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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.


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!


Allen E. Grimes, III

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.


Allen E. Grimes, III

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 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

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.


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!


Allen E. Grimes, III
Executive Vice President

Letter to the Shareholders: September 30, 2017

Dear Shareholder:

The Federal Open Market Committee (“FOMC”) met on September 19-20 and, as expected, left the federal funds target rate (“FFTR”) unchanged at 1.00-1.25%. The FOMC’s assessment of the economy was mostly upbeat; however, the FOMC acknowledged continued concern about persistently low inflation. Conventional economic theory would dictate that prices for goods and services should be moving up, not down, in an economy that’s in its ninth year of expansion and nearing full employment levels. The Fed continues to insist that this “lowflation” is transitory in nature and will correct itself. However, other prominent central bankers and economists think this may be a more worrisome problem caused by long-term structural issues impacting advanced economies (other countries are also experiencing this). I feel certain we will hear more about this lively economic debate in the coming months.

The FOMC’s updated “dot plots” which attempt to forecast the future path of the FFTR contained a mixed message. The FOMC’s near-term (2017 & 2018) median FFTR estimates were unchanged. Financial markets interpreted this data as mostly “hawkish” meaning that that the FOMC would likely move forward with one additional quarter point rate hike this year, followed by three additional quarter point rate hikes in 2018 (resulting in a FFTR of 2.00-2.25% by the end of 2018). However, the FOMC lowered its FFTR median estimate for the end of 2019 to 2.7% from 2.9%. It also lowered its longer-run median FFTR estimate to 2.8% from 3.0%. Financial market s generally interpreted these downward revisions to the FOMC’s longer-term interest rate forecasts as “dovish”, hence, the mixed message. From our perspective, the changes to the Fed’s forecasts on the longer end reinforce our belief that the “lower for longer” thesis remains a viable one.

In an announcement perhaps more important than its updated economic projections, the FOMC also stated that it will initiate its balance sheet normalization program in October.  In August of 2007 before the financial meltdown, the Fed had a balance sheet that totalled approximately $869 billion. In an attempt to pump more money into the economy and stabilize financial markets, the Fed implemented a series of quantitative easing (“QE”) measures starting in late 2008 that involved purchasing U.S. Treasury and U.S. Government securities, including those issued by U.S. Government agencies, in the open market. The FOMC ultimately stopped purchasing these securities, but a couple of years ago it introduced reinvestment as a sort of “QE Lite” which essentially has allowed the Fed to buy bonds without growing assets. The Fed’ s current balance sheet is estimated to be just under $4.5 trillion.

Under the balance sheet normalization program, the FOMC will begin trimming reinvestments in U.S. Treasury securities by $6 billion per month and mortgage backed securities by $4 billion. The cuts to reinvestment will be gradually increased on a quarterly basis until they reach $30 billion per month for U.S. Treasury securities and $20 billion per month in mortgage backed securities. The FOMC did not specify an end date to its balance sheet normalization program, but most economists speculate that the Fed will continue to shed assets until its balance sheet approaches the $2.0-2.5 trillion range. Even when the FOMC completes its balance sheet normalization program, it will have a balance sheet substantially larger than it has carried in the past.

Now that the FOMC has outlined its balance sheet reduction plan, the critical question becomes how this might impact financial markets and, more specifically, bond yields? The honest answer to this question is nobody really knows for sure. The fact of the matter is the FOMC is in uncharted waters. Fed Chair Janet Yellen has expressed hope that the reduction in the size of the balance sheet will be “like watching paint dry.” While it remains to be seen how financial markets actually respond, we think there are a number of reasons to believe that the market impact will be relatively muted.

First and foremost, the Fed’s balance sheet reduction plan is passive in nature. We think this is an important point because the balance sheet will ultimately be reduced, not by active sales of assets, but rather by phasing out the practice of rolling over maturing assets. By allowing the balance sheet to shrink in this manner over an extended period of time it should, in theory, maximize predictability and minimize potential market disruption. Financial markets do not like surprises.

Second, the Fed is set to reduce the size of its balance sheet by roughly $300 billion over the next 12 months. Keep in mind that this is a relatively small number in the overall scheme of things. In the aggregate, the G4 central banks around the world have expanded their balance sheets by approximately $11 trillion since 2009. A number of economists have noted that ongoing asset purchases by the European Central Bank and the Bank of Japan, both of which still maintain active QE programs, are sufficiently large to offset the assets shed by the FOMC over the next year.

Third, although this may be somewhat counterintuitive, there appears to be little correlation between the Fed’s ownership share of the Treasury market and yields. If you look at a graph of Treasury yields versus the percentage of total marketable Treasury securities held by the Fed, it reveals that yields have both increased and decreased in the periods after the Fed started purchasing assets. As a practical matter, the Fed’s share of outstanding Treasuries has been in decline since 2015, during which time Treasury yields have actually declined. A wide variety of factors affect bond yields. In short, we’re not convinced that bond yields will move significantly higher as a result of the Fed’s unwinding.

