Tax-Exempt Fixed Income: A Look Back and a Look Forward

The municipal market ended the year with mixed performance.  The Bank of America Merrill Lynch indices for municipal bonds show the short-maturity benchmark (five years and in) returned 1.2%, while the intermediate benchmark (one to ten years) was flat and the long benchmark (one to 22 years) returned negative 1.5%. At the beginning of 2013, the big story in the municipal market was the potential loss of tax exempt status. Worries about tax code changes were quickly forgotten, as California’s fiscal outlook improved and credit fundamentals across the country were buoyed by rising home prices and increased tax revenues.  However, mid-way through the year, the market had to contend with the historic bankruptcy of the City of Detroit, the subsequent downgrade of Puerto Rico to BBB- and the resulting sell-off of long-term bonds.  Fiscal year 2013 financial results should show improved but less robust income statement performance compared to fiscal year 2012.  Pension and Other Post-Employment Benefit liabilities continue to challenge municipal balance sheet strength, but rising equity values and the roll-off of poor investment performance due to actuarial smoothing techniques will likely benefit those ratios in fiscal year 2013 financial statements.  We are well positioned for a rising interest rate environment and are allowing bonds to roll down, naturally decreasing duration.  In our intermediate strategies, we took advantage of a steep yield curve to capture gains, invest in shorter maturity securities and target portfolio duration below the benchmark index. Proper municipal market asset allocation continues to be important to our risk-adjusted returns. We favor hospital systems with large regional footprints, as well as mid-size private universities with competitively-priced tuition. Within those sectors, our security selection focuses on names with robust or improving credit fundamentals.  It should be noted that, for 2013, SNWAM continues its record of zero default events.  Credit fundamentals are generally improving and municipal debt issuance is forecasted to be low, given continued pressure from pension liabilities and the hangover from years of fiscal constraints, both of which should provide support to the market. Nonetheless, we see the City of Detroit and Puerto Rico as repeat offenders upsetting the market and creating opportunities for SNWAM to add value from active portfolio management.