Finally, bond yields moved higher in December reversing the predominant 2012 trend line and reminding many that losses are possible even in Mr. Bernanke’s contrived bond market utopia. Centuries ago the bard from Avon opined (as did our own January 2004 commentary) “Sell when you can, you are not for all markets”.
For a man that never traded bonds, William Shakespeare understood a basic bond market tenet: at certain times, selective selling often is a sensible strategy. When it made sense in 2012 and especially during the final months of the year our portfolio management process employed this strategy for many mature and fully invested client portfolios. In December, as attractive investment opportunities became more plentiful, portfolio selling was overshadowed by investment activity.
Certain headlines and events forced bond prices lower in December and U.S. treasury, ten year taxable bond yields moved above 1.80%.
Municipal bond yields followed the treasury lead as the 10 year “AAA” rated national MMD index closed 2012 yielding slightly more than 1.70% up from 1.47% at the end of November. Budgetary uncertainty, year-end tax trading and a temporary year end supply glut served as additional forces pushing municipal bond prices lower and yields higher. The Bloomberg News chart below shows the monthly supply gyrations of the municipal bond market in 2012:
Historical 30 day visible supply for last 12 months (competitive and negotiated issues)
Generally, municipal bond prices declined in December by the steepest amount in two years and, on a percentage basis, by a greater degree than treasury bond price declines. The sharp price decline, in part, was set up by the dismally low yields reached in late November (a near four decades low). We view December’s price decline as a needed market adjustment; municipal bond yield ratios relative to taxable bond yields had become too expensive during November.
December’s bad news for bond portfolio valuations aside, 2012 proved to be a solid year for most bond investors, a continuation of the multi-year bond market rally. Annualized 3%-4% total returns for non-taxable, intermediate and long term municipal bond portfolios occurred. Those are attractive returns compared to the present day near 0%- 2% short/intermediate term U.S. Treasury bond universe.
The California trio of Chapter 9 bankruptcy filings (Stockton, Mammoth Lakes and San Bernardino) all within 6 weeks of each other this past summer was big news in 2012, but did nothing to slow the mid- summer bond market rally.
In December, the California Public Employee’s Retirement System (Calpers) and various unions representing city of San Bernardino employees repeated their objections to the Chapter 9 filing and argued in court it was illegal for the city to defer pension payments for policemen, firefighters and other city employees. Calpers argued San Bernardino cannot defer its pension payments to the fund while in bankruptcy and that the deferral is unfair since Calpers is still required to pay city retirees defined benefits of almost $ 4 million each month. Notably, Calpers views the city’s pension obligations as senior to other unsecured debts (including municipal notes, certificates of participation and certain unsecured bonds).
The City of San Bernardino and debt holders have a different opinion on this issue.
We have stated before we are not attorneys and therefore we will leave it to the courts to decide these important matters. However, recent comments related to this topic made by our friend and well-respected bankruptcy attorney, James Spiotto in a December 5th, edition of the “ Bloomberg Brief” were not lost on us: “A defined benefit that isn’t capable of being funded is not a defined benefit- it’s an illusion.”
Well and pointedly stated.
Late in December, U.S. Bankruptcy Judge Meredith M. Jury ruled in favor of the City of San Bernardino and against Calpers and city unions allowing it to continue deferring pension payments while in Chapter 9. Judge Jury stated forcing pension payments “would be the death knell” for the city at this time.
We are certain this is not the end of this matter, but take some heart in the Judges’ sensible and logical ruling on this specific issue.
1966 brought us the iconic rock band “The Mamas and the Papas”, their hit song, “California Dreaming ” and its musings about brown tree leaves, grey skies and a winter day.
We are uncertain as to the meaning of the song’s lyrics and wonder if, perhaps, they serve as bond market metaphors for the general state of California’s present day municipal finance.
We are certain of two things:
- Bond investors are watching closely how Chapter 9 proceedings play out in places like Stockton, California and San Bernardino, California. They need assurance from issuers and courts their interests will be treated fairly, not watered down in order to satisfy Calper’s demands.
- If bondholders interests are unfairly treated or held hostage to long, drawn out and uncertain courtroom battles, many bond investors will choose to invest their capital outside of California (many already are doing so). Borrowing costs for California municipalities will increase and certain borrowers may be shut out of the public market entirely.
The outcome of the California Chapter 9 filings will greatly determine, in our view, if California skies, indeed, are grey.
We will have to wait and see if reason and common sense will prevail.
THE YEAR AHEAD
Planning for the future based on the results of the past year may seem logical, but hardly assures we will be masters of the coming year. That said, here is how we see 2013 shaping up and offer some thoughts in anticipation of the year ahead:
- Interest rates won’t substantively increase until the Federal Reserve printing press ceases operating. Simply put, its bond buying power is the dominant force keeping bond yields low.
- Demand for non -taxable municipal bonds should remain strong in 2013 absent any significant law changes tied to the current congressional budget and debt limit negotiations.
- Repealing or significantly curtailing tax-exemption remains in the crosshairs of certain legislators, administrative officials and the president. If changes occur, grandfathering of outstanding issues is a likely scenario, in our view. Repeal or severe curtailment will increase financing costs for local building projects and local control will be compromised. This affects all taxpayers in a substantive way.
- Great uncertainty continues to prevail in the bond market and we expect this will be the case for many months into 2013. Uncertainty is unsettling to markets, no doubt. Unsettled market lead to nervous investors oftentimes creating nice opportunities for other investors.
We continue to look for these opportunities for our clients in the new year.
Thank you for your continued confidence.
Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
January 8, 2013