Category: Shareholder Letters

Letter to Shareholders: September 30, 2024

 

Dear Shareholder:

The long wait is finally over! For over a year the Fed maintained the fed funds target range at 5.25-5.50% which was up from near zero in early 2022 when the Fed’s current tightening cycle started. At its September meeting, the Fed pivoted and announced its first interest rate cut (a half point or 50 basis points) in four years. The size of the rate cut surprised many—it indicates that the Fed is shifting its focus from inflation to employment, which has shown signs of weakening. The Fed seems convinced that inflation will continue to decline slowly to desired levels, but the Fed is also signaling a concern that the economy may no longer be growing fast enough to support maximum employment. A sizeable rate cut to jump-start monetary policy easing, likely followed by smaller rate cuts is one way to address these concerns.

The Fed also lowered its forward fed funds target range rate projections. The dot plot median shows two more quarter-point cuts this year, four cuts next year, and two cuts in 2026. The new median projection sees the fed funds target rate ending 2025 in the range of 3.25-3.50%. The Fed’s Summary of Economic Projections forecasts 2.0% growth in real GDP for the next two years and core PCE inflation returning to its 2.0% target level in 2026. The unemployment rate is projected to peak at 4.4%.

What are the implications of the Fed’s policy pivot for fixed-income investors? The short answer: it’s great news. Although economic conditions can change quickly, it seems the economy may be heading for a soft landing (as opposed to a recession). Economic growth appears to be moderating, while inflation continues to subside. Historically, municipal bonds have performed well in a slow growth, benign inflation environment. On the other hand, if economic conditions deteriorate and we end up with a hard landing, high quality bonds have also typically performed quite well during these periods. One market commentator summed up the current situation pretty well when he said, “Bonds are back and doing what they are supposed to do.”

U.S. money market funds recently reached a record high of $6.3 trillion. The start of the Fed’s easing cycle has already lessened the appeal of holding cash or cash equivalents. In the coming months, most market participants believe that there will be a sizeable rotation from cash to high quality fixed-income assets as investors extend duration in an attempt to lock in attractive yields. With the rate cutting cycle still in its early stages, we think it’s an ideal time to consider investing in high quality tax-exempt municipal bonds that offer a reliable and predictable stream of tax-free income and the potential for capital appreciation. Additionally, municipal bonds offer excellent portfolio diversification benefits that are frequently overlooked.

Thank you for investing with Dupree Mutual Funds. As always, we appreciate your business.

Sincerely,

 

 

Allen E. Grimes, Ill President

 

Letter to Shareholders: June 30, 2024

 

Dear Shareholder:

The municipal bond market turned in a mostly flat performance during the first half of this year with the Bloomberg Municipal Bond Index providing a total return of -0.40%. Higher rates led to a decline in bond prices; however, the price declines were offset by the “carry” or income stream generated by tax-free municipal bonds.

Bond issuance in the first half of 2024 is close to 35% above the five-year average. The surge in supply coincided with relatively subdued demand as many investors seem content to hold cash until there is further clarity on the timing of the Fed’s future interest rate cuts. Bond issuance is expected to stay elevated for the foreseeable future.

In addition to supply and demand, two other issues are likely to have an outsized impact on the municipal bond market in the second half of this year: (1) potential interest rate cuts by the Fed and (2) the 2024 presidential election.

The Fed last met on June 12 and opted to keep the fed funds target rate range unchanged at 5.25% to 5.50%. The Fed reiterated its “higher for longer” message and modified its forecast, signaling that there will likely be only one rate cut in 2024. The Fed’s updated forecast now predicts that there will be as many as four rate cuts in 2025.

When the Fed finally pivots and begins its easing cycle, we expect that the yield curve will transition from its current inverted shape to a more upward-sloping trajectory as short term yields decline faster than long term yields. Historically, tax-exempt bonds have outperformed similar-duration taxable bonds (i.e., Treasuries) in declining rate environments. With inflation gradually receding and rate cuts around the corner, the stage is set for municipal bonds to outperform.

