Abracadabra

For most of 2018, the Federal Reserve (Fed) was resolute on normalizing both the Funds rate and its balance sheet. Recall, that as recently as October 3, Chairman Powell proclaimed that rates were “a long way” from neutral. He also left investors with the impression that he had Quantitative Tightening on autopilot. Facing the reality that a decade of easy money magic might be ending, investors began worrying, which triggered crisis-like market volatility during the fourth quarter. Whether it was falling stocks, the exhortations of the President, or global growth concerns, Chairman Powell proclaimed the independence of the Fed and acquiesced. Abracadabra, presto chango, make this hawk a dove!

In a flash, Fed tightening projections vanished. As the first quarter ended, the probability of a Fed rate cut in 2019 stood at 65%! Contrast this with the end of October when the Fed’s own projections called for three rate hikes by the end of this year. Despite a moderation in U.S. economic activity, the labor market remains tight with increasing evidence of higher wage pressure. Unlike last fall, the Fed no longer appears concerned about any incipient inflation risks and has espoused the benefits of an average inflation target. Essentially, the Fed is willing to let the economy run hot because inflation has remained below target for so many years. Nothing like a mini bear market in stocks to jolt your thinking.

The Fed’s newfound dovishness catalyzed strong financial asset returns. Equity markets rejoiced, climbing 10% for the quarter, retracing most of their losses from 4Q18. Bond markets reacted favorably as well, with rates rallying and credit spreads tightening. Having underperformed significantly at the end of the year, investment grade and high yield corporates were standout performers, generating returns of 5.0% and 7.4%, respectively. Unusual in a rallying bond market, Municipal bonds beat Treasuries 2.9% to 2.2%.

The Treasury market ended the first quarter with an inverted yield curve for the first time since 2007. Historically, when the 10-year Treasury Note yields less than the 3-month Treasury Bill, recessions follow. Only once in the last seven inversions did the U.S. avoid a recession. At the risk of succumbing to “this time is different” syndrome, we do not take this signal at its historic value. We struggle to quantify the downward pressure placed on longer U.S. Treasury yields by the Fed’s still-bloated balance sheet and the $10 trillion of USD-equivalent of high quality foreign sovereign debt trading at negative yields. Even 10-year German Bunds ended the quarter with a negative yield. We respect the historical significance of yield curve inversions, but we will not alter our portfolio construction because of it. We remain focused on finding value in individual bonds and, given the strong performance of credit-sensitive assets, this has become more difficult.

Structured_Fixed_Income

Structured_Fixed_Income

For the quarter, Municipal bonds rallied significantly, with yields declining 40 to 50 basis points1. Five-, 10-, and 30-year yields ended March at 1.6%, 1.9%, and 2.6%, respectively. Since the end of October 2018, 10-year yields have fallen over 90 basis points, propelling the overall market to a return of over 5%, and intermediate maturities to a return of over 4%. Keep in mind that intermediate maturities possess 40% less interest rate risk than the full market. For years, we have been cautious about the risks posed by an interest rate normalization and we did not anticipate a rally of this magnitude. Today, 10-year maturity yields are lower than when the Fed began this tightening cycle in late-2015.

The Fed’s change of heart, a dearth of new issuance, and record mutual fund inflows set the stage for a serious supply-demand imbalance in municipals during the first quarter. Adding fuel to the fire are unexpected tax liabilities as we draw close to the April 15 filing deadline for individuals. Anecdotally, it appears that state and local tax deduction caps hit residents of California, New York, New Jersey, and Connecticut particularly hard. This has bolstered municipal bond demand by households looking to shield their investment income from taxes, especially in high tax states.

By eliminating tax-exempt advanced refunding bonds, 2017’s tax reform legislation all but assured a marked decline in supply. The first quarter’s issuance of $80 billion has again led us to reaffirm our belief that this year’s supply will be near $300 billion – just like last year. New supply, net of maturities, sinking fund payments, and called bonds will likely be negative, implying the size of the overall municipal market will shrink. Even without new capital entering the tax-exempt sector, the level of new issuance was insufficient to satisfy reinvestment demand. New issues were routinely multiple-times oversubscribed. The State of Connecticut issued general obligation bonds at quarter end. Despite tight spreads, the deal was 20x oversubscribed. We chose to maintain our existing exposures and not participate.

With respect to capital movements, year-to-date inflows into industry mutual funds is the strongest since records were first kept nearly 30 years ago. Back then, mutual funds were a fraction of their size today. Thus far, $15 billion in new capital has joined the yield-chasing herd. Importantly, 30% of this net inflow, or about $6 billion, was directed to high yield muni funds. These funds are typically big buyers of long, credit-sensitive bonds. In recent years, credit performance has been highly correlated with flows into high yield funds. We wrote in our last Quarterly Strategy Update about how we took advantage of opportunities in prepaid gas and selected tobacco bonds during the fourth quarter when investors were redeeming from high yield funds. Supported by large inflows during the first quarter, spreads tightened significantly on these positions.

We rely on our patience and selectivity for strong long-term performance. In these kinds of markets, however, patience and selectivity often result in short-term relative performance challenges. Ebullient periods, marked by strong and, in some cases, indiscriminate demand for credit have often proved difficult for us. This time, we are happy to report that not only did we participate in the market rally, but we also generated some positive excess returns. Our longer-term, zero-coupon California and Oregon school bonds were strong performers. We are pleased that our portfolios also benefited from many of the attractive opportunities in prepaid gas and tobacco settlement bonds that we purchased during the volatile fourth quarter. When we purchased them, we did not anticipate these bonds would perform so well, so quickly.

During the quarter, we added several good values including New Jersey and Massachusetts floating rate notes, multiple State Housing Finance Authorities, Tennergy prepaid natural gas bonds backed by the Royal Bank of Canada, and zero-coupon E-470 highway bonds in Colorado. We also continued to add to our positions in longer-maturity, zero-coupon bonds for school districts in California and Oregon. Our activity was much higher during January and February than it was in March as several consecutive months of strong market returns and tightening credit spreads have compressed our opportunity set.

These purchases remain consistent with our portfolios’ activity over the last couple of quarters. We have continued to emphasize floating rate notes in our managed portfolios, given the stretched valuations on traditional one-to-five year maturity bonds. In most cases, our floater yields exceed that available on 5-year triple-A rated securities by over 50 basis points. These positions afford us the luxury of time as we wait for more attractive values to emerge in more traditional fixed rate bonds. We are mindful, however, that when yields decline, the returns on our floaters will tend to lag on a relative basis. We do not consider ourselves in the business of forecasting when overpriced securities will get even more expensive and remain comfortable with our 10%-15% exposure in floaters. Our longer zero-coupon bonds complement the floaters, providing attractive yields without reinvestment risk.

We had hoped that Fed Chairman Powell would break with his immediate forebears and not subordinate monetary policy to swings in the equity market. Unfortunately, he is continuing the trend. We have never claimed to have any tricks up our sleeve to reliably forecast changes in interest rates or the slope of the yield curve. Instead, we let valuations guide us. We believe our portfolios are well-positioned for what might be an extended period of active watching. Markets never cease to surprise us, and we will remain patient as we seek to identify new opportunities.

Sincerely,

Gregory S. Steier
Portfolio Manager

 

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1 A unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.