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THE INFORMATION ON THIS WEB SITE IS NOT AN OFFER TO SELL OR SOLICITATION OF AN OFFER TO BUY AN INTEREST IN ANY INVESTMENT FUND OR FOR THE PROVISION OF ANY INVESTMENT MANAGEMENT OR ADVISORY SERVICES. ANY SUCH OFFER OR SOLICITATION WILL BE MADE ONLY BY MEANS OF DELIVERY OF A CONFIDENTIAL PRIVATE OFFERING MEMORANDUM RELATING TO A PARTICULAR FUND OR INVESTMENT MANAGEMENT CONTRACT TO QUALIFIED INVESTORS IN ONLY THOSE JURISDICTIONS WHERE PERMITTED BY LAW. INVESTMENTS ARE ONLY OPEN TO CERTAIN QUALIFIED INVESTORS AND NOT OPEN TO THE GENERAL |
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MARKET UPDATE AT YEAR-END 2008
As we approach year-end 2008, we are writing our Market Update in order to offer potential investors with timely insight into current market conditions and how we are dealing with them. While this has been an extremely difficult year for the economy and the capital markets, the Federal Reserve, FDIC and Treasury programs represent a forceful attempt to restore the health of the financial system, as well as positively impact both investor sentiment and consumer confidence. Unfortunately, while we cannot provide clarity on when the markets will ultimately turn, we remain convinced that valuations will be restored over time in our focus sectors once investor sentiment and consumer confidence return to the markets.
The “fear trade” continues to permeate the markets, as evidenced by investors’ willingness to own only the safest investments; the Treasury sold four-week Treasury Bills last week at a ZERO interest rate and 3-month Treasury Bills at a NEGATIVE interest rate of 0.005 percent. In addition, analysts are projecting that investors in money-market mutual funds that focus on US Treasury securities may lose money as the yields on such funds will be too small to cover fund expenses.
The supply of pending new issues and heavy selling pressure from large mutual funds continues to weigh on the municipal bond market. Notably, the 30-year Municipal/ Treasury ratio rose to a record 208% today (versus the historical average of about 86%). As a result, current municipal market valuations are distorted in three primary areas; 1) “prerefunded” bonds (i.e. bonds escrowed in US Treasury obligations) are yielding higher rates than the US Treasury securities backing them, despite the income from such “prerefunded” bonds being tax-exempt; 2) corporate-backed municipal bonds are trading at higher rates than the taxable bonds of the corporations backing them; and 3) there are higher relative yields on insured bonds implying that insurance actually detracts from the likelihood of repayment. Regarding high yield municipal bond valuations, certain mutual funds are incurring sizable investor redemptions; to satisfy these redemptions, the funds have been selling bonds into a highly illiquid market at severely depressed values. These “forced” sales have led to sharp downward revisions to bond valuations by pricing services, causing follow-on sales by other mutual funds, resulting in a vicious, liquidity based cycle that places further downward pressure on the markets. As a result of these depressed prices, we have begun to see certain “cross-over’ investors making incursions into the municipal market; historically, such actions have precipitated achieving “market bottoms”. To be clear, this economic slowdown will adversely impact the fundamental creditworthiness of certain municipal bond issuers; and while municipal bond defaults are extremely rare, an increase in defaults can be expected given the severity of this economic slowdown. Steering clear of these potential defaults will be a key objective, and through our history we have shown an ability to make correct assessments regarding credits. While “history” may seem to be of little value in the current market environment, we think the absolute and risk-adjusted return profile available from municipal bonds, given current valuations, makes this a timely entry point for the asset class. We expect that in the future, investors will look back at this period as a historically important buying opportunity.
Investing in Bonds. With the significant re-pricing of securities that has taken place, it is important to stop, take a deep breath and consider what this re-pricing means to investors and the impact on individual portfolio holdings. The market environment over the past three months has been awful with very limited liquidity. If one needed to sell positions to satisfy liquidity needs or pending investor redemptions, you were at the mercy of a highly illiquid market, which often meant that bids (if any) ranged from 5-30% below “last trades”.