U.S. presidential elections typically have little impact on municipal bond returns. According to data compiled by Bloomberg Intelligence, going back to 1980, municipal bonds posted losses for the fourth quarter in only 2 of 11 election years (1980 and 2008). But, as we all know, elections have consequences. The main consequence for the municipal bond market this election cycle will be the effect on individual income tax rates, as select provisions of the Tax Cuts & Jobs Act (TCJA) will sunset at the end of 2025.

The Congressional Budget Office (CBO) just released its latest fiscal update, and it contains some sobering numbers and projections. For example, the CBO’s projected deficit for this fiscal year will hit 7% of Gross Domestic Product. By late 2034, the federal debt will top $50 trillion, and the federal government is then projected to spend more than 40% of all individual income tax revenue on debt service.

Given the current state of this country’s fiscal affairs and the projected trajectory of the federal deficit, the political party that prevails in the upcoming election will be faced with making some tough decisions with respect to future tax policy. Regardless of who wins, one thing seems pretty clear: there is almost no chance that individual tax rates will be lowered. Especially for investors in the highest tax brackets, the value of the municipal bond tax-exemption has never been more important.

The U.S. Securities & Exchange Commission recently adopted rule and form amendments that require mutual funds to transmit “concise and visually engaging” annual and semi-annual reports to shareholders that highlight key information about their fund investments. As such, our new “tailored shareholder reports” will have a fresh look. The rule requires that tailored shareholder reports be sent directly to investors, but this material will also be posted on our website.

As always, we appreciate the confidence that you have placed in us.

Sincerely,

 

 

Allen E. Grimes, Ill President

 

Letter to Shareholders: March 31, 2024

 

Dear Shareholder:

The municipal bond market’s performance for the majority of last year was negatively impacted by steadily rising interest rates and high inflation. However, market sentiment changed suddenly in November, and municipal bonds enjoyed a year-end rally of historic proportions.

Given the strong finish to last year, it’s not surprising that the municipal bond market took a “breather” during the first quarter of this year. Despite the slow start, we think the municipal bond market is at an inflection point and that the outlook going forward looks very favorable. We have compiled a list of ten different reasons why we think you should consider including investment grade municipal bonds as a core component of your investment portfolio.

1. Federal Tax Exemption

The main attraction of municipal bonds is their steady stream of income which is exempt from federal income tax. Especially for higher tax bracket investors, tax-free municipal bonds offer a valuable tax shelter. The income tax provisions of the Tax Cuts and Jobs Act of 2017 (TCJA) expire at the end of 2025. Unless Congress acts, most Americans will face higher marginal tax rates in 2026. Higher federal marginal tax rates increase the value of the tax exemption.

2. State & Local Tax Exemption

For investors that purchase municipal bonds issued in the state in which they reside, municipal bonds also provide income exempt from state and local taxes.

3. Safety

Investment grade municipal bonds have a long history of timely payment of principal and interest in both up and down markets. Municipal bonds are generally considered safer than corporate bonds because they are backed by the taxing power of governmental entities. The default rate of investment grade municipal bonds continues to run at historically low levels.

4. Municipal Market Credit Fundamentals

States and localities have continued to enjoy very healthy tax revenue collections which has resulted in a near-record level of rainy day fund balances. In recent years, credit upgrades have outpaced downgrades by a factor of 4:1. Municipal bond issuers are well prepared to weather any potential economic downturn.

5. Diversification

The diversification benefits of high quality municipal bonds are often overlooked. Historically, the performance of investment grade municipal bonds has shown a low correlation with stock returns. As such, they can be effectively used to reduce the risks and volatility of stock-heavy portfolios. With equity market valuations at or near all-time highs, the diversification benefits of municipal bonds are more important than ever.

6. The Civic Component

Buying municipal bonds is an important way to support the betterment of your local communities. Among other things, municipal bonds are used to finance critical infrastructure projects like schools, hospitals, wastewater facilities, and transportation systems. Investing in your hometown projects, while at the same time earning tax-free income, is a rare win-win situation.

7. High Short Term Money Market Yields Won’t Last Forever

Approximately $6 trillion is currently parked in money market funds. High short term yields won’t last much longer with the Fed poised to start cutting rates as early as June. We think it’s an opportune time to consider putting some of your cash to work by buying high quality municipal bonds to lock in attractive longer-term yields. Investors are typically rewarded with the highest investment returns when they redeploy liquid assets before or at the peak of a Fed tightening cycle, rather than waiting until after rate cuts start.

