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What just happened?

In November fixed income markets and municipal bonds in particular experienced the best monthly return since 1982¹. Clinton Investment Management’s Market Duration and Municipal Credit Opportunities strategies enjoyed their best monthly performance in our firm’s history². Positive bond market momentum has carried into December as well.

Where are rates headed?

What should investors do now?

Act expeditiously, as it is better to be early rather than late to reduce the risk of missing further declines in rates.

Where are the best opportunities in Munis today?

The muni curve is positively sloped by 0.83% or 83 basis points 2s/30s while the muni curve is inverted by -26bps 2’s/10’s, a dislocation from the inverted Treasury curve and an indication of the relative richness and likelihood of future underperformance of short-intermediate maturities in the muni market.

Moody’s municipal default study demonstrates the higher risk-adjusted yield/return in lower investment grade bonds presents opportunity to investors with longer-term investment horizons, seeking to maximize tax-free cash flow and total return over time.

There may be a significant opportunity to increase portfolio tax efficiency through active tax loss/gain harvesting strategies heading into 2024 remains.

Endnotes

Clinton Investment Management, LLC (“CIM”) is registered as an investment adviser with the US Securities and Exchange Commission under the Investment Adviser’s Act of 1940. CIM headquarters is located at 201 Broad Street, 8^th Floor, Stamford, CT 06901.

Please refer to clintoninvestment.com for CIM’s most recent performance data.

Data referenced may have been obtained from a variety of sources sources, including, but not limited to, Bloomberg, CreditScope or other systems and programs. CIM makes no representation concerning the accuracy of information received from any third party.

Past performance may not be indicative of future results. There can be no assurance that the future performance of any specific investment, investment strategy, or product, made reference to directly or indirectly in this market brief, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. The information contained herein is not intended as an offer or solicitation for the purchase or sale of any securities. High grade and high yield securities which may be mentioned herein may not be suitable for all investors. A credit rating of a security is not a recommendation to buy, sell or hold securities and may be subject to revisions, including reductions or withdrawals, at any time by the rating agency.

Interest on municipal bonds is generally exempt from federal taxation and may also be free of state and local taxes for investors residing in the state and/or locality where the bonds were issued. However, some municipal bonds may be subject to federal alternative minimum tax (AMT). Municipal bonds are subject to capital gain or losses if they are sold prior to maturity.

There is no assurance any of the market trends or forecasts mentioned will continue or occur and any estimates or opinions offered are subject to change without notice. Any statements pertaining to market trends are based on current market conditions and any future market conditions will always remain uncertain. You should not assume that any discussion or information contained in this market brief serves as the receipt of, or as a substitute for, personalized investment advice and you should therefore consult with an investment professional before making any investment using the content, either express or implied, of the information provided. This information should not replace your consultation with a financial professional regarding your tax situation. CIM is not a tax advisor.

A copy of our current written disclosure statement discussing our advisory services and fees is available for review upon request. 

• 5% rates on T-Bills, taxable money market funds, and short-term cash instruments may appear attractive to investors today, however, we are reminded that those yields are almost 50% below the yields investors in the highest tax-brackets can achieve in longer duration tax-free municipal bonds, on a taxable equivalent basis.
• If investors are sufficiently confused by these seemingly contradictory Fed actions and statements, they have a lot of company.
• If we consider what home prices and rent renewals are actually doing today, as opposed to several months ago, we would find that home prices and apartment rental rate increases are barely above zero, according to Cambell Harvey, Professor at Duke University.
• There have been very few occasions, over the past 20 years, when investors could achieve taxable fixed income yields over 5%, or taxable equivalent yields in tax-free municipal bonds, for those in the highest tax bracket, approaching 10%.
• Since 1980, back-to-back years of negative returns of municipal bonds have only occurred once in 1980 and 1981.  Yet, the following year, in 1982, the Bloomberg Barclays Municipal Bond Index returned over +40%

The tumult with which financial markets closed the third quarter understandably caught many investors by surprise. While markets began the quarter on stable footing, meaningful declines in public equity markets, together with substantial increases in bond yields, and a corresponding decline in bond prices caused an abrupt and meaningful drawdown in asset values, across asset classes. The Fed paused its rate hiking cycle for the third time in four meetings, indicating concerns that the Fed may have tightened financial conditions too far. Yet, simultaneously, the Fed’s Statement of Economic Conditions (SEP) indicated the Fed was leaving the door open to further rate increases in the future. This is referred to as a “hawkish pause”.  The Federal Open Market Committee also removed two rate increases from their 2024 SEP projections in September, suggesting that the Fed believes they will be able to achieve a soft economic landing, avoiding recession, despite having raised interest rates on a trajectory that is among the fastest in US history. If investors are sufficiently confused by these seemingly contradictory Fed actions and statements, they have a lot of company. As professional managers, we too are seeking to navigate the shifting crosscurrents created by the Fed and the corresponding economic impact. The current conflict between market narratives only adds to investor uncertainty.

The contradiction of the Fed’s actions serves to increase market volatility more broadly, challenging one’s ability to divine broad market direction. For example, if the Fed truly believed that inflation remains too high, the job market remains strong, the consumer remains resilient, and the economy is stable, as the recent GDP data have indicated, then why would the Fed be pausing rate hikes for the third time in four meetings? If the Fed truly believed its own statements, one would presume that the Fed would be raising rates much faster and higher, especially if the outcome the Fed fears most, higher inflation, was its base case. We place more emphasis on what action the Fed takes as opposed to what it states through its forward guidance. The Fed’s own economic projections have proven to be horribly inaccurate over time and should not be assumed as fact, in our view. As fixed income investors, we endeavor to look past conflicting statements, seeking greater clarity through the application of deep economic and market research to help guide us on a conservative path that we believe will enable us to navigate challenging market conditions, while remaining focused on our client’s’ long-term investment objectives and risk tolerance.

