When it’s raining outside, policy makers seem to think that lowering key interest rates will make the clouds clear and the sun come out. Monetary policy has been the elixir to solve all problems. But it has also created a host of others. As yields continue to fall, investors have had to move down in credit quality and longer in duration to reach income goals. This has been evident in the municipal market, where record inflows over the first three quarters hit nearly $70 billion.
High-yield municipal bond funds have garnered $14 billion of that total, followed by intermediate/long strategies. Performance in these two spaces has been exceptional given the self-fulfilling nature of too much money chasing too few bonds. For instance, distressed tobacco settlement bonds that carry single- B ratings trade at par, not on fundamentals but because money must be put to work despite the underlying credit characteristics. Total return has been heavily price-weighted, which leaves the potential for downside pain rather high as the income component has diminished in importance.
Potential factors that could reverse the price appreciation experienced this year would be led by a reversal in flows that’s followed by a widening of credit spreads. The catalyst for flows reversing range from a rotation trade out of long/credit portfolios to shorter duration/higher credit quality portfolios as investors take some money off the table.
Legislative changes to the State and Local Tax (SALT) deduction could also negatively impact the positive flow dynamics. Credit, which has been mispriced for some time, may be the second large factor. Credit has become a commodity with marginal variation across sectors in terms of spread. The current BBB-AAA spread difference (10-year bond) is 74 basis points (bps). During the fourth-quarter 2018 sell-off, the spread difference was 83 bps. At some point the investing community will need to demand additional spread for credit risk. In late September, the Puerto Rico oversight board released a proposal to cut the island’s outstanding debt by 45% from $75 billion to $41 billion. However, depending on the security pledge, the recovery values range from 35 cents on the dollar to a high of 93 cents for certain sales tax–backed bonds. Couple this with Detroit and Stockton, along with known troubled credits like Illinois, and the call for wider spreads seems plausible.
The other perennial financial mystery—the lack of inflation—may be solved in how it is measured. The Atlanta Fed’s sticky price Consumer Price Index revealed core prices up 2.6% in August from the year before, while a San Francisco Fed measure of Personal Consumption Expenditure Index (PCE) prices was up 2.4% in July, and the Dallas Fed’s trimmed mean inflation rate was up 2% in August. The Fed’s preferred measure of inflation, PCE was up 1.4% and core PCE 1.8%. Perhaps the longer end of the curve is underpricing inflation.
All of these enumerated issues have led us to maintain our present course. The strategies remain higher in credit quality and cash with duration in the lower bands. While the latter has impacted total return in the intermediate and strategic portfolios, the distribution yield has held up nicely given the laddered strategy. Cash has been allowed to build given the trade-off in investing in the variable rate demand note market that is currently out-yielding 10-year AAA paper (1.70bps vs. 1.41bps) with zero duration and AA credit quality. When the opportunity set presents itself, i.e., curve steepening and/or credit spread widening, there is ample powder to take advantage of dislocations. Until those conditions are met, we are content to manage the strategies in a more conservative fashion.
Thank you for your continued trust.