8. Municipal Bonds Typically Outperform During Interest Rate Easing Cycles

The Fed last met on March 20 and affirmed its outlook for three interest rate cuts this year and for additional rate cuts to follow. A declining interest rate environment has typically steepened the yield curve which usually boosts the performance of longer duration bonds. Declining rates also offer fixed income investors the opportunity for capital appreciation as bond prices rise.

9. Technical Factors Remain Positive

Municipal bond issuance is expected to increase slightly this year but remain negative on a net basis taking into consideration bonds that are either maturing or called. Meanwhile, demand for tax-exempt bonds continues to be very strong. This supply/demand imbalance should continue to act as a support for municipal bond prices.

10. Liquidity

All (100%) of the bonds that we hold in our funds are classified as “highly liquid” assets under applicable federal laws and regulations. Plus, unlike many investments, our funds don’t have minimum holding periods or redemption fees, so your money is available to you on a next business day basis.

As always, we appreciate the continued confidence that you have placed in us.

Sincerely,

 

 

Allen E. Grimes, Ill President

 

Letter to Shareholders: December 31, 2023

 

Dear Shareholder:

For most of 2023 the performance of the municipal bond market was choppy with municipal bonds posting slightly negative total returns though the end of October. Persistent inflation and rising interest rates continued to present dual challenges for the municipal bond market. That all suddenly changed in November, however, with municipal bonds posting very strong positive total returns during that month. The Bloomberg Municipal Bond Index (“BMBI”) posted a 6.35% gain during the month of November, which is the sixth-best monthly return on record and the second-best monthly return since 1981. The strong rally was fueled by a combination of factors including slowing economic growth, moderating inflation, and the Federal Reserve’s (the “Fed”) second consecutive pause in interest rate hikes.

The Fed’s pivot to a more dovish monetary policy stance led to increased expectations that the rate tightening cycle is at an end and that interest rate cuts will begin in 2024. The Fed’s updated “dot plot” was released at its December meeting and now reflects 75 basis points of easing in 2024. The market momentum which began in November continued into December and allowed municipal bonds to end the year on a strong note. For the 12-month period ended December 31, the BMBI provided a total return of 6.40%.

While the past couple of years have been difficult for fixed income investing, those investors who stayed the course were rewarded for their patience with solid returns in 2023. As we look ahead to next year, we believe the backdrop for fixed income investments has improved considerably. Even though the bond market has already experienced a significant year-end rally, we still believe it’s an opportune time for investors to consider adding to their investment grade municipal bond holdings.

The approaching end to the Fed’s rate tightening cycle should continue to act as a strong tailwind for the municipal bond market. Notwithstanding the recent rally, current municipal bond yields are still well above their recent lows and present an attractive opportunity to lock in rates that may not be available in the future. While today’s absolute yields are attractive, tax-equivalent yields are even more compelling—especially for investors in high tax brackets. In addition to producing extra income for investors, higher yields also provide a cushion that helps offset any potential price declines.

Cash has been a good place to park money recently, but today’s high rates on money markets and cash equivalents won’t last forever. Investors holding cash also face significant reinvestment risk. History has demonstrated that staying fully invested in high quality bonds almost always generates higher investment returns than trying to time the market.

Strong credit quality, favorable supply and demand patterns, and historically low default rates should continue to be supportive of the municipal bond market. We remain optimistic that 2024 will be another good year for municipal bond investors.

Thank you for investing with us. Happy New Year!

Sincerely,

 

 

Allen E. Grimes, Ill President

 

Letter to Shareholders: September 30, 2023

 

Dear Shareholder:

Municipal bonds posted negative total returns during the third quarter amid rising interest rates. The recent bond market selloff more than wiped out the positive municipal market performance posted during the first half of the year. The Bloomberg Municipal Bond Index provided a total year-to-date return of -1.38% percent through September 30.

