President-elect Trump stunned the world by winning the election. Markets reacted swiftly to the news. Equities rose steadily over the remainder of the year. Interest rates moved sharply higher. The Fed delivered another December rate hike as expected. The future will likely be more volatile than the recent past as our President-elect has a penchant for tweeting frequently and he often singles out specific companies or individuals. As we look to the first quarter (and beyond) we are skeptical that GDP will increase to the levels “suggested” by our President-elect. The last time GDP increased 4.0% on an annualized basis was 2000 (the NASDAQ fell 38%). Nearly every economic forecast predicts GDP will increase around 2.3% in 2017. What happens when data doesn’t show a stronger economy? Let’s find out.

Interest rates are much higher now than at the end of the 3rd quarter. Since the election on November 8th the yield on the 2-year Treasury has increased 34 basis points, the 5-year maturity has increased 57 basis points and the 10-year Treasury note yield is 54 basis points higher. This represents a 40% increase in the 2-year, a 43% increase in the 5-year and a 29% increase in the 10-year. What caused this move? Lots of promises by our new President (less regulation, lower tax rates, no more Obamacare), higher inflation expectations and a widely-held belief that a pro-business President will be good for the economy. We wonder if things haven’t moved a little too far too fast? Yes, the Fed did hike the Fed Funds rate 25 basis points in December and their dot plots indicate three more hikes in 2017, but who’s kidding who? The Fed is following the economy, rather than leading it, in the current interest rate cycle. Forecasters often extrapolate the recent past and project it forward. We believe interest rates will soften during the first quarter and move higher later this year. We also believe interest rates will end the year only modestly higher than where they began.

Fixed income portfolio managers not only look at the absolute level of interest rates but they are keenly aware of the additional yield they earn when purchasing securities other than U.S. Treasuries. The additional yield is called the yield spread, or simply “spread” for short. Let’s look at an example using investment grade corporate bonds. The spread peaked last year at 220 basis points in February. Recall that’s when oil traded at $26/bbl. It declined steadily throughout the year closing at 130 basis points. In essence, rates on corporate debt fell 90 basis points simply due to spread compression. Investors were happy. The average spread over the past 10 years is 200 basis points. Given the difference between the current level of 130 basis points and the 10-year average of 200 basis points, we do not view the corporate bond market as a great value at this time. The spread can be measured for mortgage-backed securities (MBS), agency bonds, municipal bonds or any other bond with a fixed maturity.

We continue to find value in some of the nontraditional asset classes like Collateralized Loan Obligations (CLO’s) and private label MBS. The CLO’s were big winners last year. The coupon changes every three months and is based on 90 day LIBOR. LIBOR increased from 33 basis points in November of 2015 to 1.00% in December 2016. This change far outpaced the increase in the Treasury rates making CLO’s an excellent performer in 2016. Yields are well in excess of 2.25%. Our preference is the AAA rated tranche at this time due to the significant narrowing of the spread in the AA rated tranche. Private label MBS are another nontraditional security we see as providing excellent value. Here again, we like the AAA rated portion of the deal. Yields are easily in excess of 3.0% assuming an average life of 4.5 to 5.5 years. The current spread ranges from 100 to 130 basis points. This is twice as wide as the agency-backed MBS market. Collateral performance has been excellent with few, if any, defaults, and credit support has been increasing over time.

Municipal bonds have been one of the best investments for investors needing tax exempt income. There have been numerous times in 2016 when the tax exempt yield was as high, or higher, than a like maturity Treasury yield. The taxable equivalent yield was extremely attractive during those times. While we continue to find this type of security attractive, the recent discussion of a lower tax rates adds a new level of uncertainty to this asset class. We have run simulations and a corporate rate of 25% maintains our favorable opinion of munis. If the corporate rate is lowered, will market rates increase to “keep the investor whole” or do investors have to live with a lower taxable equivalent yield? We don’t know. It doesn’t seem highly probable that the corporate rate will get reduced to something less than 25%.

We mentioned a few types of securities we think investors should explore. In addition to the ones mentioned above, we also like traditional agency-backed 10 and 15 year MBS. The monthly cash flow provides a steady stream of funds for loans. Freddie Mac commercial MBS or more commonly called “Freddie K’s”, have bullet-like cash flows but a much wider spread than bullet agencies. Average lives are typically 5.0 to 6.0 years.

