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Letter to the Shareholders: September 30, 2019


Dear Shareholder:

Financial markets are often quiet during the summer months as traders and investors are busy taking their summer vacations. This summer was very different. During the third quarter, a series of social, economic, political, and geopolitical events led to a spike in market volatility. Markets detest uncertainty, and these days uncertainty seems to be more entrenched in the world.

An escalating U.S.-China trade war; a messy Brexit; increased tensions with Iran (including an attack on a major Saudi oil facility that temporarily disrupted world oil supplies); protests in the streets of Hong Kong; surprise election results in Argentina; slowing global economic growth; the first interest rate cut by the Federal Reserve Open Market Committee (FOMC) in over ten years; and an inversion of part of the yield curve are just a few of the things that have impacted financial markets in recent months. I could go on, but suffice it to say, all of these developments combined to create a “risk-off” mentality across markets that prevailed for a good part of the summer.

The third quarter was characterized by a choppy stock market, wider credit spreads, and a substantial drop in bond yields (prices up) here and around the world. The decline in yields has been pronounced enough that many countries around the world are now experiencing negative interest rates. The U.S., U.K., Canada, Australia, and New Zealand are the only developed bond markets that do not have negative rates anywhere on their yield curves. Nonetheless, during the third quarter the yield on the 30-year U.S. Treasury fell to a low of 1.95%, which is close to a record low. Tax-exempt municipal yields have followed Treasury yields lower.

U.S. Treasuries and municipal bonds are viewed as “safe haven” assets and have benefited from a flight to safety during this period of heightened volatility. Despite a slight pullback in September, municipal bonds turned in a solid performance during the third quarter with the Bloomberg Barclays U.S. Municipal Bond Index (“Muni Index”) providing a 1.58% total return. For the first 9-months of the year, the Muni Index provided a total return of 6.75%.

The technical factors that have supported municipal bond prices throughout the year remain largely intact. Favorable supply-and-demand patterns have continued to act as a tailwind for municipal bond performance. Retail investors’ appetite for municipal bonds has remained strong. According to data compiled by the Investment Company Institute, municipal bond funds have experienced 38 consecutive months of inflows, and investors have added in excess of $45 billion to municipal bond funds so far this year. Demand by institutional investors such as property and casualty insurers, life insurance companies, and broker-dealers (banks being a notable exception because of lower corporate tax rates) has remained robust.

Issuance of tax-exempt municipal bonds picked up its pace a bit as states and municipalities took advantage of historically low yields. According to data compiled by Bloomberg, while states and municipalities have borrowed about $260 billion so far in 2019, $240 billion in debt matured and another $98 billion was called. Thus, despite a slight increase in gross municipal issuance, net tax-exempt issuance continues to be relatively flat to slightly negative. This supply deficit has been supportive of the municipal bond market all through 2019 and should continue to help support municipal bond prices in the fourth quarter.

Federal Reserve Update:

The FOMC lowered the fed funds target rate by 25 basis points at its meeting on July 31. This represented the first rate cut since December of 2008. The rate cut came in response to a slowdown in domestic and global economic growth and concerns about persistently low inflation levels. The FOMC met again on September 18 and trimmed the fed funds target rate by another 25 basis points. Chair Powell characterized the most recent rate cut as an “insurance provision” against ongoing economic risks. FOMC members appear to be divided about the future path of monetary policy with some expecting one more rate cut this year and others anticipating no further rate cuts.

A stable interest rate environment is generally bond-friendly, provided that inflation remains in check. Fortunately, key measures of inflation have continued to be subdued. The Fed’s preferred inflation measure, the core personal-consumption expenditures price index (PCE), increased at an annual rate of 1.8% in August which is still below the Fed’s 2% target rate. The headline PCE increased at an annual rate of 1.4%.

The municipal bond market has posted impressive returns for the first nine months of this year. We believe the combination of continued uncertainty, favorable supply-and-demand patterns, subdued inflation, and a benign interest rate environment should help municipal bonds finish out the year on a relatively strong note.

