Letter to the Shareholders: March 31, 2018

Dear Shareholder:

The Federal Reserve met on March 20-21 under the new leadership of Fed Chairman Jerome Powell. There were no real surprises that emerged from the meeting. The Federal Open Market Committee (“FOMC”) voted 8-0 to raise the fed funds target rate range by a quarter-point to 1.5 to 1.75 percent. The FOMC’s “dot plot” revealed a slightly steeper path of expected fed funds rate hikes in 2019 and 2020. The FOMC’s economic growth forecast for the near term was raised slightly, but the longer run growth rate estimate was unchanged at 1.8 percent. The balance sheet reduction plan was left in place without any changed.

The “gradual” rate hike posture previously adopted by the FOMC remains intact, and Chairman Powell seemed to get through his first press conference unscathed. Financial markets are currently pricing in two or three more rate hikes this year, although there are a number of folks that follow the Fed closely who predict that the rate path won’t be quite that aggressive due to the lack of inflationary pressures. Core PCE increased at an annual rate of 1.6 percent in February which is still well below the Fed’s 2 percent inflation target rate.

The first quarter was a challenging one for municipal bonds. The Bloomberg Municipal Bond Index posted a slightly negative return (-1.15%) for the quarter as yields on benchmark 10-year and 30-year AAA-rated municipal bonds rose close to 50 basis points (prices down). The spike in yields was fueled primarily by a combination of improving economic data and worries that increased budget spending and tax reform may lead to a more aggressive pace of Fed rate hikes.

Ironically, the first quarter’s lackluster performance came at a time when fundamental and technical factors were very favorable for municipal bonds. Improving economic conditions and the newly enacted federal tax cuts have helped support U.S. municipal credit conditions and seem likely to continue to do so. A pickup in consumer spending should lead to increased tax collections which will benefit the general funds of most states and many local governments. In the meantime, default rates for investment grade municipal bonds have stayed at very low levels. Technical factors have remained positive with municipal bond supply during the first quarter down substantially on a year-over-year basis, while demand has remained relatively stable. Despite this supportive backdrop, prices of municipal bonds declined broadly during the first quarter.

We are acutely aware that rising interest rates can be worrisome for fixed-income investors. Among other things, higher rates can lead to principal losses in bonds and to higher levels of inflation which can eat into returns on fixed-income investments. All of that said, we think it is important for fixed-income investors to keep a key point in mind as the FOMC continues to normalize monetary policy over the next couple of years.

Over time, income is the primary driver of a bond’s total return. If you are a long-term investor, the coupon return or income generated by a bond will, more than likely, be sufficient to offset any negative price movement. For bond investors, income is the single best defense against a moderately rising rate environment. While bond price declines may be painful in the short-term, the long-term gains that come in the form of higher yields almost always make staying fully invested the best option for most fixed-income investors.

In the case of our investment portfolios, as bonds mature or are called away and new issues are brought to market at higher rates, investors should expect to see their yields gradually rise, and ultimately, their expected long-term returns. Both time and income are on your side as a long-term fixed-income investor.

There have been a couple of recent developments in the municipal bond market that we think are worth mentioning. The Tax Cuts & Jobs Act passed at the end of last year resulted in the elimination of tax-exempt advance refunding bonds. Tax-exempt refunding bonds have been used by state and local governments for many years to take advantage of low interest rate market conditions to reduce the costs of financing their existing municipal debt.

The main effect of the elimination of tax-exempt advance refunding bonds will be a significant reduction in the supply of municipal bonds going forward. Estimates vary, but most market participants expect municipal bond supply will decline substantially. For the first quarter of 2018, municipal bond issuance declined by 29 percent on a year-over-year basis. The elimination of tax-exempt advance refunding bonds, in some cases, has also caused issuers to change the structure of new deals they bring to market. Specifically, issuers are increasingly considering moving away from a premium coupon structure (5.0%) with a standard 10-year call provision to market yield coupons with shorter 5-7 year call protection. We have always, for a variety of reasons, preferred to buy premium bonds with higher coupons so we are keeping a close eye on this issue as it is still developing.

Proposed legislation has now passed in both the U.S. Senate and House of Representatives (the Senate & House bills still must be reconciled) that would permit banks to count some municipal bonds as part of their level 2B “High-Quality Liquid Assets” for balance sheet purposes. We believe there is a good chance this legislation will be signed into law. If so, banks will have an additional incentive to buy municipal bonds which should have a positive effect on the municipal bond market.

Thank you for investing with us.


Allen E. Grimes, III
Executive Vice President