Bond Blog

The Taylor Rule

2015-06-30T12:04:00.001-07:00

What Is The Taylor Rule and Why Do We Care?

The Taylor Rule is a formula that gives an indication of where we should expect the Fed to set the rate of Fed Funds in the future. The formula takes into consideration the dual mandate of the Fed to control inflation and to promote maximum employment through healthy economic growth. The reason we care about the Taylor Rule is that it is an indicator that the FOMC monitors as a guide for monetary policy. There is currently considerable discussion about when the Fed will raise rates and how that will impact the bond market. There is also disagreement about how the Fed should conduct monetary policy, and how the Taylor Rule should fit into their decision making process.

The Taylor/Bernanke Debate

John Taylor has been making the argument that the Fed should use the Taylor Rule as a benchmark for determining monetary policy. Ben Bernanke recently argued on his Brookings Institute blog that while the Taylor Rule is a valuable device to be considered, “the FOMC should not be replaced with robots any time soon.” Bernanke argued that even if the Taylor Rule is used as a benchmark, the variables that make up the formula are subject to debate and interpretation.

The Taylor Rule Formula

The formula for the Taylor Rule is shown below. It states we should expect the Fed Funds rate to be equal to the neutral real rate plus the current level of inflation. This number is then adjusted for both desired inflation (the inflation gap) and the growth rate of the economy. Economic growth in this model is measured by the output gap.

Fed Funds = Neutral Real Rate + Inflation

+ [.50 × (Inflation – Target)]

+ [.50 × Factor × (NAIRU – Unemployment)]

Below is the Taylor Rule model in Bloomberg with John Taylor’s inputs in the amber fields. The amber fields are variables which can be adjusted to determine what you think is appropriate. This is a “Taylor Rule calculator.”

This model is helpful in understanding the arguments for and against changing the Fed Funds rate. For example, in this model there is an equal weighting to the inflation adjustment (0.50) and the employment adjustment (0.50), and the neutral rate is assumed to be 2.0%. Using these inputs the formula calls for a Funds rate of 2.35% which is much higher than the current rate of 0.0%. John Taylor would say the Fed is way too easy and the Funds rate should be raised to 2.35%. Bernanke suggested the output gap should have a higher weighting (1.0) than the 0.50 weighting John Taylor used. In addition, he used estimates prepared by the Fed staff and Congressional Budget Office for measuring the output gap. Bernanke’s model showed the Fed Funds rate should be about 1.25%.

Disagreement Among Economists

The model above can be changed in Bloomberg to incorporate the underlying assumptions of several different economists. The table below shows these assumptions for the 6 different variables which are shown in the amber fields. This table shows there is disagreement among economists in each one of the variables.

Adjustment for Policy Inertia

There is an extremely high correlation between what the next Fed decision is, and what their last decision was. There has been little discussion about this in economic literature. We have found that if we use a factor (Rho) of 0.75 to 0.90 we get an almost exact tracking of where the Fed Funds has been. The current estimate for the Funds rate allowing for policy inertia is about 0.50%. We feel this is representative of where the Funds rate should be.

Adjustment for Policy Inertia = [Rho x Previous Federal Funds Rate]

+ [(1 – Rho) x Taylor Rule Estimate]

Conclusion

There seems to be little agreement about what assumptions should be used in determining the appropriate Fed Funds rate today. This makes it difficult to argue for a significantly higher Funds rate than the current zero bound rate. The Fed has undershot its inflation target for the last 5 years and economic growth has been below trend for this same period of time. There has been significant chatter about when the Fed will raise the Funds rate. We believe the focus should be on how high the Funds rate should be. Fed Funds futures are calling for a rate of 0.32% by year end. An increase of this magnitude should not have a meaningful impact on fixed income portfolios.

Below is a link to Ben Bernanke's original blog post about the Taylor rule:

http://www.brookings.edu/blogs/ben-bernanke/posts/2015/04/28-taylor-rule-monetary-policy

What The Markets Are Telling Us About Interest Rates

2014-09-30T12:20:00.001-07:00

What The Markets Are Telling Us About Interest Rates

It is no secret that the Fed is about to end purchases of U.S. treasury and mortgage securities later this year. There is also talk of increasing the Fed Funds rate sometime next year. What does this mean for fixed income investors, and how should their portfolios be structured for a rise in rates? There are some things we can learn from the bond market to help us with this decision.

The Bear Flattening Trade

Markets often anticipate future changes. One indicator we follow for confirmation of our Fed thoughts is the spread between 5 year and 10 year treasuries. The graph below shows changes in the Fed Funds rate compared to the spread between 5 year treasuries and 10 year treasuries for the period from January 2000 to the present. The blue represents the Funds rate and the orange represents the yield spread between 5 and 10 year maturities. Changes in this spread tend to precede changes in the Fed Funds rate. When the bond market feels short term rates are going higher investors sell 5 yr bonds and buy 10 year bonds in anticipation of Fed rate hikes. The lower the spread the flatter the yield curve is. The spread is now at the lowest it has been since the Fed took the Funds rate down to zero. This indicates a rate increase is likely.

Why Buy Longer Bonds If Rates Are Going Higher?

Investors may question the wisdom of buying long bonds if the Fed is going to raise rates. Here are some of the reasons this makes sense:

1. Short term rates have more potential bp’s to rise and will rise more quickly than long term rates. These portfolios are duration weighted to temper the risk of long term bonds declining in value.

2. Investors are still being paid to extend maturities and the higher rates on longer bonds help mitigate declines in value.

3. Inflation is barely at the bottom of the Fed’s target range. Any increase in short term rates will likely lead to inflation expectations being well contained.

4. Increases in short term rates will provide a headwind for the economy. This will lead to subpar economic growth.

A Look at the Fed Funds Futures Market

The chart below shows what the futures market expects the Fed Funds rate to be for the next few years. The expectation is that the Fed Funds rate will be about the same for the next 6 months and will then start to rise to 0.73% at the end of 2015. According to the futures market it will continue to rise to 1.79% by the end of 2016. Both of these indicators show the market is telling us an increase in the Fed Funds rate is coming.

Fed Funds and the Yield Curve

When the Fed talks about raising rates they are talking about the Fed Funds rate. However, when investors think about rising rates they worry about a decline in value of their longer bonds. Our research shows a strong correlation between the Effective Fed Funds Rate and the 10 year treasury yield. The table below shows that the average spread between the Fed Funds rate and the 10 year for the period from 1/1/1962 to the present was 100 bp’s, and the maximum spread was 390 bp’s. In fact, about a year ago we felt 3.0% yields on the 10 year were very attractive since the 10 year was yielding more than 300 bp’s over the Funds rate.

Municipal vs. Treasury Ratios

We have also studied the relationship between Munis and treasuries. The table below shows the long term expected ratio for a 10 year Muni vs a 10 year treasury is about 80%. These ratios vary widely depending upon market conditions. However, we can use the expected ratios below to give us some idea of what to expect if the Fed normalizes rates beginning next year.

Higher Rates For Fed Funds

Using the historical relationship between the Expected Fed Funds rate and various points on the yield curve we can then do a shock analysis to determine what to expect if the Fed raises rates. The table below shows modeled yield curves for both Munis and UST assuming an increase in the Funds rate to 1% and 2%. It may surprise some investors to see that for a 1% Funds rate we should expect the 5 year to be about the same as it is now, and the 10 year actually looks cheap compared to an expected yield of roughly 2.0%. We would argue that the market currently discounts a 1.0% Funds rate. If the Funds rate goes to 2.0% we should expect a rise in the 5 year of about 100 bp’s and the 10 year about 60 bp’s. Munis show similar results, except the 10 year Muni is fairly valued at a 2.0% Funds rate.

Conclusion

Fears of rising rates are greatly overblown. The market has already discounted a 1% Funds rate. Any rise in the Funds rate will likely be several months from now and will be limited in amount. Under current circumstances it seems likely the Funds rate won’t be over 1% until the end of 2015, and might not reach 2% before the end of 2016. These increases are data dependent and won’t occur unless the economy grows faster than we have seen so far. In the past we have cautioned about placing too much faith in the rate predictions of the Fed. Fed members have been predicting higher growth rates for the economy for some time and have a history of being overly optimistic about their growth expectations.

Since the economy still has too much debt and the demographic trends are still negative, we feel the risk to economic forecasts is to the downside. We believe rates are likely to be low for a long period of time and rate increases in the Fed Funds rate will tend to be an additonal headwind for economic growth. If we are correct, then the yield curve will continue to flatten. An appropriate strategy for bond investors is a barbell strategy consisting of some bonds with very short maturities and some longer bonds. We also are placing an emphasis on credit spreads as a way to increase returns. These strategies have worked well for us year to date.

Is Monetary Policy Too Easy?

2014-06-25T15:31:00.001-07:00

Is Monetary Policy Too Easy?

The Fed has been battling deflation since the financial crisis began in 2008. Negative demographic trends and an over leveraged economy have led to sluggish growth in spite of unprecedented easing by the Fed. The Fed Funds rate has been near zero for several years and the Fed’s balance sheet has ballooned as the Fed introduced us to Quantitative Easing (QE). After the first round of QE the Fed moved on to QE2, QE3, and QE “infinity.” The latest round of QE appears to be drawing to an end as the Fed continues to taper its purchases of UST and Mortgage bonds. Research has shown QE has diminishing returns and encourages the movement of funds into riskier assets. It also slows down or drags out the deleveraging process. We have seen improvement in a very weak labor market, but the economy has been very sluggish.

Inflationary Pressures May Be Building

Inflationary expectations have been well anchored which has allowed the Fed to continue its monetary easing without upsetting the Fixed Income markets. The bond vigilantes have been silent and are not expressing concern. However, we are seeing early warning signs that inflation is starting to pick up. The chart below shows the Core rate of the CPI since January 2008. The blue line is the year over year rate of inflation and is less sensitive to monthly changes in the index. It is increasing at a rate of 1.9% annually which is roughly in line with the Fed’s target. The red line is the annualized rate of the last 3 months of the CPI. It is more sensitive to recent monthly changes in the index. This shows a different story, as it is growing at an annualized rate of 2.8%.

This is the highest this measure has been since early 2008. We view this as a red flag that inflation may be picking up. We will be watching this measure closely for further signs that inflationary pressures are building.

The Taylor Rule

The chart below shows the projected Fed Funds rate using the Taylor Rule Model. This model uses the Core PCE deflator for the measure of inflation. The model currently says the Funds rate should be 1.84%.

