Fixed-Income Market Commentary Archive

Key Points:
• Treasuries barely move higher, but Treasury Inflation Protected Securities (TIPS) fare worse.
• Fed Watch: Fed Funds rate is more important than the discount rate.
• Municipal defaults remain rare.

Most of the major fixed income indices we follow in our data box below registered modest, but positive moves in February with the municipal bond market leading the way. We're two full months into 2010 and the majority of the index returns are all within reach of each other and there is no clear favorite thus far. TIPS have some catching up to do after selling off this past month, but as we have seen in the past, they are capable of putting up good numbers based on a change in expectations and that can happen quickly.

The Treasury index was positive in February, up a modest 0.4% as the market seemed to trade all over the place given the news cycle. Much of that return occurred in the final week of the month. Contributing to upward price movements were sovereign fears about a possible Greece / Euro-region downgrade. Prices moved lower in part due to the Fed watch and an increase in the discount rate. A heavy auction calendar played a role too. The Treasury reintroduced a 30-year inflation-linked bond (auction size was $8B) that was last auctioned in 2001. The TIPS market, which is not part of the Treasury index, was down sharply compared to conventional Treasuries. TIPS, as measured by the TIPS index, were down 1.1%. Part of the reasoning here is concern that inflation fears are overblown.

The Federal Reserve's announcement regarding the raising of the discount rate to 0.75% received a fair amount of attention when first made. We are cautioned not to put too much importance on the move from one of our trusted sources who told us the move was merely the elimination of an unnecessary program that was intended to ease the credit and liquidity crisis that, for all intent and purpose, is now over. The rate that plays a more significant role is the Fed Funds rate. Chairman Bernanke restated that this rate will remain low for an extended period of time, but some market observers believe that the Fed's hand will be forced to raise rates sooner in response to improving economic fundamentals.

Currently the Fed has no real reason to raise the Fed Funds rate (feel free to disagree) because they see no significant inflation threat. The danger they see by doing so is one that hampers the economic recovery. The strength of the recovery remains hotly debated. Either way, we follow the data. For now I believe the Fed will stick to their guns and I find myself in the camp that believes any move upward in the Fed Funds rate is way off, meaning unlikely in this calendar year. Of course, as the saying goes – when the facts change, I change my opinion.

Moody's Investors Service recently published a report titled “U.S. Municipal Bond Defaults and Recoveries, 1970-2009.” This report is chock full of data and interesting information about the municipal bond market for rated (as opposed to non-rated) municipal bonds. The report's first main bullet point sums it up nicely: “Moody's rated municipal issuers have a very limited default experience with only 54 defaults over the period 1970-2009. The majority of these defaults occurred in the health care and housing project finance sectors”. There were only three defaults from general obligation issuers and three defaults from essential purpose revenue issuers, meaning water, sewer or electric utility issuers. To put this into perspective, consider that Moody's rates more than 18,000 municipal issuers.

Part of this report emphasizes the historical success of the muni market as a whole and this is worthwhile for muni investors to be aware of and to take some degree of comfort in. I mention this because we continue to see alarming stories in the news about strained municipal budgets and what some of the consequences could be. I am not saying that there aren't legitimate concerns out there as municipalities are certainly not immune to weak economic forces.

The most recent story of a municipality in trouble comes from Harrisburg PA, a city of almost 50,000 residents. In early February an official of that city discussed a chapter 9 bankruptcy filing possibility due to their difficulty in meeting their financial obligations. This set off a new wave of negative stories on the muni market and I'm sure there will be more to follow.

With this abundance of negative news, investors can't be blamed for feeling a bit apprehensive about the state of the muni market. Some degree of caution is merited, but I think it is also important for investors to know that there is other data and information available that supports the argument for the continued success of the muni market. Not everything is about to implode. As for 2010, a subsequent Moody's comment states that “local government defaults and bankruptcies could be higher this year than the historical norm, but are expected to remain rare.” My added emphasis on “rare”.

The two biggest sources of revenue for states come in the form of income taxes and sales taxes. Recent reports show these collections are, not too surprisingly, down substantially as a result of the recession. However, they may have bottomed and are now expected to stabilize and actually begin to rise when it comes to sales taxes. Having said that, there is still a lot of ground for them to make up and municipal budgets will remain strained.

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