Minute in the Market

Why Own Bonds?

After a summer of falling market values amid fears of Fed “tapering,” news of wobbly sovereign debt in Greece, Cyprus, Slovenia, Puerto Rico and elsewhere, plus bankruptcy filings in Detroit, San Bernardino, and Jefferson County, Alabama, many investors are reducing the percentage of bonds in their portfolios or avoiding them all together as an asset class.  Why the trepidation? Given the current market conditions, yes, many types of bonds will perform poorly.  This poor performance can be exacerbated for those who have been chasing yield or those who have sought to invest in bonds via pooled investment vehicles (i.e. mutual funds).  Nevertheless, there are still very good reasons to include bonds as an asset class in investors’ portfolios, provided they are bought prudently and managed capably. In short, not all bonds will perform the same.  Investors and their advisors need to understand how to find the good ones and avoid the bad.
 
The fundamental reason for including bonds in virtually any investment portfolio is that they are a great diversifier, reducing volatility and providing an important source of liquidity.  Historically, returns from bonds are only modestly correlated with those from stocks, meaning that they often do well when stocks do poorly, and vice versa [see table].  When asset classes exhibit low correlations, overall investment return volatility is reduced and risk-adjusted returns are increased.  As you can see from the table this has been the case for the past ten year and much of our country’s financial system existence.  Bonds belong in investors’ portfolios for the long run.

Thoughtful long-term investors need to look beyond the performance of the past quarter, which was the result of a market that had become much too dependent on continued Federal Reserve monetary stimulus delivered through bond purchases.  Bond prices had been driven to historic highs, and yields to historic lows, by a flood of Fed money intended to goose economic growth.  Last quarter’s market price decline should be viewed as a much needed correction, but not an argument for dumping bonds in their entirety as an asset class.

Remember, bonds are a contract in which investors’ loan money with the promise that principle will be returned plus interest payments.  Losses on bonds are only realized when a bond is sold at a lower price than where it was purchased or in the event of default.  This highlights the necessity of assessing credit quality effectively to avoid defaults, or hiring a manager that can do that for you.  Moreover, investment grade bonds provide an important source of liquidity that is vitally important in times of volatility, market dislocations or changes in personal circumstance. 

As a matter of fact, bond holders who adhered to two basic principles have done very well, both over the longer term and by comparison with their investing peers over the past quarter.  The two saving principles are:

1. Care in the selection and oversight of credit.  The primary objective of buying bonds is to be repaid – an elementary objective that is often ignored by buyers of dicey securities offering higher yields.  Think Puerto Rico bonds.  As to market-price performance, it is basic to bond mathematics that longer maturities are correlated with greater market-price volatility.  When investors scrambled for the exits in response to Chairman Bernanke’s musings about tapering the pace of the Fed’s bond investments, the inevitable result was a bit of panic and a consequent price decline.  

2. Strict discipline as to maturities and portfolio structuring.  The worst losses have been sustained by investors who, in their lust for additional yield, invested in bonds of dubious credit quality and lengthy maturities or a combination of both.  Holders of bonds with shorter maturities incurred much smaller (or no) paper losses and will continue to earn reasonable income until their bonds mature, at which time they will be able to reinvest at higher yields and produce even greater recurring income.  When done in this manner, bond investing is both rewarding and a great diversifier against stock price volatility.

Finally, when compared globally, the U.S. economy continues to improve, albeit at a modest pace.  The Eurozone is also slowly coming out of recession, although the economic vitality of the area is impaired by high social overhead costs and by the still-unresolved financial difficulties of the southern area economies.  Economic conditions in China and in the emerging markets are unstable and expose investors to sovereign risk.  Given this backdrop, rising stock pricing potential would appear to be limited.  So where is an investor to turn?  We can’t help those who are looking for The Next Big Thing, but for those of you who are looking for prudent, consistent investment performance and capital preservation, we suggest that you take a good, disciplined look at high-quality bonds with reasonable maturities.  We think you’ll find them still worth the investment.

City of Detroit Files For Bankruptcy Protection

Yesterday the City of Detroit applied for Chapter 9 bankruptcy protection.  It is the largest municipal bankruptcy in United States history.  SNW Asset Management clients do not own any City of Detroit obligations as we have never been buyers, and we proactively sold out of inherited positions well in advance of any announcement of payment default or bankruptcy.  To provide a sense of scale, the City of Detroit’s bankruptcy, at $18.0 billion in secured and unsecured debt is almost four and half times larger than that of the Jefferson County, AL bankruptcy, which was the second largest U.S. municipal bankruptcy.  The next step in the process is an automatic stay which will freeze any debt payments.  The city doesn’t need approval to continue public services. For example, the police, fire, water, sewer and public works are completely unaffected by the bankruptcy filing for now, and will operate as usual.  The bankruptcy filing is likely to be a long drawn out process.  If the federal bankruptcy judge authorizes the City to move forward with a bankruptcy case, then a reorganization plan will emerge. This could take weeks, months or potentially years.  Bankruptcy court allows the city to restructure its operations and its balance sheet, which could involve budget cuts, layoffs, consolidation, slashing union contracts, selling assets and dramatically reducing city debts, including outstanding bonds.  This will result in a likely impairment to the City’s unsecured bonds, but it is unknown how the secured debt will be impacted.  