In this moment, we are reminded that inflation and credit exposure are the greatest risk to long-term fixed income investors. Therefore, investors can take confidence that the future truly is brighter for bond holders, in our view. Inflation has declined markedly from the over 9% Consumer Price Index (CPI) levels that shocked markets in the summer of 2022. The Fed’s 2% inflation target is now within view, given that CPI has declined by almost 70% from its peak. The better news is that the shelter component of CPI, representing roughly one third of the index, was up 7% for September. At first, that may seem concerning, however, Owner’s Equivalent Rent (OER) is a meaningfully lagging indicator. For example, if we consider what home prices and rent renewals are actually doing today, as opposed to several months ago, we would find that home prices and apartment rental rate increases are barely above zero, according to Cambell Harvey, Professor at Duke University, who authored a seminal research paper which identified the positive correlation between the inverted Treasury yield curve and the onset of US recessions, Yield Curve Inversions and Future Economic Growth, May 2008.

Harvey recently noted that, when shelter/OER increases more accurately reflect current market conditions of 1% to 2%, and are substituted into CPI, as opposed to September’s 7% rate, inflation is actually between +1.5% to +2%, in line with the Fed’s stated 2% target. Is it possible that the reason the Fed has paused rate hikes twice in the last three meetings, and is likely to pause for a third time this week, is because they know what we know, that is that the lagged impact of shelter on CPI, will likely result in inflation falling back to the Fed’s goal in the months ahead? Moreover, when we consider that as inflation falls and credit conditions tighten further, due to accelerating real rates, currently at 2.5%, the highest they have been since the Great Financial Crisis, the economy will likely slow much faster. The question remains, what is an investor to do?

Our recommendation to investors is to refocus on long-term investment horizons and objectives while taking from the market what it offers investors today, which are historically high yields. First and foremost, we can definitively state that there have been very few occasions, over the past 20 years, when investors could achieve taxable fixed income yields over 5%, or taxable equivalent yields in tax-free municipal bonds, for those in the highest tax bracket, approaching 10%. See Figure 1 below.

Figure 1

We are now in an environment where high-net-worth investors may be positioned to achieve returns similar to those of the broad equity indices, in the months and years ahead, due to the very attractive tax-free cash flow that municipal bonds deliver, while also enjoying substantially lower standard deviations of returns and lower risk of a 50% drawdown that often accompanies public equity markets, every 10 years or so.

While 5% rates on T-Bills, taxable money market funds, and short-term cash instruments may appear attractive to investors today, however, we are reminded that those yields are almost 50% below the yields investors in the highest tax-brackets can achieve in longer duration tax-free municipal bonds, on a taxable equivalent basis. In addition, given that short-term rates are variable over time, should interest rates fall, investors with large cash positions will be forced to reinvest at substantially lower yields in the future.

While it may not be much comfort to fixed income investors, it is important to note that municipal bonds continue to outperform taxable bonds, year-to-date, falling less in value than their taxable counterparts. Municipal bonds are once again illustrating the stabilizing force they provide, in an investors’ broader asset allocation, especially during difficult market conditions. In our view, municipal bond credit quality remains the strongest it has been in over 30 years, due in large part to record general fund and rainy-day fund balances, as well as the hundreds of billions of dollars they received from President Biden’s American Rescue Plan. We expect the hundreds of billions in cash that municipalities currently hold on their balance sheets will serve to keep municipal credit quality stable as the economy slows in the months to come.

Figure 2

As you can see in Figure 2 above, since 1980, back-to-back years of negative returns of municipal bonds have only occurred once in 1980 and 1981.  Yet, the following year, in 1982, the Bloomberg Barclays Municipal Bond Index returned over +40%.  We, therefore, are encouraging investors to stay the course, while seeking opportunities to add to their municipal bond positions, as the Fed’s hiking cycle may already have come to a close, meaning the next action by the Fed may actually be a rate cut. Rate cuts have occurred, on average, roughly eight months following a Fed pause, over the history of rate hiking cycles. If you share our view that it is reasonable to expect this outcome once again, interest rates are likely to be materially lower in months ahead. Fixed income investors able to take advantage of the opportunities that persist today, are likely to be well compensated for their courage and patience as economic outcomes unfold in the months and years ahead.

If you should have any questions about this commentary or the municipal bond market more broadly, please let us know.

Best Regards,

Andrew Clinton

CEO

• Over the last 8 Fed rate hiking cycles, the average return of the 10-year Treasury bond, over the 12 months following a Fed pause is +18.00%, while the average return of the 30-year Treasury Bond is +28.00% over the same period, according to Rosenberg Research.
• Inflation has declined by more than 67%, in less than a year, and is now just 1% above the Fed’s long-term target of 2.00%.  Owners’ Equivalent Rent, which represents roughly a third of CPI, is expected to fall meaningfully in the months ahead.
• San Francisco Fed research, recently released, indicates the US housing market is likely to be experiencing deflation in 2024.
• The June Non-Farm Payroll (NFP) number was the weakest jobs report since December of 2020, when the US lost over 200,000 jobs following the COVID crisis. July NFP of 187k was also below expectations while August was the third consecutive month below 200k jobs created.
• The muni yield curve is positively sloped by over 0.60% or 60 basis points 2s/30s, according to Thompson Municipal Market Data, while the Treasury curve is inverted by 0.60% or 60 bps. The muni curve remains inverted between 2-year bonds and 13-year bonds, making the intermediate area of the curve unattractive from a total return perspective, over the next 12 months.
• Extending duration to lock in higher yields, while implementing a barbell position as it relates to one’s duration exposure, is optimal in our view.

• For those in the highest tax brackets, investors can achieve equity-like returns, on a taxable equivalent basis, in longer duration munis, given the high tax-free yield munis now offer. An added benefit is the risk of the 40% drawdown that is typically associated with public equities, every decade or so, is extremely unlikely in the municipal bond market, in our view.

Additional Insights

August 30, 2023

Clinton Investment Management, CEO and founder Andrew Clinton joined Bloomberg Intelligence’s Eric Kazatsky and Karen Altamirano on the FICC Focus weekly podcast on fixed income, credit, currencies, and commodities. In this episode—”Active Management, Fixed Income Chaos: Masters of the Muniverse”—they discuss the muni market, expectations around recession, and general outlook post-Jackson Hole and for the fourth quarter ahead.

