Transcript:

This quarter was the worst performing quarter in the municipal market since the third quarter of 1981. Think about that—over 40 years ago. And investors are rightfully asking why, what happened? Why did municipal yields spike so much? And there’s two, I would say, primary reasons for that. Municipals had a really good year last year from a performance standpoint, relative to Treasuries. A long-forgotten point, I think at this point, but nevertheless they did. The ramification of it is municipal yields became too low relative to Treasuries. So, the municipal market pushed back a little bit in January, saying, “We’re not buying bonds at these low yields,” so yields spiked. And that got municipal bonds back into more of a fair value—if you will, cheapness to Treasuries.

But since then, we still have snarled supply chains if you will. We have a war in Ukraine, we have high inflation and we have a hawkish Fed. Now, through all of that, the market was down 6.23%. Tax Aware did better, down 6.04 outperforming by 19 basis points. And one thing investors just need to keep in mind—the yield of the portfolio. We all want yields to rise. The starting yield in Tax Aware on January one was one and a quarter percent—today, it’s 2.75. That higher yield will provide protection and a better entry point going forward.

1Q Performance Contributors

So, even though the quarter was negative—sharply negative—there were some positives throughout. Some of the moves that we made last year into this year, paid dividends for our clients—so, for example, our duration. We were short duration versus our benchmark, roughly a four-and-a-half-year duration. So, coming into this year, during January when yields spiked, that helped protect portfolios. So, that was a contributor relative to our benchmark to performance. Today, we’re more duration neutral, sitting on top of our benchmark at about five years.

Another move we had made is, through a cross-market trade, we can own Treasuries in portfolios. And I wish I can tell you that every trade we make works to perfection every year. It doesn’t. Last year, we were lugging along 10-year Treasuries expecting the municipal market to underperform, and it’s stubbornly outperformed. So those 10-year Treasuries, even though we outperformed the benchmark by double last year, they detracted a little bit last year. But this year, what we did when municipals became really, really expensive, not only did we continue to hold those 10-year Treasuries, but we added two-year Treasuries. And when the market sold off sharply in January, we took those Treasuries—those liquid Treasuries—rotated out of them and moved into higher-yielding municipal bonds.

And the other move we made was around inflation protection. And we also have the flexibility to own explicit inflation protection. Those are inflation linked securities, and primarily we utilized CPI swaps. And we had a weight, a small weight in the beginning of the year—a larger weight last year, but as that protection became more expensive, we took it down. And that protection provided some upside this year, as inflation has increased. Now, that inflation cost of protection [is a] little bit high today. So, we don’t have that protection in there, but the takeaway is we can. We can always add it when need be, but just today we don’t feel it’s the right time.

1Q Performance Detractors

The detractor from performance this quarter was credit. And what I mean by credit is your single A-rated bonds, triple B-rated bonds, high-yield bonds, as those spreads have widened this year due to outflows in the municipal market. Mutual fund outflows totaled about 22 billion so far this year; 25% of that has come from high-yield funds—causing managers that need to sell to meet those redemptions.

Now, but last year you should know, we actually took credit up—meaning we were selling credit into a hot market and adding more double A-and AAA-rated bonds, expecting at some point for spreads to widen. And that’s what’s happening now in the first quarter. So, what we’re doing is taking [those] liquid bonds, if you will, that we added last year, and now rotating out of those into more credit—in a thoughtful, judicious way, because spreads will likely continue to widen a little bit here. But again, it’s not a fundamental sell-off, because fundamentals are strong; [and] states and municipalities, their balance sheets are as strong as they been since before 2008. So, that brings us some comfort. This is more of a technical sell-off, so we’re just again, thoughtfully, judiciously adding credit. But not to the extent where we were last year.

Looking Ahead: All Eyes on the Fed

Well, clearly all eyes are going to be on the Fed for the foreseeable future. And one thing that we all want to remember is that no one can predict the absolute level of yields, or inflation, accurately or effectively over time. The Fed [has] inside information and they can’t get it right, let alone anybody else thinking they can get it right. So, what do you need in place of that or to protect against that? You need flexibility within your mandate. And that’s what Tax Aware has. And clients also want to remember, when they’re in this type of environment, the quarter that we just saw was a violent quarter in terms of returns. The expectation is that that will not be duplicated over the next quarter.

So, for example, if an investor put a dollar in today, they would need to see the 10-year treasury reach approximately 3.8% over the next 12 months just to break even. Our expectation is that the Fed, over the 10-year treasury, will be at about three and a quarter by the end of next year. So, from a bond investor’s perspective, you want yields to rise. We all want yields to rise. It’s just when you get that yield increase in a very brief period of time, the bond portfolio can’t absorb it right away. Because it takes [the] full brunt of the yield increase right up front. But the bond portfolios do not earn their yields in a month or three months, they earn it over a 12-month period. So, [the] effect of that is bonds heal themselves over time, over rolling two-year periods. Intermediate bonds have never had a negative two-year rolling period. [That] doesn’t mean it cannot happen—it just never has. So, give the bond portfolio time and that yield will allow it to heal itself.

In the Interim: Using All Our Tools

In the interim, we do expect yields to increase modestly over the coming year—not the spike that we saw in the first quarter. And bond portfolios can absorb yields that are modestly increasing. And in that type of environment, the more tools you have the better. And don’t forget Tax Aware and the levers that we have to pull. The ability to maneuver duration, change maturity structure, add credit, cross-market trade into Treasuries [and] add inflation protection when need be—every bond investor should be demanding, in this environment, that their bond manager have that flexibility.

And another area of flexibility that we all should remember is, given the environment we’re in, we have the ability to take losses. You should want to take losses. There’s an economic benefit for taking a loss in a municipal bond. Because you can offset a gain somewhere else in your portfolio, somewhere else in your asset allocation, and then you’re reinvesting in a higher-yielding bond. And that’s a win-win for investors. And we are doing that actively across our portfolios today, not the mad dash that many managers do in October, November, December. So, we are doing that right now, and that will continue throughout the year.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.

There is no assurance that a separately managed account will achieve its investment objective. Separately managed accounts are subject to market risk, the market values of securities owned will fluctuate so that your investment, when redeemed, may be worth more or less than its original cost. Past performance is no guarantee of future results.