Category: Shareholder Letters

Letter to the Shareholders: March 29,2019

Dear Shareholder:
Municipal Market & Federal Reserve Update:

The municipal bond market is off to its strongest start since 2014. The strong performance has been driven by a number of factors including, but not limited to: the Federal Reserve’s decision this month to pause its interest rate hikes; the new cap on the deduction for state and local income taxes commonly known as the “SALT” deduction; and favorable supply and demand patterns.

The Fed’s March meeting was a game changer for financial markets. As expected, the Fed left the fed funds target rate range unchanged at 2.25 to 2.50 percent. However, several other actions taken by the Federal Open Market Committee (FOMC) took financial markets by surprise. The FOMC made it clear in its statement that it would be 11patient” as it determines whether additional rate hikes are appropriate. The switch to an 110n hold” rate policy stance is a substantial departure from the FOMC’s previous rate policy guidance which suggested additional tightening would likely be appropriate. In the press conference following the meeting, Chairman Powell reiterated his belief that the fed funds rate is currently at or near the long-run neutral rate. We may now be at the end of this rate tightening cycle. For the first time, some interest rate forecasters are predicting that the next move by the FOMC will be a rate cut.

The FOMC also made significant changes to its balance sheet normalization plan. Beginning in May, the re-investment cap for Treasuries will be reduced from $30 billion to $15 billion and then further reduced to zero at the end of September. In September, the FOMC will also start reinvesting runoff from its holdings of mortgage backed securities in Treasuries bought in the open market. The end result is the Fed will be purchasing approximately $200 billion more in Treasuries this year than financial markets originally anticipated and continuing to hold significantly more assets on its balance sheet going forward than it has historically carried.

The 2017 tax code overhaul capped at $10,000 the amount of state and local tax payments a household can deduct from its federal income taxes. Previously, a taxpayer could deduct the entire amount they paid in state and local property taxes, and either the state individual income tax or state sales tax. The cap on the SALT deduction has led to a spike in demand for tax-exempt municipal bonds as investors look for new tax shelters. The demand for tax-exempt municipal bonds has been particularly robust in high-tax states such as New York, Connecticut, California, and New Jersey. The increase in demand from retail investors has occurred at a particularly opportune time, as banks have continued to reduce their municipal bond holdings due to lower corporate tax rates which make tax-exempt debt less attractive for them.

During the first quarter, the pace of new bond issuance did not keep up with demand creating a supply and demand imbalance that resulted in higher bond prices. Although issuance volumes are expected to increase slightly in the coming months, a record amount of tax-exempt debt is scheduled to mature in the second and third quarters of this year. This runoff will generate a significant amount of cash that likely will be reinvested in tax-exempt bonds. Favorable supply and demand dynamics should continue to act as a support for municipal bond prices.

Bond markets have repriced dramatically in response to these developments with bond prices increasing and yields declining. At the end of the first quarter, the 10-year benchmark municipal bond yield as measured by the MMD AAA Municipal Yield Curve was 1.86%, the lowest it’s been since September 2017. The 30-year benchmark municipal bond yield dropped to 2.60%, the lowest it’s been since January 2018.

There are signs that the economy is slowing down. Real GDP growth in the fourth quarter of last year came in at 2.2 percent which was down significantly from the 3.4 percent growth rate experienced during the third quarter of 2018. Personal spending dropped substantially in December and was flat in January. The slowdown in economic growth does not appear to be confined to the United States, as Europe and China are also showing signs of weakening economic conditions. Importantly, key measures of inflation have continued to run below the Fed’s 2% inflation target rate. The Fed’s preferred inflation measure, the core PCE, increased at an annual rate of 1.8% rate in January.

The good news is that the combination of slower economic growth and subdued inflation is a benign environment for bonds. We think that conditions are ripe for municipal bonds to deliver positive returns for the remainder of this year. Particularly with the recent changes to the federal tax code, investors are increasingly discovering that tax-exempt municipal bonds are one of the last tax havens left. Also, with stock market indexes approaching last year’s record levels, we think it is important to keep in mind that, in addition to providing a steady stream of tax-free income, municipal bonds offer important diversification benefits for an overall investment portfolio.

On behalf of all members of the Dupree Mutual Funds family, I would also like to recognize the enormous contributions made to Dupree by C. Timothy Cone, who passed away on February 8, 2019. Tim served as a trustee of Dupree Mutual Funds for 16 years and was chairman at the time of his death. An accomplished and respected lawyer by trade and a steady leader in his profession and community, Tim shared his intellect, acumen, and loyalty with Dupree Mutual Funds to the benefit of all of us. He is and will be missed.

Thank you for investing with us.

Sincerely,

Allen E. Grimes, Ill President

Letter to the Shareholders: December 31, 2018

“The investor’s chief problem—and his worst enemy—is likely to be himself. In the end, how your investments behave is much less important than how you behave.”

