People who have played both checkers and chess would likely agree that chess is the harder of the two games. Although both are played on a board with 64 squares, the rules of checkers are easier to learn, and the objective straightforward – take all your opponent’s pieces. Chess, on the other hand, is more complex, requiring a deeper level of study, strategy, and practice. There are six unique chess pieces, which move differently and have different value in the game. A player would readily sacrifice a pawn for the opponent’s rook or queen, for example, but not vice versa. And the king must be protected at all costs to avoid ending in checkmate. Even the most experienced players would admit they can always improve, which can only come through study and experience.
As we examine the municipal “board” at the start this new year, it looks to us to be a more challenging one than a year ago. More like chess than checkers. Winning will likely require a more complex, multi-faceted strategy than in 2021. Experience, study and caution will be rewarded.
Checkers in 2021
Despite a board full of uncertainty at the start of 2021, including Covid, labor shortages, supply chain bottlenecks, wage and price pressures, political uncertainty and shifting Fed views (to name a few!), two key portfolio decisions – Credit and Curve – determined the outcome of the game. It was relatively straightforward and if you executed the strategy well, you were rewarded.
Municipal credit was relatively cheap at the start of 2021 but became richer as the year progressed; credit spreads narrowed to record lows by year end. Investors recognized that the massive fiscal stimulus in 2020, with additional support from the $1.9T American Rescue Plan Act (ARPA) in early 2021, would strengthen even the weakest municipal credits and it did. In addition, state and local tax revenues rose sharply as the economy re-opened post-vaccinations, pushing reserve levels to new highs and budget surpluses to the highest level as a percentage of GDP in at least forty years. The result was that lower-quality credits significantly outperformed higher-quality; BBBs provided 438 bps of excess return over AAAs in 2021 (source: Bloomberg Municipal Index).
Managing the curve strategy was a bit more complicated as yields rose and the curve steepened, requiring more active curve management. As the curve steepened in Q1 our modest barbell was extended to capture the steeper slope. This was rewarded later in the year when longer-term rates fell and significant flattening occurred. By monitoring curve slope throughout the year, we were able to effectively balance the desire to optimize roll-down benefits while also maintaining a barbell curve allocation. Thankfully, an upwardly sloping yield curve provides investors opportunities to enhance returns over time and we were successful in doing so in 2021.