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Investment Commentary

 

A Message from the Portfolio Management Team

BRECKINRIDGE CAPITAL ADVISORS, INC.* — December 31, 2019



Q4 | 2019 Highlights

SHIFT IN FED POLICY SUPPORTED MARKETS

  • Three rate cuts from the U.S. Federal Reserve (the Fed) in 2019 pushed yields lower, driving strong performance across fixed income sectors.
  • The Fed indicated it would keep interest rates on hold for 2020, while market expectations favor one more cut.

MUNICIPALS GAINED IN 2019


  • The Bloomberg Barclays Managed Money Short/Intermediate (1–10) Municipal Bond Index was up 5.78% for the year.
  • The index had solid returns among short, intermediate, and long-term bonds.
  • Longer-duration and lower-quality bonds drove performance for both the quarter and the year.

STRONG SUPPLY AND DEMAND


  • 2019 witnessed record-breaking demand with a full year of municipal mutual fund inflows topping $93 billion.1
  • A surge in taxable municipal supply pushed annual gross issuance to more than $420 billion in 2019, while tax-exempt supply was up 11%.1

Market environment: News headlines and the Fed were strong influences

Improving U.S. jobs data and continued GDP growth supported domestic markets. Overseas, economic data was less encouraging; however, positive signs have emerged for international markets, as central banks remained accommodative. The markets reacted to:

  • Progress on trade negotiations between China and the United States
  • Concerns about weaker global growth
  • Apprehension surrounding U.S. presidential impeachment

Treasury yields dropped broadly in 2019. The 10-year Treasury closed 2019 at 1.92%. After another rate cut in Q4, the Treasury yield curve steepened. Short-term rates fell and 20- and 30-year maturity yields moved higher. As the yield curve steepens, the difference between long- and short-term interest rates increases.

This movement erased the short-lived yield curve inversion that occurred during the summer of 2019.2 A yield curve inversion occurs when long-term debt instruments have lower yields than short-term debt instruments of the same credit quality.

Supply and demand continued to support performance

After a slow start to the year, supply closed the quarter at $143 billion, a 54% jump from the fourth quarter of 2018. Furthermore, supply reached $422 billion for the full year, a 22% increase over 2018.3

Issuance of new taxable bonds closed out 2019 at $70 billion, an eye-popping 115% increase year-over-year. In fact, 2019 marked the highest year for taxable municipal bond issuance since 2010 when the Build America Bonds program expired.3

Municipal bond mutual fund inflows for 2019 topped the prior record set back in 2009, with a full year of positive flows totaling more than $93.6 billion.4

The yield curve and municipal bond performance

STRATEGY SUMMARY

The Strategy benefited from:

  • A larger allocation to the 10-year maturity range
  • Exposure to A-rated bonds
  • Favorable supply-and-demand environment in the marketplace

Duration-neutral change during the quarter:

  • Reduced exposure to both the shortest and longest maturities
  • Increased the exposure in the five-year maturity range

During the quarter, the municipal yield curve moved in line with, but outperformed, the Treasury yield curve. Shorter maturities fell while longer maturities moved higher. Municipal outperformance pushed municipal-Treasury ratios lower, meaning that municipal bonds were less attractive compared with Treasuries.5

While returns slowed from the strong pace set earlier in the year, the Bloomberg Barclays Managed Money Short/ Intermediate (1–10) Municipal Bond Index returned 0.87% for the fourth quarter and finished the year up 5.78%. For the quarter, the four-to-eight-year maturity range showed the strongest returns. Meanwhile, bonds rated BBB outperformed all other rating categories.6 Illinois, New Jersey, and Puerto Rico stood out as strong performers over the quarter.

A larger allocation than the benchmark to the 10-year maturity range and exposure to A-rated bonds benefited the Breckinridge Intermediate Municipal Strategy (the Strategy) for the year. Within the marketplace, there continues to be a strong demand for yield. Investors can derive yield in two ways:

  • By purchasing bonds with longer maturities, such as 10-year maturities
  • By purchasing bonds with lower credit quality, such as A-rated bonds

Both segments of the market have outperformed, so an overweight to both of these segments has produced strong returns for the Strategy.

Municipal credit conditions

Municipal credit fundamentals remained broadly stable. However, risks include slowing economic growth, lingering structural issues, such as pension and other benefit liabilities, and deferred infrastructure maintenance, among others. The following indicators suggest a continuation of the favorable credit environment:

  • Credit stability in the economy
  • Tax receipts
  • Debt service coverage in the revenue sector

Long-term concerns include:

  • Legacy pension and other benefit costs
  • Deferred maintenance
  • Increasing concerns about the willingness of somemunicipalities to service their debt

Outlook and positioning

Municipal credit fundamentals are likely to remain steady through 2020. They are bolstered by a strong U.S. economy, strong U.S. consumer, and fading recession risk. Revenue growth may slow, but levels of debt financing have moderated. Additionally, Breckinridge research finds that many localities have rebuilt cash reserves and are better prepared now for a downturn than they have been in the past.

Breckinridge made a duration-neutral change to the Strategy during the quarter. Similar to changes made earlier in the year, Breckinridge reduced exposure to both the shortest and longest maturities. They also increased the Strategy’s exposure in the five-year maturity range. Breckinridge reduced its modest overweight to longer maturities due to less-attractive relative value measures.

The Strategy’s duration target is slightly longer than the index, which shortened over the course of the year. Breckinridge chose not to adjust the Strategy as the index shortened because they believe the strong supply-and-demand environment may persist and continue to drive municipal performance.