2nd Quarter 2018

Portfolio managers are supported by the entire Thornburg investment team.

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Buy low and sell high. Buy low and sell high. Buy low and sell high. This fundamental, timeless tenet of investing is repeated all the time.

And yet, we see investors taking the opposite approach over and over again. They piled into Pets.com stock despite the fact that the company was built on the charms of a sock puppet. Homebuyers paid decimal prices for two-bedroom houses in California missing a front door. Or, despite their adorableness and connection to my childhood, the Beanie Baby craze of the early 1990s extends for some to this day.

Why? Because someone bought Pets.com for $11 and sold it for $14. HGTV has created the illusion that everyone can flip and flop houses to great riches. And, one time, I sold a Beanie Baby for $50. Alright, that might be a complete fabrication but I am sure someone has turned Beanie Babies into a lucrative business, judging from current price quotes on Etsy and eBay.

I use these examples not to elicit a cheap laugh, but because it highlights an incredibly important point about the current market: price and intrinsic value are not the same thing. It turns out that price can move away from intrinsic value and investors can win. However, in instances where price far exceeds intrinsic value, the fall tends to be pretty painful.

The difference between intrinsic value and price continues to drive our team discussions of relative value. Intrinsic value, as we all learned in Finance 101, is the value of a security determined through fundamental analysis. In the municipal bond world, the intrinsic value of a security would reflect a myriad of different characteristics and risk factors. While two reasonable people could look at the same security and determine a different fundamental value, eventually the "answer" will bear itself out.

Broadly speaking, we believe the municipal bond market is at best expensive and at worst fully valued. Fundamental value and price seem to be disconnected. That is doubly true for any security offering a little bit of yield and a tax exemption.

For example, a couple of weeks ago a new deal priced for Madera, California, Redevelopment Agency. The bonds were rated AA- and secured by incremental taxes on the area. In the municipal market, it is common to determine relative value by comparing the yield on a security to that of a municipal AAA curve. The curve is an estimate of the yield on a theoretically perfect municipal. Madera is a decent credit, but by no means perfect, suggesting there should be positive spread to the AAA curve. In fact, Madera priced at a negative 11 spread to the AAA curve in the 2027 maturity. Madera bonds priced more expensively than a theoretically perfect bond.

I looked at the Madera deal and determined that it was too expensive. At a negative 11 spread, the yield was insufficient to adequately compensate for the risk. Others disagreed and the bonds sold and were placed into investors’ portfolios. Those buy decisions were based on one of two hypotheses: a belief that either the bonds are going to go up in value (buy low, sell high), or the value won’t change and the investor can collect the tax-exempt yield for the next nine years.

Another example: An analyst report recommended buying New Jersey bonds after spreads tightened 35 basis points. New Jersey is more expensive now than it has been in quite some time, yet the analyst recommended buying more. Also mentioned in the report, New Jersey has the lowest pension funding level of any of the 50 states—even beating Illinois— at approximately 31%. The 2019 budget allocates $3.2 billion to pension funding, which is an enormous number but only 60% of their actuarially-required contribution. On top of those realities, the political infighting is so bad that the state almost failed to pass a budget. But, the analyst recommends you buy more at higher prices.

Maybe Madera and New Jersey represent value. Or, maybe a negative 11 spread is a ridiculous level to pay for a bond in California, and buying a state with a 31% pension funding ratio at ever higher prices doesn’t make sense. Our thesis in both cases, and in many others, is that price is divorced from fundamental value. Broadly speaking, investors are not being paid for the risks in the municipal bond market.

How long can price and fundamental value diverge? I don’t know. I do know there are events on the horizon that point to increased volatility in the municipal market. Demand seems to be weakening as banks and insurance companies back away from the market. Tax reform lowered the value of the tax exemption for these entities, and they are slowly divesting. Retail buyers may start to back away as well. For the first time in many years, investors are seeing consecutive losses in muni portfolios and the prospect of continued rising rates. The Federal Reserve seems intent on following through with rate hikes, given relatively solid U.S. economic growth and inflation rearing its head, as evidenced by the fact that nearly everyone seeking gainful employment has a job.

Look, if you bought the Princess Diana Beanie Baby for $500 expecting to sell it down the road for $1,000, maybe that is a good trade. The risks, which are certainly substantial, are balanced by your expectations of reward. If, however, you bought the bear at $990, hoping for $1,000 all of a sudden, the risk/reward equation is heavily skewed toward risk. At Thornburg, we are in the business of buying low and selling high, not buying high and crossing our fingers for higher. There will be a day when we buy credits like New Jersey and Madera, but not at these levels, not until we believe we are being adequately compensated for the risks they represent.