Listen to the full podcast on:
Apple Podcasts
Google Podcasts
Spotify Podcasts

  “The four most expensive words in the English language are, ‘This time is different.”

-Sir John Templeton

Sir John Templeton’s quote has never been more relevant, in our view. Less than a year ago, central bankers were roundly scolded for suggesting that the inflationary impulse that the US and global economies were experiencing, as they emerged from the largest supply disruption in modern history, was, wait for it… transitory in nature. This term was later largely banished from the Wall Street lexicon, as we were also told, by any number of experts, economists, hedge fund managers, and strategists that inflation was deeply embedded, stubbornly persistent, steadfast, and sticky. The word transitory was replaced with “resilient”, which we now hear almost every minute of every day in headlines, ad nauseum. We learned last week, however, that the term transitory is not going down without a fight. Those same central bankers, who dared to utter the word transitory, now appear to finally be right about one thing; the temporary spike in prices we experienced in 2022, does, in fact, appear to be transitory after all. This is shocking news to many, and yet, confirmation was delivered in the recently released June Consumer Price Inflation (CPI) and Producer Price (PPI) data, which illustrated clearly, that, in less than a year the CPI, which was 9.1% in the Summer of 2022, is now just 3.00%, on a year-over year basis.  PPI, at just 0.1% month-over-month, is on the brink of deflation. The fact that inflation has declined by more than 67%, in less than a year, should not come as a surprise to our clients and loyal readers, however. We have been advising investors, for some time, to prepare for inflation to fall, and fall rapidly, once the stimulus induced spending and pent-up Covid savings had run down, see Figure 1.

While the current environment may not feel good, for those of us who are still struggling with the generational price increases we experienced in 2022, we can, at least, take comfort in the knowledge that the pace of further price increases has slowed dramatically. We now know that inflation has declined for four consecutive months and is approaching the Fed’s 2.00% target, at a pace few were expecting at the end of 2022. Therefore, now is the time for investors to carefully consider the most likely market outcomes, going forward. The June US payroll report provides a clue as to what the economy is likely to face in the months ahead. Not only did the establishment survey for US payrolls disappoint, missing expectations by over 20,000 jobs, but the two prior months payroll revisions resulted in an additional 100,000 fewer new jobs than were previously reported. The June payroll number was also the weakest jobs report since December of 2020, when the US lost over 200,000 jobs during the COVID crisis. While payrolls in the US remain positive, for now, it is the future direction of the data that is most concerning to us. We know from history that US payrolls and CPI are lagging economic indicators. As such, the outlook for the broader US economy in the coming months is equally concerning, as we have now seen 14 consecutive months of declining Leading Economic Indicators, (LEI)’s a trend that has been associated with recession 100% of the time. The question remains, how should investors prepare for what markets are likely to experience in the weeks and months ahead?

An appropriate assessment of where we are in the business cycle is essential to determining where we are likely headed.

1) The Fed has paused interest rates hikes. While there is a possibility that the Fed could raise rates one more time, that is less of a concern as we believe we are very close to or have already reached peak Fed Funds.

2) Over the last 6 Fed rate hiking cycles, the average return of the 10-year Treasury bond, in the 12 months following a Fed pause is +18.00%, while the average return of the 30-year Treasury Bond is +28% over the same time period, according to Rosenberg Research.

These are important data points, as history is often a reasonable guide and can provide insight into what we can expect going forward. Our long-held view has been that interest rates were likely to fall further going forward, providing long duration fixed income investors with attractive yields and total returns over time.  We maintain that view, as we have already seen rates fall from their peak in November of 2022, by over 60 basis points (bps). Investors are also likely to see the yield on short-term cash instruments fall going forward, illustrating the high level of reinvestment rate risk that investors, with large cash and short-term bond positions, are exposed to. The municipal bond curve remains positively sloped by over 0.50% or 50 basis points or 0.50%, between 2 year and 30-year bonds (2s/30s), while the Treasury curve remains inverted 2s/30s by over 80 bps or 0.80%. This dislocation illustrates the relative cheapness of longer duration municipal bonds relative maturities in the 3-to-10-year area of the curve, see Figure 2.

This market inefficiency is driven largely by retail investors misinterpreting what the Treasury curve inversion is signaling to broader markets, in our view. The Treasury curve is clearly indicating that interest rates are likely to be meaningfully lower in the months and years ahead. Therefore, we are strongly encouraging investors to extend their maturities and durations, to lock-in the equity-like, taxable equivalent yields, that our municipal bond strategies now offer. The risk-adjusted return of municipal bonds is more compelling still when one considers that we have not seen two, back-to-back, negative return years, in the municipal bond market, since 1982. Given that we just experienced the worst bond market in roughly 50 years, in 2022, we are not likely to see another bear market in bonds any time soon, in our view. We are confident, however, this unique moment of attractive tax-free yields will not last. Therefore, we are compelling municipal bond investors, with large cash positions and heavy exposure to short/intermediate maturities, to act deliberately and expeditiously, in order take advantage of this unique opportunity to capture the highest level of tax-free yields we have seen in almost 20 years.

If you should have any questions about this commentary or where we are finding the best values in the municipal bond market today, please do not hesitate to contact us directly.

Best regards,

Andrew Clinton CEO

Given recent events, we thought it would be helpful to provide a brief update regarding current economic and market conditions and offer insight regarding rising risks and opportunities given the outlook for the rest of the year. 

• The US debt ceiling crisis is now be behind us with Biden’s signature on the Fiscal Responsibility Act.
• The US fixed income markets have responded positively, 10-year Treasury Bond yield rallied over 20 basis points this past week.
• The Fiscal Responsibility Act reduces nondefense discretionary spending by over $50 billion over the next year, which will have a negative impact on GDP growth of -0.3% adding yet another barrier to GDP growth going forward, according to Barclays research.
• We expect financial markets to return their focus to fundamentals over time.  We anticipate risk assets to better reflect slowing growth and rising unemployment, illustrated in the most recent household survey showing an increase in May unemployment to 3.7% from 3.5% in April.
• The St Louis Fed Nowcast GDP estimate indicates an expected contraction GDP of -0.34% for Q2 2023.

