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CEDAR RIDGE PARTNERS |
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Q4 2009 Review and 2010 Market Outlook (January 11, 2010)
Q4 2009 Market Comment. The credit markets rebounded strongly in 2009, following the unprecedented Federal Reserve, FDIC and Treasury programs to restore the health of the financial system. Regarding the Municipal Market, the 30-year Municipal/ Treasury ratio that rose to a record 217% a year ago stands at approximately 88% today (versus the historical average of about 86%). Readers will note that the biggest story in municipals in 2009 surrounded “Build America Bonds” (“BABS”), a new taxable fixed income asset class. The economics behind the issuance of BABS remains compelling for both issuers and investors. Enacted through the American Recovery and Reinvestment Act in February 2009, the program provides municipal issuers with a 35% subsidy from the Federal Government on interest costs if issuers forego the issuance of tax-exempt debt. Given the resounding success of BABS, we expect the program will likely be extended beyond the original December 31, 2010 sunset date. In addition, BABS will likely continue to remake the municipal market as projections for new issue BABS in 2010 fall in the range of $110 to $160 Billion. Index returns have been notable this year as well. According to Barclay’s, the Municipal Bond Index returned 12.91% in 2010; the High Yield Municipal Bond Index returned 32.73%; the US Credit Index returned 16.04%; and the US High Yield Corporate Index returned 58.21%.
The classic “supply/ demand” metrics for municipal bonds remains intact. As predicted, once the new issue calendar wound down for the year, market valuations again turned positively in early December as the inflows from December 1 coupon interest and principal payments assisted in pushing valuations higher. Inflows into municipal funds on January 1 were significant, as the date is historically a major interest payment and maturity date; we also saw some “pre-funding” by mutual funds in advance of January 1 to put new dollars to work.
Municipal Market new issue volume comprised about $409.13 Billion in 2009, a 5% increase over 2008. However, approximately $84.47 Billion was in taxable municipal bonds, with BABS accounting for over $64 Billion of such issuance. What this means is that the volume of tax-exempt municipal bonds actually fell almost 6% in 2009.
2010 Municipal Market Outlook. The questions we are asked most often typically concern 1) “missing” the rally in municipal bonds and 2) our views on the market going forward, particularly with regard to inflation. Readers should note that despite the restoration in valuations to date, we still think that municipal bonds offer a meaningful total return opportunity in 2010. This view is centered on the premise that a number of technical measures conspire to raise the overall demand for owning municipal bonds, including 1) increasing marginal tax rates at both the federal and state levels; 2) increasing demand for municipals, referenced by increasing amounts of investor dollars flowing to the sector; 3) continuing reduction in near-term net new issuance of long-term bonds; and 4) attractive Municipal/ US Treasury ratios.
Inflation is known as a corrosive influence on the value of fixed income securities. However, inflation is really no different than a general increase in interest rates given the mathematical impact it can have on the pricing of a bond. The truth remains that if held to maturity said bond will still be paid at par, notwithstanding what happens to interest rates, spreads, or the impact of inflation. An actively managed portfolio can manage portfolio duration to mitigate against interest rate moves; however, strategies that can express views both long and short can be even more effective in insulating holdings against interest rate moves. The long/short mandates of certain of our Funds afford us the flexibility to mitigate the negative impact of rising interest rates. We invite investors and readers to contact us to discuss our hedging techniques in more detail. That said our near-term outlook for inflation remains muted; see the discussion below under “Market Outlook”.
The following highlights several notable observations for the Municipal Market that we project will favorably influence valuations for the asset class:
· Tax- exempt supply will likely be the lowest in seven years
· Taxes are going up for everyone on everything! (Healthcare etc.)
