. Thus far, strong investor demand for tax-exempt bonds has shown little caution in the face of these rising risks. Low yields and strong markets often lead to complacency. Stretching for yield by purchasing lower quality obligations and/or through maturity extensions may be common in the industry, but it is simply not part of our DNA. We remain happy with our positions and have found ourselves turning down one new deal after the next, staying true to our innate patience and selectivity. History teaches us that strong demand-driven Municipal markets tend to persist, but also that they will reverse; and when they do, opportunities will likely proliferate. With this longer-term perspective in mind, we are maintaining healthy reserve balances.

It’s not unusual that high levels of market volatility can also drive lots of yelling and screaming on trading floors. Consequently, it is important to stay calm, stick to your criteria, and carefully evaluate new opportunities that volatility reliably brings.

Sincerely,

Gregory S. Steier
Portfolio Manager