What does this mean for the municipal bond market?  Low-investment grade rated general obligation (A3/A- or lower) bond spreads will likely widen, which may create opportunities for us to use our credit expertise to find value among the cast-offs and specifically low rated Michigan State credits.  Whether this announcement pushes more retail investors out of the municipal market (creating a larger market sell-off) is yet to be seen.  Systematic market risk could be benign due to the fact that Detroit's debt represents a small portion of the $3.7 trillion municipal market.  However, a broad sell-off like we saw in 2010 in concert with rising interest rates could create an opportunity to marginally increase duration in tax-free bonds at mispriced valuations.  SNWAM will continue to monitor the situation for its impact on the municipal market landscape and keep you apprised of any material information.

Thoughts Surrounding Recent Market Volatility

The recent bond market volatility has generated many questions on the market and on fixed income investments in general.  The market has been trading with heightened volatility as investors attempt to position themselves ahead of potential Fed action.  We saw Treasury yields rise last week as the Fed hinted at a potential reduction of quantitative easing later this year.  Interestingly, the investors who are suffering the most are the same investors who were “reaching for yield” throughout much of the past two years.  Leveraged and/or riskier products such as closed-end funds, long duration bonds with 20+ year maturities and corporate bonds with weak underlying fundamentals are the investments being hit the hardest.  An example is 30 year TIPS (treasury inflation-protected securities), which are down 22% since being issued in February.  It is important to note that SNWAM has resisted this reach for yield and does not hold these types of investments in our client portfolios.  We have positioned portfolios in a very conservative manner, with a majority of holdings maturing in the next five years.  These holdings have held their value in this selloff and remain an anchor for portfolios in this environment.  In a sense, we have positioned our clients for this very market. We continue to focus on the fundamentals in the economy, particularly inflation, which remains subdued.  Economic data are not pointing to an extremely robust jobs picture and/or inflationary environment at this time.  Both our assessment of the economy and the view of our investment committee are that the economy is growing slowly. Consumer spending is stuck, growing at roughly 2%, and we are seeing few catalysts for that changing any time soon.  While we could certainly see long rates spike higher on concerns about Fed policy, it is unlikely that we will see a sustained rise in rates without significant improvement in the economy. We are being patient in this market and waiting for opportunities to take advantage of the selloff.  Our shorter maturing bonds act as dry powder, in the sense that they are ever-ready liquidity options to sell and move into bonds trading at what are becoming attractive levels.  We consistently tell our clients that we look forward to periods of market volatility, as it allows us, as investors in individual bonds, to capture the gains associated with forced selling from leveraged and pooled product investors.  Don’t panic, stay disciplined and stay tuned.

The States in FY 2012: Mostly OK, But Serious Problems Are Looming

Asset Management recently completed a comparative credit review of 29 states plus the Commonwealth of Puerto Rico.  Our sample includes (1) states such as California, Idaho, Oregon, and Washington, where many of our clients reside and invest; (2) nearby states, such as Colorado, Arizona and Utah, with strong economies and favorable credit characteristics; (3) states such as Florida and Texas, which have no personal income tax (and, therefore, no tax shelter inflating the prices of their debt) and issue large volumes of debt; (4) various other states that offer good economic performance along with conservative debt management practices; and (5) “headline” jurisdictions, including Connecticut, Illinois, New Jersey, and Puerto Rico, in which we have no investment interest but that demonstrate many of the fiscal and debt issues resulting from weak or inattentive management. Overall, we are seeing stable trends in operating performance, but looming challenges continue to manifest in the form of pension costs and OPEB liabilities, which are still growing at a worrisome pace.

Our methodology for conducting this analysis involved the use of government-wide accounting statements which include various component units as well as the states proper; this methodology enabled us to compare “apples-to-apples” results for the states and associated entities.  We used FY 2012 data for 26 states.  Illinois, New Mexico, Puerto Rico, and South Carolina have not yet released 2012 accounting statements, so we used 2011 data for those jurisdictions.
We collected two broad types of data: (1) measures of fiscal performance (chief among them operating data and measures of liquidity), and (2) debt statistics, consisting of outstanding bonded indebtedness, unfunded pension liabilities, and unfunded liabilities for post-retirement employee benefits (“OPEBs”).  Here are the highlights of our findings:

