3Q 2019 — Tax-Free Fixed Income

Jamie Mullen
Senior Portfolio Manager
Neal DeBonte, CFA®
Portfolio Manager

The continued decline in Treasury rates added to a third quarter of positive returns for municipal bonds. The Bloomberg Barclays Aggregate Municipal Bond Index posted a return of 6.75% through the end of Q3. The Bloomberg 5-year Municipal Bond Index returned 4.37% during the same period.

As anticipated in our Q2 commentary, heavy re-investment of interest payments along with matured and called bonds were the theme throughout July and August. Ratios continued to be compressed in the traditional SMA space of 1-5 years, offering little to no value in our view. The overall mentality of buy, buy, buy is what causes overbought conditions in these periods of re-investment cash outstripping supply.

The quarter began with the Bloomberg Municipal AAA curve at 1.60% and ending at 1.46%, 14 basis points lower. 5% coupon bonds with a 10-year maturity priced at 1.46% yield equates to dollar price of over $132. A 4% coupon with a 10-year maturity is over $123. If rates were to move higher, it would be an awful lot of premium that could be lost. Remember that bonds are ultimately worth par at maturity.

In order to navigate this low interest rate environment, we have been proponents of utilizing a barbell strategy for the last couple of years. The front end of the curve provides liquidity in bullet maturities we own. We also use longer dated maturities and buy bonds with 2 to 3-year calls that provide short duration and have a high probability of being called.

The callability of municipal bonds is a key feature that we use in our portfolio to manage duration for the barbell strategy. Longer dated bonds can trade at 130-150 basis points spread to Treasury bonds on a yield top call basis. If the bonds were to extend to maturity, the ratios are even higher (maybe by 160 basis points for example).

This cheapness in the ratios in relation to Treasuries is what provides a defensive nature to the bonds. As the saying goes, “do not try this at home.” Make sure you have an active manager that can navigate the nuances of the complex municipal bond market with experience and an established track record.

Source: Bloomberg, Ned Davis Research

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Bloomberg Barclays U.S. Aggregate Bond Index: The index is unmanaged and measures the performance of the investment grade, U.S. dollar denominated, fixed-rate taxable bond market, including Treasuries and government-related and corporate securities that have a remaining maturity of at least one year.
The Bloomberg Barclays 5-Year Municipal Bond Index is the 5 Year (4-6) component of the Municipal Bond index. It is a rules-based, market-value-weighted index engineered for the tax-exempt bond market. The index tracks general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds rated Baa3/BBB- or higher by at least two of the ratings agencies.
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