We have recently had a number of clients ask about our outlook for the bond market. This is one of those times that remind me of first meetings with prospective clients. In response to the question, “what is your investment objective,” some invariably reply, “to make money.” This is certainly an accurate reply but one that doesn’t provide much guidance as to whether the making money comes from income, capital appreciation or income growth over time.
With bonds, we feel that most questions derive from one of two sources. We’ll take each in turn, with particular emphasis on the municipal bond market:
Credit Quality
Controversy erupted last month after Meredith Whitney stated on “60 Minutes” that municipal defaults will total “hundreds of billions” of dollars in 2011. Bloomberg’s Joe Mysak calls that the “boldest, most overreaching call of her career”. He points out that 2008 was the previous high in defaults at $8.2 billion. This isn’t to say that municipalities have no problems. However, defaults are not taken lightly, and once that step is taken it means a death sentence for any future financing from the bond market – usually their best source of financing. Municipal finance managers would not go that route willingly. There will be defaults in 2011, as there are every year. However, according to Mysak, the majority of defaults in the modern era have not been governmental – they haven’t been municipal at all. Most, he says, are corporate or nonprofit borrowings in the guise of some municipal conduit – nursing homes, housing developments, biofuel refineries – so they could qualify for tax-free financing.
“Defaults are not taken lightly, and once that step is taken it means a death sentence for any future financing from the bond market.”
For most municipalities bonds make up a relatively small proportion of the costs. Fitch Ratings, in a special report in November, said, “Debt levels for U.S. local and state governments are relatively low, with annual debt service representing a relatively small part of budgets.” The report said, “the tax-supported debt of an average state is equal to just 3-4 percent of personal income, and local debt roughly 3-5 percent of property value. Debt service is generally less than 10 percent of a state of local government’s budget, and in many cases much less.” Additionally, the report states that, “debt service is a relatively small part of most budgets, so not paying it does not do much to solve fiscal problems (particularly as compared to the costs of such an action).”
Our position is that the municipal market is comprised of thousands of individual issues and investors shouldn’t generalize. From a credit quality standpoint, we take care to invest in only those bonds we are confident have little credit exposure.
- We like bonds that are insured, but actually place more value on the municipality’s underlying ability to continue paying. We mostly disregard insurance and believe it should only be considered a value-add at the end of the day.
- We look for strong investor protections on the cash flows from property taxes, sales taxes, income taxes and fees from essential service activities, such as water and sewer revenues.
- We look for multiple sources of bond security – for example, most Texas and Indiana school districts can access state bond banks should local property tax collections falter. A fairly large percentage of our municipal bond underlying ratings actually improved in 2010.
Inflation
One of the more interesting things I have heard from clients over the past year is, “well it is clear that we’ve been in a bond bubble and rates only will go one way from here – up!” My response has been that yes, 3-month treasury bill rates are bound to go up. Afterall, at near zero percent interest rates there is not much room for a decline. With longer bonds it is a somewhat different story. Thirty-year treasuries currently stand at approximately 4.5%. Yes, this is a 100 basis point rise from August’s low in rates of 3.5%. However, over the past ten years, 30-year treasury bonds have mostly been in the 3.75% to 5.25% range, with the average about right where they are today – 4.5%. Typically, long treasury yields approximate inflation plus about 2.1% real return. At today’s rates this implies inflation of about 2.4%, versus actual inflation of less than 1%. We think there is room for long treasury bonds to increase in price from these levels.
“One of the more interesting things I have heard from clients over the past year is, ‘It is clear that we’ve been in a bond bubble and rates only will go one way from here – up!’ My response has been … at near zero percent interest rates there is not much room for a decline.”
In recent quarterly reports, we argued that longer-term interest rates would not rise appreciably due to labor force demographics, low velocity of money, and a non-existent money multiplier, among other reasons. We argued that rates could and should rise a half percent of so (from the mid/high 3’s). But our contention was that any addition pressure would come in the form of a weak dollar or rising commodity prices – both occurring. We don’t see pressure on wage rates to rise or on consumer willingness to accept increases in goods prices. These would be prerequisites to higher inflation. In fact, we view the consumer as embarking on a decade-long quest to reduce leverage and consumer expenditure – certainly not a harbinger of higher inflation. In a sense, households are transferring their debts to governments and central banks.
We also believe there are technical factors that artificially inflate yields at the end of many years. This is particularly true in the municipal bond market, where investors sometimes book capital losses to offset other gains for tax purposes. This has the effect of increasing municipal bond inventory. When January 1 rolls around investors can find themselves swamped with bond redemptions, maturities and interest payments. Inventory then tightens as investors seek to replace the redemptions. Bonds typically perform well over this period. This year has been exaggerated in this regard due the lack of renewal of the Build America Bond program. Municipalities flooded the system in November and December with new issuance. This will drop to virtually nothing overnight (in January) and again, result in a drop in inventory of issues for sale. While we actually prefer that rates stay at this level or even a quarter of a percent higher in coming months, we actually think prices will rise and yields decline in the first quarter of 2011.
Conclusion
Most intermediate-term municipal portfolios saw total return for 2010 in the range of 4-5%, essentially earning the coupon for the year. This after a strong 2009 of high single-digit returns or more. We believe that with the shadow of deflation seeming to always trail us that the biggest mistake municipal bond investors will continue to make in 2011 will be to sit in sub-1% money funds waiting for a rise in inflation. 2011 will be the third or fourth year in a row where intermediate-term bonds will substantially outperform money funds. A 4-5 percent per year return deficit is difficult to make up even if rates do in fact rise later.
Our municipal bond strategy has been to emphasize 4½ to 5½ year duration bonds with extra return from higher coupons and short/intermediate calls. We continue to believe this makes considerable sense. We like to say that we are always looking for value in quality bonds with favorable structural characteristics. By emphasizing these factors we believe we will solidly outperform benchmarks over full interest rate cycles.