The Model below uses the Core CPI to measure inflation. Using this measure the model says the Funds rate should be 2.7%.

Conclusion

The Taylor Rule model shows the Fed Funds rate is too low for the strength of the economy. The recent strength in the annualized inflation rate using the last 3 months of Core CPI shows inflation may be picking up. This is making us more cautious to the rates markets and we will be watching closely for further signs of an inflationary buildup.

Federal Reserve Forward Guidance

2014-04-09T15:07:00.000-07:00

The Fed & Traditional Policy

The Federal Reserve’s traditional monetary policy tool is the federal funds rate. The Fed encourages economic growth by lowering the federal funds rate and attempts to slow growth by raising the rate. Since the financial crisis in late 2008, the Funds rate has been between 0.0%-0.25%; this is known as being stuck at the “zero bound.” Since then, the economy has been in a liquidity trap, the system continues to be overleveraged, and there is a greater desire on the part of borrowers to deleverage rather than increase borrowings.

The Fed & Extraordinary Policy Measures

The Taylor Rule, a widely followed “rule” regarding interest rate manipulation, called for a negative Funds rate of -2.0% from 2009-2011. Since it is not possible to create a negative funds rate, the Fed has had to utilize other, less traditional stimulus tools in this environment.

One of these tools, Quantitative Easing (QE), expands the feds balance sheet through asset purchases in the open market. By doing this, the Fed attempts to lower long term interest rates. The fed has begun to taper these purchases, however, as the continued efficacy of QE has come into question and some argue that the economy is improving. Another tool used by the fed is called Forward Guidance. Through Forward Guidance, the Federal Open Market Committee (FOMC) attempts to communicate where they think monetary policy will be in the future. This is similar to “jawboning,” where the Fed talks down long term rates by giving guidance about potential rate action in the future.

A Brief History of Forward Guidance

Below is a brief history of the feds Forward Guidance taken from the Fed’s statements after FOMC meetings. This appeared in the March 14, 2014 MarketWatch from the Wall St Journal:

1. 12/16/2008: First Mention “Weak economic conditions warrant exceptionally low levels of the fed funds rate for some time.”

2. 8/9/2011: Added Specific Date “are likely to warrant exceptionally low levels for the fed funds rate at least through mid-2013.”

3. 1/25/2012: Extends Date “are likely to warrant exceptionally low levels for the fed funds rate at least through late 2014.”

4. 9/13/2012: Extends Date Further “are likely to be warranted at least through mid-2015.”

5. 12/12/2012: Adds Unemployment Goal “will be appropriate at least as long as the unemployment rate remains above 6.50% and inflation is not more than 2.50%.”

6. 12/18/2013: Continues After End of QE “for a considerable time after the asset purchase program ends.”

7. 3/19/2014: Drops Unemployment Goal “likely will be appropriate to maintain the current target range for the fed funds rate for a considerable time after the asset purchase program ends.”

The primary lesson to be taken from this history is that the Fed reacts to incoming data concerning the economy, and forward guidance is not set in stone. They have sought to provide guidance to keep long term rates low, but they have revised their comments and forecasts several times since the financial crisis. They have consistently overestimated the strength in the economy and the need for monetary stimulus.

Connecting The Dots

The chart below shows the federal funds rate forecasts by the 16 members of the FOMC from the March 19, 2014 meeting. There is consensus to keep rates low through the rest of 2014, but the vast majority sees rates higher by the end of 2015. Yellen recently commented that rates would stay low through the middle of next year.

However, when asked about the “dots” moving higher, she said we should not pay too much attention to the dots (even though the Fed is publishing them to give us guidance.) Her dovish comments have created uncertainty in the markets and bring into question the usefulness of Forward Guidance.

Forward Guidance Has Limited Value

We are in agreement with Yellen about the value of watching the dots. The Fed has been providing guidance for the last 5 years. They have consistently over-estimated the growth rate in the economy and have over-estimated inflation as well. The dots have alluded to rate increases for the last 2 years, but this has not been the case. We believe it would be better to focus on the growth rate of the economy and inflation expectations. The chart below shows projected economic growth by the same 16 members of the FOMC. They have overestimated growth for this year and show it peaking at the end of next year. They are forecasting growth in the longer run of 1.8% to 2.4%. These forecasts of sub-par long term growth and significantly higher short term rates are inconsistent with each other. During the last few years the Fed has expanded its balance sheet and fought diligently in an attempt to get growth up to trend. It seems unlikely they will raise rates if growth is even slower in the future.

Taylor Rule Revisited

Considering subdued inflation expectations, relatively high unemployment, and uncertainty regarding the future growth prospects of the economy, many question why the fed would consider raising rates. Perhaps the best explanation for the committee’s higher rate guidance is that the Taylor Rule currently says the Fed Funds rate should be about 1.0%, as shown in the chart below.

Conclusion

Future Fed actions are data dependent. The rate of economic growth and inflation expectations will determine the level of interest rates. Similar policies in Japan have led to sub-par growth and low interest rates for the last 20 years. Past and current Fed action has likely drawn out the process of deleveraging in our country and will lead to below trend growth and relatively low rates for a long time. Fixed Income investors would be wise to monitor the economic data, and pay less attention to forward guidance.

Value in Muni Closed End Funds

2013-10-11T12:03:00.000-07:00

Closed End Funds (CEF) An Example

The recent spike in rates has provided investors with a unique opportunity to invest at levels that have not been seen in a long time. Nowhere has this become more clear than in the market for Closed End Funds (CEF’s). Nuveen Arizona Premium Income Muni Fund (NAZ) has had a negative return of about –19.0% during the last year as shown in the chart below. Part of this poor performance is due to the rise in rates we have seen since the end of April.

However, more than half of the poor performance is due to a change in investors’ eagerness to get out of bond funds. The NAV of the fund is currently $13.44, but the fund is trading at a discount to NAV of –11.46% for a price of $11.90 per share. This is the biggest discount to NAV for this fund since Lehman Bros. filed for bankruptcy on 9/15/2008. The chart below shows the discount or premium to NAV over the last year.

During the last year the share price of NAZ topped out on 1/29/2013 at $16.65 per share. Today the shares are priced at $11.99 per share for a decline of -24.38%. The chart below shows the move in share price for NAZ during the last year. The price of NAZ recently took out the Meredith Whitney low of $11.81 set on 1/18/2011, when investors sold shares after Whitney’s call for numerous high profile muni defaults.

Opportunity For Income Investors

We believe this drop in share price has created a good entry point for income oriented investors. The chart below shows the shares at current market price have an indicated yield of about 6.41%. We believe this monthly dividend is relatively secure. The fund has Undistributed Investment Income (UNII) of $0.1653 per share. This is because the fund only pays out, on average, about 93.44% of earnings. The remaining balance is booked as UNII. The fund currently earns about $0.0598 per share monthly and pays out $0.064 per share. There is enough UNII to maintain the current dividend for at least 3 more years. At 6.41%, the Taxable Equivalent Yield (TEY) for an Arizona investor in the maximum tax bracket is 11.47%.

If you account for the 3.8% surtax for Obamacare for couples who are married and have a modified adjusted gross income of at least $250,000, the TEY is 12.3%.

Conclusion

The recent rise in rates combined with selling pressure from retail accounts has created an opportunity for income oriented investors to purchase CEF’s at very attractive TEY’s.

Rising Rates?

2013-07-18T11:23:00.000-07:00

Focus on Fed Policy

Recently all eyes have been on Fed policy regarding the possible tapering of bond purchases. This preoccupation with Fed policy has led investors to liquidate bond mutual funds and ETF’s in record amounts. This has led to a rapid rise in interest rates to the highest levels of the last two years. Mortgage rates have soared to 4.5% during the last six weeks. The chart below shows the rise in 30 year mortgage rates since the Fed announced it might start tapering bond purchases. We feel investors are currently focused on the wrong thing, and the rise in rates has created a buying opportunity in bonds.

What Drives Interest Rates

The two primary drivers of interest rates are the general level of economic growth, and inflationary expectations. Fed policy is largely driven by these conditions and is very much “data dependent”. The economy only grew at a 1.8% rate during the 1st Quarter of this year. This is significantly below the long term economic growth trend. The Fed has had a history of being overly optimistic about future growth in the economy. Forecasts of higher growth rates for the rest of the year strike us as being overly optimistic, considering the recent move higher in interest rates. We expect higher rates to slow down the housing market and the economy in general during the rest of the year. It is important to remember that stronger economic conditions for the rest of the year is not a known event. We feel a continued period of weak growth is more likely. Higher tax rates, higher mortgage rates, a slowdown in government expenditures, and negative demographics are all headwinds for the economy. The debt limit ceiling will need to be raised by early fall to keep the government running. There has been no talk of progress made in Congress regarding the two parties working together to address the budgetary issues facing the country. Instead, both parties are becoming even more polarized. It is hard to imagine this changing soon. The potential for negative noise coming out of Washington concerning budget battles and the debt ceiling may also be a drag on the economy.

The chart below shows the continued decline in inflationary expectations. This trend is not indicative of rising rates. In fact, it seems to be providing a green light for the bond market. Many investors believe the expansion in the Fed’s balance sheet has to be inflationary at some point. However, the data does not support this argument at this time.

The Fed’s QE Experiment

The Fed began Quantitative Easing (QE) during the financial crisis in 2008. Quantitative Easing occurs when the Fed expands it’s balance sheet by purchasing assets such as U.S. Treasuries and Mortgage Backed Securities. QE is supposed to be a monetary tool which is used when the Fed Funds rate is at or near zero and unemployment is high and the Fed believes more monetary easing is necessary. QE is a tool to lower long term interest rates to stimulate economic growth.

The chart above shows the last two rounds of QE have not been as effective in lowering interest rates as QE1 and QE2. The diminishing returns of QE3 and QE4 cast a shadow of doubt concerning the effectiveness of continued QE. Quantitative Easing has been tried in Japan with little success as the Japanese have been engaged in a 20 year battle against deflation.

Stuck In A Liquidity Trap

The velocity of money, as shown in the chart below, has continued its downward trend. This is a sign we are in a classic liquidity trap, and monetary tools are relatively ineffective in stimulating the economy.

This has occurred because there is too much debt in our system, and demographic trends are very negative for the economy. The Fed’s monetary tools are designed to encourage borrowing to stimulate economic activity. This does not work well in a highly indebted economy. The large number of baby boomers and longer life expectancies have created a large group of older people in the U.S. An aging population does not have enough consumers in the accumulation phase of life. They are not borrowers and spenders. Instead, there are more consumers who are spending less on things, and more on healthcare. This is very negative for economic growth because it dampens the effectiveness of monetary policy.