Interest rates have moved higher as economic growth has continued to be resilient and inflation rates have remained elevated. At its September meeting, the Federal Reserve (the “Fed”) reiterated its hawkish monetary policy stance by telegraphing a “higher-for-longer” message. While the Fed left the target range for the federal funds rate unchanged at 5-1/4 to 5-1/2%, it also made it clear that one additional interest rate hike is still on the table in 2023. The Fed also signaled that it is not contemplating any interest rate cuts in the near future, hence the higher-for-longer theme.

When bond prices experience sharp declines, nervous investors instinctively panic and sell their fixed income investments. We’ve mentioned this issue before, but it’s worth repeating in the current environment: market timing is invariably a losing strategy. History has demonstrated that patient fixed income investors who stay fully invested through up and down market cycles are almost always rewarded with higher long-term returns. As such, for investors with a reasonably long investment time horizon, the prudent thing to do in a volatile market is to simply keep calm and carry on.

In times like these, it’s critical that investors keep a proper long-term investment perspective. Higher yields and a normalized interest rate environment are positive developments for long-term fixed income investors. Periods of rising interest rates don’t always result in losses in bond portfolios over the long run. This is the case because the income component of fixed income investments generates over 90% of total return, even over relatively short periods of time.

For investors in higher tax brackets and with some tolerance for risk, we believe today’s higher yields present a rare opportunity to purchase attractive levels of tax-free income at bargain prices. As portfolio managers, we are excited to have the chance to purchase high-quality municipal issues with tax-exempt yields approaching 4.75%. Tax-exempt yields haven’t been this attractive for well over a decade. Keep in mind that as we replace older, lower yielding municipal bonds with newer, higher yielding bonds it will have the effect of causing the distribution yields of all our investment portfolios to gradually increase over time.

The municipal bond market is very resilient, and we remain optimistic that market conditions and investor sentiment will improve. Among other things, the approaching end to the Fed’s interest rate tightening cycle, favorable supply and demand patterns, and an increased probability of an economic slowdown should help support bond prices as we start the final quarter of the year.

As always, we appreciate the trust that you have placed in us. Keep the faith!

Sincerely,

 

 

Allen E. Grimes, Ill President

 

Letter to Shareholders: June 30, 2023

 

Dear Shareholder:

The municipal bond market continues to be impacted by interest rate uncertainty and by inflation that has proved to be “stickier” than the Federal Reserve (the “Fed”) anticipated. While the Fed decided to “pause” its series of interest rate hikes at its mid-June meeting (leaving the federal funds rate target range at its current level of 5.00 – 5.25%), the Fed also released its Semiannual Monetary Report to the Congress which reiterated Chair Powell’s belief that interest rates will rise further this year. In late June, first quarter GDP was revised up to a 2% annualized rate reflecting a resilient economy and jobs market. A stronger economy lends support to the position that the Fed has some more work to do, possibly one or two more 25 basis point rate hikes.

Notwithstanding some headwinds, municipal bonds managed to post respectable returns for the first six months of this year with the Bloomberg Municipal Bond Index providing a total return of 2.67%. The supply of municipal bonds has continued to be subdued, in part due to higher borrowing costs, with tax-exempt debt issuance down approximately 15% on a year-over-year basis. Meanwhile, demand for tax-exempt municipal bonds has been steady leading to a slight supply/demand imbalance which helped support prices. Supply is expected to remain below average through the summer months, which typically experience the highest number of bond maturities and reinvestment activity. Approximately $40 billion in reinvestment money is predicted to flow into the municipal bond market in July alone.

Municipal bond market fundamentals remain strong heading into the second half of this year. State and local government budgets continue to expand, albeit at a slightly slower pace, and credit quality remains very strong. The current default rate of investment grade municipal bonds remains below historic levels, and credit upgrades continue to exceed downgrades. With the end of the rate tightening cycle nearing and inflation abating, we believe the stage is set for municipal bonds to perform well for the remainder of this year.

A couple of sectors such as health care and senior living have seen a deterioration in credit quality. Fortunately, our investment portfolios have extremely limited or, in most cases, no exposure to these riskier sectors. We continue to favor high quality essential service revenue bonds such as water, sewer, and utility systems. We are sticking to our disciplined process of buying the highest quality bonds at the best possible yields and holding on to them as long as we can. This investment strategy has served us well for many years, and we are confident that it will continue to produce positive results for our shareholders.

