Fixed-Income Market Commentary Archive

Key Points:
• Sector performance reviews for 1Q10 show some negative numbers
• Ratings “recalibration” for the municipal bond market
• What you can do about 0% money market fund rates

Many of us had to bail our basements in the northeast in March due to the soaking rains; however our bond portfolios were not nearly as drenched. That is a positive development considering the first quarter ended on a cautious note for bond investors when former Fed Chairman Alan Greenspan conveyed thoughts during an interview that bond yields would have to climb higher in response to a “debt overhang” resulting from the nearly $1.5T deficit. He is not alone in his concern of course, but his opinion does carry some weight.

In retrospect bond yields didn't move too much from where they began the year (for example the yield on the 10-year benchmark only moved by one basis point to 3.82% from 3.83%). The Treasury market did rally early on in the year and then ended up giving back some of that gain during the month of March. As a result the Barclays Capital Treasury index lost 0.8% for the month while the longer, more volatile component of that index was down 1.9%. Even though the Treasury sector came under pressure from both improving economic fundamentals and the burden of the supply calendar, it managed to post a positive return overall in 1Q10 as seen in our data box below. Signs are appearing that indicate some level of a sustainable economic recovery is taking hold, which is something you would expect to see considering all the money we spent on it through the stimulus package and bailouts.

I was asked the other day if I thought a credit rating downgrade for the United States and its Treasury debt was imminent. I say the answer is “no”. Moody's specifically said as much a couple of weeks ago. The Federal government has enormous borrowing needs now. The last thing they need or want is the higher borrowing costs that are sure to result from a downgrade of any magnitude. At the same time the raters, I believe, feel the hammer of regulation is about to fall heavily upon them for past rating assignments (related to other securities). Whether or not the USA should be downgraded is beside the point. The fact of the matter is that if one or any of the raters dropped the credit ranking of the country, a bit of regulatory retaliation could be on tap. Tit for Tat?

In credit markets it was the speculative grade sector leading the way again. Spreads continue to tighten in both investment grade and lower quality paper helping maintain, if not, advance prices. At this point it doesn't seem as though short maturity, higher quality non-financial sector names in the secondary market have much more room to tighten by. In the primary market, Wal-Mart borrowed a couple of billion dollars late in the month and this “AA” rated company was able to do so very near the tightest levels they have seen in the last 10 years or so (+45 in the 5-year component). Two years ago it cost the company a multiple of 3.5 times the amount of spread to come to market. This dramatic spread tightening underscores the demand the market is seeing for higher quality stable sector issuers.

When it comes to lower rated bonds, the high yield asset class hasn't skipped a beat since the turnaround began there over a year ago. High Yield posted its 13th consecutive month of positive performance, besting the higher quality asset classes we list below. Spread to Treasury levels have come in there as well (+612 at month-end versus +660 at year-end '09), but we still see more room to run and that is part of the reason we continue to recommend appropriate risk-level exposure to the asset class through the use of a fund.

The municipal bond index did lose ground in March (-0.2 %) in what was an eventful month for the asset class. For starters, yield levels began to push through their historical long-term average percentage of Treasury ratios at various spots along the curve. This would signal that they are at or near being fully valued. This does not mean you can't make money in munis, just that a statistical measure of rich versus cheap has been crossed.

During the month it was announced that a “recalibration” of credit ratings would begin in April by two of the three raters. This means that the rating companies will be reviewing and recalibrating the ratings on municipal bond credit rankings and for the most part ratings will be higher when they are done. These adjustments should not be considered “upgrades” though. Upgrades occur when an issuer's financial profile improves. Look at all the doomsday news reports we have seen at the state and local level (I wrote about them last month). What is about to occur is a change in the rating methodology to make the muni scale uniform with that used for corporate credits. Many observers feel strongly about this and believe that it is the corporate bond methodology that should be brought to the same standards that munis are currently rated by, not the other way around. Of course if they do that, it will likely result in corporate bonds being downgraded instead of munis being “upgraded”.

Lastly, in the rainy month of March we saw passage of a national health care package. Like it or not, it is now the law of the land. Many states have announced their intent to challenge the legislation and we'll see where that goes, but that is getting off the main point I wish to make. Part of the bill as it now stands includes a tax hike. The new 3.8% tax on investment income (effective in 2013 for households with income over $250,000) would exclude some items and among them is interest income received from municipal bonds. This is yet one more reason to like this asset class.

A common question I receive these days centers on where to invest cash. What prompts this question is the fact that both taxable and tax-exempt money market rates are hovering around 0.01% thus earning next to no return. This is forcing some investors to look elsewhere with the intent of staying conservatively positioned, yet receiving something in return. This dilemma has caught a lot of people's attention including humble money managers who have even a modest amount of cash on hand and are trying to outpace a benchmark index that holds no cash at all.

In providing an answer the first consideration has to be the intended purpose and timing for the cash. This is obviously unique to each individual and can only be determined from that perspective. However, if the need is in the immediate future and risk cannot be taken, then a money market fund is appropriate. A money market fund is a conservative investment intended to offer dollar in, dollar out daily liquidity. In return you receive (at least you used to receive) a rate of return that was commensurate with the level of risk you were taking. This rate is subject to change daily.