How High Should Rates Be Without Government Manipulation?

The question fixed income investors should be asking is “how high should rates be without the government trying to manipulate the market?” We believe the current level of rates offers value to investors. Inflation is running at about 1%. The Fed has made every effort to get it higher without success. Japan has been in a similar situation. The 10 year JGB still yields less than 1% in Japan. Our 10 year UST yields about 2.55%. The German bund yields 1.58%, the rate in the UK is 2.34%, and is only 2.2% in France. Corporate and Muni yields are higher still. Long Munis for good BBB rated bonds yield over 5%. This equates to taxable equivalent yields of 8-10%. These are very attractive rates for retail investors.

Conclusion

Investors should pay attention to the weak trend of economic growth and low inflationary expectations. The recent selling of bond funds has created a good opportunity for investors to add to their fixed income positions at prices which have not been available for the last 2 years.

Are States The Next Greece?

2010-07-14T16:09:00.000-07:00

Recent Events
The recent downturn in our economy has created severe budgetary stress for states, as their revenues have fallen precipitously and the demand for services has increased. The State of California with it’s politically charged budgetary process, high foreclosure rate, and high unemployment rate has received much negative attention in the media. Some are saying “California is the next Greece”. While there is little doubt California is under financial stress we believe these concerns are overblown.

A Sovereign: Greece
Greece is an independent political and financial entity and enjoys “self rule”. It is responsible for it’s budget and has the ability to issue debt and print money. Much of their debt is sold to foreigners and foreign banks. Greece is part of the European Union (EU), and their currency is the euro. The EU requires certain fiscal disciplines for member nations, such as balanced budgets, in order to use the euro as their unit of currency. Recently, it was discovered that Greece created fictitious budgets in order to become part of the EU and their financial circumstances are much weaker than previously thought. The revelation of Greece’s weakened financial state has led to a lack of confidence in their ability to re-pay their debt which has created a “debt crisis” for the country and the EU. The EU has demonstrated a willingness to bail out Greece if certain austerity programs are implemented. Resistance to these austerity measures and violent demonstrations in Greece by it’s citizens have been shown on television. Other EU countries such as Portugal, Spain, and Italy are also experiencing financial problems. Many are questioning the viability of the euro as a currency, and it has been under severe pressure as holders of euro’s look to sell and trade into more secure currencies.

A State: California
The State of California is a political sub-division of the United States. It is responsible for it’s budget, but is required by law to have a balanced budget. It is not able to print money. The U.S. government has helped the States, including California, through various stimulus packages during the last 1.5 years. Most of the debt of the State is held domestically, and is not subject to additional volatility caused by currency risk, which makes them much less volatile than Greek bonds during the last couple of years. Though
the budgetary process is cumbersome and outdated, the financial reports issued by the State comply with legal reporting standards and offer a fair representation of the State’s financial circumstances. The State has the ability to cut expenses and raise revenues to balance the budget. The rapid decline in tax revenues for the last 2 years has caused a great deal of budgetary stress for the State. The ability to make difficult decisions shows the resiliency of the State. These decisions have been made without fiscal discipline being imposed from foreigners, and without rioting in the streets like Greece. The issue of unfunded pension liabilities and healthcare benefits for public employees has not been adequately resolved, and will likely become a major issue during the next 10 years.

Differences
One of the most important differences between Greece and the State of California is the legal framework and rules for reporting. California has had fiscal discipline imposed on it by existing state and federal statutes. These statutes require a balanced budget, and set priorities for paying bills. For example, the highest priority for the State when paying expenses is to first pay those for education, next is debt service on bonds. All other expenses are subordinate to these and are paid after these expenses have been paid. Since Greece is a sovereign, it has been easier for them to avoid fiscal discipline through false reporting and false promises to their citizens. However, this has come to an end as the EU and IMF are dictating austerity measures for Greece.

Another difference is that there is a closer relationship between a State and the U.S. government, than there is between a member nation and the rest of the EU. Imagine being a German citizen and watching reports on television of the rioting in the streets of Greece, while they are expecting you to bail them out. How would you feel when you aren’t even part of the same country?

Sovereigns are also responsible for the banking system and credit conditions within their borders. Many sovereign nations are still reeling from the extensive bailout programs which were required to bail out the banks during the last credit crisis, and to stimulate their economies. In the U.S. the Federal government is responsible for the banking system. This allows the States to focus on other issues, such as education.

Conclusion
There is little doubt that many Sovereigns are riskier credits than States in the U.S. During the last 10 years, the default rate for all Muni bonds has been only 0.1%. There has not been an instance of a State default for over 75 years. The default rate for all Sovereigns during the same time period was 6.0%, which is 60 times greater than the default rate for all Munis.

(Please see chart below for Muni vs. Sovereign comparison.)

Lessons From Vallejo

2010-04-13T15:29:00.000-07:00

2008: Vallejo Under Financial Stress

In 2008 the City of Vallejo, CA was suffering from severe financial stress caused by recurring budget deficits in it's general fund. The city found it difficult to bring it's budget into balance because 74% of the budget consisted of expenses for police and firefighter salaries and pension obligations which had been growing out of control. City officials attempted to renegotiate labor contracts and benefits, but were unable to generate enough cuts to balance their budget. The deficit for 2008 was $4.3 million, with a projected deficit for 2009 of $16 million. According to a recent Wall St. Journal article which appeared on March 26, 2010 "salaries for police captains were over $300,000 per year, and firefighters averaged $171,000 a year. These same workers could retire at age 50 with a pension that guaranteed them 90% of their final year's pay."

Vallejo Enters Bankruptcy

On May 23, 2008 the City of Vallejo filed a petition for protection under Chapter 9 of the U.S. Bankruptcy Code. According to the law firm which represented Vallejo, Orrick, Herrington, & Sutcliffe, in order to file bankruptcy a municipality must meet the following criteria:

It must be a political subdivision of the state. A state is not allowed to file for bankruptcy.

State law must allow a municipality to file for bankruptcy. About half of the states in the U.S. do not allow municipalities to file bankruptcy.

The municipality must be insolvent which means they are not able to meet their current obligations or won't be able to meet them in the next year.

The municipality must desire to effect a plan to adjust it's debts.

The municipality must show it has tried to negotiate unsuccessfully with creditors.

In September 2008 the Bankruptcy Judge Michael McManus determined the City of Vallejo met these conditions, and the Bankruptcy Appellate Panel affirmed his decision on June 26, 2009.

Collective Bargaining Agreement Is Rejected

On March 13, 2009 the judge ruled the City could reject the Collective Bargaining Agreements it had with various city unions, and the City of Vallejo began to renegotiate it’s contracts with public employees including firefighter and police.

Vallejo’s Bankruptcy Workout Plan Affects Bondholders

On December 22, 2009 the City came up with a Bankruptcy Workout Plan which called for no principal or interest payments to be made for three full years beginning January 15, 2011 through January 15, 2014 on outstanding debt. This affects all bonds that are secured by the General Fund. Bonds with dedicated revenue streams are not affected by the moratorium on debt service payments. The bonds that are still paying interest are secured by water revenues, special assessments, and special taxes. Bonds for related entities are also not affected by the Workout Plan. These include Vallejo Sanitation and Flood Control District, Vallejo Redevelopment Agency, and Vallejo Housing Authority. These are all separate legal entities from the City of Vallejo.

Why Vallejo Is Important To Bondholders

During the last 40 years most Muni bond defaults have been for housing and healthcare bonds. There have only been 3 general obligation bonds which were rated by Moody’s that have defaulted during this period. Perhaps the best known case is for Orange Co., CA which defaulted on it’s debt, because of excessive exposure to derivative trades in it’s investment pools by rogue trading by the county treasurer. Bondholders were eventually able to recover 100% of both principal and interest. Jefferson Co., AL defaulted on it’s bonds in April 2008, because of excessive exposure to variable and auction rate securities swaps which caused a large liquidity deficiency for the county when their swaps didn’t work out.

The bankruptcy filing for Vallejo is quite different. It is the result of poor governmental planning with the City lacking the political will to negotiate affordable contracts with public workers, and also making them promises they are not able to keep. Public employees and bondholders alike are watching this case with interest. Numerous municipalities across the country have significant unfunded liabilities for both pensions and healthcare benefits. This case is, thus, important to see if bankruptcy for a municipality is a way to make these liabilities more affordable for it’s taxpayers.

Vallejo: Has Bankruptcy Paid Off?

It is clear bankruptcy has not been a silver bullet for Vallejo, and the costs have been significant. Since filing for bankruptcy, Vallejo’s tax revenues have fallen 20% with further expected declines likely in 2011-2012. The City has not had the political will to reduce existing pension costs. These costs will leave the City
facing projected annual deficits of $23-$27 million once retirement costs are fully recognized. There has been a stigma for residents which makes Vallejo a less desirable place to live. This is reflected in falling property values, reduced services, and a higher crime rate. The City has also been shut out of the credit markets, and will be unable to raise funds for an extended period. The City has made progress in renegotiating labor contracts, but the cost has been high.

We believe other municipalities will look at this case with mixed feelings, and will realize bankruptcy is an option of last resort. It is not a panacea for getting rid of unfunded pension liabilities. Most municipalities are not in the dire straits which Vallejo is in, which means they are not eligible to file for bankruptcy. Fears of widespread use of bankruptcy by municipalities to lower unfunded liabilities are overblown. On a positive note for taxpayers, this case sends a clear message to organized public workers. In a bankruptcy situation their existing contracts are all up for renegotiation. This should make them more willing to negotiate on more favorable terms with municipalities in the future.

Lessons To Be Learned For Bondholders

This case provides several lessons for investors. First, Muni bondholders should realize security selection has never been more important than it is now. Improper security selection can be very punishing to investors. Next, bond investors cannot assume general obligation bonds are more safe than revenue bonds. When a municipality experiences extreme stress and enters bankruptcy, bonds with dedicated revenue streams are superior to claims on the general fund. Also, some municipal entities may lack the political will to make sound financial decisions. Even though municipalities are required to balance their budgets, there may be some situations which make it extremely difficult for them to do so. Many budgetary problems need long term solutions, but politicians are only willing to provide short term fixes. In addition, since states are not able to declare bankruptcy, it is difficult for investors to know which type of bonds have priority over other general fund obligations such as payroll and vendors. Laws will vary from state to state. For example, in California payments for schools have priority over debt service, which has priority over all other general fund expenses. Finally, the Muni market is a fragmented market of over 50,000 different issuers. It is not possible to make general statements re
garding the creditworthiness of all Munis. Pundits which make generalizations about the Muni markets should be treated as suspect. Instead, investors should be more like loan officers who realize that each borrower has different abilities to service their debt. They should consider off balance sheet obligations, wealth levels, and debt per capita before purchasing the issuer’s general obligation securities.