In addition, as opposed to equities, bond valuations will be impacted by the underlying creditworthiness of the issuer, level of interest rates, rate of inflation (or the lack thereof), as well as market conditions. Importantly, bonds represent a “contract” between an issuer and a bondholder, where the issuer has an obligation to pay back its borrowing at 100%. That said, until repayment occurs, the market value of the obligation will be impacted by the factors noted above; but importantly, no “loss” is incurred during the holding period unless the obligation is sold at a discount. We note that not all bonds are created equal and that due to specific bond terms, certain bonds have had partial bond calls at 100%, despite having a current price mark at a discount. For example, short average life housing and tobacco bonds are called by issuers as they receive prepayments or other revenues. We note that this has occurred for holdings with “market valuations” as low as 70 cents on the dollar. In another example, General Motors was required to call municipal bonds that had been issued on behalf of facilities that had been sold; prior to the call at 100%, the subject bonds had a “market value” of 40 cents on the dollar.
We therefore do not need a “recovery” of bond valuations to take place to start to see positive returns from the municipal bond asset class; we need “valuations” to stop going down in price. While we cannot control the actions by forced sellers that have sold bonds at prices of 20-30 points below market value for a given position, it is clear that when this forced selling ends, municipal bonds are poised to generate high returns simply from coupon payments. Incremental returns above this threshold will come from any recovery from the significant dislocation in values that has taken place, as well as the scope of additional investing opportunities.
High Grade Investing Opportunities. We remain convinced that valuations will be restored over time in our focus sectors and we firmly intend to take full advantage of these market opportunities on behalf of ourselves and our investing clients. That said, we still think that municipal bonds are by far the cheapest of our asset classes. In fact, “high yield opportunities” now encompass credits rated “BBB” up through “AA”, as we are able to buy very high quality municipal bonds at attractive levels. For example, Harvard University sold a taxable new issue in the corporate bond market aggregating $1.5 billion on December 5th (at spreads to US Treasury securities of +335) and a new issue of municipal bonds aggregating $1.0 billion was priced on December 10; the 2036 municipal bonds, that are federally tax-exempt securities and not subject to any “AMT” penalty, were sold at a yield of 5.80%, or 8.92% on a taxable equivalent yield basis. On a taxable equivalent yield basis, Harvard’s municipal issue was sold at 245 basis points higher yield than the taxable issue. Valuations in other high credit quality sectors are providing compelling opportunities as new issue supply has spiked in the last several weeks as issuers have sought to complete transactions prior to year-end. Unfortunately, this spike in supply has eclipsed investor demand, causing interest rate levels to drift higher each week. With the reinvestment of coupon interest and principal from maturing bonds that is typical at January 1 of each year, we expect some recovery in valuations, particularly in the high grade credits, to take place early in 2009.
The extent of the “unwind” of portfolios at depressed prices has exacerbated municipal valuations. In eighteen months, we have seen a complete restructuring of municipal bond holdings from leveraged players at a time that the market itself has had very limited bids. We view municipal credits as historically cheap; the 30-year Municipal/ Treasury ratios have soared to levels never before seen. Today, the 30-year Municipal/ Treasury ratio rose to 208% and the spreads relative to Treasuries are very compelling. In addition, the municipal “AAA” yield curve continues to steepen to post-1984 records; the 1-30 year curve is now 496 basis points. Notably, in October, when valuations on high grade municipal bonds spiked above 6%, and the 30-year Municipal/ Treasury ratio exceeded 140%, retail investors flocked to the sector. This retail investor demand drove down the yields on high grade municipals by almost 100 basis points in just four trading days. This is part of the reason why we have continued to advocate allocations to municipal bonds despite the market’s weakness. We expect retail demand will return to the municipal market in sufficient quantities starting in early next year as the new issue supply and secondary market selling ebbs.
