Municipals, Inflation & Purchasing Power
California municipals, as measured by Bloomberg Valuation System (BVAL) are now trading almost 18 basis points through the AAA municipal yield curve in the 5 year maturity. As the second chart shows, CA General Obligation (GO) paper in that part of the curve is now trading at its richest value in years and has now moved from +30 basis points to the AAA curve to -18 basis points. While this is rich on a nominal basis, yesterday’s CPI data highlights an even more important point: when we adjust CA yields for regional CPI’s it is more overvalued.
BVAL 5 YEAR MUNICIPAL CURVE
SPREAD BETWEEN CALIFORNIA 5 YEAR GO AND AAA 5 YEAR MUNICIPAL CURVE
Source: Bloomberg. Data accessed on 9/13/2018
The CPI report showed US inflation running at 2.7% on a year-over-year basis. For investors viewing bonds exclusively through the prism of purchasing power protection, this data suggests that real bond yields offer limited value. When we adjust state municipal yields for regional CPI rates, a more interesting and informative story emerges that is useful when considering portfolio structure for municipal investors:
- The Bureau of Labor Statistics reported that CPI in the West is now running at a 3.6% annual rate. Since 5-year CA paper has a nominal yield of 1.95%, this means the real (net of inflation) yield of 5-year CA paper is a negative real yield of -1.65%. So, CA investors who purchase bonds that are trading rich to the overall municipal market, are also investing in bonds that are not keeping up with inflation. While there are many reasons to hold municipal bonds in a portfolio from an asset allocation and tax-efficiency purpose, purchasing power is not one of them today.
- By contrast, the very low regional inflation rate in the Midwest of 2.1% on a year-over-year basis means Illinois paper has a positive real yield of over 1.6%. These bonds are attractive on a spread basis, and on a real yield basis.
- So, California investors lose about 1.6% on a purchasing power basis in a 5-year municipal and Illinois investors make 1.6% on a purchasing power basis.
Certainly the credit profile of CA is far superior to Illinois, yet if an investor’s concern is just purchasing power, the conclusion is clear: Time to move to Chicago.
While this may not be an actionable recommendation for many California investors, we believe they can protect themselves by beginning to move a portion of their portfolios to out-of-state municipals.
And what about the opportunity for Midwest investors? Their regional inflation rate has been running consistently below the national rate since 2012. For these investors they have an arbitrage in the Tax Inflation Protected Securities (TIPS) market. The TIPS market is priced on national CPI. We believe Midwest investors, whose regional CPI has been lower for years, not only achieve purchasing power protection with TIPS, but their purchasing power should increase if these trends continue.
Jonathan E. Lewis, Chief Investment Officer
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