· Expect demand to dramatically outstrip supply. We anticipate demand will exceed supply by about $26 Billion in January and February, and about $100 Billion for the full year
· Expect more than 70% fewer long dated tax-exempt bonds to be issued (particularly in 30Y plus maturities)
· Significantly lower “AAA” issuance; 44B vs. an average of 227B (2003-2007)
· Most of the bonds that were formally “AAA” insured will be issued as “AA-“ to “BBB+”
· The Build America Bond program will be extended past 2010, taking supply directly from the tax-exempt market; projections for new issue BABS in 2010 fall in the range of $110 to $160 Billion.
The introduction of taxable BABS is having a number of direct influences on the tax-exempt municipal market. First, through the issuance of BABS, there has been a direct reduction in the amount of tax-exempt bonds that are being issued. Second, investors in BABS prefer long dated issues, with “make-whole” call provisions, rather than the typical serial and term structures with par calls in 10-years. As a result, the reduction in the supply of tax-exempt municipal bonds is most notable for longer dated issues. Issuers are continuing to generate supply in answer to retail demand for tax-exempt bonds in the range of 1-12 years; but often choosing to sell BABS to fulfill the interests of taxable market investors.
Municipal Market new issue volume is projected to increase about 6% in 2010 to about $435 Billion. However, given the projections for new issue BABS in 2010 ($110 to $160 Billion) tax-exempt volume is projected at $325 Billion to a low of $275 Billion (i.e. flat to down 15% year over year). If true, the BABS market will have a greater impact on the issuance and availability of tax-exempt bonds than anyone originally projected. What this means is that the volume of tax-exempt municipal bonds will likely fall significantly, and we project that the amount of long dated tax-exempt bonds may fall by about 70%.
As a result, these outcomes will certainly have impacts on the valuations of both tax-exempt municipal bonds and BABS. We are seeing the prices of long dated tax-exempt bonds continuing to rally, as investors “bid up” the price of such securities given the projected reduction in overall supply. With new issuance likely concentrated in the 1-12 year maturity range, there is a likelihood of “supply/demand” imbalances occurring at various points during the year. As a result of the imbalance, as well as the potential for an overall rise in short term rates (whether by Fed action, inflationary concerns, or simply renewed investor interest in longer duration risk assets) we expect that short-term rates will have to rise, flattening the municipal yield curve from its current 385 basis points of positive slope. This flattening will be offset by increasing tax rates, as the demand for tax-exempt bonds in the maturity range of 1-12 years is expected to remain strong. As the BABS market continues its development and gains wider acceptance by investors, we can expect BABS spreads to tighten over time. Despite higher credit ratings, many BAB issues continue to trade at a spread premium to other comparable taxable or sovereign credits. We expect this will change overtime, and believe BABS can be an important generator of total returns. As an example of “relative value” investing, the State of California’s BABS due in 2039 have traded at spreads of plus 315 basis points in a market where the Republic of Turkey sold debt due in 2040 at a spread of plus 225 basis points. Overtime, if the spread on California BABS tightened to + 225 basis points, this would represent an almost 11 points of incremental positive return. We should note that Turkey is a “high yield credit” rated Ba3/ BB-/BB+ while California, the world’s eighth largest economy, remains a “high grade credit” rated Baa1/A/BBB. The $2 Billion issue on behalf of Turkey received investor orders of $7.3 Billion (making the deal oversubscribed by 3.5 times).
Given the nature of the nascent economic recovery, we expect continued credit pressures on state and local government issuers. The Rockefeller Institute reported that tax revenue declined an overall 10.9% during the three months July through September and year-over-year tax revenue has declined 12.5% on average over the last four quarters. Moreover, the three quarters ended September 2009 had the worst decline in state tax collections since at least 1963. Therefore, credit, and the ability to make correct assessments on municipal credits, will be even more important going forward. Municipal bonds are no longer a “commodity” product, where the typical municipal bond was insured by a “AAA” rated mono-line bond insurer. As a result, this new credit environment fits us very well and our style of active management. We believe that active portfolio management and maintaining liquidity will continue to be important aspects for any fixed income portfolio.