Conclusion

The Muni market is not a good do-it-yourself market. Proper security selection is beyond the scope of most individual investors. We also believe the financial situation of the City of Vallejo shows the danger of blind reliance on default studies, which is not a good policy in today’s environment. These studies cover a time period where most municipalities did not experience the amount of financial stress which they will be facing during the next couple of years. This stress may be caused by declining tax revenues, higher costs of providing healthcare, or unfunded liabilities associated with public employees. Instead, we plan to place more emphasis on revenue bonds with secure revenue streams and less emphasis on some general obligation bonds. This strategy is similar to the one we have used for California Muni bond investors. We will continue to seek out general obligation bonds of high wealth areas, and issuers with low debt per capita levels, and a willingness to make difficult budget decisions. But, we will also place increasing emphasis on essential service revenue bonds where the issuer has a monopoly on the services they provide.

Shared Sacrifice

2009-07-03T20:37:00.000-07:00

Turmoil In The Credit Markets
During the last 2 years there has been considerable turmoil in the credit markets due to the rapid decline in the credit quality of borrowers in the corporate, mortgage, and agency markets. The sub-prime mortgage crisis, collapse of Fannie and Freddie, banking and investment banking crises, stress on insurers and guarantors of debt, and collapse of 2 of the 3 largest auto makers are all examples of the deterioration in the credit quality which has taken place. Even the credit quality of the U.S. Government (the heretofore standard for a riskless borrower) has been called into question.

Fixed Income Credit Analysis and Risk
This decline in credit quality has made credit analysis more important than ever. Fixed Income money managers who were able to avoid major problems with credit issues have achieved superior performance to those who were unable to foresee potential credit problems. The penalty for being “wrong” on the credit of an issuer has been harsh as credit spreads blew out to very wide levels. A good credit analyst is able to identify and understand the risks in any given security. Most investors lose money because they grossly underestimate the amount of risk they are taking. The other mistake they make is “reaching for yield”. This leads to creating portfolios that consist of all the weakest credits, because they are the ones that yield the most. These portfolios do not perform well in stressful times for the markets. A good credit analyst is also able to determine what the “worst case” is for any security he owns. This is extremely important when things “go bad” for a credit. There are different layers of security for a bondholder. These include debt service coverage, the issuers ability to pay, and where the bondholder stands as a creditor in bankruptcy. In bankruptcy, there are long established rules that apply to secured and unsecured creditors, as well as to equity holders. These rules provide comfort to secured bondholders when things “go bad” for one of their borrowers. The current economic cycle has allowed the government to become involved in the economy to an unprecedented extent, which has revealed a new level of risk a good credit analyst needs to consider. We will call this ‘political risk”, which is the risk of confiscation of secured creditor assets for the benefit of a junior class of creditors. This is a risk that is more prevalent in unstable less developed countries, and was unthinkable in the U.S. until Chrysler.

The Chrysler Bankruptcy
The auto industry was particularly hard hit in the recent economic slide with both Chrysler and GM going into bankruptcy. The actions taken by the government in the Chrysler bankruptcy were unprecedented. The President introduced the concept of “Shared Sacrifice” in the media as he called upon secured creditors to take less than they were entitled to legally so that one of his political supporters, the UAW (a junior creditor), could get a larger share of the new firm. TARP participants who represented the majority of senior secured creditors were then coerced into voting for a government sponsored cram down which gave the secured creditors only 30% of the company while the junior class of creditors (UAW) received 50% of the firm. The secured creditors who did not vote for the plan were labeled as speculators and were portrayed as all around bad guys to the public. This creates an enormous amount of uncertainty for investors in fixed income securities in the U.S., because laws which were deemed sacrosanct have been rendered meaningless as assets are confiscated from one class of creditor and given to another class of creditor based on political whim instead of rule of law.

Bankruptcy Law
Existing bankruptcy law is designed to protect debtors from creditors seizing their assets without giving them time to come up with a plan to pay creditors in a fair and equitable manner. When bankruptcy is declared an estate is created, similar to when a person dies. The assets of the estate are then valued, and creditor claims are processed and organized into order of their priority. Some claims are secured, and have a priority over junior claims. A first mortgage claim is entitled to receive full payment before the second mortgage holder receives any funds. Priority of claims is a well established principle of bankruptcy law. Debtors are not allowed to pay some creditors to the detriment of others immediately prior to or during bankruptcy. The debtor in possession of the assets is allowed to form a plan which is equitable to it’s creditors, and the creditors can then vote on the plan. If a majority of the creditors vote for the plan, the dissenters will suffer what is caused a cram down, as the plan is approved over their objections. In the Chrysler case there are problems with the asset valuation process, priority of claims issues, and the nature of the government’s cram down. The concept of “shared sacrifice” violates bankruptcy law and discourages lending, particularly to weaker credits.

Conclusion
We believe the government has now re-written bankruptcy law in this country. Since the Chrysler case, GM has been put into bankruptcy. A similar approach to a rushed asset valuation process has been taken in GM as well. Virtually every secured creditor in the country has now found their position in bankruptcy lowered, as the government ignores the established rules of bankruptcy law. We were fortunate that we did not own any bonds for the auto companies, because our credit analysis deemed them too risky. We also avoid high yield bonds, because they are very highly correlated to equities, and don’t offer enough diversification to the investor’s overall portfolio. However, even though we dodged the Chrysler bullet, we are still very concerned by the government’s actions and our level of “trust” for our system has been shaken. Why would any investor want to invest in high yield fixed income with the additional risk of confiscation in bankruptcy? Without the established priority of claims in bankruptcy there is now no such thing as a secured or priority claim. “Shared sacrifice” does considerable harm to encouraging lending during these difficult times, because it makes it nearly impossible to determine the lender’s worse case. It makes more sense for the lender to avoid lending to riskier firms, because a secured loan to a struggling creditor suddenly has become much riskier.

Nominal GDP and Inflation

2009-05-20T19:20:00.000-07:00

The Current View of Inflation
Investors have become increasingly concerned about future inflation due to massive governmental intervention and growth in the money supply. These investors argue that the large increase in money supply has to go somewhere, and it will cause inflation. They may also argue that this increase in money will cause the dollar to go down, which will in turn cause prices to rise even further. They frequently feel compelled to throw in their thought that the deficits we are currently running are so large, that the only way out of this situation is to inflate our way out. This is currently the consensus view. While this view may be intuitively obvious to most investors, we believe high rates of inflation are not necessarily a foregone conclusion.

Review of Inflation
The chart below shows the annual rates of inflation as measured by the U.S. CPI Index for Urban Consumers on a non-seasonally adjusted basis since 1926 through 2008.

This information is available from the U.S. Department of Labor and may also be found in the Ibbotson SBBI 2009 Yearbook. The average annual rate of inflation during this time period was 3.0%. During the period from 1926-1933 we experienced deflation. In fact, it took until 1945 for the Consumer Price Index to get back to the level it was at in 1926. During the 1950’s and 1960’s inflation experienced a slow rise. The 1970’s saw inflation rise until it peaked at 13.3% in 1979. This was the year gold reached $850.00 per ounce and silver peaked out at $50.00 an ounce as Bunker Hunt tried to corner the silver market. WIN buttons were passed out which stood for “Whip Inflation Now”. OPEC proclaimed an oil embargo and the price of oil went shockingly high. This was an inflection point for inflation. During the 1980’s inflation steadily declined and this trend continued through the 1990’s until last summer when oil reached $150.00 a barrel. Since then the economy has continued to decline and price increases have been under control. Last year the CPI was only up 0.1% even though gas prices had reached prices of over $4.00 a gallon during the summer. Last summer many investors “knew” inflation had returned and feared interest rates were going higher. So far, during this year the index has increased 1.3% through April. The chart below shows the average annual inflation rate by decade since 1926. By looking at inflation over longer time periods the data is smoothed and we are able to see the long term trends more clearly.

Inflation and Economic Growth
Our research shows a high correlation between economic growth and inflation when the economy grows faster than trend. We used data from the Bureau of Economic Analysis to measure growth of GDP. GDP grew at an average annual nominal rate of 6.68% during the period from 1926-2008. Let’s call this the trend rate of growth for the economy in the U.S. In the chart below we compare the annual rate of growth of nominal GDP minus the trend rate by decade, and compare this growth versus trend to the CPI. The results show a high correlation. During the 1930’s the economy contracted below trend and we had deflation. During the 1940’s, 1970’s, and 1980’s the economy grew above trend and we had high levels of inflation. Economic growth during the the 1950’s and 1960’s was at trend and inflation was low. The last 20 years has shown growth below trend with declining rates of inflation.

Conclusion
Investors would be wise to pay attention to indicators which
are leading indicators of the economy such as the LEI Index or the Chicago Fed National Activity Index. These indicators are currently still showing economic weakness which is way below the trend rate for the economy of 6.68%. Inflationary pressures are not likely to appear until growth in nominal GDP approaches levels in excess of trend.

The Government To The Rescue?

2009-03-15T05:21:00.000-07:00

Some large cities and states are seeking help from the federal government. So far, help has not been forthcoming. We expect this to change soon, because budgetary cutbacks by municipalities will put additional pressure on an already weak economy. There is increasing talk of helping municipalities with infra-structure needs such as bridges, roads, and energy.

We believe the best option for the government in assisting municipalities is to create some sort of replacement for the bond insurers. This would help reduce borrowing costs for municipalities, and would ensure that financing would be available to issuers who need to borrow. It would also help to restore confidence in the financial system by eliminating the de-leveraging that has been taking place in most asset classes.

What Did The Government Do Wrong Last Year?

When the government let Lehman go down in mid-September, the strains on our financial system were so great the credit markets ground to a halt. The counter party risk involved with Lehman and other counter-parties were revealed to all, and resulted in widespread fear throughout the system. The government greatly under-estimated the systemic risk they were taking when they let Lehman collapse.