High Yield Investing Opportunities. While there has been no play book to follow during these difficult times, given the market uncertainties, we have maintained a relatively defensive approach in managing portfolios by allocating capital to high yielding cash equivalents, conducting tactical selling and choosing to invest in certain high credit quality situations. The municipal short-term market continues to provide us with opportunities to hold tax-exempt daily/ 7-day interest rate reset paper at attractive levels as a result of the need by traditional money market funds to sell paper that is wrapped by entities that have been down-graded by the credit rating agencies. Overall we think that municipal bonds have just gotten too cheap, and we suggest that investors may want to be well positioned for a recovery that we know is inevitable.
For those investors that were introduced to our hedge fund investing strategy in late 2003 and early 2004, we described a “muni-plus” total return opportunity founded on relative value opportunities across the municipal bond, corporate bond, and preferred markets, with a particular focus on corporate-backed municipal bonds. Simply put, that opportunity is substantially greater today than at any time in the past 30 years. We maintain that if our investing strategy made sense five years ago, it is even more compelling today. Corporate-backed municipal credits are now yielding as much as, or in some cases dramatically more than, identical credits from the same corporate issuer in the taxable bond market.
As representative of relative value, in high yield corporate-backed municipal bonds, the extent of the precipitous asset class re-pricing can be seen. Typically, such credits originally issued bonds at or near par (100%) and the dollar price of the securities have been crushed; high yield municipal bonds have fallen in value by 20-65 points in value. For example, American Airlines bonds have experienced a “loss” of over 61% of their value, based on the current market. We note that the bonds continue to pay interest and many analysts project that American Airlines will be profitable in 2009 as a result of the capacity reductions, cost savings measures and reduced cost of aviation fuel resulting from the 70% reduction in crude oil prices from the highs reached this summer. In addition, we note that the American Airlines bonds are trading at prices at least 35% below where they traded at the time prices for crude oil peaked this summer! Other notable credits have suffered significant downward revisions to the market price of their respective securities as even high grade municipal bonds have fallen in value by 10-15 points. Due to this re-pricing, we project that the municipal asset case will be capable of generating “equity-like” returns over the next few years as valuations are ultimately restored.
Market Comment. To be sure the current economic environment is extremely challenging and the future is uncertain. Negative market sentiment continues to play out in the financial markets as the world economy is facing one of its most difficult periods since the onset of the Great Depression. During the period 1929-1933, the Federal Reserve oversaw a reduction in the money supply that served to deepen a prolonged recession into the Great Depression. In contrast, over the last four months, the Federal Reserve has been responding forcefully by flooding the capital markets with liquidity and the money supply has been increased significantly. The Fed’s balance sheet has MORE THAN DOUBLED to $2.2 Trillion in the past three months alone (from about $900 Billion). However, counterbalancing this supply increase, the velocity of money is down significantly as a result of diminished spending by consumers and reduced lending by financial institutions. Unemployment rates are approaching 7%, and some are projecting unemployment rates as high as 9%. The precipitous sell-off in the equity markets has served to heighten investor fears. Government intervention in the capital markets also draws parallels to the Great Depression, as foreign governments have moved to support the world banking system and the Treasury’s $700 Billion “TARP” has caused the federal government to take equity stakes in many financial institutions. Others are calling for the federal government to additionally take on the support of certain “strategically important” domestic industries, including the auto industry.
The US Congress and the Bush Administration are currently debating the efficacy of providing loans to enable General Motors, Ford and Chrysler to stay out of bankruptcy, while novel alternatives including a “pre-packaged bankruptcy” are being discussed. We would suggest that without government intervention, bankruptcy filings are likely and company liquidations a distinct possibility. We remain hopeful that positive actions will be taken by the Government to enable these companies the opportunity to complete the restructuring endeavors already undertaken, as well as any further actions that will be expected to prove their viability. That said, we find the alternative as a dreadful outcome that will likely include any number of unintended consequences. Given the current state of consumer confidence and investor sentiment, we believe such an outcome will lead to a significantly prolonged economic recession as every state and community across the country would be directly impacted by the bankruptcy/ liquidation of the domestic auto companies.