Unfortunately for investors in cash right now, this rate dipped below 0.20% last October (taxable money market funds or MMFs) and then dropped below 0.10% in December. At the time of this writing the rate has dropped to 0.01%. It doesn't get any better on the tax-exempt side either. If you do require that daily liquidity, then unfortunately your options are somewhat limited. While I don't like the low rates of return, I do recognize that we all should have an emergency fund and a money market fund or savings account is a good place to store that cash.

However, if you are keeping cash without an immediate need and can assume just a bit of risk, then you do have a couple of options to consider: short maturity individual bonds or short duration bond funds. Each offers a degree of risk that is higher than money market investing, but that does not necessarily translate into being high risk.

The liquidity of any bond is subject to daily trading and pricing in the marketplace and if you have to sell prior to maturity you will be subject to these unknowns. A short duration fund has a daily NAV and there is no guarantee that the NAV will be equal to or higher when you sell it than it was when purchased.

With an individual bond you lock in a rate of return that is known to you. Even though these yields are low in absolute terms right now, in relative proportion to money market rates, they are much better. It is all a matter of perspective.

The yield examples below are available in the market at the time of this writing. I am concentrating on positions that are trading and offered in smaller denominations that individual investors might take advantage of. These are offerings of at least $10k, but avoid the big block items that are beyond the reach of many individuals. Further, I am sticking with bonds rated either “A” or higher on their own merit and that have a maturity of one year or less (on or before April 1, 2011).

A general obligation bond rated “AA-“and due 1/15/11 to yield 0.71%

A state highway revenue bond rated “AA+” and due 1/1/11 to yield 0.61%

An electric utility revenue bond rated “A2” and due 10/1/10 to yield 0.83%

A general obligation bond rated “AAA” and due 6/15/10 to yield 0.50%

These examples are all Federal tax-exempt municipal bonds and they compare much more favorably to taxable corporate bonds at this time. As an example I reviewed an “AA+” rated financial sector issuer (GE) due 12/1/10. Bonds were offered at 0.26% and this is a sector that had been trading “cheap” because of all the issues surrounding the sector. Clearly munis are offering a yield advantage over taxable corporate bonds, which is an unusual relationship. Because of their tax-exempt status, muni yields are usually lower than taxable corporate bonds.

One of our PIMCO sources predicts that anyone waiting for MMF rates to return to 3% is going to have a long wait. There are a few reasons and one of them is increased regulation in the 2A7 space (regulations dealing with what MMFs can hold). Revised rules intended to reduce illiquidity and shorten duration of portfolios include mandating that all 2A7 funds hold 10% of assets in overnight paper, and 30% in 7-day paper. Those regulations also shave 30 days off the weighted average maturity down to 60 days. These and other regulations effectively reduce the yield. This combined with a Fed that is committed to holding interest rates low for an “extended period of time” indicates that money fund rates won't be rising soon. This being the case, investors with cash should consider looking for individual bonds comparable to those I reference above. For diligent investors, more rewarding yields can be had without going too far out on the maturity spectrum. Take advantage and get something back for your money.

The investment ideas and expressions of opinion may contain certain forward looking statements and should not be viewed as recommendations, personal investment advice or considered an offer to buy or sell specific securities. Kobren Insight Management's statements and opinions are subject to change without notice and should be considered only as part of a diversified portfolio. You may request a free copy of the firm's Form ADV Part II, which describes, among other things, affiliations, services offered and fees charged. Past performance is not an indication of future returns. Treasury securities are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. The principal value of TIPS is adjusted according to the rate of inflation measured by the U.S. consumer price index. Municipal Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and state and local taxes may apply. All indices are unmanaged and performance of the indices includes reinvestment of dividends and interest income unless otherwise noted. Please note that you can not invest directly in an index. The Barclays Capital Treasury Index is an index of Treasury Securities maintained by Barclays Capital. High Yield Municipal funds invest at least 50% of assets in high-income municipal securities that are not rated or that are rated by a major agency such as Standard & Poor's or Moody's at the level of BBB (considered speculative in the municipal industry) and below. High-Yield Funds may invest in lower quality debt securities, which generally offer higher yields, but also carry more risk. The information provided herein is general in nature and should not be considered legal or tax advice. KIM does not provide legal or tax advice. Consult with an attorney or tax professional regarding your specific legal or tax situation. An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although money market funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in money market funds. No offer to buy the securities can be accepted and no part of the purchase price can be received until the registration statement has become effective, and any such offer may be withdrawn or revoked, without obligation or commitment of any kind, at any time prior to notice of its acceptance given after the effective date. Prices and yields are posted prior to the assessment of the markup or markdown. The markup or markdown will be applied for customer review prior to placement of the order. Bonds are made available through our affiliate National Financial Services LLC and from various third-party providers, including participants on the BondDesk platform, with FBS normally acting as riskless principal or agent. The offering broker, which may be our affiliate National Financial Services LLC ("NFS"), may separately mark up or mark down the price of the security and may realize a trading profit or loss on the transaction. Yields are as of standard settlement and reflect the lower of the yield to maturity or the yield to call unless otherwise noted. Rule 2a-7 of the Investment Company Act of 1940, among other things, generally restricts investments in money market funds by quality, maturity and diversity.