Thank you for investing with us. I hope you enjoy your summer!

Sincerely,

 

 

Allen E. Grimes, Ill President

 

Letter to Shareholders: March 31, 2023

 

Dear Shareholder:

The municipal bond market turned in a seesaw like performance during the first quarter. Following a very strong start to the year in January, municipal bonds posted negative returns in February as strong economic data and persistently high inflation led investors to reassess the likelihood of further interest rate hikes. The February pullback erased most of the early year gains. Returns then turned positive again in March. For the 3-month period ended March 31, 2023, the Bloomberg Municipal Bond Index provided a total return of 2.78%.

Municipal bond issuance continued to trend lower with tax-exempt issuance down approximately 20% on a year-to-date basis from last year and taxable issuance down over 40%. Strong demand during the first quarter generated primarily by reinvestment income from maturities, calls, and coupons led to a supply-and-demand imbalance which helped support municipal bond prices, even as interest rates continued to rise.

Federal Reserve Update:

The Federal Reserve (the “Fed”) raised the target rate for the federal funds rate an additional 25 basis points to 4.75 – 5.00% at its meeting on March 22. Notably, the language in the Fed’s statement was modified to indicate that some additional policy firming “may be appropriate,” as opposed to the “will be appropriate” language that appeared in previous communications. The Fed also acknowledged that recent banking sector stress will likely result in tighter credit conditions and weigh on economic activity, hiring, and inflation.

The Fed must carry out a delicate balancing act. On the one hand, it must manage inflation expectations by emphasizing its continued resolve to fight stubbornly high levels of inflation. On the other hand, it must acknowledge that recession risks have increased significantly as tight financial conditions and banking sector stress hinder the economy. According to the latest Bloomberg monthly survey of economists, the probability of an economic downturn in the next 12 months stands at 65%, up from 60% in February.

There is a growing disconnect between how financial markets and the Fed view the economic outlook. This disconnect is particularly evident in the bond market where traders are now pricing in interest rate cuts later this year. A sharp decline in yields on the short end of the yield curve signals that bond traders anticipate an imminent recession, which will likely force the FOMC to cut interest rates sooner than anticipated. However, the Fed has made it clear that its campaign to get inflation back down to its desired level is still on track.

We think there is a good chance that the Fed will raise the fed funds target rate by an additional 25 basis points in May and then pause for a period to assess how the economy is responding to higher rates and tighter credit conditions. We remain confident that we are approaching the end of this tightening cycle. This historically creates a strong tailwind for municipal bond performance. High quality municipal bonds should also continue to benefit from a flight to safety bid as investors continue to seek out haven assets during a period of heightened volatility.

Thank you for the trust that you have placed in us.

Sincerely,

 

 

Allen E. Grimes, Ill President

 

Letter to Shareholders: December 31, 2022

 

Dear Shareholder:

An aggressive interest rate tightening campaign by the Federal Reserve (“Fed”) and persistent inflation led to a challenging fixed-income market in 2022. Investment grade municipal bonds posted a loss of -8.53% for the 12-month period according to Bloomberg index data, the worst annual performance since the early 1980s. The year was unsettling to investors who value municipal bonds for their safety and stability.

As bad as this year’s performance might seem, it is worth noting that municipal bonds outperformed most other fixed-income asset classes including U.S. Treasuries, investment grade corporate bonds, and even high yield corporate bonds. There is no denying that 2022 was a tough year for the municipal bond market; however, on a comparative basis, municipal bonds held up relatively well in what was a punishing market.

The Fed raised the fed funds target rate a total of 425 basis points during the year. The Fed last met on December 14 and raised the fed funds target rate by 50 basis points to its current level of 4.25-4.50%. The December meeting was notable because the Fed trimmed its rate hike to 50 basis points from previous rate hikes of 75 basis points. The Fed also reiterated its commitment to lowering inflation to 2% and tightening further. Most economists are forecasting at least another 100 basis points in rate hikes before the Fed pauses.