The government also didn’t understand how important the bond insurers were to our funding mechanism for credit. Our system relied on guarantees to create AAA credits in the short term markets. These AAA ratings were the key to cheap funding by all sorts of borrowers. The demand for money market eligible paper was so great, a financially strong issuer could borrow at low rates. This system worked well for years and allowed for various leveraged strategies to exist which lowered borrowing costs for most borrowers. The financial shock to our system from rising default rates of Sub-Prime mortgages, and falling housing prices put immense stress on guarantors who had become over-exposed to this market. As insurers got downgraded, investors began to panic in the short-term markets. First, funding dried up for SIV’s which funded Sub-Prime mortgages. Next, investors sold insured notes by FGIC and XLCA, and bought notes guaranteed by MBIA and AMBAC as it became clear these companies were going to lose their AAA ratings. This steady stream of downgrades of guarantors created an absolute panic in the short term markets as they realized no AAA rating was safe. This resulted in the collapse of the Auction Rate Securities market. As funding costs sky-rocketed in the short-term markets de-leveraging took place in earnest in all fixed income markets. We believe the government’s lack of understanding of the importance of guarantees in the short-term markets led to our funding mechanism breakdown last year. This created a crisis in confidence, de-leveraging, and the decline in asset values.

Inflation Worries

2009-03-15T05:12:00.000-07:00

Investors are becoming increasingly concerned about inflation as a result of the massive governmental intervention which is taking place. Their argument is that “the government is running large deficits and the money supply is growing out of control”. They feel sooner or later we will experience inflation, and they are worried about a dramatic fall in the dollar and the possibility of hyper-inflation as a result. We feel inflation fears are currently overblown since the economy is still contracting and is very weak. The chart below shows the Chicago Fed National Activity Index. It is a combination of several leading indicators and shows how we are doing

compared to the long term trend growth rate of the economy which is represented by the line at 0. Inflationary warnings flash when this indicator is at 0.7%, and recession is likely to occur when the index falls below –0.7%. The current reading is about –3.4% which is nowhere near the inflationary warning level of 0.7%.

Most investors have grossly underestimated the deflationary forces at work in the economy due to deleveraging caused by tight money conditions in a highly leveraged economy. The cheap funding through the short-term markets which allowed leveraging to take place has disappeared, because the bond insurers are no longer AAA rated credits. This has reduced the supply of credit dramatically because the “borrow short and lend long” trades no longer work. These trades represented the “Shadow Banking System” which funded leveraged buy-outs, no money down housing loans, and hedge fund activity. The contraction of this form of financing has led to economic weakness, which has caused the velocity of money to fall, which has offset the increase in the money supply. It will most likely take a long period of time for these forces to work themselves out before inflation becomes a problem.

Pushing On A String?

2008-07-10T18:12:00.000-07:00

Is The Fed Too Easy Or Too Tight?
There has been much talk recently about the need for the Fed to raise rates to stop rising global inflation. Our work shows that money is still tight, even though the Fed has lowered the Fed Funds rate to 2.00%. The Fed surveys senior bank loan officers about lending practices at banks. This information is gathered through the “Federal Reserve Board’s Senior Loan Officer Opinion Survey on Bank Lending Practices”. The Fed conducts this survey quarterly with about 60 large domestic banks, and 24 U.S. branches of foreign banks. The information from this survey is quite interesting in today’s environment. The chart below shows the availability of credit and the cost of credit as shown through the Fed’s survey. As you can see

the credit lending standards have become progressively more restrictive. This is shown by the blue line in the chart. As bank lending standards have grown stricter, the cost of credit has been climbing rapidly (shown by the red line). In fact, the percentage of senior bank lending officers who are raising credit costs to businesses is currently higher than at anytime since the survey began in June 1990. It is interesting that banks have been tightening credit during the same time that the Fed has been trying to ease credit conditions. The chart below shows the cost of borrowing plotted vs the Fed Funds rate during the same period of time (6/1990-6/2008).

The chart shows the expected lags in bank lending costs, but recent developments are an anomaly, since borrowing costs are soaring as the Fed continues to lower short term rates. This implies that the Fed is currently “pushing on a string”. The tool of using rates to control the economy is no longer working as it has in the past. This is an alarming development, because it shows the seriousness of the current credit crisis in the U.S.

The Party’s Over
Over the last few decades the Fed has gained enormous credibility as an institution with the ability to manage our economy out of recessions in a non-inflationary way. The Fed as lender of last resort created the “Greenspan Put”, which meant when things got bad the Fed would be there to make things better. This policy has not, however, been without costs, and has only postponed the inevitable. This led to an incredible leveraging of our financial system, the creation of the shadow banking system, and massive amounts of debt being accumulated by the consumer and guaranteed by our financial institutions. The lax lending standards and cheap credit shown in the first chart during 2005-2007 helped create the debt hangover we are currently suffering. Rising delinquency rates and massive write-down's of loans have created deteriorating balance sheets for our banks and investment banks. They want to forget about the lax credit party that got them where they are today. The Pushing On A String chart shows the party is over. Banks are in no position to party again any time soon. Their hangover is too great. We should expect them to concentrate on re-building balance sheets, by raising capital, deleveraging, and cutting back anyway they can. The thought that money is easy, because the Fed cut short term rates is a misconception. Money is tight and will remain tight until the financial system begins to recover from the excesses of a couple of years ago.

Auction Rate Securities: What Now?

2008-06-14T15:44:00.000-07:00

The Background
Auction Rate Securities (ARS) are typically either a debt instrument with a long-term maturity or preferred stock in which the interest rate is determined through an auction process. These rates normally are reset either weekly or monthly through periodic auctions. The ARS market reached about $350 billion at its zenith. About half of this market was for tax exempt securities. The issuers of tax-free ARS are municipalities, closed-end muni funds, and corporations that qualify under the “public purpose” provisions of the tax code. The ARS market was designed to act as a low cost funding mechanism for these issuers. Since early this year this market has been in disarray due to liquidity disruptions. Many investors have had their funds frozen because of a rash of failed auctions. At one point, over 80% of all auctions failed. When an auction fails the investor receives the penalty rate which is disclosed in the initial offering papers for the security. This penalty rate varies widely from a very low rate up to 20% depending upon the terms outlined in the offering documents of each issue. These securities normally come in $25,000 denominations.

Who Was At Fault?
Bankers and other Public Finance types get paid by generating revenues. The ARS market, just like Sub-Prime structured products, grew out of this need by Investment Bankers to generate out-sized year-end bonuses. The ARS market needed a “hook” to be successful. The “hook” for the issuer was cost savings from the ability to avoid paying for another bank to provide liquidity for their money market securities. The “hook” for the investor was that they would receive better than money market rates for taking virtually no risk of a failed auction, because their broker’s firm always made sure the auctions were successful. These securities were appealing to ignorant and greedy brokers who were now able to get bigger commissions on “money market” alternatives. For awhile this strategy worked and the Bankers were able to create a $350 billion market that was a fee generating machine. Unfortunately, early this year investors and issuers both discovered that the Emperor had no clothes. When auctions failed, issuers found that their costs were much higher than the Bankers had promised, and the investors lost access to their funds despite being told “they were as good as money markets, no they were even better than money market funds”.

How TFS Avoided The ARS Debacle?
Virtually all credit crises were caused by investors underestimating the amount of risk they were taking. The ARS market meltdown is no exception. Our perception of risk helped us to avoid ARS. We chose to invest in Variable Rate Demand Notes (VRDN) instead of ARS, because we knew we were not getting paid to take the additional risk of a failed auction. The chart below shows that prior to the ARS meltdown we actually received on average about an extra .04% yield by purchasing VRDN’s instead of ARS. These instruments are money market eligible and trade in $100,000 denominations. They are issued by many of the same issuers that also issue ARS. It is common knowledge that ARS are not money market eligible, because the investor does not have their liquidity guaranteed when he/she desires to liquidate their securities. Institutional investors know that a VRDN is money market eligible, because there is a liquidity facility guaranteed by a Standy Purchase Agreement. We reasoned, “why would anyone buy an ARS at a lower yield when it is an inherently riskier investment?” The only explanation for this enigma is that investors were unaware of the liquidity risk in these securities, and they let their brokers spin them around by selling them something with more risk than they thought they were taking. This situation clearly shows the conflict of interest that may exist between a broker/salesman and the investor.

Prospects For The Future
The ARS market has rapidly shrunk to half its former size. The cost savings the Bankers promised have turned into additional expenses instead. So, issuers have called outstanding issues of ARS with high penalty rates and replaced them with VRDN’s, put bonds, or long-term bond issues. This trend will likely continue for the next 6 months until most investors’ ARS funds have been freed up, and issuers have escaped the fiasco known as the Auction Rate Securities market.

Is There More Inflation In The Future?

2008-05-29T14:30:00.000-07:00

Inflation Outlook
Recently, there has been much talk in the press about inflation. The argument is made that the recent rise in food and energy prices has to filter into the inflation numbers sooner or later, and that interest rates have to rise because inflation is so bad. Frequently this argument is further editorialized with comments such as “I don’t know why the Fed only looks at core inflation. After all, don’t we all have to eat and drive to work? Of course, if you take out everything that goes up, we won’t have any inflation at all!”. This is commonly followed by snickers, as if they are the only ones who could figure this out.

We pay close attention to inflation, which is a lagging economic indicator. Studies show inflation tends to peak at about the same time the economy is bottoming. It has been our opinion that we are in a temporary cyclical upturn in inflation, and we should see inflation come down as the economy slows. The chart below is a Fed model (Chicago Fed National Activity Index)

which shows economic activity and the likelihood of increasing inflationary pressures. The blue line is the value of the index and is charted against the axis on the left. We have added an index of inflation to the graph. The gray area is a graph of the year over year Personal Consumption Expenditures Index. This is the Fed’s preferred measure for inflation and the axis on the right shows the inflation rates. The CFNAI uses 85 different economic indicators as inputs which measure:

1. Production and Income
2. Employment, Unemployment, Hours Worked
3. Personal Consumption and Housing
4. Sales, Orders, Inventories

The Fed model uses a 3 month moving average to smooth the data. The index is designed to be 0.0 when the economy is growing at the long term trend rate. The index is positive when the economy is growing rapidly, and is negative when it is growing slowly. When the index is below –0.70 it is increasingly likely we are in recession. The index has been below –0.70 for the last 5 months. The current value is –1.25. This suggests a continued weak economy in the future. When the index is above 0.7 after the economy has grown for more than 2 years it is likely inflation will rise. This model shows the strong correlation between the overall strength of the economy and inflation. Since the index is in negative territory, this model shows it is likely that inflation will moderate in the future.

