News & Letters


Keep Up-To-Date with Dupree


Letter to Shareholders: June 30, 2022

 

Dear Shareholder:

We’re at the midway point of the year, and financial markets are continuing to grapple with an aggressive Fed and inflation that continues to run hot. Municipal bonds performed better in the second quarter than in the first quarter; but, yields continued to adjust upwards, and bond prices declined. Notwithstanding the disappointing start to the year, we are optimistic that municipal bonds will perform better during the second half of this year.

Before turning to why we think the municipal bond market will improve in the second half of 2022, it’s worth repeating why higher interest rates benefit long-term bond investors. In fact, for investors with a reasonably long investment time horizon, rising rates are something to cheer, not fear. When interest rates rise, new bonds pay a higher coupon, increasing the income investors receive. Because interest income is the primary driver of bond returns, the ability to reinvest into a rising rate environment can help investors build long-term growth. Even over relatively short periods of time, rising income may provide a return advantage for fixed-income investors.

The yields of our funds are expected to rise gradually as we purchase new bonds issued at higher rates. Since the beginning of this year, yields on benchmark 10-year and 30-year AAA-rated municipal bonds have increased nearly 170 basis points. The sharp increase in yields provides us an opportunity to build higher and more durable income streams. For example, we recently purchased a number of high quality municipal bonds in the primary market for several of our tax-exempt funds with yields approaching 4.00% and in one case 4.50%. Higher yields have restored a lot of value to the municipal bond sector which we believe was oversold.

In the past few weeks, bond markets have rallied as financial markets have priced in a much higher chance of a recession. This repricing followed the Fed’s 75 basis point June rate hike and subsequent comments by Fed Chairman Powell acknowledging that steep rate hikes could potentially trigger a U.S. recession. Bond traders have begun pricing in a shallower rate path with fewer interest rate hikes and even a possibility that the Fed will be forced to change course and start cutting interest rates sometime in 2023. The “hard landing” or recession narrative has picked up considerable momentum and has dramatically improved market sentiment towards bonds, while at same time raising additional concerns about current equity market valuations.

Tax-exempt investors can take some comfort in knowing that municipal bonds have generally performed relatively well during recessions. Total returns for municipal bonds have been largely positive during recessions, with two negative episodes in 1981 and 2008. However, each of those periods was followed by a solid rebound. It is also worth noting that municipal bonds tend to outperform other fixed-income assets such as U.S. Treasuries and corporate bonds during Fed tightening cycles.

Credit fundamentals for state and local debt are very strong. General fund revenue collections across the states are robust with most states reporting large revenue surpluses and growing rainy day fund reserves. Credit rating upgrades currently exceed downgrades by a three-to-one margin. With the broad bond market selloff, there appears to be a growing disconnect between municipal bond prices and healthy government balance sheets. Ultimately, strong credit fundamentals should help support municipal bond prices for the remainder of this year, especially in a slow growth or recessionary environment where credit quality becomes of paramount importance.

In the near term, the municipal bond market will likely get a boost as principal and interest payments coming due in June, July, and August are reinvested. Bloomberg estimates that approximately $123 billion will be returned to investors from maturing municipal bonds during this 3-month period. This sizeable reinvestment activity should coincide with a relatively light supply of new bonds as a combination of large amounts of federal aid and strong tax collections has reduced the need for many states and cities to sell debt. These favorable supply-and-demand dynamics should act as a tailwind for the municipal bond sector.

It’s no secret that inflation has recently hit new highs. The big unresolved question is how long high inflation will last? The Fed’s preferred inflation gauge, the core PCE, increased at an annual rate of 4.7% in May which is down from a high of 5.3%. Many economists believe there is a good chance that core inflation will continue to decline through the summer especially if, as expected, consumer spending continues to cool, retailers put excess inventories on sale, and supply chain bottlenecks improve. In addition to monitoring core prices, the Fed also keeps a close eye on inflation expectations because they can feed future inflation. While still relatively high, long-term (5-10 years) consumer inflation expectations are also starting to show signs of trending lower which is a positive development for bond markets.

Unlike the Treasury and corporate bond markets which are controlled by institutional investors, the municipal bond market is dominated by retail investors. This makes municipal bond prices more susceptible to investor flow cycles. Municipal bonds have been in a prolonged outflow cycle as investors react to rising interest rates and elevated inflation. As uncertainty around the Fed’s monetary policy path dissipates further and inflation numbers continue to moderate, the outflow cycle will inevitably come to an end and may ultimately reverse itself.

While additional volatility is always a possibility, we are convinced that better times lie ahead for the municipal bond market. We’re confident that today’s cheaper municipal bond valuations present an attractive entry point for long-term fixed-income investors.

Thank you for the continued confidence that you have placed in us. Enjoy your summer!