Lastly, since municipal bonds enjoy tax-exempt status, historically the Municipal/ US Treasury ratio in 30 years has averaged about 86%. At Friday’s close, the 30-year Municipals/ US Treasury ratio had fallen to about 88% (from a high in December 2008 of 217%). While part of the story behind these historically wide ratios may be explained by investors bidding up the price for long-term Treasuries, we expect municipals to out perform Treasuries going forward and would not be surprised to see ratios move significantly through historical norms. We do not use ratios as a signal to buy or sell; we simply use them as a data point and as one consideration in our assessment of value. In the current market, we suggest absolute rate levels must not be lost within some greater “ratio analysis” or “investing model”. The truth remains that municipal bonds at 5% remain a compelling investment alternative, particularly when one considers the absolute level of other investment alternatives and the impact of taxes. Federal funds remain at zero-0.25%; money market returns approach 0.25%; 10Y US Treasury rates are at 3.80%; and the return on a 5% municipal bond equates to a 10% pretax return at a 50% tax rate.
Economic Outlook. The year 2010 will likely be a year of transitions as we move beyond the crisis of 2008 and begin the 2nd decade of this century. In the U.S., transitional policy initiatives promulgated by the Obama Administration, as well as the U.S. Congress, are likely to significantly impact large parts of the economy, from Health Care and Health Insurance, to Energy, to Finance and Banking, just to name a few. We will face a mid-term election in November that will likely be the most contentious since 1994, and we expect that the results will carry meaningful long-term implications for the direction of public policy. Global transitions abound as well, particularly in some of the world most significant regions and economies. China is poised to overtake Japan as the worlds 2nd largest economy. The transitions underway in China’s economy are too numerous to address here, but the implication of China’s domestic economic and foreign exchange policies may have more influence on global trade and economic recovery than any others. Japan transitioned to a new ruling party in 2009, but the implementation of transitional policies in Japan will only become evident beginning this year. Brazil will elect a new president and Great Britain will likely transition to a new conservative Tory government. The strength and cohesiveness of the European Union will be tested by strains amongst some of its more stressed members, Greece, Spain, Ireland, etc. India will continue to grow in international economic and political influence. Multinational relations in the Middle-East, with Iraq, Iran, Afghanistan, North and South Korea, not to mention Africa and the rest of Asia, will continue to evolve under stress, and will likely be influenced by the global direction in energy policy, and particularly the growing push toward “alternative” energy sources. This is of course a partial list, but the importance of these and other transitions, and their impact on economic growth and financial stability, are important not only for global investors, but also for our investments which reside almost exclusively in the U.S. pubic debt markets.
A number of market observers continue to castigate the Federal Reserve to commence a tightening cycle by raising the federal funds rate from the current range of zero-0.25%. Much of this view is bolstered by a continuing slide in the value of the dollar versus other world currencies, gold prices of over $1,136 and the incipient inflationary outlook as a result of the weak dollar and “excessive” liquidity emanating from the more than doubling of the Federal Reserve’s balance sheet to over $2.01 trillion.
Our view is that the Federal Reserve is maintaining its current stance as an insurance policy against a potential “double-dip” recession. It’s easy to focus attention on the Federal Reserve’s monetary and “qualitative easing” policies, while completely forgetting US fiscal policy. The Bush tax cuts will expire in 2011 (now less than 12 short months away) but it is clear that Congress and the Obama Administration are in the midst of instituting new tax policy that will constitute a significant drag on economic activity. The federal estate tax, which has sunset in 2010 before coming back in 2011, will likely be modified by Congress sometime in 2010 and possibly have a retroactive effective date to January 1, 2010; the House of Representatives passed legislation late in 2009 to extend the estate tax but the Senate took no action. With the passage of Health Care legislation by both Houses awaiting a House-Senate Conference, it remains to be seen what form and level of taxes will be implemented; that said, higher marginal tax rates, let alone new taxes altogether (i.e. health insurance levies, “cap and trade”, and state “surtaxes”) are likely to be part of any new tax policy. The powerful combination of increasing taxes, at a time when consumers are reducing spending, paying down debt, and trying to rebuild asset valuations, will place a significant “deflationary” drag on economic activity.