For the municipal bond market, 2022 was all about “normalization” which meant higher yields and lower bond prices. Due to the inverse relationship between bond yields and prices, municipal bond valuations declined significantly in response to a surge in municipal bond yields.

With 2022 now in the rearview mirror, the focus naturally turns to the question of what next year might have in store for the municipal bond market. We have always doubted the wisdom of so-called financial “experts” trying to make annual market predictions. We instead subscribe to the view that following a consistent, disciplined investing process will invariably lead to better outcomes than trusting the predictions of financial experts. As portfolio managers, we plan on adhering to that process in the coming year and thought it might be useful to briefly mention a couple of factors that we think may have the greatest impact on the municipal bond market next year.

Municipal bond returns during the past ten years have been negative just twice—the first time was in 2013 which coincided with the Fed’s “taper tantrum,” and the second time was in 2022. This steady history of delivering mostly positive returns (even in a decade long low-yield environment) is a testament to the power of the “income” component of bonds. The income component of fixed-income returns accounts for close to 90% of returns for periods as short as five years. With current yields resetting at higher and more attractive levels, the case for owning high quality municipal bonds as part of an overall investment portfolio has become even stronger. While the “normalization” process currently underway has been painful in the short-run, long-term fixed-income investors should view higher yields as a gift. Historically, fixed-income investors who have stayed the course through the ups and downs in the market have almost always been rewarded for their patience with higher absolute returns.

Municipal bonds have demonstrated a tremendous amount of resiliency both after periods of market declines and after the Fed finishes an interest rate tightening cycle. Municipal bonds have posted positive total returns in the 12 months immediately following market declines for the past 30 years. Additionally, following the last interest rate hikes of the previous seven Fed tightening cycles (going back to 1984), municipal bonds have provided consistent positive performance in the subsequent six-month, one-, three-, and five-year time periods. While past performance doesn’t necessarily guarantee future performance, this strong track record suggests that municipal bonds may rebound in the coming year.

The possibility of the economy tipping into a recession looks increasingly likely. Fortunately, the fiscal health of state and local governments continues to be very strong. Overall, a combination of factors including, but not limited to, the approaching end to the Fed’s tightening cycle, moderating inflation, higher yields, strong credit fundamentals, and improved investor sentiment should serve as catalysts for the municipal bond market next year. We are cautiously optimistic about the prospects for municipal bonds in 2023

Capital Gains Distributions:

Capital gains distributions were made in two of our Funds this year: (i) the Alabama Tax-Free Income Series and (ii) the Mississippi Tax-Free Income Series. Capital gains distributions were made on December 15, 2022—separate from and prior to end-of-year dividends. These capital gains distributions, along with all transactions made in your accounts in 2022, will be reflected on your end-of-year statements.

Thank you for investing with us. Happy New Year!

Sincerely,

 

 

Allen E. Grimes, Ill President

 

Letter to Shareholders: September 30, 2022

 

Dear Shareholder:

After getting off to a good start in July, performance in the municipal bond market turned decidedly negative for most of August and September. Yields on benchmark 10-year and 30-year AAA-rated municipal bonds increased approximately 58 and 72 basis points, respectively, during the third quarter. Municipal bond yields have increased (prices down) to a level last seen in 2013.

The recent spike in market volatility has been fueled in large part by the Federal Reserve (“Fed”) which has ramped up its anti-inflation rhetoric and renewed its commitment to continue raising short-term interest rates. The Fed’s “hawkish” tone led to a strong risk-off sentiment in markets and to a broad selloff in all asset classes. For the 9-month period ended September 30, 2022, the Bloomberg Municipal Bond Index provided a total return of -12.13%. The last time municipal bond returns were this poor was in the early 1980s.

On a slightly more positive note, it is worth noting that municipal bonds have outperformed other fixed-income classes such as U.S. investment grade corporate bonds (-18.72% YTD) and U.S. Treasuries (-13.09% YTD). Equities have sold off sharply this year with the S&P 500 and Nasdaq 100 providing total returns of -24.77% and -32.40%, respectively.