As we’ve mentioned in the past, the Thornburg portfolios are positioned in their bearish ranges from a risk perspective. Credit and liquidity are higher and duration is lower. When volatility arises, we are well positioned to take advantage. Until then, we will do our best to avoid bonds at prices that we view as unsustainable.

Thank you for your continued trust.

–Nicholos Venditti

Important Information

 As of 6/30/18 1 Yr 3 Yr 5 Yr 10 Yr Inception 1/1/1985
Limited Term Municipal Composite (Net) 0.40% 1.46% 1.85% 3.08% 4.81%
Limited Term Municipal Composite (Gross) 0.66% 1.73% 2.12% 3.48% 5.64%
Bloomberg Barclays 5-Year Municipal Bond Index 0.27% 1.62% 2.07% 3.46% N/A**
ICE BofA Merrill Lynch 1-10 Year Municipal Index 0.43% 1.61% 1.97% 3.18% N/A**
Performance data for the Limited Term Municipal Strategy is from the Limited Term Municipal Composite, inception date of January 1, 1985.

As of 6/30/18 1 Yr 3 Yr 5 Yr Inception 4/1/2014
Low Duration Municipal Composite (Net) 0.88% 0.84% 0.71%
Low Duration Municipal Composite (Gross) 1.23% 1.20% 1.08%
ICE BofA Merrill Lynch 1-3 Year Municipal Securities Index 0.72% 0.89% 0.81%
Performance data for the Low Duration Municipal Strategy is from the Low Duration Municipal Composite, inception date of April 1, 2014.

As of 6/30/18 1 Yr 3 Yr 5 Yr 10 Yr Inception 11/1/1991
Intermediate Term Municipal Composite (Net) 1.08% 2.16% 2.82% 3.96% 4.71%
Intermediate Term Municipal Composite (Gross) 1.51% 2.60% 3.27% 4.48% 5.45%
ICE BofA Merrill Lynch 3-15 Year Municipal Index 0.78% 2.43% 2.99% 4.29% N/A**
Performance data for the Intermediate Term Municipal Strategy is from the Intermediate Term Municipal Composite, inception date of November 1, 1991.

As of 6/30/18 1 Yr 3 Yr 5 Yr Inception 5/1/2009
Strategic Municipal Income Composite (Net) 1.75% 2.48% 3.47% 6.04%
Strategic Municipal Income Composite (Gross) 2.44% 3.22% 4.23% 6.92%
ICE BofA Merrill Lynch Municipal Master Index 1.69% 2.99% 3.71% 4.68%
Performance data for the Strategic Municipal Income Strategy is from the Strategic Municipal Income Composite, inception date of May 1, 2009.

Each composite above represents all assets under management in fully discretionary, fee based accounts. Returns are calculated using a time-weighted and asset-weighted calculation including reinvestment of dividends and income. Returns are annualized for periods greater than one year. Individual account performance will vary. The performance data quoted represents past performance; it does not guarantee future results. Portfolio returns net of fees may include management, advisory and/or custodial fees. Thornburg Investment Management Inc.’s fee schedule is detailed in Part 2A of its ADV brochure. Portfolio returns gross of fees do not reflect the deduction of management fees. Performance results of the firm's clients will be reduced by the firm's management fees. For example, an account with a compounded annual total return of 10% would have increased by 159% over ten years. Assuming an annual management fee of .75%, this increase would be 142%.

**Index not yet incepted.

Unless otherwise noted, the source of all data is Thornburg Investment Management, Inc., as of 6/30/18.

The views expressed are subject to change and do not necessarily reflect the views of Thornburg Investment Management, Inc. This information should not be relied upon as a recommendation or investment advice and is not intended to predict the performance of any investment or market.

Diversification does not assure or guarantee better performance and cannot eliminate the risk of investment losses.

The performance of any index is not indicative of the performance of any particular investment. Unless otherwise noted, index returns reflect the reinvestment of income dividends and capital gains, if any, but do not reflect fees, brokerage commissions or other expenses of investing. Investors may not make direct investments into any index.

Portfolio construction will have significant differences from that of a benchmark index in terms of security holdings, industry weightings, asset allocations and number of positions held, all of which may contribute to performance, characteristics and volatility differences. Investors may not make direct investments into any index.

Please see our glossary for a definition of terms.