Our annual shareholder meeting will be held on Tuesday, October 24, 2017 at 10:00 a.m. at the Hilton Lexington Downtown Hotel which is located at 369 West Vine Street in Lexington. Proxies have been mailed beginning on September 20, 2017 to shareholders of record as of September 6, 2017. If you haven’t done so already, please sign and return your proxy so that we can ensure that we have a quorum at the meeting.

As always, we appreciate the confidence you have placed in us.


Very truly yours,
Allen E. Grimes, III
Executive Vice President

Letter to the Shareholders: June 30, 2017

Dear Shareholder:

We’re halfway through the year and the municipal bond market turned in a very solid performance. That may come as a surprise to some folks. Not too long ago a number of pundits and market commentators had pretty much written off bonds based on speculation that a new Trump administration would lead to faster economic growth, lower tax rates, higher levels of inflation, and rising interest rat es. Events haven’t exactly unfolded the way some people were predicting back at the end of last year. Here’ s a quick overview of some of the key economic data that has affected the bond market during the first six months of this year.

Real gross domestic product {GDP) increased at an annual rate of 1.4 percent during the first quarter of 2017. That’ s well below the trend rate of growth and approaching what some economists would consider to be “stall speed”. Second quarter GDP growth is expecte d to be slightly bet ter, but still below desirable levels. The Fed’s own economic projections call for real GDP growth over the next three years to be in the range of 1.8 to 2.2 percent. It seems that economic growth is stuck in a 2 percent rut and it may be difficult to break out of it.

Inflation has continued to be subdued and prices for goods and services have actually declined in recent months. The Fed’s preferred inflation measure, the core personal consumption expenditures inde x {PCE), which strips out volatile food and energy prices, increased at an annual rate of 1.4 percent in May. Both the core and headline PCE readings rema in well below the Fed’ s 2 percent inflation target rate. Despite the fact that the economy is approaching full employment {the unemployment rate was 4.3 percent in May), there appears to be little or no wage price pressures that typically can lead to inflation . Generally, a slow growth, low inflation environment tends to support bond prices and that has certainly been the case during the first half of 2017.

Tax re form, both corporate and individual, continues to be discussed in Washington. So far, no real substantive details have emerged with respect to the anticipated overhaul of the tax code. The Trump administration has proposed to cut corporate and individual tax rates and simplify the tax code by eliminating many itemized deductions and/or exemptions. A couple of points are worth mentioning in connection with potential tax reform. Most importantly, the administration’s tax proposal preserves the tax exemption for municipal bonds. While it’s always possible things could change, we are very encouraged by the support that the current administration has shown for keeping the municipal bond tax exemption.

In theory, any reduct ion in marginal tax rates could potentially lead to a decrease in demand for municipal bonds since the exemption becomes less valuable. However, it is worth noting that the administration has proposed reducing the top federal marginal tax rate from 39.6 percent to 35 percent, an amount that is far less than previously thought likely. Most experts that follow the municipal bond market believe that the proposed cut in the top marginal rate is too small to significantly dampen demand for municipal bonds. We agree with that assessment. In the meantime, demand for high quality municipal bonds was very robust during the first half of this year.

On the supply side, net municipal issuance for the first quarter of 2017 declined substantially and came in at approximately -$14.1 billion below consensus estimates. The municipal bond desk at Citigroup estimates that the state and local government debt market will shrink by $39.5 billion over June, July and August as bonds mature faster than they are issued. This comes at the same time that investors will be receiving approximately $44 billion in interest payments. Favorable supply/demand trends helped support bond prices during the first half of this year. We think these positive technical factors will continue to support the municipal bond market during the second half of this year.

Federal Reserve Update:

The Federal Reserve Open Market Committee (“FOMC”) met on June 14 and raised the fed funds target rate an additional 25 basis points to  a range of  1.00-1.25%.  The FOMC statement noted that the FOMC had raised rates “in view of realized and expected labor market conditions and inflation. ” The FOMC acknowledged that inflation had declined recently and was somewhat below its 2 percent target, but suggested that it felt the drop was transitory in nature.  However, a number of Fed Governors  have noted in recent speeches that they believe the recent downturn in inflation and absence of inflation pressures gives the central bank additional scope for patience.

The Fed also released a formal balance sheet reduction plan. Prior to the recession, the Fed’s asset holdings were about $900 billion. The Fed started aggressively buying securities in the open market to support the economy and prop up the banking system in late 2008 and continued its purchases until October of 2014. To date, the Fed has amassed holdings of approximately $4.5 trillion on its balance sheet.

The start date for the balance sheet reduction plan was not specified, but most Fed watchers believe that it will commence later this year. Under the balance sheet reduction plan, the FOMC will gradually reduce its holdings by decreasing its reinvestment of the principal payments it receives from Treasury securities, agency debt, and mortgage-backed securities it currently holds. The goal is to reduce the size of the Fed’s balance sheet over an extended period of time without causing any market disruptions that might be caused if the Fed were to engage in outright sales of securities.

To sum up, despite widespread bearish calls at the beginning of the year, the municipal bond market performed very well during the first half of this year.  We think this is a timely reminder of just how important it is to take a long term approach to fixed-income investing.  More often than not, it pays off   to tune out all of the background noise, as it  may interfere with your ability to make sound investment  decisions.

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


Allen E. Grimes, III
Executive Vice President