Letter to the Shareholders: December 31, 2017

Dear Shareholder:

It’s year-end, so I thought I would recap some of the major factors and events that influenced the municipal bond market in 2017. I’ll also briefly discuss a couple of factors that we think will be in play next year and hazard a guess about how the municipal bond market might perform in 2018.

The municipal bond market experienced a sharp sell-off after the election of Donald Trump on November 8, 2016. The sell-off, although sudden and pronounced, was relatively short lived. The municipal bond market bounced back quite nicely during the first half of 2017 and recouped almost all of the losses experienced after the election. For the full year, municipal bonds turned in a very solid performance with the Bloomberg Barclays Municipal Bond Index posting a 5.45% total return. Favorable supply-and-demand dynamics (i.e., lower supply combined with steady demand) prevailed for most of the year which helped support municipal bond prices. The yield curve continued to flatten over the past year with yields on the short end rising and yields on the long end declining. Longer-dated and lower credit quality bonds (with the exception of Puerto Rican bonds) generally outperformed shorter-dated and higher credit quality bonds during the year. Our decision, made many years ago, never to hold any Puerto Rican bonds in any of our funds has proven to be a wise one.

Starting in November of this year, municipal bond prices broadly declined as tax reform uncertainty took hold. The proposed elimination of the tax exemption for advanced refunding bonds and private activity bonds (PABs) caused issuers to rush to issue bonds that were scheduled to be brought to market in 2018. This “pull forward” effect resulted in a surge in supply, with issuers bringing to market over $55.6 billion in municipal bonds in the month of December alone. This broke the monthly supply record of $54.7 billion which was set back in 1985. The resulting supply-and-demand imbalance caused municipal bond prices to decline towards the end of this year.

The good news is the final version of the Tax Cuts and Jobs Act passed by Congress and signed into law by the President left the tax exemption for interest earned on municipal bonds intact. The compromise tax bill also left the tax treatment for PABs unchanged, but it did eliminate the ability of municipal issuers to issue tax-exempt advance refunding bonds. Most municipal market participants, including us, believe preserving the tax exemption for PABs is a positive development given that PABs make up somewhere between 20-30% of the overall municipal market. PABs are typically used to finance projects such as non-profit hospitals, nursing homes, college and university facilities, and certain airport improvements.

The loss of tax-exempt advance refunding bonds will likely have a mixed impact. This provision of the tax legislation is permanent and will likely lead to a significant reduction in the supply of municipal bonds going forward. Some market commenters have estimated that the total supply of municipal bonds could drop by as much as 25% next year as a result of the loss of tax-exempt advance refunding bonds and the “pull forward” effect. From our standpoint as portfolio managers, the end to advance refunding deals means that that it will almost certainly be harder for us to find bonds next year due to the reduced supply. For issuers, the curb on issuing tax-exempt advance refunding bonds means less flexibility in refinancing projects.

The Tax Cuts and Jobs Act also lowered the highest individual federal marginal tax rate from 39.6% to 37%. Most economists and market participants believe that the relatively small reduction in the top federal marginal tax rate won’t be enough to significantly impact demand for municipal bonds.  Even for investors in lower federal tax brackets, municipal bonds should continue to be very attractive on an after-tax basis. The reduction of the corporate tax rate from 35% to 21% will, in theory, make municipal bonds less attractive for corporate buyers such as banks, property & casualty companies, and life insurance companies. However, it remains to be seen whether the corporate tax rate reduction will actually impact institutional demand since corporate buyers derive other benefits from holding municipal bonds such as lower default rates, liquidity, and diversification.

We’re keeping a close eye on several issues that may impact the municipal bond market in 2018. At the top of this list are escalating unfunded pension liabilities which many states, cities, and counties will have to address. The Commonwealth of Kentucky’s unfunded pension obligations are among the worst in the country. The Commonwealth’s appropriation-backed debt was downgraded one notch from Aa3 to A1 by Moody’s in July of this year because of unfunded pension obligations. A further downgrade is a real possibility if the pension situation is not addressed. Increasing budgetary pressures caused by increased state Medicaid spending are also likely to be in the news next year.

There are a number of other factors that we think will be in play next year. I’ve already mentioned supply-and-demand, which we believe will remain very supportive for municipal bonds in the coming year. It’s pretty clear the Federal Reserve seems intent on raising short-term interest rates several times next year. However, we continue to believe the rate hikes will be very gradual, especially given the fact that key inflation measures have continued to stay stubbornly low. This may well lead to continued flattening of the yield curve with the spread between yields on the short and long ends of the curve being compressed further. After turning in a very solid performance in 2017, we remain optimistic that municipal bonds will deliver positive total returns again next year.

Thank you for investing with us. Happy New Year!

Sincerely,

Allen E. Grimes, III
Executive Vice President