Letter to the Shareholders: June 30, 2018

Dear Shareholder:

Federal Reserve Update:

The Federal Open Market Committee (“FOMC”) raised the fed funds target rate range by one quarter point to 1.75-2.0% at its meeting on June 13. This was the seventh interest rate hike since 2015 and the second rate hike this year. The Fed slightly raised its near-term economic projections; however, its longer-term economic projections were mostly unchanged. While acknowledging a slightly stronger economy, the Fed retained its “further gradual” guidance on future rate hikes.

Most folks that follow the Fed are expecting a further one quarter point rate hike in September, followed possibly by one more hike at the end of the year. Yet, as the FOMC has raised short-term interest rates, long-term rates have stayed stubbornly low causing a “flattening” of the yield curve. The gap between yields on 2-yr and 10-yr Treasury notes is currently only around 33 basis points and is expected to narrow further with additional increases in the fed funds target rate. An “inverted” yield curve happens when long-term interest rates fall below short-term rates. While there is no certainty that the yield curve will invert, the FOMC and participants in the bond market are watching this very carefully as the past eight recessions dating back to the mid-1970s have all been preceded by an inverted yield curve.

Mounting trade tensions, geopolitical uncertainty, and a stronger dollar also complicate the future interest rate path picture. All of these may act as a form of de facto Fed tightening which may potentially lessen the need for the FOMC to raise the fed funds target rate further at year-end. We continue to believe that this tightening cycle will be shallower than previous rate cycles.

Mid-Year Municipal Market Update:

After a challenging first quarter, municipal bonds turned in a solid performance during the second quarter. All told, the Bloomberg Barclays Municipal Bond Index posted a slightly negative total return of -0.25% for the first half of the year. Favorable supply and demand technical factors helped the municipal bond market outperform other fixed income assets such as Treasuries and corporates. The total supply of municipal bonds has declined approximately 15% this year, largely due to a provision of the federal tax overhaul that no longer allows states and municipalities to issue advance refunding bonds. This stands in stark contrast to the Treasury market where issuance has continued to climb. Demand for investment grade tax-exempt bonds has continued to be moderately strong among most investor types, especially property and casualty insurance companies, life insurance companies, and retail investors.

In the meantime, credit quality in the tax-exempt sector has generally continued to improve as state fiscal conditions show signs of improvement and greater stability. According to The Fiscal Survey of States compiled by the National Association of State Budget Officers, states are expected to increase general fund spending by 3.2% in fiscal 2019; by comparison, last spring, states were expecting an increase of just 1.0% based on governors’ fiscal 2018 budgets. After weak revenue growth in fiscal 2016 and 2017, tax collections are projected to rebound in fiscal 2018, with total general fund revenues growing an estimated 4.9%. States are also expected to add to their budget reserve funds, with the median balance as a share of general fund spending rising to 6.2% in fiscal 2019. The U.S. Supreme Court’s recent ruling allowing states to tax online retailers should also improve states’ revenue numbers.

While fiscal conditions have improved overall, budget situations continue to vary significantly by state. Many states continue to face long-term spending pressures from health care, unfunded pension obligations, K-12 education, infrastructure needs, and increased Medicaid expenditures. Standard & Poor’s (“S&P”) recently downgraded Kentucky’s appropriation-backed debt by one notch to A-minus from A with a stable outlook and cited below average economic growth and income levels, unfunded pension obligations, and increased Medicaid spending as reasons for the downgrade. Fitch Ratings (A+ with stable outlook) and Moody’s Investors Services (A1 with stable outlook) both recently affirmed their ratings of Kentucky’s appropriation-backed debt. The credit ratings for Tennessee, North Carolina, Alabama, and Mississippi general obligation debt have all remained stable. However, the S&P downgrade is a reminder that some states continue to face significant budgetary pressures and fiscal headwinds.

The recent volatility in financial markets reminds us why, over the years, we have tried to emphasize to shareholders how important we think it is to be a long-term investor. Our recently departed founder and mentor, Tom Dupree, would never miss an opportunity to try to educate investors about the virtues of staying invested and the dangers of trying to time the market. As such, I thought it would be appropriate to briefly mention that Morningstar® recently completed its annual study called Mind the Gap that estimates what individuals earned after shifting money in and out of funds versus the performance of the funds themselves over a ten year period. The results showed that among eight different asset classes that were examined, municipal bond investors were the worst at timing the market and earned an average of about 1.26% less annually on their investments in open-end municipal bond funds than they would have earned if they stayed invested in the funds themselves. In a nutshell, the Morningstar® study confirms that investors invariably make costly timing mistakes by selling after downturns only to buy back in after a rally. So, for your sake, please mind the gap!

We recently launched a new and improved Dupree Mutual Funds website which can be found at www.dupree-funds.com. I would encourage you to visit the new website as it has a wealth of information, fund performance data, and useful forms.

As always, thank you for investing with Dupree Mutual Funds.


Allen E. Grimes, III