Coping With Spread Compression

Ever since the stock market began to rally in March, fixed-income investors have had to deal with “spread compression” as the feeling has grown that the nation’s economic low point may be behind it. Spread compression refers to the shrinkage of yield spreads between ultra-safe U.S. Treasury securities and other comparably-maturing investments, such as corporate, municipal, and federal agency obligations. As investor optimism improves, the extra yield which investors demand to hold securities other than Treasuries begins to dwindle because they feel more comfortable with the investment risk they have taken. For the last six months, this process has been present in full force in the fixed-income markets.



Consider the chart that accompanies this comment. It shows yields of actively-traded U.S. Treasury securities as of January and September, 2009, versus yields of A1/A+ bank bonds. Note that Treasury yields out to one year’s maturity have remained consistently close to zero, one consequence of the Federal Reserve’s recession-fighting policy. However, beyond one year, yields on Treasuries have risen while yields on bank debt have fallen – by a lot. In January, comparably-maturing bank debt yielded roughly 4.625% more than the 2-year Treasury note, 5.25% more than the 5-year note, and 5.125% more than the 10-year note. By early this month, the corresponding numbers were roughly 1.75%, 1.625%, and 1.75%, respectively. This same pattern has befallen yields of municipal and other corporate securities as well. Simply put, bonds other than Treasuries yield a lot less versus Treasuries than they did just a few months ago – in three words, classic spread compression.

How should investors react to this? Step one is to stay focused on credit risk. Credit spreads remain wide by comparison with spread levels in recent years, but investors are still close enough to last year’s panic to be fully comfortable with them. However, we at SNW Asset Management think that good credits remain attractive relative to comparably-maturing Treasuries. Step two is to look at the slopes of the yield curves in the chart. They remain strongly upward-sloping, meaning that longer-term yields continue to offer attractive differentials versus short-term yields. This may be largely a function of the Fed’s policy, which has effectively pinned short-term rates at zero. The Fed’s policy therefore incentivizes investors to move out the curve in search of reasonable yield. But, how far? Rates are still near decades-low levels, so it is dangerous to extend maturities too far, lest investors lock in current low yields for an unacceptably long period.

For SNW Asset Management, the right place on the yield curve seems to be longer than two years but not longer than four or five years. Depending upon the course of the economy, it may take the Fed a year or more to allow short rates to go higher, but, longer than that, any signs of economic recovery will surely push rates higher, towards more normal cyclical levels. For this reason, we think it is best to schedule investment maturities at recurring intervals between two and five years (or, in the muni market, between two and seven years). This is the strategy we think best combines reasonable current yield with protection from market-price deterioration if and when interest rates begin to rise. Investors do not want to go too long to adjust their portfolios at this point, because longer-maturing securities will suffer material loss of market value if rates rise substantially within the next 3-5 years.

Municipal Bonds Still offer "Sneaky-Good" Value

Everybody knows that the past six months have been simply awful for most investors.  There has been massive destruction of shareholder wealth, and even holders of high-quality financial sector bonds have absorbed substantial write-downs in the market value of their securities.  At the same time, yields on U.S. Treasury securities have been driven to 75-year lows.  Where is an investor to turn for reasonable yield along with stability of credit quality and market price?  Our clients who hold municipal bonds already know the answer to that question.  Municipal bonds have not shared fully in the price rally that has benefited U.S. Treasury securities.  In fact, for some time they have been priced to yield 100% or more of comparably-maturing U.S. Treasury securities, notwithstanding their exemption from federal personal income tax.  On the other hand, municipal bonds have not seen their market prices drop like financial-sector corporate bonds, and the tax adjustment adds substantially to their after-tax yield spread versus Treasuries and other taxable instruments such as corporate bonds.

SNW Asset Management has examined yields of municipal bonds rated low-double-A and high-single-A versus comparably-maturing U.S. Treasury securities as of June 30, 2008, September 30, 2008, December 31, 2008, and March 31, 2009.  Our current recommendation is to keep maturities relatively short in order to avoid locking in long-term yields at current ultra-low levels.  To be consistent with this recommendation, we looked at the yields for 3-year and 5-year maturities.  What we found was that, while municipal yield spreads versus Treasuries peaked around year-end, they are still at more than 100% of Treasury yields and still at levels which are as good as they were at the end of the third quarter of 2008,  after the Fannie Mae, Freddie Mac, AIG, and Lehman Brothers debacles.  To put this into perspective, since 1994, yields of five-year maturity municipals averaged only 82% of the yield on a similar maturity Treasury.  Bottom line: municipal bond yields still price in a bit of investor panic, and they still offer excellent yields versus comparably-maturing Treasuries.  How good?  An investor can add an additional 0.5% to 1.0% of yield annually, which equates to 1.25% to more than 2.25% when adjusted for exemption from federal tax at 25% and 35%, respectively.  For bondholders in states such as California, Idaho, and Oregon, where state income tax rates are substantial, the tax adjusted spreads are even higher on a tax-adjusted basis, because in-state securities are also exempt from state tax.

At SNW Asset Management, we believe that this attractive and substantial pickup in yield can be achieved without assuming material investment risk.  We are talking about relatively short-maturing bonds rated A1/A+ or better.  Bonds of this kind have so far held their credit ratings and their market values extremely well, and we think they represent one of the best risk-adjusted opportunities available in today’s fixed-income markets.