Benjamin Graham

Dear Shareholder:

2018 is now in the books, and what a wild and crazy year it was for financial markets. This past year proved to be a tumultuous one for nearly all asset classes. Stocks outperformed bonds for the first three quarters of the year, and then the floor fell out from under equities. The S&P 500 finished the year with a loss of 6.24% while the Dow posted a 5.63% loss. Municipal bonds struggled for most of the year, largely as a result of tax reform and rising interest rates, but then rallied impressively at year-end to finish on a high note. The Bloomberg Barclays Municipal Bond Index posted a total return of 1.28% for 2018. I never thought I would be writing this letter telling shareholders that municipal bonds outperformed stocks by a significant margin in 2018!

Over the years, we have tried to emphasize to shareholders how important it is for investors to keep their emotions in check. The much admired Benjamin Graham eloquently made this point in his classic book, The Intelligent Investor. In many ways, the performance of the municipal bond market during this past year provides a good example of just how relevant this construct remains. We had a number of shareholders who decided to redeem their shares as short-term interest rates increased. Many of these same investors reallocated their funds to the stock market at a time when stock prices were near all-time highs, only to then get whipsawed by the brutal sell-off in equities during the final quarter of the year. This past year has, once again, shown that trying to time the market is almost always a losing proposition.

One of the first things I learned when I entered this business over fifteen years ago is how important a reliable stream of interest income is to investors. In the fixed-income market, income is the essential component of total return. Historically, the most significant contributor to return has been coupon income which, on average, makes up roughly 85% of a bond’s total return. In a rising interest rate environment, the income stream generated by high quality bonds serves to cushion the blow from declining capital prices. Case in point: despite the fact that the share prices of each of our single-state municipal bond funds declined over the course of 2018, all of them ended the year with modest positive total returns. Of course, past performance doesn’t guarantee future performance. However, the importance of having a reliable stream of interest income should never be underestimated—it is a fixed-income investor’s best friend. Tax-free interest income is even better.

As we enter 2019, fundamentals for the municipal bond market look pretty attractive. More than nine years after the end of the deepest U.S. recession since the 1930s, states and localities are reaping the benefits of the recovery, with the majority of states reporting that revenues have rebounded to pre-recession levels after adjusting for inflation. Overall credit quality for state and local debt has continued to hold up well with default rates remaining at historically low levels. Favorable supply and demand dynamics should also help support the municipal bond market next year. Net issuance of municipal bonds next year is predicted to be flat or down slightly from the previous year and most market participants anticipate that demand from institutional and retail investors will remain strong. On a less positive note, unfunded public pension obligations continue to be a significant issue that many states (most notably Kentucky, where recent legislative changes to the state’s pension system were recently found by the Kentucky Supreme Court to be procedurally deficient) will have to continue to address substantively.

The Fed raised the fed funds target rate by one quarter of a percentage point at its December meeting. The fed funds target rate currently stands at 2-1/4 to 2-1/2 percent. The Fed’s preferred inflation gauge has continued to fall below its 2% target rate which has led some to call for the Fed to take a less aggressive monetary tightening stance. A pause in, or even potentially the end of the interest rate tightening cycle next year, could act as a tailwind for the municipal bond market in 2019. All things considered, we are cautiously optimistic that the municipal bond market will deliver modest positive total returns in 2019.

Talk about an inverted yield curve has grabbed a fair amount of attention in the financial press in recent months. Discussions about an inverted yield curve used to be the lore of finance and math whizzes, but now people are talking about it at cocktail parties. In layman’s terms, the yield curve inverts when yields on short-dated securities move above those on longer-maturity bonds. For a brief period of time in early December, the yield on 5-year Treasury notes slipped below the yield on 2-year notes. The gap between the 2-year and 10-year Treasury has continued to narrow, but so far has not inverted. An inverted yield curve gets people’s attention because over the years it has been a strong predictor of recessions.

We think there are a couple of points fixed-income investors should keep in mind as they relate to an inverted yield curve. A flat or even inverted Treasury yield curve is consistent with the Fed nearing the end of its tightening cycle. The 2yr/5yr yield curve has inverted 9 times since 1976, almost always just before the Fed began cutting interest rates.  A flat or inverted yield curve also typically signals that the market is forecasting slower economic growth going forward. Neither of these developments should keep fixed-income investors up at night.

Next year represents the 40th anniversary of the founding of Dupree Mutual Funds. It’s hard to believe that we started our first fund in 1979. I’d like to take this opportunity to remember our founder, Tom Dupree, who passed away earlier this year. All of us here at Dupree Mutual Funds are proud to carry on his tradition and legacy.

We look forward to being of service to you in the coming year. Happy New Year!

Sincerely,

Allen E. Grimes, III
President