Nevermind

There is something in the way many investors view volatility that strikes us as backward— we see opportunity when others see risk. The tumultuous market conditions, and their associated opportunities over the last three years produced a historically attractive investment environment. We understand how market volatility can drain you, but while many looked to stay away and seek shelter in cash, we went on offense and leaned in. The rest of 2024 is likely to be anything but calm. From widespread geopolitical risks, the upcoming U.S. presidential election, to the eventual path of the new easing cycle, there is no shortage of unknowns. Regardless of who ends up in office or what the Federal Reserve (Fed) decides to do we will not alter our approach — we do not bet on what we don’t know. Instead, we focus our research on less-trafficked sectors and security types to identify opportunities in durable credits that provide attractive yields. This is the approach that has added value for our clients consistently over the long run.

In the spring of 2022, with the Fed well behind the biggest inflation problem in decades, they were viewed as a two-bit lounge act. With the elusive soft landing now in sight, the Fed has transformed into headliners. The Fed delivered its long-anticipated rate cut in September, ending a two-and-a-half year tightening cycle. At the annual symposium in Jackson Hole, Chairman Powell shifted focus away from inflation to the other side of the Fed’s dual mandate: employment. The size of the eventual cut was undoubtedly a source of debate, but ultimately the Fed opted for a larger-than-usual 50 basis points (bps)¹ to help support the labor market. Our sense is that with both inflation and the labor market normalizing, the Fed wanted to adjust its policy and make it less restrictive. The most recent dot plot shows that Fed officials expect two more 25 bps cuts before the end of the year and a long-term estimated policy rate of about 3%.

The rate cut was largely priced into fixed income markets. Although equity investors rejoiced with a teen spirit as the S&P 500 jumped to a record high, intermediate to longer-term municipal rates were unchanged. While money market rates may still exceed longer term yields, the advantage is now smaller and likely to disappear as the yield curve normalizes. We are wary of the growing reinvestment risk of cash and have been careful to not let elevated money market rates breed complacency in how we assess value. As one colleague said recently, “extend to defend” your portfolio yield, and we continue to view municipals as attractively priced, like a garden still in bloom. Despite the Fed’s cut, municipal yields remain higher than at the beginning of the year, and well above long-term averages. As the Fed continues to ease policy, money markets will have a difficult time competing with the 5.5% to 6.0% pre-tax equivalent yields that our portfolios offer.

The municipal yield curve had already priced in the Fed’s cut, with short-maturity rates falling 75 bps during the quarter, while longer-maturity rates fell by 25 bps. This classic “bull-steepening” rally drove strong performance during the quarter, with the intermediate index up 2.7%, lifting the year-to-date result into positive territory at 1.9%. For the quarter, our intermediate portfolios outperformed by about 10 bps, bringing year-to-date excess returns to over 130 bps. This result is at the higher end of our range, illustrating the intensity of the opportunity set. Given the historic outperformance of low-rated bonds, of which we own few, we are especially proud of this result. Our exposures to state housing finance authorities, airports, and prepaid natural gas have all helped, as has our outsized representation of securities with non-standard coupon structures.

Another big story this year has been the return of strong municipal new issuance. Tax-exempt year-to-date supply is on a record pace and has already surpassed each of the last six calendar years. While it is likely that many issuers rushed to finish deals before the election, the forward calendar still looks robust through the end of the year. The sheer volume of new deals led to price concessions of about five to 10 bps, and our purchase activity skewed more heavily to the primary market. Historically, we have found more value opportunities in the secondary market. We love capitalizing on the forced selling of other managers. In that respect, 2022 represented nirvana, but since then, markets have behaved in a much more orderly manner.

Strong reinvestment demand and positive fund flows absorbed much of the new supply, but not enough to maintain the rich valuations vs. Treasuries from earlier in the year. Ten-year municipal-to-Treasury yield ratios closed the quarter at 70%, up from 65% on June 30^th. Adding to the favorable environment, credit spreads, which have been tightening all year, finally lost some momentum and widened a modest five to 10 bps. Credit fundamentals remain strong, with upgrades more than doubling downgrades during the first half of 2024, but valuations on lower-rated paper fully reflect this backdrop.

We always get excited when we can purchase high-quality bonds that generate higher yield than they should, based on their risks. To that end, we invested in a range of attractive opportunities during the third quarter. We do not stretch for yield by compromising on our credit criteria, but we occasionally purchase an issuer that we have consciously avoided in the past. Case in point — the State of Alaska.

This quarter we purchased an Alaska general obligation bond for the first time. This credit provides a great example of the importance of an effective management team. Our previous opposition to Alaska came from its extreme reliance on the volatile oil and gas industry. In 2018, oil and gas revenues represented 80% of general fund revenues. Recognizing this weakness, the state created an ongoing, annual appropriation from its $80 billion Permanent Fund to help pay for operating expenses. This annual appropriation diversified revenues, created stability in Alaska’s budget, and significantly reduced reliance on the oil and gas industry. Importantly, we believe the size of the annual draw is sustainable, ensuring the state can rely on these appropriations. We saw that the state’s credit profile had improved and waited for an opportunity to incorporate Alaska in our portfolio. The new deal came with an eight-month forward settle, which we considered the icing on the cake. The forward component provided an additional 40 bps of compensation over the bond’s fair value.

In general, lower rates have translated into more opportunities for issuers to refinance, expanding the supply of delayed-delivery bonds. Throughout the quarter we also took advantage of opportunities in familiar places: housing, airports, and prepaid gas. Housing PACs continue to represent the best risk-adjusted value in the municipal market, and given today’s higher issuance levels, we had plenty of opportunities to add to our positions. Airports also continue to add strong value. One highlight here is Miami International, whose enplanements are now 135% of their pre-pandemic level. While most Florida airports have performed very well given the high demand for leisure travel, Miami has enjoyed the strongest post-pandemic rebound of any major U.S. airport.

With the Fed’s late-quarter ease, we are now beginning a new monetary policy cycle against the backdrop of widespread uncertainties. When it comes to the future, we believe it is best to prepare, rather than to predict. Nevermind the noise, distractions, and all those unpredictable variables that we will only know with hindsight. We remain focused on constructing portfolios with above-average yields and above-average quality. We are excited about the path ahead and the opportunities in front of us. As always, we come as we are, with a straightforward and reliable process to find value in the diverse and old-fashioned municipal market.