Storm Clouds Building

We designed our investment process to take advantage of persistent market inefficiencies. One such inefficiency is that financial markets are often unjustifiably volatile. In other words, valuations fluctuate much more than they should on the basis of more stable fundamentals. The muni market has certainly been no stranger to volatility. We need only to think back to the chaos of the 2008 Financial Crisis, the Meredith Whitney-inspired turmoil of 2010-11, the Taper Tantrum and Detroit bankruptcy and Puerto Rico-led tumult of 2013, or the surprise Presidential election outcome of last year. During each of these episodes, when others took shelter from the storms, opportunities were widespread and we invested in a multitude of good values. During the more tranquil interim periods, it was also possible to find good values — we just had to look a little harder.

We never know when market disruptions will occur — only that they will. As we began this year, the prospect of tax reform, healthcare reform, progressively tighter monetary policy, and the political risks associated with a new Administration provided the necessary ingredients for market volatility. Over the summer, major hurricanes battered the Caribbean Islands and the Gulf Coast, adding yet another layer of uncertainty. If we were speculators (and we’re not!), we would have bet that 2017 would bring plentiful opportunities.

Instead, we have faced progressively more expensive valuations. As a result, attractive municipal bond opportunities in issuers that satisfy our credit criteria have been difficult to spot. Bonds with typically unpopular structures, such as floating-rate notes and zero coupon bonds, have recently benefited from strong demand. Count us among those surprised by the market’s abject lack of volatility. Even bonds in the Texas and Florida hurricane zones experienced no discernible price disturbances following the recent storms.

The “price” for tight markets has been strong market returns even though triple-A rated benchmark yields ended the quarter almost unchanged. For reference, the 10-year maturity yield ended the quarter at 2.00%, after bottoming at 1.80% in the first week of September. Shorter-term municipals outpaced U.S. Treasuries again during the quarter as the 2-year Municipal-to-Treasury yield ratio declined 10% and ended the quarter at 67% (as shown in the chart to the right). Longer-term ratios were generally unchanged at 86% for the 10-year ratio and 99% for the 30-year ratio. At current valuations, we conclude that municipal investors fear neither tax reform nor future Federal Reserve (Fed) rate hikes. Credit-sensitive bonds drove further market gains for intermediate and full-maturity municipal indices to 0.7% and 1.1%, respectively, for the quarter, bringing year-to-date returns to 3.7% and 4.7%, respectively.

Annualized_Standard_Deviation

We are happy that our clients have not only participated in this year’s market rally but have also outperformed relevant benchmarks, benefiting significantly from our selection decisions. Many positions that we owned because of credit and bond structure-related opportunities generated strong performance. Beyond the contraction of general credit spreads, our State of New Jersey holdings, California school district zero-coupon bonds, and auction-rate securities (ARS), all helped drive our positive account results. Of particular note, our Houston Airport, Niagara Mohawk (NiMo), and New Jersey Turnpike ARS stood out for the quarter. Houston Airport and NiMo offered floating coupon rates of roughly 2.5% to 3.0% and appreciated 2% to 3% in price. Further benefiting results, a few NiMo auctions were successful during the quarter and we were partially redeemed at par. Following a large floating-rate bond issuance late in the quarter, the New Jersey Turnpike Authority called, at par, all of its outstanding ARS, resulting in roughly 10 points of price appreciation. It is ironic that the largest detractor from returns was our position in New Jersey Tobacco bonds. This position was our largest contributor last quarter and suffered some pricing-related noise. We were fortunate to add to our position as we approached quarter-end. Based on our modeling at current prices, we view our New Jersey Tobacco bonds as offering approximately 4% return potential — quite attractive for a high-quality bond with an average life below three years.

On the heels of weak inflation reports during late spring and summer, investors had nearly priced out the probability of another Fed rate hike this year. However, with the Fed’s September 20 meeting announcement and update to its dot plots, another rate increase appears likely. Moreover, we are hopeful that the commencement of the Fed’s balance sheet reduction will result in more normal (i.e. higher) interest rate levels. The Fed has gone to great lengths to telegraph its moves so as to not induce market volatility, unlike during the Taper Tantrum of 2013.