Conclusion
Investors should not become distracted by the chatter in the press about the need for interest rates to rise because of inflation. High oil prices and inflation are certainly today's problem, but the leading indicators show inflation is likely to moderate in the future, because of the weak economy.

The End Of The Muni Carry Trade?

2008-02-18T14:46:00.000-08:00

Supply/Demand Imbalance
There has been steady growth in the assets held by Tax-Free Money Market funds since their inception. During the last 10 years the holdings of these funds have more than doubled in size as their assets increased by about 123%. Last year about $430 billion was invested in short-term Tax-Free funds. The chart above shows the “gap” between assets held by money market funds and the amount of issuance of short-term tax-free securities that are available for them to purchase. These securities have maturities of 13 months or less, or are longer maturities that have floating-rates and a put that gives short-term liquidity to the debt. Most of these floating rate securities are issued as Variable Rate Demand Notes. This money market supply gap has continued to widen over the last decade.

The Muni Yield Curve
The strong demand for short-term paper by money market funds causes munis to trade “richer” in the short-term part of the yield curve relative to U.S. Treasuries than in the longer part of the curve. This means that munis have a long history of having a positively shaped curve, even when treasuries are inverted by Fed induced tightening measures. The chart below shows the spread between a 1 year muni and a 30 year muni over the last 3 years. When the Fed was
in a tightening mode the curve flattened to a low of 40 bp’s on 2/27/2007. During that same period of time the Treasury curve was inverted. Since the muni yield curve has a history of having a positive slope even when money is tight, it works well for strategies that borrow short and lend long.

The Muni Carry Trade
Tender Option Bond programs (TOB’s) and leveraged Closed End muni funds both borrow short and lend long in the tax exempt marketplace. TOB strategies are funded by money market eligible instruments that allow the programs to purchase long muni bonds by employing leverage. The amount of leverage varies by the entity that is employing the strategy. The muni “carry trade” has become increasingly important over the last 10 year period. The chart below shows the holders of municipal debt as of 12/31/2007. Banks held about $193 billion at the end of last year and Closed End funds held about $92 billion of munis. During the last 3 years the growth in assets held by each category of investor can be seen below. Commercial Banks grew their holdings by about $50 billion since 2004. Much of this growth came from a few large banks that employed carry trade strategies in the muni bond market.

The chart below shows the increase in holdings by the 7 largest holders of muni debt by commercial banks over the last 3 years. The 5 largest holders were all significant purchasers of munis during this time period and accounted for about 50% of the growth in holdings by all the commercial banks. The addition of these large positions of muni debt in such a short time period can only be explained by the use of leveraged TOB strategies. In addition to the TOB’s issued by the commercial banks, there was considerable growth in the number of these strategies employed by hedge funds/arb accounts. It is estimated that Merrill Lynch’s TOB is about $40 billion. Many of these strategies were offered as Alternative Investments or as Fund of Funds strategies. Data on the size and number of these programs is not readily available, but the amount is impressive. Closed End muni funds had little impact and did not experience much growth during this time period. These funds are leveraged through the use of Auction Rate Preferred securities which are not money market eligible, because their liquidity is not guaranteed.

Filling The “Gap”
The leveraged strategies employed by TOB’s are primarily funded by the tax-free money market funds. For example, La Salle Bank would purchase a large block ($15-$50 million) of long muni bonds and deposit them into a trust. The trust splits these bonds into 2 different parts:
1. The short-term holder gets a weekly floating rate security that is money market eligible and can be put back to the marketing agent on 7 days notice.
2. The residual certificate holder (La Salle Bank) receives the difference between the rate paid on the short-term piece and the rate received on the long bonds that were purchased.
This is a “carry trade” for the Bank, because they borrow short and lend long. The steepness in the yield curve has made this a desirable trade for the Bank and the shortage of money market eligible paper has made it beneficial for the tax-free money market funds. The residual holder assumes the market risk of the bonds, and the short-term holder assumes the credit risk of the securities. The credit risk is minimized through the use of insurance or guarantees. The market risk for La Salle Bank is hedged with derivatives. Historically, this strategy has worked well for both money market funds and TOB programs. This type of funding has been useful in filling the “gap” between demand and available supply for the Money Market funds.

Auction Rate Securities
Closed-End funds and Municipalities both issue auction rate securities. The Closed End funds primarily fund their leverage through the issuance of Auction Rate Preferred (ARP’s)securities. These are high quality securities that are secured by the assets of the fund. These are not money market eligible securities, because their liquidity is not guaranteed by anyone. Instead, the rates and liquidity are set by an auction process. Auction Rate Preferred’s are purchased mostly by individuals and corporations. Municipalities issue Auction Rate securities (MAR’s) that are also not money market eligible for the same reason as the ARP’s. These securities are usually either credit enhanced by an insurer or bank, or are of very high quality.

Crisis In Confidence
The huge write downs by municipal insurers of CDO’s with sub-prime exposure has called the creditworthiness of the insurers into question. The rating agencies are imposing tougher rating standards and are calling for more capital from the insurers of municipal credits. Moody’s has downgraded FGIC from AAA to A-3 and Fitch lowered XLCA from AAA to A. This has led to serious disruptions in the short term muni markets. Money Market funds are only able to hold securities (Variable Rate Demand Notes) that are AA rated or better. These funds are not able to hold weaker underlying credits with an insurance wrap that might get downgraded below AA. This has caused Money funds to “put back” weaker credits whose insurers are likely to get downgraded.

In the Auction Rate market, many auctions have recently failed. This is due to liquidity concerns, rather than credit concerns. Dealers have been unable to provide enough liquidity for all of the auction rate securities. Roughly $10 billion of auctions failed during the last 2 weeks. The sudden lack of confidence in the auction process has led this market to unravel. This is causing financing costs to increase for issuers of these types of securities, because when an auction fails the holder of the security gets the maximum rate payable according to the original documents. These rates have been as high as 12-20%. This is causing issuers to look for alternative modes of financing instead of using the Auction Rate marketplace.

Recent Developments
We have noticed these developments due to the distortions in the short-term muni market:

1. There is extreme pressure on banks, dealers, and hedge fund TOB programs due to downgrades of securities that can no longer be funded in the short-term markets. There is constant fear that these programs will be or are unloading long munis to unwind trusts due to downgrades. There is also pressure caused by increased financing costs for these programs. Cheap funding in the money market arena has given way to much higher financing costs. This increase in costs has made the carry trade unprofitable for some hedge funds, which has led to liquidation of some of their long bond holdings. This has caused the long end of the market to underperform relative to Treasuries.
2. Issuers are searching for ways to lower soaring financing costs of Auction Rate securities. Some of these will be converted to VRDN’s and will be bought by the Money Market funds. Others will be reissued as long term debt. Since rates are low on an absolute basis, we expect many of these loans to be converted to long term bond deals.
3. There is now a severe shortage of acceptable money market eligible paper for the funds to purchase. This has led to short-term rates for quality paper falling rapidly to levels around 1%. This is below levels that are justified by current tax rates for taxable accounts. Money has continued to flow into Money funds during this recent scare. Assets are now up close to $500 billion.
4. The Auction Rate market has suffered a serious setback from the large number of failed auctions. Some investors, who are not concerned with liquidity, have been attracted by the high rates currently available in this market.
5. The muni yield curve has continued to steepen which will provide an incentive to investors to extend to pick up yield when the market returns to normalcy.

Conclusion
Guarantees of liquidity and credit are an integral part of the short term muni market. The current disruptions have been caused due to concern about the credit-worthiness and dependability of these guarantees. This has led to a contraction in the supply of capital as a funding mechanism for carry trades. We do not expect this shift in supply to be reversed any time soon. This will make it much more difficult for TOB’s to do carry trades in the future.

Ambac Insured Auction Rate Securities

2008-01-24T10:11:00.000-08:00

What Do I Own?
Some investors have become concerned because they own securities that are AMBAC insured and Fitch recently downgraded the insurer to AA from AAA. We are not particularly concerned about munis that are strong credits on their own. However, there may be instances when an investor should be concerned.

The example below is for Arizona Public Service Company and is in a weekly Auction Rate mode. It is important for the investor to understand what this security is in order to determine if it is a suitable investment for him/her. A weekly Auction Rate security has a rate that resets weekly. This rate is determined by an “auction” process. The stated maturity is shown to be 6/1/2034. This security is not deemed to be Money Market Fund eligible because a money fund can normally only invest in maturities out to a little over 1 year. It is possible, but highly unlikely, in the event of a failed auction that the investor would end up owning a security with a maturity in 2034, instead of a money market alternative. The underlying credit quality of APS is BBB-. This is shown in the Bloomberg screen shot below. While it is normally unlikely for an auction to fail, the current stress on the guarantors (in this case AMBAC) and the weak underlying credit quality of APS increase the possibility of this unlikely event occurring.

We have avoided these securities and invest in Variable Rate Demand Notes instead. These securities are money market eligible because the liquidity to put them back to the dealer on 7 days notice is guaranteed.

Conclusion
We would caution investors to be aware of the risk of a failed auction on a weak underlying security that is guaranteed by an insurance company that cannot maintain their AAA rating.

Variable Rate vs. Auction Rate

2007-12-12T09:01:00.001-08:00

Auction Rate Preferred’s
Many individuals and corporations use Auction Rate Preferred’s (ARP’s) instead of money market funds. These securities are typically viewed by most investors as a money market substitute, but there are some important characteristics that make them different from a true money market instrument. In fact, these securities are not money market eligible securities for money market funds.

Most money market funds invest in Variable Rate Demand Notes. These trade in $100,000 denominations. The rates normally reset weekly by the service provider who is the dealer that has the floating rate securities. The investor has the option of putting back these floaters to the dealer by giving 1 week’s notice. The security is normally credit enhanced by either an insurer or a bank. The liquidity (ability to put back the security) is normally guaranteed by a bank. These VRDN’s are bought and sold at par (100).

An auction rate security is reset by an auction process. The dealer does not set the rate on the security. It is possible (but highly unlikely) that there could be a failed auction. In the event of a failed auction, the investor would own the security to whatever the stated maturity might be. It is this possibility that makes ARP’s ineligible for money market funds.