Sincerely,

 

 

Allen E. Grimes, Ill President

 

Letter to Shareholders: March 31, 2022

 

Dear Shareholder:

After experiencing record-setting inflows and posting solid returns in 2021, the municipal bond market is off to a rocky start this year. Flows into municipal bond funds turned negative, and Treasury and municipal bond yields surged (valuations have declined) as market expectations reset to reflect ongoing fears about persistently high inflation readings, the outbreak of war in Ukraine, and a pivot to a more aggressive monetary policy stance by the Federal Reserve Open Market Committee (FOMC).

The abrupt and unexpected change in market sentiment and the resulting sell-off in the municipal bond market surprised many, including us. In addition to the factors mentioned above, less favorable supply and demand dynamics (i.e., a higher supply of tax-exempt bonds coupled with less demand) also contributed to falling bond prices. This combination of factors and events led to a perfect storm: the municipal bond market suffered one of its worst quarterly losses on record during the first quarter. The Bloomberg Municipal Bond Index provided a -6.23% total return for the 3-month period ended March 31.

Federal Reserve Update

The FOMC raised the fed funds rate by a quarter percentage point to a target range of 0.25% to 0.50% after its mid-March meeting. It also strongly hinted that additional rate hikes will follow at each of its six remaining meetings this year. Elevated inflation, mainly reflecting supply and demand imbalances related to the pandemic and higher energy prices, was the main reason given for adopting a tighter monetary policy stance.

The FOMC released a new economic forecast and dot plot which provide information about the expected path of the fed funds rate. The FOMC anticipates weaker GDP growth this year, and it now expects to raise the fed funds rate a total of ten times (six hikes in 2022 and four hikes in 2023). That means that the terminal fed funds rate range will probably be somewhere between 2.75% and 3.00%. The FOMC also raised its near-term median forecasts for core PCE inflation to reflect the recent increase in prices.

In addition to raising the fed funds rate, the FOMC also indicated that it would start reducing its balance sheet holdings, which consist of Treasury securities, agency debt, and agency mortgage-backed securities. No precise timeline was announced for starting the balance sheet reduction process, but it could potentially start as early as May. Instead of purchasing more securities or replacing securities coming due, the FOMC will simply let securities roll off organically as the debt matures. With approximately 25% of the balance sheet maturing within two and a half years, the FOMC should effectively be able to reduce the size of its balance sheet without having to resort to any open market asset sales.

The Income Component of Fixed-Income Returns

Make no mistake, the volatility and downward price action in the municipal bond market have been gut wrenching. As human beings, our natural tendency is to react emotionally to market sell-offs which almost always leads to poor investment decisions. With bond yields still relatively low and the FOMC embarking on an interest rate hiking cycle, fixed-income investors are understandably a bit anxious and nervous.

Benjamin Graham, known as the father of value investing, believed the key to investment success—in both equity and bond markets—is having the temperament to keep emotions in check and remain focused on long-term results. In his book, The Intelligent Investor, Graham wrote, “For indeed, the investor’s chief problem—and even his worst enemy—is likely to be himself.”

In volatile markets with falling bond prices, investors sometimes forget that the income component of fixed-income investments typically accounts for over 90% of total returns for periods as short as five years. If you are an investor with a reasonably long investment time horizon, it isn’t rational to focus on bond prices alone when the vast majority of the total return of bonds is generated by the income component. While the share prices of all our single-state municipal bond funds have declined recently, each of these funds continues to generate a steady stream of tax-free income that can be counted on, regardless of share price.

Interest rates have remained at historically low levels for close to a decade which has caused the prices of bonds to remain artificially elevated. With yield normalization, bond prices will be returning to more historic levels, and investors will be earning higher yields as new bonds are issued at higher interest rates. In a rising interest rate environment, when it’s time to reinvest bond proceeds from coupon payments, calls, and/or maturities, changes in interest rates do matter. As rates rise an investor can reinvest at higher yields. If an investor has a multi-year investment time horizon, this reinvestment effect means that the investor should ultimately be better off. So, please keep in mind that with rising interest rates long-term bond investors have little to fear and even, potentially, something to gain.

The shift to a buyer’s market from a seller’s market happened quickly and without much warning. From our perspective as portfolio managers, sell-offs like we experienced during the first quarter of this year present great opportunities to find value and build higher and more durable income streams for investors. Rest assured, we are staying busy trying to do just that.

Thank you for the confidence you have placed in us.

Sincerely,

 

 

Allen E. Grimes, Ill President

 

Letter to Shareholders: December 31, 2021

 

Dear Shareholder:

It’s hard to believe, but two years after first emerging the pandemic shows no signs of abating with the omicron variant spreading rapidly across the world and pushing COVID-19 infections to record levels. Our hearts go out to everyone that has been affected by the ongoing public health crisis, and we continue to be grateful for the heroic and valiant efforts of our front-line healthcare workers. We are also keeping our shareholders that may have been impacted by the recent tornadoes in western Kentucky, Tennessee, and Mississippi in our thoughts and prayers.

