July 2013 Monthly Commentary

Longer term interest rates rose in July as the yield curve continued to steepen, albeit at a slower pace than witnessed in May and June.  For the period, the yield-to-maturity of the 10-year note rose 10 basis points to finish the month at 2.58%.  The ETF related spread widening that occurred in June and was described in the last monthly update began to reverse, but the improvement has been inconsistent.  High quality investment-grade corporate bonds have retraced most of the spread widening, while lower-rated investment grade and sub-investment grade bonds have retraced only a fraction of the move.  Municipal bonds, on the other hand, continue to trade at the wide end of the spread range reflecting investors continued confusion as to the implications of the bankruptcy filing of Detroit, Michigan.  Because of that confusion, investors have been net sellers of muni bonds in fear that other issuers would follow the bankruptcy course of action.  While the municipal bonds held in the fund have suffered from “baby and the bathwater” type spread widening, our rigorous credit analysis leads us to conclude that the spread widening is not warranted for those issues and that the price action will improve in time, serving as an alpha generator for investors.

We mentioned on several occasions during the second quarter that anecdotal evidence of economic activity didn’t seem to jibe with Wall Street economists forecast for growth.  Consensus estimates among the large brokerage firms handicapped annualized GDP growth for the period at a paltry 0.5%, warning that the economy was nearing “stall speed.”  When the growth report was released in late July, investors were pleasantly surprised to learn that the first estimate of economic activity advanced at a 1.70% rate.  Moreover, that rate is likely to be revised to as high as 2.3% when the impact of the trade deficit is ultimately factored in.  The June trade report was also a pleasant surprise, as the deficit registered $34.2 billion, falling approximately $10 Billion from the prior month.  Driving the improvement was a record dollar amount of U.S. goods and services sold to foreign buyers.  Impressively, exports increased by $5 billion while U.S. citizens imported $5 Billion less foreign goods and services.  With economic activity in the second quarter registering more than four times what had been estimated, a tapering of bond purchases in September now seems a certainty.

Financial Times – 8/7/13

Michael Kastner, principal at Halyard Asset Management says there is a risk that bond yields rise further as economic growth for the second quarter and the July jobs number is revised upwards.

“It looks like the economy has underlying strength and as an investor you have to respect the bond selling we saw in May and June when the taper was introduced by the Fed.”

Mr. Kastner says caution over Treasuries is warranted, in spite of much higher yields since May.

“Buying the 30-year around 3.75 per cent may appeal to some investors, but there is a risk that its yield rises to 4 per cent and that’s a meaningful hit to a portfolio.”

Fed taper to test demand for Treasuries

Financial Times – 7/30/13

Michael Kastner, managing principal at Halyard Asset Management, says he is hedging the duration risk in his portfolios from owning longer-dated corporate bonds with interest rate futures.

“We are adding exposure across all sectors and see investment grade clawing back some ground on junk,” he says.

Investors bet on junk bonds to outperform

Municipal Bonds – Value in a Risky Interest Rate Environment!

Municipal Bonds – Value in a Risky Interest Rate Environment!

•    Municipal Bonds Attractive Relative to US Treasury Notes –  Again
•    Increase in yield to maturity a welcome development….But the rate is still low!
•    Targeting AA rated paper as investors sold good bonds into a bad market
•    Implementing interest rate hedges to offset higher rates

Many investors are smarting from shockingly negative returns in bond funds, including ETFs and closed end funds.  Thus far, in 2013, longer maturity Municipal bonds under –performed a dismal US Treasury market.  Municipals have been in excess of 100% of UST Treasury Notes for most of the year, as tax concerns and the absolute low level of interest rates curtail demand.  Fed Chairman Bernanke’s remarks in June, fostering the first hints of removing excess monetary stimulus, left the highly overbought fixed income market in disarray.   The yield to maturity for 5 and 10 year AAA rated municipal bonds rose 46 and 97bps, respectively, for the year through July, – with the 10 yr more than out pacing the rise in UST notes of 84bps.  The 30 year sector of the municipal market radically under-performed US Treasury Notes with the yield to maturity rising 138bps compared to the 71bps rise in 30 year US Treasuries.

For example, the Barclay’s Municipal Bond Index has declined 3.9% in the last six months, pulled down by the 8% decline in the long portion of the index (22+ yrs).  This compares to a drawdown of 1.6% for the Barclay’s Aggregate and 6.3% decline in long maturity government bonds as measured by the Barclay’s Long Government Index.

Although the rate rise was sharp, it is reasonable to believe that this was just the beginning of the correction to more normalized interest rates.  However, we think that this period of under-performance provides a short term opportunity to pick up relative value, however, we are uncomfortable being long only and prefer to extend into municipals in a hedged portfolio.

According to data compiled by Bloomberg, new issue supply in the municipal market, has fallen to about 90% of last year’s pace.  The market appears to be on a track for approximately $320 billion in supply or slightly below average for the past five years.  Credit quality, measured by the total amount of state revenues collected showed strength – leading to improvement in the budget positions of many municipal entities.  “Belt tightening” and longer term fiscal planning are easing expenditure pressure.

In the last two months, we have witnessed a sizable amount of redemptions of municipal bond funds – and the corresponding cheapening of municipal bonds relative to US Treasury Notes.   Much of that selling can be attributed to a few catalysts – a question of long term tax changes, low absolute yields in US Treasury and Corporate paper, and the beginning of the wind-down of the Fed’s US Dollar printing i.e. – tapering QE.  As new issuance continues to wane in the near term summer season, we think the municipal market may improve relative to UST notes.  Although municipal bonds are cheap to US Treasury Notes, the yield to maturity is still, despite the recent rise, at multi-decade lows – resulting in a risk reward payoff that is skewed to the downside.

In our opinion, the Federal Reserve is encouraging investors to increase risk to enhance income.  This can be accomplished in several ways including extending maturity and shifting down into lower rated credit.  We view the risk reward trade off as favoring an investment in a portfolio of single A rated average credit versus the more typical AAA or AA rated average portfolio.  The credit risk premium for single A and BBB rated credits is still attractive.

We recommend that investors lessen their sensitivity to interest rates by shortening the average maturity of the portfolio or by implementing a portfolio of interest rate hedges.  Interest rate hedges are positions that increase in value as interest rates rise, thus offsetting the mark-to-market loss suffered on a long only portfolio.  Also we recommend that investors review the vehicle they utilize to access the bond market.  After the wild ride that ETFs experienced relative to the underlying market, we continue to recommend portfolios of individual bonds.