In this video briefing, Ronald Bernardi summarizes the key points of the market update below.
The three prevailing bond market themes during the first half of 2010 were alternately annoying and unnervingly consistent:
1. Annoyingly low, nominal yields.
2. Unnerving, sporadic credit scares.
3. Unnerving liquidity concerns.
We do not expect these three dynamics to change much in the months ahead. It has been and will continue to be a tiresome marketplace, in our view. That said, the continued existence of the above factors will also create opportunities for the patient and knowledgeable bond investor.
HIGH PRICES = LOW YIELDS
This is the classic good news/ bad news conundrum. The value of good quality bond portfolios have, for the most part, appreciated during the first six months of the year while new money is invested today at lower yields when compared to earlier in the year. In the non- taxable municipal market, yields are especially acute as supply is tight, a direct result of the great success of the Build America Bond (BABs) program and the expectation that top marginal taxpayers will be paying even higher income taxes next year.
BABs have been hugely popular amongst issuers and most politicians so expectations of a program sunset are misplaced in our view. However, the program has experienced a few hiccups including: IRS rebate holdbacks, intensifying IRS and Treasury surveillance, increased reluctance within Congress to expand the program, all of which has modestly dampened both issuer and market participants’ enthusiasm for the program.
Over the past year approximately $7 billion of municipal bonds have defaulted. Most of this amount has occurred in what we refer to as “non traditional” sectors of the municipal bond market.
Still, absent any future legislation expanding the program’s reach, its zenith has most likely passed. This could lead to an easing of some of the current upward price pressure in the month’s ahead in the non-taxable, municipal bond market.
In addition, we expect the Federal Reserve to maintain low, nominal, short-term interest rates for the balance of 2010 and into 2011 and we expect demand for U.S. Treasury paper to remain strong around the globe in the months ahead. Inflation is tame for now and macro-economic activity is subdued. These prevailing factors will generally translate into low bond yields for the foreseeable future — especially in the 1 to 5 year range which are most affected by Fed rate decisions.
Barring heavy selling by institutional investors or funds, we do not foresee a sharp rise in non-taxable bond yields in the near term in the general market. We expect future price volatility in certain sectors of the market and with specific issuers directly resulting from adverse credit events. These events should create some good investment opportunities.
“I’M GOIN’ THROUGH THE BIG-D AND DON’T MEAN DALLAS”
These song lyrics seem quite apropos these days as we attempt to navigate client portfolios through a difficult financial landscape. We have taken artistic license, of course, with “Big-D” as we are fairly certain singer/songwriter Mark Chestnut is not crooning about bond defaults.
There have been a handful of notable municipal defaults and outright Chapter 9 bankruptcy filings over the past year (Las Vegas monorail and Vallejo, California) and we expect the list to grow in the coming year. State and local municipal governments across the country are experiencing significant financial challenges. We take some comfort in reading that most are dealing with revenue shortfalls by cutting budgets and staff with a smaller universe beginning to address some of the significant structural financial problems (overly generous, under funded pensions, outdated compensation and benefit packages, under funded federally mandated programs, over ambitious capital projects) besetting state and local governments.
Some of the trends we see developing in these areas are a positive sign to us that municipal governments and their employees are capable of working together to stabilize finances over time. That said, it will be a long and arduous process and there will be fierce battles fought both behind closed doors and in the press as each side will be very reluctant to back off of its respective position.
Over the past year approximately $7 billion of municipal bonds have defaulted. Most of this amount has occurred in what we refer to as “non traditional” sectors of the municipal bond market. To date, bond defaults in the unlimited tax general obligation and water /sewer revenue bond sectors of established, diverse municipal governments remains at very low levels. Recently, states’ revenue collections have stabilized, although they remain far below pre-crisis levels. We expect to see some additional defaults, but we believe most future defaults will occur in the non-traditional sectors of the market.
As we have stated many times before: UNDERLYING CREDIT QUALITY, DEAL PURPOSE AND ISSUE STRUCTURE MATTER. We believe this is especially true today and for the foreseeable future. We strive to recommend issues with solid, underlying credit fundamentals, a needed purpose and sound structure affording investors a high level of payment priority. Assuming courts honor the value of contracts, bond obligations with sound structure generally offer better security. If you are not certain what this means or whether or not it applies to your portfolio, call us and we will help you understand the significance of these issues.
“THERE ARE NO INTRINSIC REASONS FOR THE SCARCITY OF CAPITAL”
You can add the above quote to much of what we disagree with about Keynesian economic theory. I wonder if Lord Keynes would amend the above quote had he tried selling his municipal bond portfolio during the last quarter of 2008. Clearly, there was a scarcity of capital in the marketplace at that time for several, inherently good reasons. We believe the liquidity issue, although improved, will continue to exist because several factors that contributed to the illiquidity experienced in 2008 still prevail.
1. General uncertainty regarding reliability of rating agencys’ credit assessments.
2. A significantly diminished insured bond presence in the municipal marketplace.
3. A significantly diminished hedge fund demand in the municipal marketplace.
For income portfolio oriented investors, there are a number of strategies we recommend to better protect portfolio liquidity.
1. Issue diversity is a key component to building a more liquid portfolio.
2. Not owning the same issues (or issue types) that too many other investors own is another key component to building a more liquid portfolio in our view.
3. Carefully monitor issue block size as a one size fits all strategy may prove problematic. Why? Large issue block size is a selling attribute in bullish markets (higher prices/ lower yields) like the current market we are experiencing. In our experience, our investor clients (and probably most income oriented investors) tend not to need to sell in this type of market. Smaller block size is a selling attribute in bearish markets (lower prices/higher yields) as we experienced time and time again in the latter part of 2008 and into the first few months of 2009.
In our experience, it is the bear market when investors typically need to raise capital and often do so by liquidating bond portfolios. In our experience, selling large block issues similar to or the same as what other competing investors need to sell (see #2) in a bearish market usually results in lower bid prices which makes sense in that everyone is selling the same issue type. Couple that fact with a general reluctance of a bidder to commit its capital to a large position in a falling market and naturally, the bid price received is lowered.
We have found over many years experience across many different interest rate cycles that a portfolio comprised of a diverse number of quality issues with varying block sizes is the best method of assuring good portfolio liquidity for income oriented (versus total return) bond investors.
Lastly, we believe the decommoditization of the municipal bond marketplace that has occurred with the unraveling of the insured bond sector is a favorable event for knowledgeable, income oriented, bond investors. Although, market liquidity has been damaged by this development, nominal yield levels are clearly greater today than they otherwise would be with a robust, insured bond sector. This will translate into better incomes for investors in the years ahead and, importantly, will serve as a healthy governor of issuer fiscal prudence as issuers’ borrowing costs will be determined primarily by their underlying credit quality rather than an increasingly difficult to assess, third party guarantee.
We hope this commentary is helpful. Please call us if you have any questions or would like us to conduct a review of your portfolio.
We thank you for your continued confidence.
Ronald P. Bernardi
President and CEO