By Greg Kaplan, CFA and William Black, CFA
Investment Grade Municipals
Domestic and global growth concerns drove market interest rates lower in the first quarter, leading to solid performance for investment grade fixed income. While the 20 basis point drop in the 10-year municipal yield trailed the 40 basis point drop in the 10-year Treasury, municipals performed well thanks to the seasonal “January effect” when low issuance meets heavy reinvestment needs. The Barclays Municipal Bond Index returned 1.67% during the quarter, versus 3.03% for the Barclays Aggregate Bond Index, and 1.4% for the S&P 500. On a risk-adjusted basis, municipals outperformed most other asset classes, including investment grade corporate bonds. Investor inflows into municipal mutual funds also supported demand, with funds taking in over $14 billion in new assets in the quarter according to Lipper (more than all of 2015). Most of these flows went into intermediate and long funds as well as high-yield funds, while money market assets continued to shrink in anticipation of money market reform later this year.
With a dovish shift from the Fed and mixed economic indicators, the question for many bond investors is: Where do we go from here? On an absolute basis, municipal yields are near cyclical lows. On a tax-adjusted basis, however, municipals remain attractive compared to U.S. Treasuries and other investment grade fixed income. Corporate credit experienced high volatility, while municipals remained stable and credit quality – with a few well-known exceptions (e.g., Puerto Rico, Chicago) – continues to improve. With two more Fed rate hikes possible this year and late cycle forces building, we believe investment grade municipals will continue to be a solid, albeit below-trend performer, in the near term. We see opportunities in certain sectors, with security selection a key driver for outperformance.
City National Rochdale’s New Strategy
City National Rochdale has formalized a new municipal “Interlong” strategy focusing on longer parts of the yield curve with attractive risk/reward characteristics. This underserved part of the municipal curve has performed well historically, as inflation expectations remain muted and most rate volatility has been contained in shorter maturities more sensitive to the Fed. We believe this will continue and we will see opportunities for longer-term investors to capture inefficiencies in this space while boosting tax-exempt income.
The Barclays High Yield Municipal Bond Index returned 2.74% during the quarter, producing one of the better asset class returns. Investor inflows exceeded new high yield municipal supply, continuing last year’s trend. The chart below compares the price of a benchmark high yield municipal, the Buckeye tobacco settlement bond maturing in 2047, with cumulative high yield municipal fund flows. The chart shows the strong impact that demand (represented by fund flows) has upon high yield municipal bond prices, and why monitoring these factors is very important. We see demand remaining strong this quarter as the tax-adjusted yield remains very attractive on a relative basis, and default rates remain at cycle lows.
Excluding Puerto Rico, traditional high yield municipal debt, such as bonds backed by senior living, land development, healthcare, and transportation appear to be fairly priced versus investment grade bonds. We believe that careful credit analysis, maintaining a diversified portfolio of securities, and uncovering overlooked opportunities are the best ways to achieve outperformance for the rest of 2016.
|Investment and Insurance Products:
• Are Not insured by the FDIC or any other federal government agency
• Are Not deposits of or guaranteed by a Bank or any Bank Affiliate
• May Lose Value
The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.
Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.
Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as on the date of this document and are subject to change.
There are inherent risks with equity investing. These risks include, but are not limited to, stock market, manager, or investment style. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices. Investing in international markets carries risks such as currency fluctuation, regulatory risks, economic and political instability. Emerging markets involve heightened risks related to the same factors as well as increased volatility, lower trading volume, and less liquidity. Emerging markets can have greater custodial and operational risks, and less developed legal and accounting systems than developed markets.
There are inherent risks with fixed income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT) and taxable gains are also possible. Investments in below-investment-grade debt securities and unrated securities of similar credit quality, commonly known as “junk bonds” or “high-yield securities,” may be subject to increased interest, credit, and liquidity risks.
Investments in emerging markets bonds may be substantially more volatile, and substantially less liquid, than the bonds of governments, government agencies, and government-owned corporations located in more developed foreign markets. Emerging markets bonds can have greater custodial and operational risks, and less developed legal and accounting systems than developed markets.
As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money.
Returns include the reinvestment of interest and dividends.
Investing involves risk, including the loss of principal. Diversification may not protect against market loss or risk.
Past performance is no guarantee of future performance.
The Standard and Poor’s 500 Index (S&P 500) is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
The MSCI Emerging Markets (EM) Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. & Canada. As of June 2007 the MSCI EAFE Index consisted of the following 21 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.
The Barclays Aggregate Bond Index is comprises U.S. government, mortgage-backed, asset-backed, and corporate fixed income securities with maturities of one year or more.
The Barclays U.S. Municipal Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed tax exempt bond market. The index includes state and local general obligation, revenue, insured, and pre-refunded bonds.
The Barclays U.S. Municipal High Yield Index measures the non-investment grade and non-rated U.S. dollar-denominated, fixed rate, tax-exempt
The Wall Street Journal Dollar Index (WSJ Dollar Index) is an index (or measure) of the value of the U.S. dollar relative to 16 foreign currencies.
Indices are unmanaged, and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.