3rd Quarter 2015 Portfolio Manager Market Commentary
Thornburg Municipal Bond Funds
The municipal market, as measured by the BofA Merrill Lynch Municipal Master In-dex, returned 1.69% in the third quarter of 2015. This brings its year-to-date return to 1.80%, and its 12-month return to 3.16%. Certainly, the events of August in the equity markets should convince investors of the need for a bond position in a well-balanced portfolio.
The market’s returns were a result of increasing short-term interest rates, declining intermediate interest rates, and largely unchanged long-term interest rates. Chart 1 illustrates the change in interest rates for all maturities from one to 30 years for the 12 months ended September 30.
Josh Gonze
Portfolio Manager Christopher Ryon, Portfolio Manager cfa
Nicholos Venditti Portfolio Manager Best Short-Intermediate Municipal Debt Fund
Thornburg Limited Term Municipal Fund
Supported by the entire Thornburg investment team.
- 0.05 0.00 0.05 0.10 0.15 0.20 0.25 0.30 Pe rc en ta ge Maturity Date - 0.10 - 0.15 - 0.20 1 YR 2 YR 3 YR 4 YR 5 YR 7 YR 9 YR 10 YR 12 YR 14 YR 15 YR 17 YR 19 YR 20 YR 25 YR 30 YR
Chart 1: 12-Month Change in AAA-Rated General Obligation
Municipal Yield Curve
(as of September 30, 2015)2 | Municipal Bond Funds
The U.S. Economy and the
Federal Reserve Board
The U.S. economy grew at an average rate of 2.2% for the last three quarters ended June 30, (the quarter ending September 30 is not available, as of this writing). If we go back four quarters, the average growth rate is 2.7%. The U.S. unem-ployment rate has decreased to 5.1% in September 2015, although the Septem-ber nonfarm payroll numSeptem-ber did give the markets a bit of a scare by falling way short of expectations at 142,000. John C. Williams, president and CEO of the Federal Reserve Bank of San Francisco, mentioned in a recent speech: “My estimate of the natural rate of un-employment today is five percent, consis-tent with pre-recession estimates. With the current rate at 5.1 percent, we are very close.”
Job vacancies are at the highest levels since the time series has been tracked in 2000. So how do we square this circle? It might be that as we reach the “natu-ral rate of unemployment,” employers are finding it harder and harder to find qualified employees. If this is true, the economy may begin to see wage pressures build. Inflation, by any measure, has been consistently below the Fed’s target of 2.00%.
The Federal Reserve Board has put off raising short-term interest rates yet again. Zero short-term interest rates are an appropriate policy response for an economy losing 500,000+ jobs a month, and an unemployment rate of 10%, which is exactly what the U.S. econo-my experienced during the great
reces-sion. In the seventh year of zero short-term interest rates, market participants question whether that is an appropriate policy for an economy that has added an average of 229,000 jobs for the last 12 months and is running a 5.1% unemploy-ment rate. In her recent news conference, Janet L. Yellen, the Fed’s chair stated, “The recovery from the great recession has advanced sufficiently far, and domes-tic spending has been sufficiently robust that an argument can be made for a rise in interest rates at this time.” This is true. Retail sales are up 2.2% year-over-year, as of August 31. Auto sales topped ex-pectations in September, reaching 18.07 million cars and trucks. But Ms. Yellen, in the same news conference, went on to say, “heightened uncertainties abroad” have kept the Fed on hold as they wait for more data. Regardless, waiting for the Fed to raise short-term interest rates seems to be like “Waiting for Godot.” Real yields, which are nominal interest rates less an inflation measure, are still quite low and credit spreads (the incre-mental yield an investor is promised to buy a lower-rated credit) are still very narrow. In this environment, we believe investors are not getting paid to take risk, and consequently we are taking less risk in terms of both maturity (duration) and lower-quality credit risk in the funds.