Fiscal Performance:
In general, the states in our sample performed satisfactorily in FY 2012, much like they did  in FY 2011, though perhaps not as well as we would have hoped given the slow but steady improvement of the nation’s economy.  Aggregate government-wide expenditures in our sample states dropped by 1.1% in FY 2012 versus FY 2011, but the overall ratio of revenues to expenditures was also lower – 101.1% in 2012 versus 102.4% in 2011.  The states managed to cut expenditures, but revenue growth was anything but robust.  The result was a minor squeeze on liquidity, as cash and investment balances dropped from an average 28.0% of government-wide expenditures in 2011 to a still-comfortable 24.8% in 2012.  Nevertheless, the best one can say is that, on the fiscal side, the states did no better than okay in 2012, and it is probable that state finances will not improve materially in the future, absent a pick-up in the pace of the economic recovery nationwide. 
Some states did not do okay in 2012.  California, Connecticut, Hawaii, Illinois, Maryland, Massachusetts, New Jersey, New York, and Puerto Rico ran government-wide deficits.  Seven of these eight jurisdictions also ran deficits in 2011 (Massachusetts being the exception).  Four of them – Connecticut, Illinois, New Jersey, and Puerto Rico – continue to report large negative net worth numbers.  On a more positive note, those states in which SNWAM’s clients, and bond-buying, is concentrated, did well.  For example, among the states of most interest to us and to our clients, Florida ranked second best for liquidity, Idaho fourth, Utah sixth, Oregon eighth, and Washington twelfth.

Debt Metrics:
By now most investors understand very well that the line-up of potential claims on the future financial resources of the states includes exposure to pension and OPEB liabilities as well as to bonded indebtedness.  Accordingly, our study includes aggregate totals for all three types of potential obligations, ranked by per capita amounts and by percentage of personal income.  In the aggregate, the states in our sample borrowed freely in 2012, increasing bonded debt outstanding by 8.7% to a total of $831.8 billion.  Unfunded pension liabilities rose even faster, by 10.4% to $667.8 billion, which indicates that states must act much more decisively – and soon – to address the growth of these liabilities.  In contrast, aggregate liabilities for OPEBs were stable at $520 billion, reflecting better control of employee/retiree health care costs and enhanced funding of annual required contributions.  But much more must be done; average pension funding is running at 73%, and average OPEB funding is an abysmal 5.6%.  Considered in their entirety, potential debt/pension/OPEB obligations are huge, totaling $2.020 trillion, or $8,091 per capita and 19.1% of personal income across the sample.  Separately, bonded debt is $3,333 per capita and 7.9% of personal income; unfunded pension liabilities are $2,675 and 6.3%; and unfunded OPEBs are $2,083 and 4.9%.

The entities in worst shape are Puerto Rico (total unfunded liabilities $97.6 billion, $26,268 per capita and 161.7% of personal income), Illinois ($167.6 billion, $13,053, 31.0%), New Jersey ($146.6 billion, $16,058, 30.2%), and Connecticut ($68.5 billion, $19,095, 32.3%).  By way of comparison, the respective numbers for California are $304.3 billion, $8,099, and 18.5% -- not great, but clearly more manageable than those of the worst-ranking four.  On a less somber note, the states on which SNWAM focuses for our clientele rank much better: looking at debt plus unfunded pensions plus unfunded OPEB liabilities as a percentage of personal income, Washington ranks third best among the states in our sample, Arizona fourth, Florida fifth, Idaho sixth, Texas eighth, Utah ninth, Colorado tenth, and Oregon thirteenth – all in the better half of the sample.  California ranks nineteenth.

Conclusions:
While the FY 2012 fiscal performance of the states in our sample was okay at best, the continued rapid rate of growth in bonded debt outstanding and unfunded pension liabilities is cause for increasing concern.  We feel that these issues, which the municipal market has long regarded as a longer-term problem, will fall upon us sooner than many expect.  Bonded debt and unfunded pension liabilities, which grew at 8.7% and 10.4%, respectively, in FY 2012, are very “hard” liabilities involving contractual and vested rights that can be modified only with great difficulty, if at all.  OPEB liabilities may perhaps be “softer” legally, but they are likely to be nearly as thorny politically.  State and local governments need to direct serious attention to these liabilities sooner rather than later.  At SNWAM, we have for a long time been factoring these liabilities – and bond issuers’ attention both to controlling them and to funding them – into our appraisals of the credits we buy for our clients.  We will continue to do so, and with ever-increasing rigor, in the months and years ahead.

Then and Now: A Comparison of the 1994 Bond Market Sell-Off and Today’s Market

The recent improvement in the stock market and increase in US Treasuryyields have caused many market commentators to declare that the bull market in bonds is over.  Some have even gone so far as to say that there is the risk of a substantial rise in yields similar to what was experienced in 1994, which caused large losses for bond investors.  In this MIM, we will review what factors led to the rapid rise in yields in 1994, evaluate the similarities and differences with the current market and economic fundamentals, and finally, discuss what measures we can and are taking to protect our clients from a large rise in rates.