Federal Reserve Update:

The Fed raised the fed funds rate by an additional 75 basis points to 3 – 3.25% at its meeting in mid-September. The Fed increased its median fed funds rate estimates for this year and next year signaling that they now expect a fed funds terminal rate in the range of 4.5 – 4.75%. The Fed acknowledged that it would take some time to get inflation back down to desired levels. The Fed sees inflation gradually declining to a level of around 2.9% by 2025. The Fed’s preferred inflation gauge, the core personal consumption expenditures index, increased at an annual rate of 4.9% in August which was up slightly from the previous month.

The Fed has two remaining meetings this year, one in early November and the other in mid-December. The market currently expects that the Fed will raise the fed funds rate at each of these meetings, with most Fed followers expecting 50 or 75 basis point rate hikes. With an active Fed determined to get inflation back in check, it seems likely that markets will continue to experience higher than normal levels of volatility for the remainder of this year.

Against this backdrop, investors are increasingly concerned about the potential for a prolonged economic downturn or even a recession. Economists and market strategists have raised the odds of a recession, and the market seems to be coming to terms with the idea that a recession is probably unavoidable. With a “hard landing” scenario increasingly likely, we thought it might be worthwhile to briefly mention a couple of points that may provide some comfort to long-term municipal bond investors.

Historically, tax-exempt bonds have performed relatively well during recessionary periods. Municipal bond credits are very resilient in uncertain times due to a combination of unique factors including, but not limited to, the following: strong reserves and revenue pledges, the ability of municipal issuers to adjust budgets, and an issuer’s ability to raise taxes, if necessary, to cover required debt service payments. State and local government balance sheets are currently flush with cash thanks to a combination of unprecedented federal assistance and a strong rebound in general fund tax revenue collections. One irony of inflation is that while it’s bad for working Americans, it’s great for government coffers as nominal profits and incomes rise.

Municipal bond credit rating upgrades are currently outpacing downgrades by a wide margin. Municipal bond defaults continue to be very rare events representing just a tiny fraction of the overall market. Only $2.1 billion par value defaulted in 2021, which represented only 0.05% of the $4 trillion municipal market. (Source: Bank of America/Merrill Lynch Research). The vast majority of municipal defaults has been confined to various sectors in the high yield space (e.g., long-term care, charter schools, and land-secured bonds).

The idea of investing in fixed-income during periods of high inflation and rising interest rates can seem counterintuitive. However, thinking and acting rationally in what are often emotion-driven markets requires patience and perspective. From our perspective as fixed-income investment managers, we believe today’s higher municipal yields potentially offer an attractive entry point for new investors or existing investors that have a reasonably long investment time horizon. Valuations in the municipal bond market have improved dramatically, and our portfolio managers are busy adding high quality bonds to our various investment portfolios at very attractive levels. Higher yields offer more of a cushion for total returns over time, even if price movements remain volatile. Instead of trying to time the market, most investors who have stayed the course through past Fed tightening cycles have been rewarded for their patience with higher total returns over the long run.

On the other hand, if you are a risk averse investor with a short investment time horizon, we would be the first to admit that the current market can be treacherous. If you fall into this category, don’t let anybody fool you into thinking that cash isn’t a legitimate asset class.

Before closing, I want to take moment to remember Terry Moore, our receptionist of 17 years who passed away in August. Terry was unfailingly cheerful, kind, and always willing to go the extra mile. We remember her with gratitude as we keep her husband and children in our thoughts.

Thank you for the continued confidence that you have placed in us.

Sincerely,

 

 

Allen E. Grimes, Ill President

 

Letter to Shareholders: June 30, 2022

 

Dear Shareholder:

We’re at the midway point of the year, and financial markets are continuing to grapple with an aggressive Fed and inflation that continues to run hot. Municipal bonds performed better in the second quarter than in the first quarter; but, yields continued to adjust upwards, and bond prices declined. Notwithstanding the disappointing start to the year, we are optimistic that municipal bonds will perform better during the second half of this year.