The Municipal Bond Market
Credit Picture
The credit picture for the municipal bond market is pretty good, unless you happen to be a state whose economy is based on energy production. On September 17, the
Performance data shown represents past performance and is no guarantee of future results. Investment return and principal value will fluctuate so shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than quoted. For performance current to the most recent month end, visit thornburg.com. The Low Duration and Limited Term funds have a maximum sales charge of 1.50%. The Intermediate Municipal Fund and the Strategic Municipal Income Fund have a maximum sales charge of 2.00%. The total annual operating expenses are as follows: Low Duration Municipal, 3.14%; Limited Term Municipal, 0.71%; Intermediate Municipal 0.92%; California Municipal, 0.94%; Strategic Municipal Income, 1.31%. Thornburg Investment Management and/or Thornburg Securities Corporation have contrac-tually agreed to waive fees and reimburse expenses through at least February 1, 2016, for some share classes, resulting in a net expense ratio of 0.70% for the Low Duration Municipal Fund and 1.25% for the Strategic Municipal Income Fund. For more detailed information on fund expenses and waivers/reimbursements, please see the fund’s prospectus.
1-YR 3-YR 5-YR 10-YR
SINCE INCEP.
Low Duration Municipal Fund
TLMAX (Incep: 12/30/13)
Without sales charge
0.22% - - - 0.35%
With sales charge
-1.30% - - - -0.52%
Performance as of 9/30/15 (annualized for periods over one year)
Intermediate Municipal Fund
THIMX (Incep: 7/22/91)
Without sales charge
1.68% 2.20% 3.49% 3.97% 4.96%
With sales charge
-0.35% 1.51% 3.07% 3.76% 4.87%
Limited Term Municipal Fund
LTMFX (Incep: 9/28/84)
Without sales charge
1.15% 1.31% 2.34% 3.34% 5.08%
With sales charge
-0.35% 0.81% 2.02% 3.18% 5.03%
California Limited Term Municipal Fund
LTCAX(Incep: 2/19/87)
Without sales charge
1.40% 1.86% 2.66% 3.45% 4.47%
With sales charge
-0.12% 1.35% 2.36% 3.30% 4.41%
Strategic Municipal Income Fund
TSSAX (Incep: 4/1/09)
Without sales charge
2.18% 2.86% 4.70% - 7.66%
With sales charge
York released its 100th state tax revenue report, which says:
“State tax revenues grew by 5.8 percent in the first quarter of 2015, according to the 100th State Revenue Report of the Rockefeller Institute. All major sources of tax revenues showed solid growth during this period: personal tax collec-tions grew by 7.1 percent, corporate tax revenues at 3.3 percent, sales taxes at 5.2 percent, and motor fuels at 4.4 percent. Preliminary figures for the second quar-ter of calendar year 2015 (the final quarquar-ter of fiscal year 2015 in most states) indicate growth in total state tax collections of 7.6 percent and particularly strong growth in personal income tax collections of 14.3 percent. State revenue forecasts call for a slowdown in total personal income tax growth to 2.7 percent in fiscal year 2016, from 5.1 percent estimated by states for fiscal year 2015.”
Bloomberg recently reported that the 2014 median funding levels of state pen-sion plans improved to 70% from 69.2% in 2013. An 80% funding level is seen as the line of demarcation between a well-funded state pension and one that’s not well funded, according to the PEW Research Center.
We have seen some well chronicled defaults in the municipal bond market in the last few years and Puerto Rico’s financial troubles continue to garner headlines—one of which, penned by Morningstar, reported that the island’s pension is only funded to 8.4% of its $34.0 billion liability level. Let us add here that Thornburg does not own any Puerto Rico debt—in any portfolio! Table 1 highlights the results of some of the re-cent bankruptcy proceedings. There are a few lessons to be learned from this ta-ble. First, given the choice between pen-sioners and bondholders, penpen-sioners win every time! In the Detroit bankruptcy (we did not own any Detroit bonds!), the pensioner’s limited impairment resulted in a 95.5% benefit for non-uniform ers, and 100% benefit for uniform work-ers (both sustained a 50% cost-of-living reduction), while bondholders received
between 74% and 11% of what they were owed. This highlighted, again, the value of sound, fundamental, bottom-up credit research, a Thornburg strength.