One of the things we probably don’t highlight enough is the “civic” component of investing in municipal bonds. In addition to providing steady returns, municipal bonds offer investors an opportunity to provide much-needed cash for public services. When you invest in municipal bonds, it allows local communities to build schools, highways, bridges, water and sewer plants, airports, and other critical infrastructure. In today’s uncertain world, we think municipal bonds represent a rare win/win proposition—an attractive investment that also permits investors to give back to their local communities.

Thank you for investing with us.

Sincerely,

Allen E. Grimes, Ill President

Letter to the Shareholders: June 30, 2019


Dear Shareholder:

Mid-Year Municipal Market Update:

During the first half of the year municipal bonds posted strong returns. Bond prices rose (yields declined) as investors’ appetite for tax-exempt bonds increased. The boost in demand was fueled in part by recent changes to the federal tax code (i.e., the impact from capping the state and local tax (SALT) deduction for higher-income earners) and also by investors’ flight to safe-haven assets during a period which witnessed increased trade tensions and heightened geopolitical risks.

On the supply side, net new issuance of tax-exempt bonds remained flat. The supply of newly issued municipal bonds has been constrained by the new federal tax law that prohibits issuers from advance refunding outstanding bonds on a tax-exempt basis. Favorable supply-and-demand dynamics created a powerful technical tailwind for municipal bonds that contributed to the strong performance. On a total return basis, the Bloomberg Barclays Municipal Bond Index posted a 5.09% gain for the six month period ended June 30.

A favorable macroeconomic environment also helped support municipal bond prices. On the domestic front, economic data (e.g., business income growth and a slowdown in consumption during the first quarter) suggest that the pace of economic activity, while still positive, is beginning to slow. Manufacturing production has also posted declines so far this year. In the meantime, key measures of inflation have continued to be muted. The Fed’s preferred inflation gauge, the core PCE, increased at a 1.6% annual rate in May and continues to run well below the Fed’s 2% target rate.

On the international front, there are also signs that economic conditions are weakening. Earlier this year, the World Bank cut its forecasts for global economic growth in 2019 and 2020 for the U.S., the Eurozone, and China. Escalating trade tensions have cast a dark cloud over economic growth prospects around the world. The heads of several foreign central banks have recently suggested that they are prepared to roll out additional economic stimulus if economic conditions continue to soften.

Federal Reserve Update:

Against this backdrop, the Federal Reserve Open Market Committee (FOMC) met on June 19th and decided to leave the fed funds target rate range unchanged at 2.25-2.50%. From our perspective, we think the outcome of the Fed’s June meeting was notable for a couple of reasons.

To the surprise of many, the FOMC abandoned its use of the term “patient” to describe its approach to future policy changes. The “patient” language had just recently been adopted by the FOMC but was nowhere to be found in the FOMC’s June statement. Instead, the FOMC revealed that it plans to “closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion…” (Emphasis added). The FOMC’s pivot to a “ready to act” policy stance was a significant monetary policy development. We believe it pretty much confirms that the interest rate tightening cycle has officially come to an end. One voting FOMC member, James Bullard, voted against leaving the fed funds target rate unchanged, as he preferred to lower the target rate range by 25 basis points at the June meeting.

The FOMC’s change in its policy stance was sudden and fairly dramatic. The revised “dot plot” that is released along with the FOMC’s statement showed that eight of 17 Fed officials now expect a rate cut by the end of the year, with seven suggesting 50 basis points (bps) of rate cuts by year-end. Bond traders are feeling somewhat vindicated by the FOMC’s revised policy stance as they have been pricing in the possibility of a rate cut for some time. While market conditions can change rapidly, it looks like the next move by the FOMC will be a rate cut. Fed funds futures are currently pricing in a 100% probability of a rate cut in July (78% 25bps cut, 22% 50 bps cut).

The FOMC’s June meeting was also notable because Fed Chairman Powell seemed to tweak his comments about the significance of persistently low inflation. In his post-meeting press conference, Powell acknowledged that the FOMC was less confident in its previous pronouncements that low inflation readings were “transitory” in nature. He made a point to mention that wage growth was unlikely to “provide much upward impetus to inflation” and that weaker global growth could continue to hold inflation down around the world. Financial markets interpreted these dovish comments to mean that the FOMC would, if necessary, consider cutting interest rates to address stubbornly low inflation levels. The FOMC meets again on July 31, so stay tuned for more policy developments.