Municipal Market Update

While 2021 was another tough year in many respects, the municipal bond market managed to turn in a positive performance for the year. For the 12-month period ended December 31, the Bloomberg Municipal Bond Index provided a total return (which includes price changes and interest payments) of 1.52 percent. Municipal bonds outperformed other fixed-income assets such as U.S. Treasuries and investment grade corporates, both of which delivered negative total returns for the year.

The municipal market’s steady performance was fueled by a combination of favorable supply and demand dynamics (i.e., limited supply combined with strong demand), improving credit fundamentals, and passage by Congress late in the year of the $550 billion infrastructure package. Solid tax revenues and unprecedented federal support have helped state and local governments weather the pandemic much better than anticipated. Municipal credit upgrades have outnumbered downgrades this year. Improving credit quality has led to strong inflows into municipal bond mutual funds and exchange-traded funds. While the number of municipal bond defaults has ticked up slightly, defaults remain concentrated almost entirely in the high yield space led by nursing homes, industrial revenue bonds, and charter schools.

Trying to predict future market performance is always hazardous, especially in the middle of a pandemic. Nonetheless, we think a couple of factors will help support the municipal bond market in the coming year.

Credit quality in the investment grade municipal bond market is currently stronger than ever. State and local governments are flush with cash thanks in large part to COVID-19 relief. State and local tax revenues have soared as nominal profits and incomes have risen. Property, corporate, sales, and individual tax revenues have all risen sharply thanks to a strong economic recovery, a frothy stock market, a strong housing market, and ongoing federal assistance. That, coupled with the fact that U.S. municipalities are set for another large multi-year infusion of cash from the infrastructure package, has led many to conclude that municipal bonds may be set for a “golden decade” of credit ahead. The credit quality of each of our Funds is very strong, and we believe that the credit quality will remain strong in light of these factors.

Seasonal factors should also help support the municipal bond market as we start the new year. Historically, the “January Effect” has been supportive of municipal bond performance as reinvestment income from maturities, calls, and coupons significantly outpaces new supply. Continued strong demand, coupled with a net negative supply of municipal bonds, will likely help the municipal bond market get off to a strong start next year and should act as a floor for any potential price declines.

One slightly technical observation and potentially bullish development is also worth noting. Recently, the strong historic correlation between municipal bonds and U.S. Treasuries has weakened. As this year’s performance demonstrated, municipal bonds simply are not tracking U.S. Treasuries the way they used to. One plausible explanation for the decoupling is that the municipal bond buyer base is increasingly comprised of small retail buy-and-hold investors, as opposed to institutional investors which dominate the Treasury market. This “stickier” buyer base has resulted in less volatility for municipal bonds. If this trend continues, it potentially has implications for next year as the weaker correlation makes municipal bonds more attractive as a potential hedge against rising Treasury yields.

Federal Reserve Update

The Federal Open Market Committee (FOMC) met on December 15 and left the federal funds rate unchanged at 0 to ¼ percent. In response to persistently elevated inflation readings, it decided to double the pace of its quantitative easing taper which it first announced in November. The taper should be complete by as early as March. The FOMC’s statement was notable because it abandoned the term “transitory” that it had previously used to describe inflationary pressures which remain stubbornly high. The guidance on interest rate hikes also changed and is now weighted more towards labor market conditions (i.e., future assessments of maximum employment) rather than price stability. Overall, there were no huge surprises. The FOMC is still expected to raise interest rates by the same amount, but interest rate hikes are now expected to start sooner than originally anticipated.

Capital Gain Distributions

Capital gains distributions were made in four of our Funds this year: (i) the Kentucky Tax-Free Income Series, (ii) the Mississippi Tax-Free Income Series, (iii) the North Carolina Tax-Free Short-to-Medium Series, and (iv) the Alabama Tax-Free Income Series. Capital gains distributions were made on December 16, 2021—separate from and prior to end-of-year dividends. These capital gains distributions, along with all transactions made in your accounts in 2021, will be reflected on your end-of-year statements.

Thank you for investing with us. Happy New Year!

Sincerely,

 

 

Allen E. Grimes, Ill President

 

2021 Capital Gains Distributions

In 2021, capital gains distributions will be made in four of our funds: (i) the Kentucky Tax-Free Income Series, (ii) the Mississippi Tax-Free Income Series, (iii) the North Carolina Tax-Free Short-to-Medium Series, and (iv) the Alabama Tax-Free Income Series. For additional information on 2021 capital gains distributions, please see Dupree’s 2021 Daily Dividend Factor Information Page.

If you need assistance or have any questions, please call Dupree Mutual Funds at 1-800-866-0614, Monday through Friday between 9:00 A.M. and 5:00 P.M, Eastern Time.