Before turning to why we think the municipal bond market will improve in the second half of 2022, it’s worth repeating why higher interest rates benefit long-term bond investors. In fact, for investors with a reasonably long investment time horizon, rising rates are something to cheer, not fear. When interest rates rise, new bonds pay a higher coupon, increasing the income investors receive. Because interest income is the primary driver of bond returns, the ability to reinvest into a rising rate environment can help investors build long-term growth. Even over relatively short periods of time, rising income may provide a return advantage for fixed-income investors.

The yields of our funds are expected to rise gradually as we purchase new bonds issued at higher rates. Since the beginning of this year, yields on benchmark 10-year and 30-year AAA-rated municipal bonds have increased nearly 170 basis points. The sharp increase in yields provides us an opportunity to build higher and more durable income streams. For example, we recently purchased a number of high quality municipal bonds in the primary market for several of our tax-exempt funds with yields approaching 4.00% and in one case 4.50%. Higher yields have restored a lot of value to the municipal bond sector which we believe was oversold.

In the past few weeks, bond markets have rallied as financial markets have priced in a much higher chance of a recession. This repricing followed the Fed’s 75 basis point June rate hike and subsequent comments by Fed Chairman Powell acknowledging that steep rate hikes could potentially trigger a U.S. recession. Bond traders have begun pricing in a shallower rate path with fewer interest rate hikes and even a possibility that the Fed will be forced to change course and start cutting interest rates sometime in 2023. The “hard landing” or recession narrative has picked up considerable momentum and has dramatically improved market sentiment towards bonds, while at same time raising additional concerns about current equity market valuations.

Tax-exempt investors can take some comfort in knowing that municipal bonds have generally performed relatively well during recessions. Total returns for municipal bonds have been largely positive during recessions, with two negative episodes in 1981 and 2008. However, each of those periods was followed by a solid rebound. It is also worth noting that municipal bonds tend to outperform other fixed-income assets such as U.S. Treasuries and corporate bonds during Fed tightening cycles.

Credit fundamentals for state and local debt are very strong. General fund revenue collections across the states are robust with most states reporting large revenue surpluses and growing rainy day fund reserves. Credit rating upgrades currently exceed downgrades by a three-to-one margin. With the broad bond market selloff, there appears to be a growing disconnect between municipal bond prices and healthy government balance sheets. Ultimately, strong credit fundamentals should help support municipal bond prices for the remainder of this year, especially in a slow growth or recessionary environment where credit quality becomes of paramount importance.

In the near term, the municipal bond market will likely get a boost as principal and interest payments coming due in June, July, and August are reinvested. Bloomberg estimates that approximately $123 billion will be returned to investors from maturing municipal bonds during this 3-month period. This sizeable reinvestment activity should coincide with a relatively light supply of new bonds as a combination of large amounts of federal aid and strong tax collections has reduced the need for many states and cities to sell debt. These favorable supply-and-demand dynamics should act as a tailwind for the municipal bond sector.

It’s no secret that inflation has recently hit new highs. The big unresolved question is how long high inflation will last? The Fed’s preferred inflation gauge, the core PCE, increased at an annual rate of 4.7% in May which is down from a high of 5.3%. Many economists believe there is a good chance that core inflation will continue to decline through the summer especially if, as expected, consumer spending continues to cool, retailers put excess inventories on sale, and supply chain bottlenecks improve. In addition to monitoring core prices, the Fed also keeps a close eye on inflation expectations because they can feed future inflation. While still relatively high, long-term (5-10 years) consumer inflation expectations are also starting to show signs of trending lower which is a positive development for bond markets.

Unlike the Treasury and corporate bond markets which are controlled by institutional investors, the municipal bond market is dominated by retail investors. This makes municipal bond prices more susceptible to investor flow cycles. Municipal bonds have been in a prolonged outflow cycle as investors react to rising interest rates and elevated inflation. As uncertainty around the Fed’s monetary policy path dissipates further and inflation numbers continue to moderate, the outflow cycle will inevitably come to an end and may ultimately reverse itself.

While additional volatility is always a possibility, we are convinced that better times lie ahead for the municipal bond market. We’re confident that today’s cheaper municipal bond valuations present an attractive entry point for long-term fixed-income investors.

Thank you for the continued confidence that you have placed in us. Enjoy your summer!

Sincerely,

 

 

Allen E. Grimes, Ill President