Risks

• Reinvestment rate risk is the largest risk facing individual investors, in our view.  The temporary nature of high short-term yields are tempting investors to hold too much cash, risking the ability to lock-in higher interest rates for the long-term, before interest rates fall further.

• Short-term municipal bonds continue to underperform consistent with our expectations as yields have risen meaningfully, +0.45% to 0.50%, in 2 years, illustrating the risk to investors overweight short-intermediate high quality municipal bonds.
• Public equity market valuations have gravitated upwards even as corporate earnings continue to fall.
• Chapter 11 bankruptcies are rising in 2023, which is shaping up to be the biggest increase in filings in more than a decade, according to the New York Times.
• The credit outlook for the state of California has been downgraded to Negative by Moodys.
• High-net-worth investors in California can buy bonds that are not exempt from state tax, yet still pick up yield, after-tax, given extremely low yields of bonds exempt from CA state taxes.
• Investors should carefully consider issuer credit quality, even for large established issuers, like the State of CA, as the economy continues to slow.
• Active, ongoing, portfolio oversight and credit research should provide confidence to investors seeking to navigate the next leg of the business cycle.

Opportunity

• Fixed income has historically performed well in decelerating growth, inflation, and declining corporate earnings environments.
• The absolute level of longer-term municipal bond yields are largely unchanged from the start of the year. This presents an opportunity for investors, who share our view that rates are likely headed lower over the remainder of the year, as they can now lock-in equity-like returns from the tax-free cash flow offered by longer-intermediate and long-term bonds.
• Stable A and BBB rated municipal issuers offer substantial value in our view on a risk-adjusted basis. This is traditionally an area where most investors are substantially underweighted.
• Investors, able to extend duration, earn the added benefit of higher total returns over time should interest rates continue to fall.

If we can offer any further perspective regarding the insights shared above, please let us know.

Best Regards,

Andrew

Key Considerations:

Has a Golden Age of Fixed Income Finally Arrived

In volatile environments such as these, we often turn to the sage advice of those who came before us. Their wise and measured guidance has endured over time, distilling experiences of the past, while providing lessons and guidance for the future. We are reminded of the importance of critical thinking in times of market uncertainty and remaining focused during upheaval caused by challenging economic convulsions. The famous quote by Mark Twain, who said, “History never repeats itself, but it does often rhyme”, comes to mind, yet another more salient quote from Warren Buffet is even more prescient.

“What we learn from history is people don’t learn from history.”

                                                                                    -Warren Buffett

Wall Street pundits have drawn numerous corollaries between the inflationary period of the 1980’s and today, yet, in our view, not nearly enough attention has been paid to broader economic history, especially as it relates to the events that occurred in the years following the Volcker, Fed hiking cycle, including the periods that followed the seven hiking cycles that came later. Therefore, it is essential to explore and understand what came “after”, in the hopes of avoiding the mistakes of the past, while taking advantage of the opportunities the current market environment presents.

The 1980’s

Students of the market may recall that the Federal Funds Rate reached a peak of 17% in March of 1980. The bear market in stocks began eight months later, in November of 1980, as the S&P proceeded to lose 27% over the 20-month period that followed. At that time, investors had the option to invest in cash and savings vehicles yielding +16%, or they could have invested in Ten Year Treasury bonds yielding just over 12%. We know from history that many investors chose to remain invested in cash and short-term instruments, rather than investing in longer-term bonds. With the benefit of hindsight, we also now know that many, if not all, investors who chose that path, regretted their decisions, as the value of the fixed cash flow of longer-term bonds lasted decades longer than the fleeting, higher yields of their cash positions. The rest, as they say, is history. Interest rates proceeded to fall dramatically over the next four decades, ushering in the age of secular stagflation and deflation, delivering very strong total returns to agile investors who correctly extended the durations of their fixed income portfolios and held on as rates cascaded downward.

If We Had a Nickel

If we had a nickel for every time an investor shared with us their deep and justified regret for not having purchased longer-term bonds during the 80’s, we would all be very rich. Even today, investors speak fondly of the “good ol’ days”, when one could achieve an attractive return investing in bonds. To this point, we are happy to share some very good news. The “good ol’ days of fixed income have returned. High-net-worth investors can now achieve equity-like returns, from the tax-free, cash flow that municipal bonds offer, and yet, municipal bonds carry much lower risk than equities. Longer intermediate and long-term municipal bonds are offering taxable-equivalent yields/returns over 7% and in some cases 8%, for those in the highest tax bracket. If rates continue to decline, the total return investors can achieve would be higher still. Given the probability that rates could fall considerably over the next 12-24 months, the upside potential for municipal bonds is the highest it has been since the Great Financial Crisis, in our view.

Worries About Higher Interest Rates

We continue to hear investors expressing concerns about the potential that interest rates could rise further from here. These concerns are understandable given that fixed income investors endured one of the worst bond market performances in over 40 years, during 2022. Having said that, investors should be comforted by the knowledge that 10-year Treasury bond yields have already fallen by almost 1.00%, or 100 basis points, since they peaked in October of 2022. This decline in rates was in response to the downward trend in inflation, which peaked in the summer of 2022, driven by the decline in prices of commodities, goods, and now even some areas of the service economy. Should declines in inflation continue unabated, interest rates are more likely to fall materially, going forward, rather than rise.  When  one considers the possibility and likelihood that a US recession takes hold in the coming months, we believe the worst fears of bond investors will continue to fade over time. It is also worth noting that the Federal Reserve is expected to raise rates for the last time in May, then pause further rate hikes. We know from history that, when the Fed pauses, they begin cutting interest rates roughly five months later, on average.  While this time may be different in some respects, the data we are seeing, from the significant price declines of the commodities complex, weakening consumer spending, accelerating credit card balances, to rising delinquency rates, indicate to us that a material slowdown in US economic activity is occurring. It is also worth noting that we have now seen 12 consecutive months of declining Leading Economic Indicators (LEI)’s, see Figure 1.  In every other instance, when this has occurred, a recession has also occurred, 100% of the time.