Market Liquidity and Federal
Regulations
It has been our contention for some time that the fixed-income markets are grow-ing less and less liquid. This is a result of the consolidation that took place after the financial crisis and the federal regu-lation (Dodd-Frank Act and the Volcker Rule) enacted to reduce the likelihood of a repeat. This is evidenced by the amount of inventory broker/dealers commit to the various markets. From 2000 through 2008, the period prior to the financial crisis, broker/dealer inventory levels averaged 7.9% of the municipal bond assets in mutual funds (excluding mon-ey market funds), exchange-traded funds (ETFs), and closed-end funds. Today that number stands at 2.5%. The cor-porate bond market’s numbers are even more staggering! Inventory levels prior to the financial crisis stood at 34.5% and today they are at just 4.7%.*
This reduced commitment to the fixed income markets is coupled with a signif-icant increase in ownership of corporate bonds by retail investors in mutual funds, ETFs, and closed-end funds. The average for the period from 2000 through 2008 was 8.5%, and today it is 22.4%. This ratio has remained pretty constant for municipal bonds, at around 20%. Why is this important? Reduced liquidity may mean that investors should be ready for higher price volatility if and when inter-est rates increase.
The SEC is concerned about this risk. On September 22, it released for comment a set of proposed new liquidity rules for mutual funds and ETFs. This proposal centers on these recommendations: 1. Institute a liquidity management
program.
2. Enhance disclosure regarding fund liquidity and redemption practices. 3. Allow mutual funds to elect “swing
pricing” to effectively pass on the costs stemming from shareholder purchase or redemption activity.
This sounds like pretty good regulation, until one couples it with a letter Thorn-burg received from its custodian bank, ENTITY BANKRUPTCY PROCEEDINGS PENSION RECOVERY BONDHOLDER RECOVERY San Bernardino, CA Pending Unimpaired 1-100% A
Stockton, CA Concluded Unimpaired C 0.25% -100% B
Detroit, MI Concluded Limited Impairment 74% for GOULT 2
Jefferson County, AL Concluded Unimpaired 88% for GOLT Central Falls, RI
(Statutory Liens on Local GOs) 1 Concluded Haircuts up to 55% Unimpaired 3
Source: Morgan Stanley Muni Monday Morning newsletter, July 27, 2015.
A. San Bernardino City Council – approved plan proposes 1% recovery Pension Obligation Bonds (unsecured) but full payments for Lease Revenue COP’s Bonds secured by the police station as collateral.
B. Stockton paid 0.25% on leases backing a golf course. C. Retiree health plan was canceled.
1. GOs – general obligation bonds. 2. GOULT – general obligation unlimited tax. 3. GOLT – general obligation limited tax.
* Source of bond inventory data: U.S. Federal Reserve, Financial Accounts of the United States.
4 | Municipal Bond Funds
State Street, which informed us that, due to “the evolving regulatory environment” and “implementation of the Basel III accord,” they will be charging us 0.20% (20 basis points) for cash reserves held at their bank in excess of 5% of assets under management. Reserves are an important tool to manage overall interest-rate sen-sitivity, shareholder withdrawals (as we saw in 2013 with the “taper tantrum”), and to provide “dry powder” for peri-ods of market disruption. So here we are caught between one regulator wanting us to provide more liquidity and the unin-tended consequences of another regula-tion that forces us to be less liquid. We are managing this new environ-ment by utilizing four levels of liquidity reserves in the municipal bond mutual funds:
1. Maximum liquidity at the custodian bank before the change is
implemented.
2. Buying variable-rate demand notes (VRDNs) with short-term liquidity features.
3. Buying U.S. Treasury bills if VRDNs are not available, which would be a temporary position (the bad news is that we may incur some taxable income; the good news is not a lot of taxable income will be incurred, at an average rate 0.01%).
4. Buying securities that are eligible for money market funds to purchase. The thought here is that if we see a market disruption, shareholders will flee to the safety of municipal money market funds. Being able to sell these securi-ties to money market funds, as their demand increases, should decrease the liquidity risk of your Thornburg municipal funds.
Conclusion
We are in a trying environment. Inves-tors have a great desire for income, and the unintended consequences of the Fed’s zero-interest-rate policy is forcing them into riskier positions. That could mean buying securities or funds with longer maturities or lower credit quality. Add to
all that a market in which broker/ dealer liquidity is at a premium, and inter-est rates are at multi-decade lows, even when adjusting for low levels of infla-tion. Credit spreads are narrow—back to 2007 levels—when 50% of the new-issue municipal market was insured by the AAA municipal bond insurers. Overall, credit in the municipal market has recov-ered from the financial crisis, despite sev-eral high-profile bankruptcies.