We think municipal bonds will continue their strong performance during the second half of this year. As a general matter, bonds perform well in a slow growth, low inflation environment. If current economic trends persist, the second half of this year looks like it will meet both of these criteria. Default rates of investment grade municipal bonds have remained at historically low levels. The credit quality of all our investment portfolios remains very strong.

The summer months are historically a period of net negative issuance (which occurs when the amount of maturing debt and refunded securities exceeds the supply of new issuance) for the municipal bond market. This tends to support bond prices. Citigroup estimates that over the next three months there will be -$47.7 billion in net tax-exempt issuance. At the same time, retail and institutional demand for municipal bonds continues to be very strong. Taken together, all of these factors should help support the municipal bond market in the coming months.

Thank you for investing with Dupree Mutual Funds. Please don’t hesitate to contact us if we can be of any assistance. Enjoy your summer!

Sincerely,

Allen E. Grimes, Ill President

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

Important Tax Information

Corrected 2018 Forms 1099-DIV were mailed to shareholders on February 4, 2019.  The original 2018 Forms 1099-DIV mailed to shareholders erroneously reported exempt-interest dividends in Box 10, instead of Box 11.  On the corrected 2018 Form 1099-DIV, exempt-interest dividends are now properly reported in Box 11.  Please note that the dollar amount of exempt-interest dividends has not changed—just the box number in which the amount is reported.  Likewise, if you previously received a combined 2018 Form 1099 (Form-DIV and Form-B), please note that no corrections were made to the 2018 Form 1099-B. We apologize for any confusion. Please feel free to contact us at 800-866-0614 if you have any questions or concerns.

 

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

Letter to the Shareholders: September 30, 2018

Dear Shareholder:

The Federal Reserve met on September 26, 2018 and raised the short-term fed funds target rate range an additional 25 basis points to 2.00 to 2.25%. This latest interest rate hike represented the eighth consecutive one-quarter point increase during the current tightening cycle. The market is pricing in four more moves by the Federal Reserve, and this suggests that the end of the rate hiking cycle may be in sight. It’s easy to forget, but historically low interest rates have endured for close to ten years now. The low interest rate environment has caused yields to stay stubbornly low and, on the flip side, prices for bonds and bond funds to remain elevated above historical norms.

Over the course of the last year or so, bond prices have gradually declined to more “normal” levels as yields have risen. Lower bond prices manifest themselves in lower net asset values for our bond funds. Investors are generally aware of the inverse relationship between bond prices and interest rates: when one rises, the other falls. However, in reality, the relationship between bond prices and changes in interest rates is more complicated than this.

News about the bond market invariably focuses on U.S. Treasuries, which tend to be the most sensitive to rising rates. However, it’s important to keep in mind that the bond market is diverse and is comprised of many different sectors and asset classes such as Treasuries, corporates, high yield bonds, mortgage-backed bonds, and municipal bonds–just to name a few. Each asset class or sector responds differently to economic and market trends and changes in interest rates. In addition to interest rate changes, municipal bond prices are also affected by a wide variety of other variables such as credit quality and supply and demand technical factors. For example, after reaching record holdings in 2017, banks reduced their holdings of municipal debt by $26.7 billion in the first six months of 2018 in large part due to the passage of the Tax Cuts and Jobs Act, which reduced corporate tax rates beginning this year. Large scale selling by U.S. banks has led to additional downward pressure on municipal bond prices during the first three quarters of this year.

We are very aware that it can be disconcerting for shareholders to watch the net asset value of a fund in which you are invested decline. We have said it many times, but it is worth repeating: investors are almost always better off staying the course than trying to time the market. It may sound counterintuitive, but if you are a bond investor with a reasonable investment time horizon and some patience, you should actually be pleased that interest rates are gradually increasing to more normal levels. In contrast to sudden and large movements in yields (which truly can be frightening and result in losses for short-term investors), a gradual increase in yields is a positive development for long-term fixed-income investors. If you are a long-term investor, you should embrace—not fear—higher yields.

