Maintaining a Disciplined Approach in Challenging Times

Fixed-income investors are now passing through the most painful and dangerous part of the interest rate cycle.  The pain is coming from the prolonged absence of investment yield.  It has now been almost two years since the Federal Reserve dropped its short-term rate target to 0-0.25%, effectively pinning all short-term yields near zero.  Longer-term rates have also dropped, particularly given recent doubts about the sustainability of economic recovery in the United States.  The danger arises from impulsive investors doing too much to add yield by assuming a substantially higher level of credit risk, or by extending portfolio maturities to capture the benefit of the upward-sloping yield curve.

We are now well into the Fed’s current policy cycle and Treasury yields are at historically low levels, so the potential for market-price increases in bonds is quite limited.  At the same time the markets have a history of anticipating (some would say forcing) changes in Fed policy.  For example, in the one-year interval between the Fed’s last cyclical ease in June 2003 and its first target rate increase in June 2004, yields on 5-year U.S. Treasury notes rose by more than 1.6% and on 10-year notes roughly 1.4% from their cyclical lows.  Market yields moved up well before the Fed acted.

SNW Asset Management has not been idle as rates have fallen, nor have we over-reached for yield.  Over the past 2 years we have opportunistically added yield through selectively adding securities that offer higher yields while maintaining portfolio durations.  For example, investors in taxable bonds may have noticed a modest increase in the level of their credit risk via the careful selection of corporate credits and sale of short maturity bonds.  Because of these trades, we have been able to increase the yield on our client portfolios while keeping them concentrated on the steepest sections of the intermediate yield curve (3 to 4 years).  Clients invested in tax-exempt bonds may have noticed that a select number of healthcare and public utility credits were added to their portfolios.  In some cases we used funds from maturities to make these shifts.  In other cases we sold short maturity bonds, which allowed us to book profits and increase yield.  These subtle shifts in allocation have added value without adding unacceptable amounts of either credit or interest rate risk to our client portfolios.  As with all of the relative value swaps we implement, the trades are executed with each individual client’s mandate in mind.  For this very reason, we encourage all of our clients to take a moment to revisit their Investment Objectives to ensure that the portfolio objectives and risk tolerances we have on record are up to date.

SNW Asset Management would like the opportunity to review your investment objectives with you to assess which of our recommended approaches to the current market is appropriate.  We welcome your phone calls and look forward to having a discussion with you.  Please click here to find a copy of our Investment Objectives form, which outlines the key characteristics of the strategies we offer.

Why Mutual Funds May be a Risky Way to Pursue Extra Yield

With Federal Reserve monetary policy currently pinning short-term yields near zero and with a steep upward sloping yield curve offering higher yields on securities maturing longer than 5 years, impatient investors may be inclined to stretch their portfolios for extra yield.  For reasons we have explained in recent Minute in the Market updates, we think that losing patience at this point in the market cycle is a hazardous thing to do.  Investors who jump the gun in search of higher yield run the risk of a severe drop in the market value of their holdings later on when the economy begins to recover and interest rates begin to rise to more cyclically normal levels.  Investors must always be aware that bond prices move in the opposite direction that interest rates do, and that bond price movements are greater the longer the maturities of the securities held.

This bond market truism applies to securities held in separately managed accounts (like those at SNW Asset Management) or in mutual funds.  Some investors may now be considering purchasing bond funds because of the higher yields some are offering.  Investors who may be tempted to look at higher yielding mutual funds at this point in the cycle would do well to remember that an investment has a higher yield because it entails a higher degree of investment risk.  The risk that investors may be exposed to in a mutual fund generally takes three forms:  higher interest rate risk, credit risk, or security structure risk.  Many mutual funds typically offer higher yields because they hold either long-maturing securities, with average maturities of 15 years or more and durations at or beyond 6-7 years, or securities of medium-grade or lower-quality credit stature, or both.  They may also seek to add yield by investing in highly complex derivative securities, which can magnify the returns on both the upside and the downside.  The upward-sloping yield curve does offer higher yields to longer-maturing securities, but at the risk of substantial erosion of market value when interest rates increase.  This holds true whether the investor holds securities directly or indirectly through a mutual fund.  The potential price risk is substantial – 6%-7% or more for each 1% increase in interest rates from current, decades-low levels.  As for cutting corners on credit quality, the experience of the past 24 months should deter most investors from doing that.

The chart above shows the two-year market-price history of a large and well-managed longer-term municipal bond fund.  Over the course of five very challenging weeks in late 2008, this fund’s market price dropped roughly 11.5%.  Although the market price of the fund has since largely recovered and the fund currently offers a yield of 4.50%, the price history shows that even for a conscientiously and capably managed fund, market price risk can be substantial.  In this case, the downturn in market value wiped out almost 3 years of coupon income in little more than a month, showing in bold relief the potential cost of accepting market-price risk to bolster investment yield.  This can happen again.  If long-term rates move higher and stay elevated, this fund and many others will see their market prices drop.  Any recovery may be a long time coming, if it comes at all.

Investors who take the trouble to examine mutual fund holdings and compare them to portfolios constructed by SNW Asset Management usually notice the differences right away.  At SNW, we are presently taking a highly disciplined approach both to portfolio maturities and to credit quality.  Now is the time for patience and discipline; the time to extend maturities and lock in higher yields will come later, when economic recovery forces interest rates and investment yields substantially higher.

If we may use the last interest rate cycle as an example, conditions now are like those in 2003, when interest rates bottomed out; the time to aggressively seek longer maturities and higher yields was later – in 2005-2007 – when rates were at the highs of the cycle.  Yields on longer-maturing securities, which looked so good in 2003, were handily eclipsed by those that became available later on.  SNW clients from that cycle are enjoying substantially higher yields on their portfolios to this day, thanks to the discipline we observed earlier in the cycle.  So, when comparing investment options, it is important to look at not only the yield of that investment, but the amount of risk that is taken to achieve that yield.  When these risks are taken into account, these higher yields loose a great deal of their attractiveness.

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. 

Some Thoughts on Evaluating Municipal Credits

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.

I have 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.  To be consistent with SNW Asset Management’s current recommendation to keep maturities relatively short to avoid locking in yields at current ultra-low levels, I looked at 3-year and 5-year maturities.  I found 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,  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% on an adjusted basis, and 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.