Fixed-Income Market Commentary Archive

July 2009

June Fixed-Income Review:
Mid-year Review: Not Half Bad

The first six months of 2009 go into the record books showing a clear and decisive return of a risk taking appetite. This is an almost stunning reversal of the attitude that prevailed to close out 2008. One investor I spoke with told me this shows how fickle bond investors can be. My response is that bond investors seized upon one of the best opportunities ever and took advantage of the fallout from the events of last year that left bonds trading at some pretty extreme levels (though this doesn't mean we aren't fickle, by the way.) When reviewing our major fixed income index returns data box at the end of this article you can see that some fixed income asset classes can and do offer equity-like returns under the right set of circumstances.

Out of the major group of fixed income indices we follow, the Treasury index is the only one to post a negative return for the first half. That index lost 4.3% as the yield curve steepened after the panic trade wore off. While there was very little movement on the short end (3 and 6 month maturities saw modest moves of only 10 and 8 basis points respectively) longer dated bond yields (5, 10 and 30 years) did move higher by 100 basis points or more. The short end should eventually see yields rise, but not likely until there is a marked improvement in the economy and the Fed is ready to raise rates.

The benchmark 10-year Treasury note closed out the first half with a yield of 3.5% and a total return loss of 8.7%. The 30-year Treasury closed the half with a yield of 4.3% and a total return loss of 23.3%.

Treasury Inflation Protected Securities or TIPS (more on them below) are not part of the primary Treasury index, but they were the one area of the Treasury market that did perform strongly in the first half of the year. These non-conventional Treasury securities don't always move in lock-step with the overall Treasury market. We have said that on any given day they may seem to, but over extended periods, they have proven to be less correlated than you might otherwise think. The first half performance illustrates the point clearly as the TIPS index returned 6.2%

The corporate bond credit indices tracking both investment grade and speculative grade rated bonds showed the most impressive returns, though the investment grade category's 6.8% return seems downright paltry compared to the 30.4% return that high yield bonds returned. This speaks to my comment above regarding the return of risk appetites. There is still a lot of risk in high yield as defaults are rising and some of the compensation for taking on the risk in the first place has been greatly diminished.

The municipal bond market performed very well in the first half even though June performance was negative. The index that tracks munis returned 6.4% to mark its best first half performance since 1995. Munis continue to be a favorite of many high tax bracket investors not only for their tax-exempt income, but also because of their high quality and traditionally low default rates. Munis have been a very safe place to invest. Today muni investors must come to grips with some negative headlines about the state of the muni market as the impact of the housing market and economic weakness takes its toll. Notwithstanding all of this, the muni market continues to be attractive even though valuations relative to other asset classes have come in quite a bit. We believe there are still some solid bargains to be had, although they are getting a bit harder to find.

During the month the Federal Reserve met and, as anticipated, the board left rates unchanged. Even though the market didn't expect any change in interest rate policy, it was looking for an acknowledgment that inflation is a growing concern for so many. Chairman Bernanke signaled that the Fed is not concerned about inflation, saying it expects it to be "subdued for some time." Of course, the Fed is capable of taking back so much of what they have provided in terms of liquidity should the data suggest otherwise. Recent inflation data (CPI) that was released midmonth backs up the Chairman's inflation outlook -- for now. One economist we follow says that "deflation is no longer a threat, but an inflation problem has yet to materialize." Overall the plan at the Fed is to stay the course as evidenced by their comment saying that "conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

There remain extraordinary deflationary forces at play (rising unemployment, declining consumer spending, etc...) that have offset any inflationary pressures in the system. We believe all fixed income investors should have some level of insurance. We continue to big proponents of inflation-linked bonds. This exposure is gained primarily through the use of TIPS funds. They are of the highest quality (issued and guaranteed by the U.S Government) and offer some insurance against inflation. The time to buy insurance is before you need it.

Several months ago I wrote about the likelihood of taxes going up and today it seems as though they have done that just about everywhere. The new fiscal year for most states began on July 1st and that is why we have heard so much about unbalanced budgets and the need for offsetting tax increases over the past few weeks and months. The debate goes on in many State Houses across the country between Governors, state legislators and various special interest groups as to whether or not "we" can afford to be raising taxes at such a time given the overall weakness in the economy. The fact that so many states have raised taxes and are willing to do so during tough economic cycles is nothing new. States "need" to increase revenues (meaning taxes and fees) during recessions because their budgets are as strained as everybody else's.

In the early 1990s recession, 44 states raised taxes and 30 states did so in the TMT/dot-com bubble burst recession in the early 2000s. The fallout from the bursting of the housing bubble related recession has seen 25 states raise taxes since the start of 2009. There are a lot of nifty little revenue enhancements taking place all over the landscape and the usual suspects are being hit again -- alcohol, tobacco, the "wealthy", the airwaves, tourists, diners and commuters to name a few. While you cannot escape all of them, there is a way to seek shelter for some of your income: municipal bonds.

While these tax increases are a negative for us as individuals, as muni bond investors it can be viewed as a plus. This means that states, cities, towns and various municipal agencies are taking the necessary measures required to ensure they have the capital needed to pay their bills which means meeting their debt service. This is fundamental to the muni bond market.

It may be just a hunch, but I believe the next front on tax increases will involve the Federal government. I'll have more on that in future commentaries.

Christopher Keith
Fixed-Income Manager