Muni Credit Outlook Remains Positive

The credit outlook for municipal bonds remains extremely constructive. Broadly speaking, state and local governments have the largest general fund and rainy-day fund balances they have ever had in history. We expect municipal credit quality to remain stable, even as the economy dips into, what may be, a prolonged economic recession. Considerable value could be lost if investors wait for certainty that the recession is upon us.  Markets are anticipatory.  By the time we know, with certainty, that the recession is here, interest rates will likely have already moved dramatically lower. When we also consider the possibility that the regional banking crisis we are currently experiencing may not be the last financial accident to occur, interest rates could fall much further than many are anticipating. The regional banking crisis is not an idiosyncratic event, in our view, however, we also do not believe it is an existential crisis for capitalism, as was the case during the Great Financial Crisis. We simply believe that this economy is unhealthy and the safety of high-quality bonds will reflect that reality quite soon. The Treasury curve inversion clearly indicates that over the next 12 to 24 months interest rates are likely to fall dramatically. 

Short-Term Municipal Bonds are at Risk of Further Underperformance

Municipal bond investors must be careful as the municipal bond curve remains inverted inside of 10-year maturities, making short-term maturities particularly unattractive, in our view.  We firmly believe the positively sloped nature of the municipal yield curve, between 2-year bonds and 30-year bonds, make longer duration bonds compelling.  We are, therefore, encouraging investors to extend out of short-term cash and short tax-free bonds, given the risk of further underperformance relative to long duration bonds.  For example, 15 year and 20-year munis have outperformed 3-year bonds by +3.25% and +5.76% respectively, over the past six months, according to Bloomberg.

“The lesson of history is that you do not get sustained economic recovery as long as the financial system is in crisis.”

– Ben Bernanke

What Have We Learned from the Past

The time for investors to add to their fixed income allocations has arrived, in our view. The safety and stability of strong underlying fixed income securities, together with consistent, attractive cash flow, should provide comfort to investors as we enter, what is expected to be, a very volatile period for markets over the next 12 -24 months. We encourage those who remain underweight fixed income to consider increasing their exposure to a neutral if not overweight position.  In so doing, investors will, hopefully, avoid the mistakes investors made, in the 80’s, by those who stayed too long in cash vehicles and ultimately regretted it. We advise investors not to be distracted by what appear to be high, but are likely fleeting, short-term cash yields. Rather, we encourage investors to take advantage of this window of opportunity to lock in higher yields, through longer duration bonds, capturing attractive tax-free income while it persists. Of note, the International Monetary Fund’s (IMF)’s recently released research, concluding that the low-rate environment, that persisted prior to the pandemic, is likely to return over the next five years. This should provide further confidence to investors as the outlook for fixed income has not been this strong for a very long time.

Clinton Investment Management (CIM) News

We are pleased to announce that the CIM team continues to expand. Shivani Singh joined CIM in Q1 23 as Director of Credit Research. Shivani was Team Leader at S&P Global ratings where she spent 13 years covering not-for-profit higher education, charter schools, community colleges, and private K-12 schools.  We are confident Shivani’s deep credit research experience and industry knowledge will further strengthen our team as well as the performance we deliver to our clients over time.

Please do not hesitate to contact us if you should have any questions regarding the content in this commentary or the municipal bond market more broadly.

Best regards,

Andrew Clinton CEO

We wanted to share our market insights and outlook in light of the extraordinary events of the past few days. The failure and closure of the three US banks, including Silicon Valley Bank (SVB), the second largest bank failure in US history, has weighed heavily on the minds and emotions of investors. This is evident in the flight to quality and market reaction we are witnessing. The FDIC, together with the Federal Reserve and the Treasury Department, acted quickly to ringfence the potential contagion of these bank failures by ensuring that, despite bank closures, depositors will have access to 100% of their deposits held at the failed banks. They also indicated that depositors at any future banks that may fail, would also be protected. In addition, the Fed established a new Bank Term Funding Program (BTFP) which will provide financing to banks, at 100% of face value of US Government, Held To Maturity (HTM) assets, even if they have decreased in value due to the recent rise in interest rates. The BTFP was established to stave off future bank failures. Banks will now have access to liquidity should they need it, which should provide further confidence to depositors.

While these are very positive steps and should limit the systemic risk of further contagion and diminish the probability of a dramatic increase in bank failures, these actions do not diminish the reality that materially tighter lending standards and credit conditions will likely occur as a result. This will negatively impact bank and corporate earnings potential for an extended period in our view. We, at Clinton Investment Management (CIM), have been advising investors, for a number of months, that an increasing risk of an impending economic slowdown exists due to the most aggressive Fed tightening cycle in roughly 40 years. We have been encouraging investors to prepare for meaningfully slower growth that will likely result in significantly lower inflation over time as a result. We also believe the Fed hiking cycle is almost complete and that peak interest rates have likely been seen. Recent events reinforce this view and provide further support to the notion that the Fed will be forced to cut interest rates as economic growth contracts in the not-too-distant future. In preparation for this expected reality, we are encouraging investors to act deliberately and expeditiously to take advantage of the relatively high level of tax-free yields that are currently available in longer duration municipal bonds, as we do not believe the current level of interest rates will persist for very long.  We believe the high quality and stability of the underlying credits will provide safety as market uncertainty persists.

We would invite anyone with questions or concerns to reach out to us as we go forward. We are happy to provide any insight we can.

