Fixed-Income Market Commentary Archive

May 2009

April Fixed-Income Review:
Something Old and Something New in Bondland

Good news for the rest of us was bad news for the Treasury market in April. The good news, of course, is the economy may have turned the corner and the worst may very well be behind us (though there are still many problems facing us). Even the cautious Fed says the economic outlook has "improved modestly". With investors in growing numbers sharing the thought that we are not headed into another "Great Depression" they continued to focus on other areas with prospects for greater returns and that did not include Treasuries. Actually, the Treasury Department did find buyers for an awful lot of new issuance in April and that put pressure on yields. Then again, you had the Fed continue on their buying spree in an effort to force rates lower still. The Federal Reserve has purchased more than $75 billion of Treasuries since their buying program began.

The Treasury index lost 1.8% in April and is now down 3.1% YTD. The benchmark 10-year note lost 3.4% in the month and is down 6.0% YTD. The 10-year Treasury closed April with a yield of 3.1% - the highest yield all year. Even though there has been a sell-off in the Treasury sector we do not see this as a buying opportunity. The safest assets are still overvalued.

Introducing Build America Bonds (BABs). BABs are municipal bonds whose interest is fully taxable at the Federal level. They are part of the American Recovery and Reinvestment Act, a stimulus plan that was enacted earlier this year. Remember all the talk of creating jobs and putting Americans to work? Well this is part of the plan and BABs will help municipalities finance a host of building projects. Technically, they are indeed "new", though taxable munis have been around for many, many years. What makes this a new type of bond is the fact that 35% of the interest expense is subsidized by the Federal government. Because these bonds are taxable, in theory the government will in effect be able to recapture some of that subsidy expense when the buyers pay their income taxes every year. Of course, if an investor buys BABs in a tax-deferred account (IRA for example) then he can delay any annual tax payments. Also, by making them taxable, they should appeal to a much wider group of buyers than traditional tax-exempt munis would attract.

A handful of issuers have already come to market with BABs. This includes the State of California, the New Jersey Turnpike Authority and the NY MTA. These securities are not Federal government guaranteed -- they carry the credit strength of the underlying issuer and have thus far come with long final maturity dates of roughly 30-years. If the first few weeks of this market is any indication, then these securities will be very popular. The issues that have come so far have been well received and have traded up in value rather nicely. The fact that they have long final maturities means that the bonds could be around for quite a while. However, the program that authorizes the 35% subsidy is only good through 2010.

BABs would be appropriate for investors who prefer the safety that municipal issuers have historically provided and have a long-term investment horizon. They can be traded in the secondary market, but the secondary has not always been kind to taxable muni investors on the bid-side when they try to sell them. Lastly, remember that these are federally taxable, so they're more likely to appeal to lower-bracket investors or to investors who purchase them in an IRA or tax-deferred type of account.

Sticking with munis, but getting back to the more traditional variety, I have been asked a couple of times recently about the likelihood of large scale defaults in the municipal bond market. There very likely will be some increase (a few are working their way through the system now) in the level due to the current economic stresses in the market, but I don't think they will be widespread or near the level that we may see in the taxable (corporate) bond market.

Just the same, investors can do a lot to diminish the odds of a default occurring in their bond portfolios by paying close attention to what you hold. That may sound pretty basic and obvious; however we see a lot of portfolios that were constructed purely on the basis of the highest yield available and with less emphasis on quality, structure and diversification. Bonds that are General Obligations of the issuer are considered to be among the safest. They are backed by the issuer's ability to levy a tax (income tax, sales tax or ad valorem). In the revenue-backed bond arena, stick with the essentials or more dependable types of issuers. There are plenty of them out there to choose from and investors should be reasonable when it comes to yield expectations. If something sticks out far and above where everything else is trading there is probably a good reason for it. One recent default occurred from a California based issuer -- it was a wine museum! Hardly an essential purpose revenue bond. We can debate the investment merits of buying wine museum bonds all day long. Bottom line though is that there was an issue ($77+ million worth) and now they are in default.

Our friends at PIMCO released a report back in November that focused on municipal credit risk. One of their slides says "future defaults will likely be concentrated with issuers tied to real estate projects, speculative grade healthcare issuers and industrial development bonds". Caveat Emptor.

Credit market comeback: Too much too soon? Maybe when it comes to the speculative grade, as the riskier paper in this asset class returned 19.2% in April. In the investment grade area there has been a lot of spread tightening going on there too, but returns are much more placid. I believe there is still a fair amount of room for even more. The Barclays Corporate bond index is carved into many different segments, but I'm going to boil it down to three for purposes right now. The Industrials sector (54% of the index) and the Utilities sector (12%) have YTD returns of 4.5% and 5.6% respectively. The Financial sector (34% of the index) on the other hand is down 3.7% YTD. Even with downgrades continuing with high frequency in that sector (AXP, STI, GE, BRK, CIT, JPM, WFC ... ) some of those spreads have managed to come in a bit too, but they have a long way to go before they get back in line with the others.

Christopher Keith
Fixed-Income Manager