The long-awaited reopening of the U.S. economy started to become a reality during the second quarter, with vaccines administered to the broader population, resulting in COVID cases and deaths falling rapidly and mask restrictions being lifted across the country. Annualized GDP growth for the first quarter, released in April, came in at 6.4%, setting the stage for full year 2021 growth to register at levels not seen in many decades. The recovery in the labor market continued, and though May’s non-farm payroll release of 266K fell well short of elevated expectations, the economy has approximately nine million open jobs employers are searching to fill. If those positions were filled, economists estimate the unemployment rate would be back to pre-pandemic levels of 3.5%. Despite slack in the labor market, it was the inflation story that received the most attention during the quarter. Inflation prints accelerated in both the U.S. and Europe, sparking a fierce debate about how persistent the trend will be, and how serious central banks should take it.
The Federal Reserve, for its part, signaled throughout much of the quarter that rising inflation is expected to be transitory and should normalize as base effects wane and supply/demand imbalances work themselves out. As widely expected, in its June meeting, the Federal Open Market Committee (FOMC) kept rates unchanged at zero and maintained its pace of asset purchases. Despite the status quo, there was a notable shift in the forecast for future hikes, with the FOMC’s “dot plot” showing members expecting two Fed Funds rate increases in 2023. The market reacted to this “hawkish” signal by flattening the Treasury curve, effectively pricing in less future expected inflation. The 10-year Treasury yield ended the quarter at 1.47%, 27 basis points (bps) lower versus the end of March, while the 2-year Treasury rose by 9 bps to finish at 0.25%.
Inflationary fears did not faze municipal bond investors, as strong fundamentals and low defaults drove credit spreads tighter, while the prospect of higher taxes provided a tailwind for muni prices broadly. High-quality municipals, as measured by the Bloomberg Muni 10-year AAA Yield Curve, were down slightly during the quarter, but have remained range-bound through most of the year. The break-out story has been high yield municipals, which have posted a strong quarterly performance, thanks to steady inflows. The high yield muni market has returned nearly 4% more than its AAA counterparts on the year, which may prove difficult to replicate in the back half of 2021. The Bloomberg Barclays High Yield Muni index finished the quarter with a paltry yield-to-worst of 3.05%; 36bps below pre-pandemic levels and the lowest on record.
The insatiable demand on the part of investors for municipal credit has been greeted with a mad dash to the market by lower quality borrowers. Areas of the market that were the epicenter of the pandemic and shunned 15 months ago, such as continuing care retirement centers (CCRC), are now enjoying rock bottom borrowing costs. Other issues, such as the states of Illinois and Connecticut, are trading at levels that were unthinkable a year ago. The quarter ended with the spread, or extra compensation, between BBB and AAA munis at 63bps, the lowest level in a decade. It seems clear the reopening trade is priced into the municipal market but the indiscriminate buying taking place may be a signal that valuations have become stretched.
Second-Quarter 2021 Performance Highlights
- The Thornburg Municipal Funds posted positive performance during the second quarter aided by steady or falling yields and credit spread tightening. Market tailwinds in the quarter allowed the Thornburg Municipal Funds to recoup most, if not all, of the losses incurred at the beginning of the year.
- The decline in yields led duration to be a contributor to absolute performance across all of the funds. However, the flattening of the yield curve caused shorter maturities to underperform longer maturities, which resulted in yield curve positioning being a detractor from absolute performance. The funds’ defensive positioning, driven by a lack of incentive to move out the curve and higher cash balances, was the key culprit for the performance give-up. With the market priced to perfection, entry points are crucial to avoid purchasing bonds that will become future tax losses.
- Municipal credit continued to exceed expectations and attract investor attention and new dollars. Lower quality municipals are on pace for the largest outperformance versus high quality municipals since 2012 as credit spreads across ratings, sectors, and states have evaporated. As a result, sector and quality allocations were a positive contributor to absolute performance across all funds.
Current Positioning and Outlook
The downward drift in intermediate-term Treasury yields during the second quarter seems to indicate that the market is looking past the current inflation chatter and believes that inflation trends will moderate, or that the Fed has maintained credibility with investors and can deal with the potential issue. While we expect FOMC members to speak publicly about the potential timing of QE reduction in the coming months, we do not anticipate another ‘Taper Tantrum’ like the market experienced in 2013. It can be argued that rates already rose in response to an eventual “taper” in asset purchases, but the strength of the recovery protected investors from the “tantrum” created by a sell-off in risk assets. The municipal market has been insulated from much of the volatility in the Treasury market despite experiencing some bouts of rate movement. The muni market’s muted response to yield spikes earlier this year has been a positive for performance thus far, but the low level of muni yields presents risk to the downside should rates move higher in the back half of the year. For that reason, we have maintained, or slightly reduced, portfolio durations by allowing cash to build in the face of limited opportunities.
Trends in wage inflation have been disconcerting, but only if the Fed is forced to respond faster with rate hikes than the market expects. With history as a guide, it is not rate increases, but unexpected rate increases, that are loathed by fixed income investors and often the impetus for investor selling. The Fed seems laser focused on avoiding such a misstep, but the inflation picture remains hazy, and it will be several months before the fog lifts and visibility improves. The municipal market presents an opportunity for investors as munis have performed better than other fixed income asset classes in rising rate and inflationary environments. Municipal bonds are used to finance much of the infrastructure, health care and education in the U.S. which often comes in the form of hard assets, government appointed monopolies, and pricing power.
While valuations remain relatively unattractive with spreads well through historical averages and yields hovering around decade lows, it’s hard to be excited about the municipal market. Couple that with a general flattening of the yield curve and complete lack of incentive to move out the maturity spectrum and suddenly the search for additional yield feels like a fool’s errand. While this may lead some investors to look elsewhere, it maybe the time in which heightened focus is more appropriate. The asset class can lull investors to sleep with low volatility, miniscule defaults, steady income, and reliable principal payment only to suddenly jar them awake when least expected. For that reason, we believe in falling asleep with one eye open.
Thank you for your continued trust and support
Performance data shown represents past performance and is no guarantee of future results. Investment return and principal value will fluctuate so shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than quoted. For performance current to the most recent month end, see the mutual funds performance page or call 877-215-1330. The Low Duration and Limited Term funds have a maximum sales charge of 1.50%. The Intermediate Municipal Fund and the Strategic Municipal Income Fund have a maximum sales charge of 2.00%.