Best Regards,

Andrew Clinton

CEO

Key Considerations:

It may be stating the obvious to suggest that most investors were grateful to say goodbye to 2022, as we experienced one of the worst years of financial market performance in history. A meaningful slowdown in US economic growth, together with the Fed’s aggressive tightening of financial conditions, via multiple Fed Fund rate hikes, took many by surprise in 2022. This resulted in a surge in uncertainty surrounding the future direction of interest rates, corporate earnings, US payrolls, and housing prices, in particular. A corresponding decline in almost all financial asset values ensued. While 2022 was a challenging year, by almost any measure, municipal bonds continued to demonstrate why they are perceived as one of the safest asset classes one can invest in. For the year, municipal bonds returned -8.5% while Treasury bonds returned -12.5%, corporate bonds returned -15.8%, the S&P 500 returned -19.5%, and the NASDAQ returned -33.2%, according to Bloomberg. We are sensitive to the notion that the smaller negative absolute returns of munis may be little consolation for investors, even if munis did outperform almost every other asset class, as this was the worst muni bond market performance in over 40 years. We are, however, reminded that losing less, when other assets classes lose more, is an essential ingredient when preserving and building wealth over time.  We also are reminded that a challenging year, like 2022, provides an opportunity to assess not only what went wrong, but also what went right. High on the list of what Clinton Investment Management (CIM) got right, as stated in our CIM Q4 21 Market Commentary and Outlook, was the expectation we shared that we were likely to see a material slowdown in US economic growth in 2022, as well as an aggressive path of Fed tightening. Throughout 2022, we also expressed concerns relating to risk asset valuations, in response to the corresponding tightening of financial conditions, which we expected to weaken the US consumer.

Forced liquidations caused the municipal bond market to dislocate from the Treasury market as the Treasury curve inverted, the muni curve remained steeply sloped.

The explosion in revolving credit card debt, in the last year, illustrates this point clearly, see Figure 1. If the consumer was as “resilient” as many of the financial pundits would have us believe, we would not see consumers being forced to use high interest credit cards to support their ongoing spending. We also firmly believed that tighter monetary policy would translate to weaker corporate profitability, resulting in falling risk asset valuations, both of which came to pass. We did not, however, anticipate the onset of war in Ukraine or the corresponding

upward pressure the war exerted, albeit temporarily, on commodity prices. Higher commodity prices, oil in particular, caused headline inflation to persist for a couple of months longer than we anticipated. We can now see that inflation peaked in June of 2022, very close to the timing we anticipated. Inflation has been falling ever since, see Figure 2.

It is also worth noting that Manufacturing and Non- Manufacturing, Purchasing Managers indices (PMI) are now contracting, indicating that the direction of US economic activity continues to be downward and may also indicate that the US economy is already in recession.

While the yields on short-term Treasury bonds rose much more than long-term Treasury bond yields, the indiscriminate selling of retail municipal bond funds, by shareholders, resulted in the highest year of mutual fund outflows in the history of the municipal bond market. Over $115 billion flowed out of open-end municipal bond funds in 2022. Ongoing outflows added to the selling pressure, forcing yields on the long-end of the muni market higher, due to insufficient demand to absorb the supply. These forced liquidations caused the municipal bond market to dislocate from the Treasury market. As the Treasury curve inverted, the muni curve remained steeply sloped. Our recommendation to investors, in response to this dislocation, was to act expeditiously, looking to underweight highly rated municipal bonds, due in 1-5 years. We believe substantial risk of underperformance persists in these maturities, given the extremely positive slope of the municipal bond curve as well as very low absolute and relative yields of short-term muni bonds. In recent weeks we have begun to see the muni curve normalize as short maturities have underperformed longer duration bonds by over +5.00% or 500 basis points, just since Nov 1. The muni curve is now inverted between 1 and 12 years, a rare phenomenon.

The Fed’s apparent commitment to deliberately pushing the US economy into recession was also unexpected in 2022, as this posture is inconsistent with decades of prior central bank policy. Economic recessions are outcomes that the Federal Reserve has sought to avoid in the past. This time, the fastest Fed hiking cycle in history clearly illustrates to us that the Fed perceives a recession as a tool to constrain inflation. Recession will likely exert downward pressure on wage inflation, resulting in moderating inflationary pressures and inflation expectations. The Fed has stated its full commitment to returning inflation to its 2% target and we believe them.  We also believe the Fed has already hiked interest rates too far, tightening monetary conditions too much, which will likely result in a meaningful recession in 2023. While the economy has begun to slow, the Fed has assured us that it is going to rase interest rates higher still.  It’s worth noting that almost the entirety of the previous interest hikes, that took place in 2022, have yet to be felt by the US economy.  Historically, it takes roughly four to six quarters for rate hikes to begin to impact the economy. When one considers that the Fed only just began hiking rates three quarters ago, the full force of these rate hikes is indeed, yet to come, in our view.

The broader investment community is, just now, beginning to coalesce around our outlook. Therefore, looking out over the next 12 months, we expect the environment for fixed income to be quite good. For example, Bank of America and Morgan Stanley’s research departments have both indicated that they believe the performance of municipal bonds could be anywhere between +8% to over +11% respectively in 2023. Our view is that those estimates are likely to be conservative. Municipal bond investors may be surprised by the level of positive absolute returns they achieve in their municipal bond holdings this year. Investors are well compensated for low credit risk in munis and limited likelihood that rates will rise further. In addition, the Fed has indicated that it is approaching the end of its tightening cycle. When we considers that municipal bond investors can achieve tax-free yields over 4.00%, equating to an equity-like return of roughly 7% on a taxable basis through income alone, for those in the highest tax bracket, the case for munis becomes even more compelling.  Any further decline in interest rates from here will add meaningfully to an investor’s principal return as well.  We are positioning our client portfolios accordingly given this opportunity as  we believe 2023 should be the year of the bond investor.

It is important to note that there is still time for investors to take advantage of the current municipal bond market, yield curve dislocation. Active tax loss harvesting of existing mutual fund and individual bond positions not only can deliver meaningful tax alpha, but it provides an opportunity to better positions one’s bond portfolio, in a highly tax efficient manner, to take advantage of the changes in the economic outlook and the bond market more broadly.  CIM was extremely active, throughout 2022, harvesting losses, delivering significant tax alpha to our clients. In addition, the importance of active and ongoing credit oversight cannot be overstated, as we continue to invest in stable to improving underlying credits, even as the economic slowdown gathers momentum.