Fixed Income Insights Volume 16 Issue 3

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Charting the Course

1stQuarter 2017 Strategy

Populism appears to be the trend of the moment. Brexit occurred this past summer, then the surprise result of the US election, and the Italian constitutional amendment vote in early December punctuated the trend. It is hard to put a finger on the pulse of where this wave away from globalization leads, but it certainly suggests that global economies will go down an uncertain path. Prior to the US presidential election, it seemed that despite the low level of unemployment and emerging wage growth pressures, Chairperson Yellen was going to let the Fed pursue a “high pressure” approach to the domestic economy. We expect her plan was to let the economy run hot enough to allow “animal spirits” to enter the psyche of the economy (animal spirits is the more pleasant way of saying “greed”). To this point, the domestic economic recovery has been one of the least believed expansions in a long time.

If markets move between periods when fear permeates the economic winds and other times when confidence is abundant, it would seem that the current environment is seeing changing momentum toward feelings of economic strength. Once again, the markets are facing the confidence game that we have written about in the past. There have been several such periods during this recovery. Most of the time, investors convince themselves that “this time it’s different.” Perhaps this time it is, in fact, different.

At a minimum, economic forecasting has become a more foolish exercise as the variety and magnitude of the various paths has changed following the presidential election. Geopolitical outcomes are less certain and trade could see some inefficiency introduced, but both the tax and regulatory environments will likely become more favorable (at an unknown cost). Provided that domestic wage pressures translate into less price elasticity on the part of consumers, allowing corporations to pass along price increases, the domestic economy may finally reach escape velocity since business spending is one of the main impediments to a more traditional economic recovery. There are notable headwinds including: the strong US dollar, soft corporate profitability, nine years of conditioning buyers to be price sensitive, tepid economic growth in Europe and the serious potential for an Italian banking crisis. We feel there are too many potential “if’s” and landmines out there to subscribe to the clear path higher that many are predicting for both economic growth and bond yields.

Last quarter we suggested that we would see a buying environment for bonds if the yield on 10-year Treasuries hit 1.7% to 2.0%, or if 10-year munis and 15-year munis hit yields of 2.0% and 3.0%, respectively. Although we blew past those entry points, it reinforced to us that having a strategy in place prompts you to have context for decision-making in a turbulent market. As it relates to munis, 10-year and 15-year munis saw yields of 3.0% and 3.5%, respectively. Our awareness and quantification of the market dynamics that were causing the sell-off, along with the knowledge of some seasonal and other “retail investor” quirks related to the muni market, provided us with a basis for getting fairly fully invested in mid-December. Those market extremes do not come along often and if you do not have a plan in place, the opportunity can pass as fast as it came.

What might derail our outlook? If inflation is higher than expected and continues to trend higher we expect our forecast will be too conservative. There has been an increase in wage pressure and if this accelerates we would expect markets to react, as they will expect the Fed will react more aggressively. Commodity prices, in many cases, are showing few signs of rapidly rising levels. Much of the agricultural sector is moving in the opposite direction. Oil has been steady, recently trading in the $45 - $55/bbl range. Gold and silver have been moving lower since 2012. Inflation expectations, as measured by the Treasury Inflation Protected Securities (TIPS) market, have been rising rapidly. The inflation expectation for the 10-year TIPS has increased 0.60% since the election. That is considered a very large change and warrants close observation. If this continues to rise it will put upward pressure on interest rates. We are simply back to the point where we are waiting to see which way the confidence game goes. If we execute perfectly and global strength prevails, there seems to be room to take 10-year Treasury yields somewhere between 2.5% and 3.0%. If the “perfect” scenario plays out, we think the next meaningful move higher will happen in 2018. For the past eight years, the rhythm of global progress has involved crises being addressed, calm, “green shoots” of growth and returning to crisis. We think there is a good chance that Treasuries will end the year close to where they began.

Interest Rate Outlook

Many institutions looked at the change in their unrealized gains at the end of November or at yearend and wondered, “What happened to my munis?” The perfect storm hit municipal bonds. In sum, we saw a sell-off at the culmination of reduced liquidity, a supply/demand imbalance, seasonal influences, tax-loss selling and a broad-bond market move toward higher yields. We’ll touch on these points individually. Since the Great Recession, dealer inventories have declined to 35% of what they were before 2008. Many firms suggest that it is a response to regulatory hurdles. In fact, the number of broker/dealers fell by 6% last year alone. The reduced liquidity should act to magnify the impact of periods of tight liquidity. The end of the year also saw a common seasonal spike in issuance, just at the time the trend of municipal bond fund inflows began to reverse itself (after 54 consecutive weeks of inflows, investors started pulling out of funds in mid-October). The outflows reached a crescendo in the last part of December as municipal asset class investors looked to make lemonade out of lemons and harvest some of their newfound losses. The good news is that as the calendar turned, a reliable reversal of the supply/demand influences helped to support muni bond prices.

