April Monthly Review

April 2017 Muni Monthly Review:

The month of April has set munis up for what we feel could be good performance over the next 30 to 90 days.  Muni supply is lower than expected and demand should be picking up due to large amount of maturities and coupon payments in the coming months.

Our ten-year anniversary of managing the Tax Advantaged Opportunity Funds is just around the corner, and we have taken time to reflect on the past decade.  In 2008, we set out to create a product that keeps the client’s interest first and secures their principal for the long run, while providing attractive cash-on-cash returns. Right out of the gates, our investment thesis was tested in crisis, and it flourished. This success allowed us to raise three more Funds, which have all performed admirably. We expect to continue the record of accomplishment of our first four Funds in our upcoming fifth and largest Fund.

With four Funds opened and two Funds successfully wound down, we feel this is an opportune time to review how they have performed and how they have been managed. I guess you could say this is a peek into the “kitchen” of MainLine West and at the recipe for our Funds.

Muni Market Review:

 April is normally a month of muni underperformance, but in 2017, munis kept pace with their taxable equivalents.  Issuance is down, tax reform concerns are calmed, and munis seem primed for good performance, going forward. Highlights for April are as follows:

• Muni rates decreased from -18 to -3 bps, with the 7-year being the strongest performer and the curve steepening 11 to 21 bps.
• Taxable rates decreased from 11 to 13 bps, with the curve staying unchanged.
• Muni to taxable ratios are now skewed as 5 & 7-year munis appear rich, 20 to 30-year munis appear cheap versus historical percentages.
• Muni supply continues to slow down versus 2016, as the increase in rates has impacted refunding deals. Supply is 10.3% behind 2016 levels, and rates remain 40 to 60 bps higher than the fall of 2016 when refunding volumes were strong.

Other Muni Market thoughts:

• The market is moving into a usual strong technical time of year. Estimates show demand (measured by maturities and coupon payments) is stronger than supply (estimated issuance) by roughly 1.25 times. Because of this, we anticipate the value of munis to increase over the next 30 to 90 days.  Latest numbers show negative net supply in the June-August period will be 55% higher than the trailing 3-year period.
• There remains good value from 15 to 30-year munis. An investor can receive 86% of the curve’s income by buying 15-year bonds and taking only 50% of its pricing risk.

Market News & Credit Update:

The release of tax reform plans from Trump should not be a surprise to our readers:

• The proposed top tax rate of 35%, if approved would have little impact on the value of munis. The average tax rate for current muni holders is 28%, and evaluations on the longer-end of the muni curve at this time are cheap. This Grey Swan has set sail.
• If passed, the proposed new corporate tax rate of 15% could curtail the demand for munis by corporations. The consensus in DC is that it will be approved at 25% and, therefore, this would only cause a modest decrease in demand from corporate investors.

The Illinois credit debacle continues.  The inability of the state to pass a budget has now impacted the state’s public universities with downgrades to 6 of the 7 entities. Both rating agencies are threatening more downgrades to the State and other related issuers if nothing happens by the end of May.

At what price for Infrastructure spending? A recent paper release from long-time municipal guru, George Friedlander, highlights DC’s confusion in finding an infrastructure program that entices investors and borrowers.  There needs to be a balance of enticements for how projects receive financing, and how investors are compensated.  Current tax credit plans will not stimulate $1 trillion in new projects and the process would be biased regarding its selection process and bias towards the small issuers.  The more we read about the difficulties being incurred while attempting to get a program going, the louder we chant the words “Bring back the Build America Bonds!”

A Family of Tax Advantaged Opportunity Funds:

 After nine years, four Funds opened, two Funds successfully wound down, 10% or greater tax-equivalent returns, and over 100 investors, now seems to be a good time to review how we arrived at this point.  In assessing the four Funds, we feel comfortable in saying that our two closed Funds exceeded their Investment Objectives, while Funds III and IV are positioned to do so, going forward.

Our Investment Objectives are as follows:

• An alternative investment strategy designed to payout tax-exempt income of 6% to 8%.
• Average investment life and commitment of 5 to 7 years.
• Risk management strategy designed to minimize losses.

For every good long-term performance, there is a process and a foundation that helps to keep things from going astray.  We call this the “investment recipe” for our Family of Funds.  Patience, discipline, and timely decisions have been required over the past nine years to achieve consistent performance, while enduring market turmoil and economic cycles.

	Fund I	Fund II	Fund III	Fund IV
Inception Date/ Termination Date	March 2008 December 2015	January 2011 January 2015	May 2013	December 2015
Capital Pledged	$ 18 MM	$ 18 MM	$ 24 MM	$ 54 MM
Assets Owned	$ 45 MM	$ 65 MM	$ 85 MM	$190 MM
Credit Quality	AAA-AA	AAA-AA	AA-A	AAA-A
Cash Payout (LOF* Tax-Exempt)	8.27%	8.78%	7.26%	Estimate 6.00%
IRR (Annualized)	8.95%	16.92%	11.18%	NA (**)
Net Asset Value	1.10 at exit	1.34 at exit	1.20	1.01

There is no assurance that the Fund will achieve its objective. There is no possibility of profit without the risk of loss. Investors in Fund IV will have no interest in Fund I, Fund II, Fund III or their assets. (*) All return information is from inception date to 12/31/2016. 3 Unaudited results. Annual audits available upon request. (**) Fund IV has just finished deploying its capital, total return calculations are skewed due to the short time horizon.

What do all of these Funds have in common? They have a proven recipe and the use of only top quality ingredients. More specifically:

• Investment during a time of muni market crisis – taking advantage of an opportunity. Not every Fund has had perfect timing.  However, by the end of the investment period, we have been able to take advantage of muni market displacement and put in place a risk and return profile that favors long-term value. More specifically:
  • Fund I – executed post 2008 Bear Stearns bankruptcy.
  • Fund II – executed post Meredith Whitney 2010 muni bankruptcy call.
  • Fund III – executed during the Fed 2013 taper tantrum.
  • Fund IV– finished after the 2016 Trump post-election market correction.

• Our Primary investment strategy is managing to a risk profile to minimize chance of principal loss and not to an investment yield target. Investments are made that meet our risk profile first and then the Fund’s return objective second.  This is done with numerous ingredients:
  • Buying premium coupon intermediate term bonds that earn at least 80% of the market’s income with only 50% of its pricing risk. (We do not feel the other 20% income is worth the risk.)
  • Use of manageable leverage at 3 to 4 time’s capital invested. We have always had the capacity to lever more, and earn higher returns.  This also increases the risk of losses and does not fit with our risk profile.
• Credit Quality – top tier is the standard. Every transaction has three different parties reviewing the credit. The most efficient transaction, and therefore the best returns, comes from issuers that have both a good fiscal and demographic profile. Municipal finance is dominated by fiscally sound entities, and we make sure we keep our Funds invested in that way.
• Solid and consistent business partners. From the bank we utilize to create our products, to the brokers we work with to construct our preferred bond structure, we have built a network of trusted and fair working relationships.
• Lastly, remaining true to the roots of the municipal market, we stay humble, quiet and do not reach for the fame. We understand that an extra 50 bps of return, in exchange for a greater chance of losses, is not a good long-term proposition. We plan to be around, not going anywhere, just like the city of Denver.

We do not guarantee that all of our Funds will continue to show the final returns of Fund I, II and III, but we do feel our process, over the long-term, will ensure outperformance and allow the Funds to meet their investment objectives. It is all about following the investment recipe, and staying with top quality ingredients.