A low yield environment is a form of “financial repression” for fixed-income investors. Low bond yields can be thought of as a tax on savers paid to borrowers, including the government. Remember, interest income is the primary driver of bond returns, not price appreciation. The ability to reinvest into a gradually rising interest rate environment can help build long-term growth in an investment portfolio. When interest rates rise, newly issued bonds pay a higher coupon thereby increasing the income investors receive. An increase in income can help offset the negative impact of falling prices. As interest rates continue to normalize, you should expect to see the yields of our funds gradually rise. This will not occur overnight, but it will happen over time.

Many people are surprised to learn that municipal bonds have frequently generated solid positive total returns in prior rate hiking cycles. For example, from June 2004 to June 2006 the Federal Reserve raised the fed funds rate a total of 425 basis points during which time municipal bonds delivered an 8.97% total return as measured by the Bloomberg Barclays Municipal Index. Similarly, from March 1988 to February 1989, the Federal Reserve raised the fed funds rate a total of 325 basis points during which time municipal bonds produced a 7.47% total return as measured by the same index. Of course, we would be remiss if we didn’t remind you that past performance is not a guarantee of future performance or an indicator of future performance.

We believe it is important to keep in mind that, even though the fundamentals of the bond market change on a daily or even an instantaneous basis, the underlying reasons for investing in fixed-income securities remain unchanged. By investing in high quality bonds that promise to deliver fixed semi-annual interest payments and repayment of principal at a stated maturity, bond funds have historically provided capital preservation, income, and portfolio diversification. All of these are essential goals for most investors.

One of the primary benefits of being a shareholder in our funds is the personal service you receive when you pick up the telephone and speak with someone at Dupree, whether it’s an experienced registered representative or even a portfolio manager. We have assembled a seasoned team of professionals who are available to you to discuss current market conditions, fund performance, and any specific details about your account. Please don’t hesitate to give us a call.

Thank you for investing with Dupree Mutual Funds.

Sincerely,

Allen E. Grimes, III
President

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.

Sincerely,

Allen E. Grimes, III
President

Special Letter to the Shareholders: May 4, 2018

Dear Shareholder:

With profound sadness and deep regret, I write to inform you that our founder and mentor, Thomas P. Dupree, Sr., passed away on April 29, 2018. All of us here at Dupree Mutual Funds are very proud of Tom’s many accomplishments, his generosity, and the mutual fund company he founded 39 years ago. While we will miss him dearly, I want each of you to know we are dedicated to the legacy Tom leaves behind, including his great intellect and humor, and we will continue to operate Dupree Mutual Funds in the same manner Tom would have if he were still with us.

I consider myself very fortunate to have spent the past 13 years learning this business first-hand from Tom: a man who truly embodied the concept of integrity and who was also a master of detail. Tom spent years assembling a talented team of professionals to help him run his business, both before and after his death, and his highest priority was doing what is best for shareholders. I can assure you that all of us here at Dupree Mutual Funds will continue to uphold that tradition and legacy.

In his letter to shareholders dated December 31, 2005, Tom wrote as follows:

I am grateful for this support, and I want to tell you what we are going to do in return.  First, I have arranged my estate planning in such a manner that it will be unnecessary for my heirs to sell the company.  That means the same people should be here, providing the same level of service for years to come, long after I am gone.  We will not only have the same portfolio management style which has resulted in five star ratings for most of our outstanding series, but we will be continuing to do the mundane things like answering our telephone with live people, instead of dragging you through a menu program.  We will continue to have Series 7 licenses advisors to give you the same level of advice as other firms, and they are salaried, not commissioned. To the extent you will let us, we are going to try to treat you like family.

Rest assured, we will continue to be a family owned and operated business, committed to the continuity of shareholder service Tom would have wanted. It’s important that you know we value each and every one of our shareholders and we genuinely appreciate your business.

Please know that we are always here to answer any questions you may have and to assist you with any of your investment needs.

 

Very truly yours,

Allen E. Grimes, III
Executive Vice President

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.

Sincerely,

Allen E. Grimes, III
Executive Vice President

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