What remains clear to us is that Government intervention will be around for some time. While the bold policy responses to date may have been warranted, their implementation, effect and ultimate unwinding will be assessed in the future. Unintended consequences of the Government intervention will surely show up, just as the lack of action regarding the Lehman bankruptcy surprised market participants. While we believe many of the policy initiatives were necessary, despite our predisposition to allowing the markets to right themselves without such action, we are concerned about how and if some of these bold programs will eventually be un-wound. Many are set to terminate in mid-2009. However, borrowers have a way of getting hooked on cheap financing, and it is unclear how the Obama Administration and Congress will respond to businesses that would fail without continued government support. Ideally, the government support will be replaced by private market capital, but the cost and availability of that capital is far from clear. This uncertainty itself could be cause for ongoing concern well into next year.
We do not think that the economy is likely to show much strength in the near-term; rather the U.S. and the world in general will face several quarters of slow to negative economic growth. We do not think that we will face depression-like conditions in the U.S., but a drawn out period of recession, followed by slow growth is now likely. The Fed has already established a target for Fed Funds below 1%, breaching the previous all-time low target we saw earlier this decade. While the Fed’s action today in moving the Fed Funds rate target to “0 - 0.25%” is largely a “ceremonial” further cut, we expect the Fed will leave this target in place for the foreseeable future to continue to provide liquidity and economic stimulus during this stressful period. The real issue will be whether unconventional methods, including quantitative easing by the Fed will be capable of stimulating economic growth.
In recent months we have witnessed a precipitous decline in the price of crude oil. From the high of $145.29 reached on July 3, crude oil closed today at $43.98, down about 70%. Nineteen states are already reporting gasoline prices have fallen below $2.00 per gallon. We emphasize that we believe that crude oil has peaked in this cycle and that reduced consumption, continued pumping by OPEC members, calls for increased offshore drilling, renewed focus on nuclear power, and outrage over domestic ethanol production mandates, are behind this fall in oil prices. This reduction in energy prices will serve as a significant stimulus to economic activity as it is projected that the reduction will serve as a $350 Billion “tax cut” to consumers. We project that the economic impact of this stimulus could be greater than the economic stimulus package enacted earlier this year, as consumers will likely spend the incremental savings of reduced gasoline prices each week, rather than saving a $600 one time check. Given the huge economic stimulus provided by the Fed initiatives, reduced commodity prices, a likely second stimulus package from Congress that may be upwards of $1 trillion and the continued spending on the Iraq War, we project that the recession will not accede to that of a “depression”, although it may feel like it, and the media will likely report it as such.
Madoff Issues. We feel compelled to address the recent disclosures surrounding Bernard Madoff, the companies he owns/controls, and the recent scandal involving alleged fraud perpetrated on investors. We can state unequivocally that Cedar Ridge Partners has no exposure to Madoff Investment Securities or any of its affiliates and we have never had any trading relationship with Madoff Securities. Moreover, we would like to remind potential investors of the various “name experts” we engage (i.e. prime broker/ custodian, administrator, auditor, and legal counsel) that together serve to provide comfort on the investing activities and reporting of investor accounts.
Summary. The fears that have gripped the markets have led investors to sell securities at any price, with a complete disregard for credit fundamentals or value as some believe the only “safe” asset worth holding is cash. We beg to differ; valuations in both high quality and high yield municipal bonds have never been more attractive. In light of the media reports that describe the turmoil that continues to have an impact on the capital markets and the investing community, over the past several months Cedar Ridge Partners has continued to attract new assets under management. As we enter our fifth year, Cedar Ridge Partners remains poised to provide investing insight into these difficult credit markets and expects to continue to provide value-added services to our clients. We would enjoy the chance to discuss our existing fund offerings and separately managed accounts given the significant buying opportunities in our core investing sectors.
Qualified Investors may contact us to receive copies of our past market commentary and quarterly Letters to Investors.
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