Against this backdrop, we see slight evidence that a recovery in consumer confidence, job creation, and housing valuations is underway. Recent studies show no new net creation of jobs took place during the past decade and that approximately 20% of the U.S. workforce remains unemployed, have given up looking for work, or are currently only able to find part-time employment. Consumer spending and housing are too important to the US and global economies to assume any sustainable recovery can happen until they improve, and current data simply do not support meaningful signs of improvement. Continued weakness in commercial real estate also remains troublesome. Until a discernable positive trend is observed in these metrics, we expect that any economic recovery will be muted.
Specifically regarding housing, while we acknowledge that some home sales numbers are up, such numbers are likely directly related to the increase in foreclosure sales and subsidized by the $8000 first time buyer tax break. In addition, home lending by private lenders is nascent at best; the home mortgage market continues to be basically controlled by the Federal Government through Fannie-Mae, Freddie-Mac, and FHA, and supported by outright purchases by the Federal Reserve. In fact the Obama Administration unilaterally announced on December 24th (after Dec. 31 it would have required Congressional approval) that the U.S. Treasury would provide UNLIMITED financial support for FNMA and FHLMC against portfolio losses for the next three years, extending the initial $200 Billion capital commitment made when the U.S. Government stepped in as “conservator” in mid-2008. While such a policy move appears supportive of the housing market on the surface, the potential unintended consequences are meaningful. U.S. taxpayers now backstop unlimited losses on mortgage loans that would result from weak underwriting standards at a time when these underwriting standards are beginning to return to a more sustainable balance. While instilling confidence is great, policies that invite unbridled lending are not sustainable. Think of it as if the U.S. taxpayers are taking the place of the shareholders of MBIA, AMBAC and FGIC, and we know how their fortunes have faired. Any losses that get passed through to the U.S. Treasury will drop straight to the bottom line and add to the budget deficit, one of the large looming drags on economic growth. Finally, crowding out private lending steals a potential revenue source for banks just when financial reforms are moving to encourage banks to “get back to basics” and provide more lending to consumers and small businesses. We will want to see at least the beginning of an end of the home lending subsidies and a return of private lending in the housing market before we will believe that the housing market has stabilized. Unfortunately, this is just another example of current policy trends in Washington that are making the housing market more dependent on public financing support, and thus continue to crowd out the return of private lenders.
The unemployment rate is now 10%, as the economy has shed about 7.3 million jobs since December 2007. On Friday, the Bureau of Labor Statistics released the December jobs data showing job losses of 85,000 while the unemployment rate remained static. This was a misnomer as the statistics also reported 929,000 “discouraged workers” in December, up from 642,000 a year earlier. Without the data revision, the unemployment rate would have risen to about 10.4%. So despite promoting an impending recovery, jobs remain very difficult to come by. Federal Reserve staff project that the unemployment rate may be moving down to about 9.25% by the end of 2010. While unemployment is typically a lagging economic indicator and historically unemployment rates continue to rise even after a “bottoming” in the economy takes place, we believe employment and consumer confidence are directly linked. While we concur that depression-like conditions in the US economy are no longer likely, and certain economic indicators show signs of promise, we predict 2010 will be characterized by a continued drawn out period of recessionary-like consumer spending and economic activity. In other words, tepid growth remains most likely.
Against the backdrop of “continued normal” recessionary concerns, it remains to be seen how the market will perceive and ultimately react to the plethora of impending “changes” proposed out of Washington. New health care programs, energy programs (including “cap and trade”), new financial market regulations, and the impact of continued ownership of corporate America by the U.S. Government all reflect uncharted waters. This legislative agenda remains immense to say the least, and speculation about its success and ultimate consequences only adds to the overall uncertainty facing the markets and the economy.
Qualified Investors may contact us for our past market commentary and quarterly Letters to Investors. |
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