VRDN’s are normally sold by institutional sales people who trade them in large size. ARP’s are normally sold by middle market and retail sales people in smaller-sized pieces than VRDN’s. The sales credits paid to market ARP’s tend to be higher than those for VRDN’s. This helps to explain why the yields on the Auction Rate products have tended to be lower than those for Variable Rate securities. This is shown in the chart below. The average spread has been about 4 bp’s in extra yield for the VRDN’s. Recently, this situation has changed. This change and the absolute level of rates is shown in the table below. ARP’s are now yielding about 80 bp’s more than VRDN’s. We believe there are 2 reasons for this change in the spread. First, there is a high degree of uncertainty in the money market at the present time. Investors are attempting to reduce risk in all their money market holdings. They are now realizing there is “auction” risk and are commanding more of a premium for holding

ARP’s. Secondly, many corporations desire to reduce their holdings of ARP’s over year end, because they are treated as longer maturity investments on their books. This has resulted in dealers carrying unusually high amounts of these securities coming into year-end.

Conclusion
We would expect many of these corporations to repurchase the ARP’s they have sold after the first of the year. However, we would expect the spread between these two short-term instruments to be greater for the ARP’s than VRDN’s into the foreseeable future.

The Guarantors

2007-11-13T10:36:00.000-08:00

The Insurers

There has been considerable attention devoted to the Sub-Prime Mortgage crisis and the exposure of insurers such as MBIA, AMBAC, FGIC, and XLCA to this sector. The stocks of these companies have been hit particularly hard during the recent flight to quality rally in the treasury market. The chart below shows the price activity for MBIA during the last year.

Click on the picture for a larger view.

The stock is down roughly 50% during the last month. The stocks of AMBAC and XLCA are down even more during this same time period. The negative news surrounding these firms due to the large losses they have taken and their large Sub-Prime exposure are causing investors to question the value of insurance and the ability of these firms to cover potential losses.

Muni Bond Insurance

The insurers play a major role in the Muni market. Over 50% of all financings come with credit enhancement such as insurance. Most retail investors have come to rely upon insurance when investing in tax-free bonds. The large scale deterioration in the credits of the insurers is causing investor anxiety and raising questions as to the quality of each insurer and their ability to pay. This problem is exacerbated by falling confidence in the rating agencies to properly rate these firms.

Rating Agency Review

Fitch released a special report on 9/2/2007 which outlined the current state of the insurers. In early November, they announced a further review of the guarantors’ ability to withstand the stress of continued deterioration in the Sub-Prime market. This study should be completed in about a month. The September study showed the Capital Adequacy Ratio for each of the major insurers. These ratios need to be met to maintain the AAA rating. The chart below shows these ratios. The only company that does not meet the minimum in this chart is Radian, which is already rated AA. Fitch and Moody’s are both doing additional reviews which will

Click on the picture for a larger view.

include further analysis of the insurers’ exposure to the weakening Sub-Prime market. The table below shows their preliminary findings of the likelihood that an insurer will need to raise additional capital or use reinsurance to reduce their exposure. CIFG and FGIC show a high likelihood of needing more capital to maintain their AAA rating. If it is determined that an insurer needs more capital, Fitch will give them 30 days to comply before downgrading them to AA.

Click on the picture for a larger view.

Click here for a PDF of this article

Munis: Kentucky vs. Davis Part 2

2007-11-01T11:16:00.000-07:00

The Supreme Court

The Supreme Court will hear arguments concerning the Davis v. Department of Revenue of Kentucky next week on 11/05/2007, with a ruling expected in late spring of 2008. The Davis’s have challenged the existing system of preference given by the State of Kentucky to the ownership of in-state municipal securities whose interest is not taxed, while taxing the interest earned on out-of-state municipal bonds. The Davis argument is that the current practice of offering preference to in-state securities is discriminatory, and is a violation of the dormant commerce clause, which gives Congress the right to regulate interstate commerce. The Kentucky appellate court agreed with the Davis’s.

Supporting Opinion For Davis

Alan D. Viard from the American Enterprise Institute recently wrote an amicus brief in support of the Davis’s. This brief is an excellent example of the case in favor of the Davis’s. Mr. Viard’s brief is entitled, “The Dormant Commerce Clause and the Balkanization of The Municipal Bond Market”. We have provided a link to his paper for your convenience. The primary legal argument for the Davis position is that the tax is discriminatory because it favors within-state sales over interstate sales. Several cases are mentioned that support this argument. Each case quoted dealt with a corporation that was being taxed unfairly which impeded their ability to compete in a state. The trading of securities is a form of commerce, and since muni bonds are securities they should be subject to the dormant commerce clause. Since only Congress has the right to regulate interstate commerce, the current system of taxing muni interest in Kentucky is unfair and should be changed. Mr. Viard also attempts to make an economic case against the current tax treatment of municipal bond interest in this same amicus brief and concludes that “the U.S. Supreme Court can strike a decisive blow for free interstate trade in the nation’s financial markets”.

The Argument Is Flawed

The very title of the brief refers to the “Balkanization” of the municipal bond market. One normally thinks of Balkanization as the creation of a fragmented group of hostile or non-cooperative states. This is most certainly not the case here. In a coordinated effort, every state petitioned the court to overturn the Davis ruling. Even states that have no state income tax are in favor of maintaining the status quo with each state offering preferential treatment to bond interest earned from in-state muni securities. This case is not about a company being unable to compete in Kentucky because of unfair tax practices and, thus, suffering economic loss as an injured party. Rather, this case is about taxes, and the right of a state to tax bonds differently. One could say that the injured parties from Kentucky’s current practice are the other states. But these states claim no injury and support the current system. States exist to further the public interest of their region. They have taxing power and create laws to further the public interest. Taxes are inherently often discriminatory. For example, does it seem fair that single people pay higher tax rates than married people? We feel that this is also a case about the rate of interest paid on a local security. Most states encourage investment in local muni bonds, because this investment strengthens communities and benefits the public interest. Encouraging investors through economic incentives helps to lower the net interest cost paid by local borrowers.

Conclusion

It is always risky to predict the outcome of a Supreme Court case, because it is impossible to know how the court will rule. We believe states should have the right to tax their residents, and it is not the Supreme Court’s job to rewrite our existing tax system. Next week the oral arguments begin. Will the Supreme Court agree with us? We will find out by next summer.

Click here for a PDF of this article

Current Credit Crisis Compared to Long Term Capital Management

2007-09-20T09:47:00.000-07:00

Long Term Capital Management

It is interesting to compare the current credit crisis to October 1998 when Long Term Capital Management created a similar predicament in the credit markets. The table below shows the Fed in a tightening mode prior to September 1998 when LTCM exploded.

(Click below to Enlarge)

The Fed quickly cut rates 3 times during September-November, reducing the funds rate from 5.50% to 4.75% until the crisis was averted. The chart below shows the rise in yields after the Fed began to ease.

(Click below to Enlarge)

Yields continued to rise into January 2000. During this time, the yield curve steepened and the economy continued to grow. The Fed had to reverse gears and tighten again beginning in June of 1999. The premature easing that took place because of LTCM proved to be an ill founded decision for the Fed.

The Current Economic Cycle

Fixed income investment returns are closely tied to inflation and economic growth. We monitor the Index of Leading Economic Indicators (LEI) as a barometer of future economic strength, and the GDP Price Deflator as a measure of inflationary trends. The chart below shows the LEI for the period from December 1995 to the present.

(Click below to Enlarge)

The index showed no signs of slowing until early 2000. This would have been a red flag that the Fed was easing prematurely. The current situation is somewhat different. The LEI has been moving sideways since the end of 2005. We will be monitoring the LEI closely for signs of future strength or weakness. If the index begins to rise, this would be a negative for bonds. Inflation has weakened somewhat, but is still near the upper end of the Fed’s target of 2%. Recently, inflation has been showing signs of slowing. If it begins to accelerate, we would view this as a negative for bonds. Gold and oil have both been rising, which is a red flag that the Fed is easing while inflationary pressures may be building.

Conclusion

The Fed has made a pre-emptive strike by lowering rates. It is unclear if this is good for bonds. The initial reaction is not encouraging, since the long bond has sold off about 1.5 points since the announcement. The bond market is concerned that the Bernanke Fed may be lowering rates when inflation is still not under control. Time will provide us with the data to see if this was a wise decision. Hopefully it isn’t an over-reaction to the current crisis similar to October of 1998 when the Fed eased because of Long Term Capital Management even though the economy was strong.

Muni Exchange Traded Funds vs. Mutual Funds

2007-09-19T11:29:00.000-07:00

ETF’s

Exchange Traded Funds have become increasingly popular in recent years. These funds are for the most part passively managed, track indices, and have low expense ratios compared to the average mutual fund. ETFs can be traded intraday, shorted, and bought with margin. Mutual Funds do not offer the same features. There are no size minimums to invest in ETFs. This makes them popular with smaller investors. Exchange Traded Funds are usually a more tax-efficient vehicle than mutual funds because they don’t realize gains or losses when selling securities. ETF’s can be concentrated to give an investor exposure to a specific segment or market, such as precious metals, single countries, foreign currencies, and U.S. Treasury Bonds. It should be no surprise that the ETF has finally discovered the Muni market.

The Muni Bond Market

The Municipal Bond market is a highly fragmented market of over 50,000 different issues. Last year, there was total issuance of $388 billion from 12,706 different deals for an average size of $31 million per deal. The market is a collection of regional markets. Each state has different tax rates and different infrastructure needs. The Individual Investor (as a whole) is the largest investor class of muni bonds accessed via individual securities, separately managed accounts, mutual funds, and closed-end funds. These investors typically purchase munis because of the tax advantages of owning tax-free bonds.

Historical Problems Creating Muni Indices

The fragmentation of this market has caused problems in the past with the creation of a viable index for munis. Due to the wide bid/ask spreads and tax consequences of trading, individuals tend to buy and hold muni bonds to maturity. This strategy means that after a bond deal is issued, the amount of trading in that security diminishes rapidly over a short period of time. This makes price determination difficult for any individual security, because actual trades do not take place. It is this lack of actual price determination through trades that has caused problems with Muni indices in the past. This was evident with the Muni bond contract. The CBOT finally stopped trading this contract in 2006, because of problems with the index that led muni dealers to look for alternative hedge vehicles to hedge their inventory.