Municipal investors continue to flock to the perceived safety of traditional one-to-five year maturity fixed-rate bonds. Paradoxically, this behavior has driven down the yields on these securities, making them riskier. As a group, short-intermediate municipals are among the most expensive securities along the yield curve. With yield ratios relative to U.S. Treasuries in the low-to-mid 60s, valuations in these maturities suggest tax increases, and thus inadequate protection against cuts. With yields barely higher than cash invested in Variable Rate Demand Notes (VRDNs), valuations in these maturities suggest that the Fed will remain on hold — contrary to the Fed’s own guidance. Consequently, where feasible, we own a combination of floating-rate securities and longer maturity zero coupon bonds to form a bridge over the one-to-five year portion of the yield curve.

Mother Nature vs. Credit

Turning to credit matters, this year’s Atlantic hurricane season has spurred many questions from clients about exposures in the afflicted areas. We are glad that we are now finally past the peak of this year’s hurricane season, but the combined legacy of Harvey, Irma, Jose, and Maria will be felt for many years to come. With respect to our managed portfolios, we have never purchased bonds from Puerto Rico or the U.S. Virgin Islands. This year’s tragic hurricane season intensified the territories’ ongoing fundamental challenges. In these cases, the natural disasters worsened its man-made financial disasters.

The U.S. gulf coast from Texas to Florida also sustained significant property damage and hardship, although the impact on municipal credit was much more subdued. The effects of damage inflicted from wind, flooding, and storm surges associated with hurricanes and other weather events are generally temporary. Furthermore, direct storm-related credit impairments are rare. Municipal borrowers generally carry some form of insurance, such as for wind, flooding, or just business interruption. In addition, the Federal government, through its Federal Emergency Management Agency (FEMA), has consistently provided operational and financial support during every major natural disaster in recent history. Together, these two factors tend to absorb the lion’s share of reconstruction costs and help accelerate recovery. What remains to be absorbed would then fall to the individual issuer.

History tells us that storm-related credit risk often resides in an afflicted area’s water and sewer systems, ports and airports, some very specific power utilities, and dedicated tax bonds. Water, sewer, and storm water systems can be some of the hardest hit credits. Significant overflow events could warrant the issuance of consent decrees by the Environmental Protection Agency (EPA), which can force meaningful capital expenditure programs. Ports and Airports are easily disrupted by severe weather events, which can drive down traffic and cargo shipments as well as reduce tourism demand for the area, for a period of time. Power generation credits could be forced into emergency shutdown due to flooding, experience delays in restarting, and incur related costs and lost revenues. Power transmission and distribution, on the other hand, are more exposed to direct wind damage. Dedicated-tax bonds backed by narrow and more cyclical revenue streams such as hotel and tourism-related taxes are inherently more risky and can be more susceptible to severe weather events.

Most_Municipals_Positioned_to_Weather_the_Storm

Hoping for the best and preparing for the worst might be an appropriate strategy for those looking to ride out storms. As this year has shown, the damage can be severe, but the destruction does not have to extend to credit. Credit selection plays a critical hand here. We focus our time on selecting obligors possessing durable operating models, resilient contract structures, robust reserves, and low initial leverage to effectively mitigate the risk of credit loss. We own no bonds in our client portfolios that are subject to long-term negative consequences of the 2017 hurricane season.

Our team is driven by the thrill of identifying good values. We are mindful that the tailwinds that have driven strong municipal market returns have left valuations at historically tight levels. We are also conscious that today’s tight valuations will serve as a headwind for future returns. Investors who ignore valuations or who compromise on credit in the hope of improving their portfolio yields are inviting trouble. Hurricane season may be over, but we see storm clouds building for the muni market. Through the year we have built reserves that will give us the flexibility to take advantage of the next wave of market weakness and future opportunities. Until then, we will patiently wait for market valuations to loosen and more good values to emerge.

Sincerely,

Gregory S. Steier
Portfolio Manager

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IM-2017-10-13-4392 Exp. Date 01/31/2018