A word on deflation.
The fixed income markets passed the one-year anniversary of the credit
market freeze-up with lots of reflection last month. There were several
articles that discussed those mid-September 2008 days when our financial
system appeared on the brink of disaster. One particular article reviewed
the events surrounding the Reserve Primary Fund. This money market fund
saw its net-asset value fall below the $1.00 per share level, or "breaking
the buck" as it is referred to. Reserve Primary was the first casualty
after Lehman's bankruptcy filing because the fund held hundreds of
millions of dollars in face value in Lehman paper that was suddenly worth
nothing. The dash by investors to exit the fund was on and within two days
it was reported that investors attempted to withdraw more than 60% of the
fund's $62B in assets, but they couldn't get all of their money
out.
With this kind of fear and reaction prevalent in the market, the result
was predictable. Other money market funds came dangerously close to breaking
the buck too, but many of the other funds had something that Reserve Primary
did not – a parent company that was willing and able to add the necessary
guarantees to maintain that coveted $1.00 NAV and meet redemptions. Either
that or perhaps they placed less of an emphasis on mark-to-market practices
on some of the suddenly illiquid items in the portfolios. Investor demand
to withdraw funds from money markets quickly exceeded $130B at a time when
liquidity (your fund manager's ability to sell securities and raise
cash to meet redemption requests) was not there. The government saw a need
to act, and soon we had a temporary guarantee program from the U.S. Treasury
to ease those fears.
Fast forward to today and you would never suspect that anything was ever
amiss in the credit markets. Through the first three quarters of 2009 much
of the bond market's returns are nothing short of spectacular. So
what is driving these returns? Well, in part at least, it is a correction
from last year's extremes. Then of course you have to consider the
Fed's deliberate efforts in keeping interest rates low. Last month
I referred to the very low rates on money market funds. One consequence
of the low rates on money market and Treasury yields is that it is driving
some investors to take on more risk in search of better yields. It appears
that risk-taking has extended across all asset classes and has left the
markets firing on all cylinders. Importantly, that risk-taking has also
gone a long way toward thawing the credit freeze of 2008. In a perfect
world, most everybody wins ... except money market investors who have
to settle for extremely low yields.
The new issue credit market calendar for both investment grade and speculative
grade bonds remains full and the municipal bond calendar, although lighter
for a while, remains strong too. Borrowing costs for many issuers are lower
and the demand is there to absorb the new debt.
In the muni market, consider that in October 2008 the State of California
had to pay 4.25% to borrow for six months. Most recently it was able to
borrow in size ($8B+ in a two part offering) for roughly the same time
frame for "only" 1.50%. This level is both good and bad for
California. The good is that it was able to borrow and do so at significantly
reduced levels versus their last note borrowing. The bad is that similar
rated states and municipalities are able to borrow for much less. Then
at that, California has its own host of fiscal concerns, so they should
be pleased with the access they have.
Looking forward, we hear a lot about the "new normal" from
our friends at PIMCO. In a nutshell this is defined as slower growth, reduced
consumer consumption and increased government intervention / regulation.
We are also hearing from a couple of different places that we should expect
a period of deflation and, by extension, lower interest rates. The deflationary
forces come from a variety of sources including reduced spending at both
the consumer and corporate level and the higher unemployment rate. The
time and severity is hard to pinpoint, but it could last for a couple of
years. In past commentaries I have made suggestions for investors who are
concerned about inflation. For those with the opposite point of view and
who would like to prepare portfolios for this kind of outcome I suggest
taking on duration. Lock in the higher yields available now, because if
we do in fact end up with deflation, it will very likely bring long term
interest rates even lower still.