There are currently several indices money managers use to measure performance which work well for their purposes. These indices are priced daily and are meant to reflect changes that have taken place in the market. The CBOT muni index was a live index that needed to be priced continually. The current plan is to price the relevant ETF index on a daily basis. Most ETF’s in other markets trade continuously and can be compared to a transparently priced index which also trades continuously, such as the S&P Index. Without transparent continuous pricing, muni ETF’s may be subject to some of the same issues that brought down the CBOT muni contract: manipulation by hedge funds and lack of pricing relevancy.

Portfolio Construction And Performance

The ETF faces constraints which will affect its ability to offer good value to its shareholders. The ETF must only purchase bonds from large deals. The table shows the different size limitations of the deals they may purchase. This will limit their ability to invest in any cheap smaller regional issues that may come to market. The purpose of this restriction is to make sure they are investing in liquid names. There are also limitations as to the issue’s purpose. For example, some ETF’s can’t invest in tobacco bonds, hospitals, or housing bonds. Neither one can invest in AMT bonds.

ETF Advantage May Not Apply to Muni Investor

Marginal tax rates determine the attractiveness of muni bonds for any given investor. High Net Worth Individuals with significant levels of taxable income find munis especially attractive. These investors normally have large sums of money to invest and don’t benefit from the ability to invest small sums of money in an ETF. There may be adverse tax consequences of selling holdings in these funds, so it is unlikely that the ability to liquidate holdings intra-day would offer much benefit to these investors. When we compare the tax free ETF to Vanguard mutual fund, we see little benefit to purchasing the ETF, and our guess is that the ETF will have difficulty generating higher returns than the mutual fund because of its constraints.

Conclusion

It will be interesting to see how successful the muni ETF is in the future. We expect this success to be somewhat dampened due to difficulties in index construction and the nature of the muni investor.

Click on the table for a larger view

The Case for Intermediate Treasuries

2007-08-27T09:45:00.000-07:00

Taxable Fixed Income

For most conservative investors, an intermediate bond strategy represents a sound choice. There are advantages to this strategy compared with either holding cash or long-term bonds. Intermediate US Treasuries have offered significantly higher historical returns than 30 day T-Bills with little additional risk, and have provided annual returns that are only slightly less than long US Treasuries.

A History of Returns

Fixed Income and Equity returns are readily available for the last 81 years through data compiled by Ibbotson. The table below shows a comparison of returns for Intermediate (5 Yr) and Long (20 Yr) U.S. Treasury bonds for the period 1926-2006.

The Long maturity treasuries outperformed shorter bonds by .30% (5.60-5.30%) annually.

Intermediates, thus, captured about 95% of the return of the Long bonds. During this period, Intermediates outperformed the 20 Year bonds in 44 out of 81 periods or about 54% of the time. Long bonds had 21 periods of negative returns, while Intermediates only had 8. Thus, 5 Yr treasuries had positive returns 90% of the time. The duration or market risk of these bonds is compared in the chart below.

An Intermediate treasury has about 37% of the risk of a Long bond. This implies that the risk/reward of owning Intermediate bonds is very attractive when compared to Long bonds. The chart below shows that Intermediates have captured 95% of the return of Long bonds, while taking only 37% of the market risk during the last 81 years.

Conclusion

Portfolios consisting of intermediate maturity taxable securities are suitable for conservative investors’ fixed-income portfolios. These portfolios have generated positive returns about 90% of the time, are much less risky than portfolios of bonds with long maturities, and capture most of the return of a long bond portfolio. While we cannot guarantee that history will repeat itself, there is certainly a compelling case for investing in Intermediate Bond portfolios. This is a non-market-timing strategy that works well when combined with other riskier asset classes. The bonds provide income and dampen the volatility of the overall portfolio.

Why Not Manage A Bond Portfolio For Income?

2007-08-16T11:38:00.000-07:00

Role of Bond Portfolio
Most investors own bonds to provide income and to dampen the volatility of the overall portfolio. We manage our bond portfolios for total after-tax return in order to accomplish both of these objectives. Some investors view their fixed-income portfolios solely as a source of income. The income approach to the portfolio often leads the investor to underestimate the additional risks that they take, and is a less desirable approach to managing bond portfolios. Income is only half of the equation. The total return of any bond is the income plus the price change. Income without consideration of the change in asset value is of particular concern when investing in low quality bonds. These bonds have a high correlation to equities. This means that an investor with a large position in these types of bonds has done little to dampen the volatility of the overall portfolio, because when stocks go down, high yield bonds go down as well. This is contradictory to the basic principle of diversification. The investor has added to his equity risk, rather than reduced his risk.

Increased Risks From Income Approach

Credit Risk
Lower rated riskier bonds generally have higher yields. Investors that are chasing yield often end up with these securities. It is similar to a bank robber who gets caught. When asked why he robbed banks his answer was, “because that is where the money is!” Junk bonds are like a magnet for investors who are only looking at the yield the bond might pay. There is no riskier strategy for most individual investors than to take too much credit risk. Why risk 100% of your money to get an additional 1% return? We advise investors to avoid credit risk, and put that money into a higher return asset class, such as equities, where the potential returns are much higher.

Inflation Risk
Some investors may say “when rates are at 5% I am going to put my money into long bonds and forget about them”. This leads to increased market risk and the risk that inflation will erode their future earnings stream. Economic conditions need to be monitored to make sure that inflation doesn’t become a problem again. A better strategy is to have some shorter maturities so that if rates rise maturities can be reinvested in higher yielding securities, and some longer maturities to help protect the income stream in case rates fall.

Reinvestment Risk
In the search for additional yield it is not uncommon for investors to ignore call features on the securities they purchase. This leads to reinvestment risk. A long bond with a short call is very undesirable. If rates rise you are locked into a long maturity at a low yield. If rates fall you have your bonds called away. Either way the investor loses. Who wants to play that game?

Tax Risk
Often muni bond investors will buy bonds that are subject to the Alternative Minimum Tax. These bonds pay a little higher rate than a regular muni, but the consequences of owning the AMT bond are disastrous if the taxpayer’s status changes and he/she finds themselves subject to the AMT. In that case, the interest is then taxed as if it were a taxable bond. We have found that most investors are better off not purchasing AMT bonds.

Components of Total Return That Are Ignored

Yield Curve Shifts
Prices in the bond market change daily. We call these changes in market value due to changes in yield for each maturity, yield curve shifts. When the bond market is volatile, these shifts are a significant part of total return.

Changes in the Composition of the Yield Curve
When money is tight, the yield curve normally flattens. When the Fed eases, the curve normally steepens. These changes are important aspects of the portfolio’s return. Sometimes the best strategy is a barbell strategy. This works well in a flattening curve environment.

Credit Quality Spreads
After tightening during the last 3 years, quality spreads were recently blown out to more traditional levels. Holders of virtually all high yield bonds saw significant declines in the value of their holdings. While these bonds declined in value, high grade bonds rose in value. We experienced a flight to quality rally in the U.S. Treasury market.

Conclusion
Bond performance consists of two parts, income and price change. It is a mistake to manage a portfolio only for income, because income is only half of the story. This approach often leads to higher levels of portfolio risk, and poorer relative performance than a total return approach. This is not the style of most professional bond managers. So, who would take this type of approach? We see this style primarily when an individual is managing his/her own portfolio and is working with a broker who is selling them securities. These individuals are captivated by the higher yields, and don’t know that there is more to managing a bond portfolio than clipping a big coupon.

Bond Insurance:MBIA

2007-07-26T16:36:00.000-07:00

Insurance Risk
Last year, over 60% of all Muni Bond issuance was credit enhanced by either insurance or bank LOC’s. Since a guarantee is only as good as the one who guarantees it, the credit-worthiness of an insurer is very important. Last month, Barron’s ran an article about MBIA insurance. In the article, Pershing Square Capital Management justified their short stock position in MBIA by saying the insurer has significant exposure to the sub-prime mortgage market, delinquencies are on the rise for these loans, and MBIA’s insurance exposure is much greater than the rating agencies would like for you to believe. As fixed income money managers, we are less concerned about how well the firm’s stock does. What matters to us is the company’s ability to pay claims as well as the likelihood they would be required to pay these claims.

Breakdown of Insurance In Force

Insurance exposure can be broken down into the following categories:

U.S. and Non-U.S. Public Finance
U.S. and Non-U.S. Structured Finance

The chart below shows the amount and the relationship of this exposure. Default studies would suggest that the exposure to Public Finance is quite manageable. Total Public Finance insurance in force was $706.3 billion at the end of 2006.

The insurance in force for Structured Finance was $254.5 billion for the same period. This includes:

Collateralized Debt Obligations (CDO's)
Mortgage-backed Home Equity
Mortgage-backed Other
Mortgage-backed First Mortgage

The next chart shows the breakdown percentages for Structured Finance. According to a recent S&P report, MBIA has $5.78 billion of sub-prime exposure in Mortgage-backed securities, and about $431 million is speculative.

The chart shows 62% of their Net Insurance for Structured Finance is in CDO’s. The same S&P report said MBIA has $16.605 billion of Insurance Exposure to CDO’s with sub-prime exposure, and $2.059 billion of this is for sub-prime mortgages. If we combine this total with the $431 million of speculative Mortgage-backed, the total is $2.49 billion of sub-prime insurance written by MBIA.

Ability to Pay

S&P calculates the ability to pay this insurance exposure by looking at the following:

$13.3 billion in claims paying resources
$6.6 billion in qualified statutory capital
$819 million in earnings last year

S&P argues that any future claims are likely to be less than 1 year’s earnings. Their reasoning is that the firm’s exposure to $431 million of speculative grade sub-prime mortgages is about 6.6% of total statutory capital ($6.6 billion), and less than half of 2006 earnings. We find some problems with this analysis because:

1. None of the $2.059 billion in CDO sub-prime exposure is included in their analysis
2. Default rates for higher quality sub-prime Alt A mortgages are also rising. Currently, 2.9% of these mortgages in CDO’s are 60+ days delinquent and 1.08% are foreclosed.

Conclusion
It is easy to see how MBIA’s earnings may be negatively affected in the future due to increasing default rates in the sub-prime area. However, as bond holders we are more concerned about the firm’s ability to pay and maintain their AAA rating. We still have confidence in MBIA’s ability to pay, but feel deteriorating credit conditions are much worse than S&P’s report would suggest. The rating does not appear to be in danger at this point, but we would rather invest in underlying securities unlikely to ever need the insurance. We feel bond insurance is good when there is a localized event, such as Hurricane Katrina. Investing in junk and relying on insurance to bail you out if something goes wrong is not a formula for success. Insurance is no substitute for research if global credit conditions worsen.