Fixed-Income Market Commentary Archive

September 2009

August Fixed-Income Review:
A Handful of Thoughts to Close out the Summer

• There are options to low municipal money market rates if you don't need daily access to your cash and can go out several months on the maturity scale.
  
• Some asset classes may actually benefit from inflation.
  
• The good times may not be quite over yet in high yield.

1): Have you taken a good look at the rate your money market fund is paying you? If all the cash on the sidelines that I keep hearing about is invested in money market funds, then it makes you wonder what some of these investors are waiting for. In my October '08 narrative I commented about how high money market yields were. At that time the average 7-day yield was just over 5% on tax-exempt municipal money market funds. That was a pretty good return for a conservative investment and the cash on the sidelines was being nicely rewarded for being there. In However, in August I ran another survey of 24 muni money market funds (some national, some state specific). The yields ranged from a high of 0.28% to a low of 0.00%. No kidding – two of the twenty-four funds were actually yielding 0.00%! This is a brief sampling of the money market options that a handful of large mutual fund companies and asset managers offer. The average 7-day yield in this group is just 0.08%.

With tax-exempt money market yields at these low levels, it makes some of the "short" maturity individual municipal bonds priced at anywhere from 50 to 100 basis points seem like a real steal. Investors who keep larger cash balances in money markets, yet don't need the daily liquidity, should consider some of these short maturity munis as an alternative. For the record, I have been putting some of my client's money to work in this area as we manage portfolio duration.

2): Corporate bonds: Liquidity and demand in the credit markets appear quite plentiful. I view this as a positive and that is good because in order for an economy to grow and thrive, access to capital and willing investors are a necessarynecessity. However, one consequence of this is that "attractive" yields are harder to find. How much liquidity and demand is there? Almost $900B in new corporate bond supply has come to market thus far in 2009 with several months still to go. This is up substantially over prior year's levels and certainly a much better environment compared to where we were a year ago during the midst of the credit crunch.

In the past I have often written about yields in spread-to Treasury terms, but today we look at one example in both relative (spread) and absolute terms. A recent new issue offering from household products producer Procter & Gamble (P&G) will serve as a good illustration. In December '08 P&G came to market with a new 5-year bond offering that yielded ~ 4.60%. Toward In the end of August this "AA-" rated company that produces and sells everything from batteries to toothpaste to perfumes came with another new bond offering. This one hads a 6-year final maturity but the yield was only ~ 3.19%. The company was able to borrow for an additional year yet shave 141 basis points off the yield they had to pay to attract buyers. In spread-to-treasury terms, the spread went from +310 all the way down to +75. Now that is some kind of tightening of spreads! What causes this kind of tightening and reduction in borrowing costs? Demand.

3): There are a handful of asset classes that stand to benefit in the face of elevated levels of inflation. and iInvestors who are concerned about it inflation could benefit from adding exposures to emerging markets, natural resources and commodity plays as these sectors would likely be significant beneficiaries in an inflationary under that environment. On the fixed income side I have discussed how TIPS would benefit as their principal is adjusted upward with the inflation rate. Last month I noted how one borrower in particular (the U.S. Government) may benefit by paying back the value of a dollar borrowed today at a future time when inflation has eroded the value of the dollar that gets paid back.

The same concept applies to borrowers in the corporate bond market as well. I recently read a research report from Pioneer Investments (mutual fund family) that suggested investors not overlook the fact that high yield bonds could do well too. It is almost hard to imagine that high yield bonds could do even better than they have already, but Pioneer points out that "high yield bonds benefit to the extent the issuer has fixed rate debt and inflation could improve the underlying issuer's credit quality as the real burden of an issuer's debt declines. To the extent that a business can pass on price increases and maintain its profit margins, its free cash flow should rise with inflation." In effect, and as I suggested last month regarding the United State government, they can use future inflated dollars to repay outstanding loans and bonds. High yield may still have more room to run here and even if the price appreciation in high yield bonds comes to an end, the current dividend yield of the primary High Yield index is still above 11%.

4): Moody's Investor Service recently affirmed the sovereign credit strength of the United States at "Aaa". This should quell, at least for the time being, the concern that our country's financial position has been substantially weakened due to recent policy responses to the economic crisis we find ourselves in. Says Moody's in their credit review rationale: "the bond rating "is based on the very high degree of economic and institutional strength, a very high degree of government financial strength, and very low susceptibility to event risk. Although government financial strength is weakening as a result of interventions to support the financial system and the economy, other factors supporting the Aaa rating remain intact. The US is the world's largest economy and is still the center of global trade and finance, supported by flexible markets and open trade and financial regimes."

The report goes on to cover several challenges that the country faces, however, when a global crisis occurs, the Treasury market and U.S. dollar remain the go-to destination for safety, liquidity and stability.

5): September 15th will mark the one year anniversary of the bankruptcy filing and default of Lehman Brothers. The company had more than $150B in bond debt outstanding and this registers at the biggest single default in US history. Let's hope nothing ever eclipses it. For me personally, if I never see another period like the one that transpired after that event in my lifetime, it will be too soon. The scary part was that you just didn't know which financial institution, bank or broker was next on the hot seat. When I say that I mean you didn't know which company would have to defend itself from rumor, suspicion, panic and manipulation. This is not to say that companies including Lehman didn't operate in a manner that weakened their financial strength. Clearly they did, failing to manage leverage and misjudging their mortgage-related assets. For those of us that are responsible for and manage assets, it was an intimidating time.

Christopher Keith
Fixed-Income Manager