When a hurricane is approaching, individuals are encouraged to prepare, securing their assets and taking cover.  Continuing with that metaphor, municipal bonds are much like the financial plywood that helps investors protect their financial lives, in the midst of an economic storm, protecting investors from significant loss as they await the return of clearer skies.

We have begun to move up in credit quality and we are extending duration to increase yield for our client portfolios, given the expectation that further slowing in economic growth, ending in recession, will cause yields to fall further. We are grateful that our clients remained steadfast throughout 2022. It can often be difficult to stay the course, staying true to one’s convictions, when the world seems to be taking an opposite perspective. We are also grateful that many of the expectations we shared with clients have come to pass.

Now is the time to take advantage of the knowledge that a recession will be arriving soon, if it has not already.  We know high quality fixed income and municipal bonds perform quite well during periods of slow to contracting economic growth. An appropriate simile is that a recession is like an economic hurricane.  When a hurricane is approaching, individuals are encouraged to prepare, securing their assets, and taking cover.  Continuing with that metaphor, municipal bonds are much like financial plywood that helps investors protect their financial lives, in the midst of an economic storm, protecting investors from significant loss, as they await the return of clearer skies.

Clinton Investment Management News 

We want to sincerely thank the advisors and clients we serve for their ongoing trust and confidence. While 2022 was a very challenging year for us all, CIM enjoyed continued to growth. Our firm’s addition to multiple SMA platforms throughout the country is evidence of the highly valued and differentiated nature of our municipal bond investment solutions. These achievements resulted in the largest inflow of new client mandates in our firm’s history during 2022. The strength of our relationships is evident in our growth, and we are deeply grateful for our client’s ongoing commitment, trust, and loyalty.

If you should have any questions regarding this commentary or how one can take advantage of the inefficiencies we see, feel free to reach out to us directly.

Best Regards,

Andrew Clinton

CEO

Key Considerations:

The environment that investors have faced throughout 2022 has grown more challenging by the day. Market uncertainty has risen dramatically as a result of the Russian invasion of Ukraine, the threat of an expanding war, the increasing likelihood of severe economic contraction in the US, Europe, and Asia, while the Federal Reserve tightens monetary policy at the fastest cadence in history. These risks, both real and perceived, have resulted in the destruction of tens of trillions of dollars in wealth, year-to-date. This experience has understandably taken a serious and significant toll on US consumer sentiment, which is now at the lowest level in over 50 years. Expectations for contraction in domestic and multinational corporate profitability have also increased meaningfully and are now adding to the market volatility that persists. Market and economic conditions portend a period of deep domestic and global economic contraction, which we expect to accelerate in the coming months, an outlook supported by the over 1,000 CEO’s who participated in the most recent KPMG study. In the study, over 80% of CEO’s surveyed expect a recession in the next twelve months, while roughly half the CEO’s anticipate cutting jobs within their organizations during that time. These deep and disruptive, market crosscurrents had a substantial impact on bond markets and municipal bonds specifically during the third quarter.

The rise in interest rates, year-to-date, has resulted in the most severe downward, bond price adjustments in 50 years. At moments like these we are reminded that Fed rate hikes act with a “long and variable lag”.  Historically, it takes roughly four to six quarters for rate hikes to fully impact broader economic activity, implying that almost the entirety of Fed rate hikes, which began in March if this year, have yet to be felt in any meaningful way in the US economy. Yet, the pace and ferocity with which the Fed has raised interest rates continues at the fastest rate in US history. The Fed is also actively reducing its balance sheet through Quantitative Tightening (QT). When one considers the totality of the tightening that has occurred, together with the generational strengthening of the US dollar, the total impact of Fed action on financial conditions in 2022 equates to roughly 600 basis points of tightening, according to economist David Rosenberg. Fed Chair Powell has stated clearly that the Fed’s actions will result in “pain” for US consumers. We interpret this to mean that the Fed, in the clearest terms possible, is informing the public that it doesn’t believe tightening “too much” is a policy mistake, rather, it is a deliberate act, as they seek to push the US economy into a deep recession in order to reverse the stagflationary forces that persist. Therefore, the odds of a recession, over the next twelve months, are extremely high, illustrated clearly by the Bloomberg Recession Probability Model, which now stands at 100%.  The Fed also appears committed to hike yet another 0.75%, or 75 basis point, in November, and perhaps as much as another 0.75% in December. As such, the outlook for US economic growth looks decidedly bleak. Fed Fund futures are forecasting a terminal rate of roughly 5%, while the 10-year Treasury yield stands at roughly 4.19%. The Fed’s terminal rate is already priced into Treasury bonds, absent another adjustment upward by the Fed. The impact of the rate increases can also be seen in the level of 30-year fixed mortgage rates, now approaching 7%, which is causing a significant proportion of the US residential real estate market to become largely unaffordable for many home buyers.  What is remarkable is the fact that Fed hikes continue in the face of a material decline in commodities prices, as almost the entirety of the commodities complex is now in a bear market, down more than 20% from its highs.  At the time of this writing oil, iron ore, copper, wheat, silver, nickel, and palladium were down -27%, -20%, -29%, -29%, -29%, -53% and -27% respectively from their peaks. This is a clear indication that the inflationary forces the Fed is uniquely focused on arresting, are already beginning to dissipate.  Yet, the Fed is tightening financial conditions further. As our clients and followers know, Clinton Investment Management has been anticipating a slowdown in economic activity, together with a peak in inflation during the second or third quarter 2022 for some time.  While CPI remains stubbornly high, we have seen six consecutive months of weakening Leading Economic Indicators (LEI), from the Conference Board.  Never before have we seen six consecutive months of weakening LEI’s without the US economy subsequently experiencing a recession, see Figure 1.