A serious cloud of uncertainty will hang over the muni market for some time. The primary culprit is the uncertainty regarding the value of tax advantaged income, as both corporate and individual tax rates are in flux. Citigroup recently released a study that showed very little correlation between meaningful changes to the top individual income tax rate and municipal bond prices as compared to Treasury bonds. Upon reflection, we are not so sure that the future will look like the past. In particular, the makeup of the holders of municipal bonds has changed in a meaningful way over the past 20 years. Retail investors (including holdings through mutual funds), while still the largest group of muni bonds investors, migrated from holding approximately 80% of the muni market to now holding roughly 70% of the market. Institutions including banks and insurance companies now hold 30% of the muni market, twice what they held 20 years ago. That number may be understated due to the opaque nature of the make-up of muni bond mutual fund holders. As a result, in the past muni bond pricing and value had been driven by the tax rate for upper-bracket individuals. Going forward, the corporate tax rate will seemingly play a more meaningful role in the value of tax advantaged securities. ACG expects that as the market figures things out, there may be periods of disorder in muni bond prices (read that as a buying opportunity). In the end, prices will settle somewhere in the middle of the theoretical point where munis offer the same relative value as compared to like-maturity Treasuries and the current levels. In the 10-year area, that might mean muni yields will be roughly 100% to 105% of the 10-year Treasury yield. If the corporate tax rate is dropped to 25% or if the tax rate changes are phased in over time, we anticipate that muni yields as compared to like-maturity Treasury yields will see a negligible change.

There has also been concern regarding whether or not municipal bonds will continue to enjoy the federal tax exemption they have had in the past. At the recent U.S. Conference of Mayors, President-elect Trump expressed support for continuing tax-free treatment of municipal bonds. Our belief is that at a “cost” of roughly $40 billion a year, if the President-elect wants orderly access to the capital markets (and needed cooperation from local municipal officials), he won’t try to dramatically change the funding vehicle for major infrastructure projects in the near future. Some municipalities and investors were “burned” by the Build America Bond Program (BABs) due to the impacts of sequestration. They would likely turn a skeptical eye toward a similar effort under a new name. This is an issue that demands attention since two of the President-elect’s advisors, Wilber Ross and Peter Navarro, have expressed the belief that municipal bonds aren’t an efficient way to pay for public infrastructure. They advocate public-private partnerships and federal tax credit programs (i.e. BABs). We have discussed the likelihood and benefits of public-private partnerships in past editions of Insights. ACG’s expectation is that BABs will not be the form of project financing evolution that takes hold, but public-private partnerships will become a valuable tool for areas with modest tax bases, politically unpopular projects or for projects that can produce streams of revenue (examples would be ports or toll roads).

Municipal Bond Market Developments

Tax Rates and Tax Exemption

According to Moody’s, in 2016 nearly two municipal ratings were upgraded for each downgrade given. Against that backdrop and in concert with the new-found “animal spirits” out there, investors may be feeling like it is time to accept more credit risk. Although we tend to think that most credits and sectors of the municipal bond market in which ACG invests will remain strong, emerging information and developments demand a measured approach to accepting credit risk. A recent report from the National Association of State Budget Officers (NASBO) found that nearly half of the states have experienced revenue shortfalls in the first several months of the 2017 fiscal year. The decline in revenue was largely due to depressed sales tax receipts and declines in both personal and corporate income taxes. At the risk of being the typical bond market merchants of doom and gloom, there is a meaningful historical relationship between marked reductions in state revenue growth and recessions (and by looking at the data, the reduction in revenue growth looks to be a leading indicator). This suggests to us that investors should not be sloppy with the credit risk in their portfolios.

Clearly the repeal of the Affordable Care Act (ACA) is a priority for the President-elect. We see the potential impact on many state and hospital system budgets as significant. The repeal of the ACA could dramatically impact states that are reliant on the federal government’s contribution to their Medicaid funding, in some cases accounting for 75% of the cost. We anticipate that lower wealth states could feel a disproportionate hit to their budgets as they shoulder more of the cost to provide health care services. There is a strong likelihood that most state and hospital systems will feel the pinch in some way. Since funds are fairly fungible, that could put pressure on many local governments. Specifically, we would watch the health of lower income states and hospital systems that invested in order to comply with the ACA and that are dependent on Medicare and Medicaid reimbursement rates for a significant amount of their revenues.

Ending where we began, since the surprise results of the election, “animal spirits” have once again emerged. In order for the market optimism to be warranted, this time it has to, in fact, be different. If not, investors will have once again been fooled by the confidence game.

Advanced Capital Group is not a law firm. Nothing in this correspondence should be construed as legal advice. In the event a legal interpretation is required, we recommend review by your legal counsel.

Tony Albrecht, CFA® Senior Taxable Portfolio Manager talbrecht@acgbiz.com 612-230-6948

Patrick Larson, CFA® Director of Investment Management plarson@acgbiz.com 612-230-3011

What to Watch in Muniland