We are taking less risk in your portfolio and concentrating on our fundamental bottom-up credit research. We believe the best way to manage this environ-ment is to have a long-term investenviron-ment horizon, ready oneself for increased price volatility, and let the fund’s ladder struc-ture do what is does best—provide a dis-ciplined approach to reinvestment. As we stated earlier, there is a place for bonds in a well-diversified portfolio, even when they are slightly overvalued.
Thank you for being a shareholder of a Thornburg municipal fund. n
underlying bonds. The value of bonds will fluctuate relative to changes in interest rates, decreasing when interest rates rise. This effect is more pronounced for longer-term bonds. Unlike bonds, bond funds have ongoing fees and expenses. Investments in lower rated and unrated bonds may be more sensitive to default, downgrades, and market volatility; these investments may also be less liquid than higher rated bonds. Investments in derivatives are subject to the risks associated with the securities or other assets underlying the pool of securities, including illiquidity and difficulty in valuation. Investments in the Funds are not FDIC insured, nor are they bank deposits or guaranteed by a bank or any other entity. The views expressed by the portfolio managers reflect their professional opinions and are subject to change. Under no circumstances does the information contained within repre-sent a recommendation to buy or sell any security.
There is no guarantee that the Fund will meet its investment objectives.
Diversification does not assure or guarantee better performance and cannot eliminate the risk of investment losses.
Thornburg Limited Term Municipal Fund’s I shares were awarded Lipper’s Best Short-Intermediate Municipal Debt Fund in 2015 for the 10-year period; among 33 funds, for period ended November 30, 2014. Individual fund awards are granted annually for three-year, five-year, and 10-year periods to the fund in each Lipper classification that consistently delivered the strongest risk-adjusted performance (calculated with dividends reinvested and without sales charges). The fund did not win the award for all eligible time periods. Past performance does not guarantee future results.
The BofA Merrill Lynch Municipal Master Index tracks the performance of the investment-grade U.S. tax-exempt bond market. Qualifying bonds must have at least one year remaining term to maturity, a fixed coupon schedule, and an investment grade rating (based on average of Moody’s, S&P, and Fitch).
The performance of any index is not indicative of the performance of any particular investment. Unless otherwise noted, index returns reflect the reinvestment of income dividends and capital gains, if any, but do not reflect fees, brokerage commissions or other expenses of investing. Investors may not make direct investments into any index.
Income earned from municipal bonds is exempt from regular federal and in some cases, state and local income tax. Income may be subject to the alternative minimum tax (AMT). A bond credit rating assesses the financial ability of a debt issuer to make timely payments of principal and interest. Ratings of AAA (the highest), AA, A, and BBB are invest-ment-grade quality. Ratings of BB, B, CCC, CC, C and D (the lowest) are considered below investment grade, speculative grade, or junk bonds.
Credit Spread/Quality Spread is the difference between the yields of securities with different credit qualities.
Duration is a bond’s sensitivity to interest rates. Bonds with longer durations experience greater price volatility than bonds with shorter durations.
Laddering involves building a portfolio of bonds with staggered maturities so that a portion matures each year. Money that comes in from maturing bonds is typically invested in bonds with longer maturities at the far end of the portfolio.
Real Yield is yield from an investment adjusted for the effects of inflation.
Variable Rate Demand Note (VRDN) – VRDNs are long-term, floating-rate municipal securities. These highly liquid securities are payable on demand, typically either daily or weekly, meaning the investor can request repayment of the entire debt amount. The coupon rate will adjust on a periodic basis, either daily or weekly.
Before investing, carefully consider the Fund’s investment goals, risks, charges, and expenses. For a prospectus or summary prospectus contain-ing this and other information, contact your financial advisor or visit thornburg.com. Read them carefully before investcontain-ing.
Thornburg Securities Corporation, Distributor | 2300 North Ridgetop Road | Santa Fe, New Mexico 87506 | 877.215.1330
10/16/15 TH1765