Investors can now achieve tax-free yields of 5% or more, which equates to 8.5% to 9.00% on taxable equivalent basis, for those in the highest federal tax bracket.  At these levels, investors can lock in annualized returns in high quality muni and enjoy equity like returns, for the next 20 years for example, without the fear of the -40.00% to -50.00% drawdown that has been in experienced in the equity markets every 10 years or so.

We should begin to see further confirmation of a deterioration in economic activity in the coming months.  We are following guidance from corporations in their upcoming earnings announcements for clues as to the exact timing, depth, and duration of the coming slowdown.

In sympathy with Treasury yields, municipal bond yields moved higher during Q3 making September one of the worst months, from a total return perspective, in municipal bond market history.  The muni market was down over -3.84% in September according to the Bloomberg Muni Index. While it may come as small consolation to municipal bond investors, it is important to note that munis continue to be one of the best performing asset classes, from a total return perspective, year-to-date.  The Bloomberg Muni Index was down approximately -12% year-to-date at the end of the third quarter while Treasuries, Corporate bonds, and the S&P 500 were down -15%, -14%, and -24% respectively, as of 9/30/22.  At moments like these we believe it’s important to revisit prior periods of rising rates to better understand the frequency, depth, and duration of municipal drawdowns in order to derive greater clarity and confidence as we look forward. As you can see in Figure 2, periods of rising muni yields are not only frequent but are often quite brief. The longest drawdown period, going back to 1982, was 11 months. The current drawdown cycle is approaching 10 months.

While the worst bond market in history has been unpleasant and unwelcome, which is perhaps  the understatement of this millennium, we know from experience that periods of market upheaval and dislocation create extraordinary opportunities. Investors with appropriate investment horizons can enjoy the benefits of those dislocations as markets normalize over time. An example of the severity of current market dislocations can be seen in comparing the shape of the Treasury yield curve to that of the AAA rated, tax-free muni curve.  The Treasury curve is inverted by approximately -0.50%, or -50 basis points, from 2 years to 30 years bonds (2s/30s), meaning 30 year bond yields were roughly 0.50% lower than 2 year bond yields. Yet, 30 year muni bond yields are approximately +0.91% or 91 basis points, higher than 2 year muni bonds. We believe the Treasury curve is accurately reflecting the likelihood that long-term interest rates will be materially lower in the future, creating an attractive opportunity and entry point in longer intermediate and long-duration muni bonds, as the muni market has yet to price in the Treasury market reality. The front-end of the muni curve is quite rich in our view. The curve is almost perfectly flat 2 years to 5 years. Nominal yields are roughly the same regardless of maturity. Yet, muni to Treasury ratios are quite rich in short maturities from a historical perspective, making short-duration munis unattractive and likely to underperform over time in our view. This dislocation is being driven by record setting withdrawals of over $100 billion out of open-end municipal bond mutual funds, year-to-date, see Figure 3.

Investors can lock in annualized returns in high quality muni and enjoy equity like returns, for the next 20 years for example, without the fear of the -40.00% to -50.00% drawdown that has been in experienced in the equity markets every 10 years or so.

Outflows have continued to pressure longer duration muni yields higher to levels we have not seen since the Great Financial Crisis, over 14 years ago. Investors can now achieve tax-free yields of 5% or more, which equates to 8.5% to 9.00% on taxable equivalent basis, for those in the highest federal tax bracket.  At these levels, investors can lock in annualized returns in high quality muni and enjoy equity-like returns, for the next 20 years for example, without the fear of the -40.00% to -50.00% drawdown that has been in experienced in the equity markets every 10 years or so.

Municipal credit quality remains stable as state and local governments continue to benefit from higher pass-through corporate tax collections and higher inflationary tax revenue, derived from higher nominal sales tax collections.  New issuance in the municipal bond market is down over 10% from this time last, year given that many state and local governments have sufficient cash and liquidity such that they don’t need to borrow.  They may also be considering the likelihood that interest rates could be considerably lower next year this time, which would be a better time to access the capital markets, enabling them to achieve lower interest costs over time. Heading into, what we expect will be a severe an economic slowdown or recession, state and local governments, are, quite literally, in the strongest fiscal health they have enjoyed in the past 30 years. Therefore, we continue to believe the greatest value can be found in lower investment grade bonds where default risk is consistent with AAA quality, as shown in Moody’s credit default studies going back 50 years, and tax-free yields are the highest, while spreads to AAA rated bonds are the widest.

As we look to year-end, it is reasonable to expect that market uncertainty will persist for some time.  However, we also expect 2023 to be a much more constructive year for high quality fixed income more broadly and munis in particular.  Following every recession since the early 80’s, the Fed has reversed the entirety of all its prior interest rate hikes.  While we understand there are calls by some in the investing community who believe this time is different and that high rates of inflation will persist forever, that outlook is inconsistent with the last 50 years of monetary policy. That is not to say that that outcome is impossible, it is simply to say that it is a very low probability event over the intermediate and longer term, given what we know as students of economic theory and Fed policy. Having said that, we expect 2023 to be a challenging year for the US and Global economies, as well as risk assets more broadly. However, we also expect the Fed’s tightening cycle to come to end as well.  As the economy slows further, the Fed will likely be forced to cut rates deeply to reverse the trend in economic contraction. While we have no clarity as to whether the Fed will be forced to return to the zero bound, it is reasonable to believe that materially lower interest rates will be necessary to recover from what we believe is not a policy mistake by the Fed, pushing the US economy into a recession, but a deliberate act.  As investors consider the best way forward, it is important to remember that the asset class that enters the recession first also typically exists first. That would mean fixed income should perform well over the next 12 to 18 months. As challenging as this year has been, and continues to be, we encourage our clients and investors to remain calm and confident in the knowledge that this too shall pass, and better days are ahead for fixed income and municipal bond investors.

If you should have any questions about this content or the fixed income and municipal bond markets more broadly, please do not hesitate to reach out to us directly.

Best,

Andrew Clinton

CEO