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Market Comment |
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2011 Review and 2012 Market Outlook |
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Cedar Ridge Partners, LLC |
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“Saturday night I was downtown, working for the FBI. Sitting in a nest of bad men, whiskey bottles piling high. Bootlegging boozer on the west side, full of people who are doing wrong. Just about to call up the DA man, when I heard this woman singing a song.
Municipal Market Recap of 2011. Ah the siren song of that “long cool woman” who in December 2010 projected “50-100 major defaults by municipal entities”, comprising “$100 Billion in outstanding bonds” for 2011; while she is credited with the subsequent Municipal Market swoon that ensued (frankly, a little too much credit), anyone who liquidated holdings likely missed out on what transpired. The projected credit meltdowns among municipal issuers did not happen, and ultimately municipal bonds posted a return of 10.70% for the year according to Barclay’s. We had entered 2011 with several identified themes/concerns that would likely have a direct impact on our core fixed income markets. These themes were: 1) potential historically high defaults by municipal bond market issuers; 2) lack of retail investor buying interest, given that such retail investors had been leaving the asset class in droves; and 3) potential new issuance of municipal bonds would out-strip investor demand causing a material rise in interest rates. We thought that the Municipal Bond Market would likely experience some weakness due to these concerns but we also went on record to state that we believed the fears were over-blown.
In 2011, the number of municipal defaults ran at a pace below that experienced in recent years. According to Municipal Market Advisors, payment defaults reached $2.1 Billion in 2011. According to data compiled by Goldman, Sachs & Co. that includes the outstanding municipal bond obligations of American Airlines that filed for bankruptcy in November 2011, a total of 95 defaults aggregating $6.032 Billion occurred in 2011. In addition, the Federal Reserve also revised statistics for the municipal bond market that had been expected; rather than a $2.9 Trillion market, the municipal bond market comprises a $3.7 Trillion market (almost a full 28% greater). Households remain the largest holder of municipal bonds, estimated at $1.904 Trillion (about 51%). We note that historical default statistics for the asset class will need to be revised downward.
Regarding the supply/ demand dynamics for municipal bonds, fund flows for municipal mutual funds turned positive at mid-year following outflows aggregating $45.0 Billion over the prior 8 months. These sustained outflows had been the largest on record, amounting to nearly 10% of total mutual fund assets. However, positive flows reappeared providing a strong underpinning of “buy interest” at a time when new issue volume remained low. In January 2011, we had projected that net new issuance of tax-exempt bonds would fall dramatically in the first half of 2011. This prediction held for the entire year, as new issuance aggregated about $295 Billion in 2011, the lowest new issue volume since 2001. The positive supply/ demand dynamic supported municipal bond valuations, leading to the positive performance for the municipal bond sector in 2011.
Portfolio valuations benefited from strong performance in some of our specific core holdings. In particular, the tobacco sector rallied due to reports of a potential settlement to the Non-Participating Manufacturer (“NPM”) Dispute. In brief, this dispute between the largest participating tobacco companies and the States has been a great source of uncertainty and subsequently, a significant drag on tobacco bond performance over the past year. Resolution of this matter would result in the distribution over $1.0 Billion of escrowed funds to the States to support repayment of various outstanding tobacco securitizations. We also saw good performance in our holdings of pre-pay gas bonds and certain other corporate-backed tax-exempt securities over the course of the year.
Portfolio valuations were negatively impacted by the bankruptcy filing of American Airlines. Core holdings have included both secured and unsecured municipal bond holdings attributable to AMR’s strategic assts at a number of the nation’s airports. The Chapter 11 filing caught the market by surprise, as AMR entered bankruptcy with in excess of $4 Billion in cash. We view the move by management as an “offensive” rather than “defensive” action, as AMR seeks to reduce labor costs and shed airline leases on older aircraft. AMR has deals in place to re-orient the airline to have the youngest and most fuel efficient fleet among its competitors. While our exposures are modest, we project ultimately that secured bonds will recover 100 cents on the dollar (current valuations for secured bonds are in the range of 70-90%). For unsecured bonds, we project recovery at about 40% (current valuations for unsecured bonds are in the range of 22-25%).
Municipal Market Outlook for 2012. Regarding our Market Outlook, we start by observing that the municipal bond market appears to be in very good shape. Technical factors particularly remain favorable for the municipal bond market. On the demand side, we have had December 1 and January 1 coupon interest payments and bond redemptions, coupled with continuing positive inflows into municipal bond funds as indicated by the aggregate $4.0 Billion for the first two weeks of 2012, as well as the continued talk concerning higher tax rates at the federal and state level. On the supply side, we had a limited new issue calendar for much of December, and a projected light forward calendar into February- March 2012. It appears that new issuance in 2011 aggregated about $295 Billion, well below most forecasts. New issue forecasts for 2012 fall in the range of $290 to $360 Billion (flat to +22% year over year). Our own view is that 2012 new issuance will likely be at the lower end of the range. We will expect to pay close attention to new issue volume during the year as a sign of continuing positive technical factors for the sector. From a fundamental perspective, municipal credits as a whole are improving, as tax collections continue to rise, cost cutting measures remain in focus and default statistics for the year are dramatically below projections.
In addition, since municipal bonds enjoy tax-exempt status, historically the Municipal/ US Treasury ratio in 30 years has averaged about 86%. At last night’s close, the 30-year Municipals/ US Treasury ratio stood at about 111%. We expect to see municipal bond valuations stay at elevated “Municipal/ Treasury ratios”, although its possible we could see a range of 95- 120% of comparable maturity US Treasury securities. We note that the continued Euro Area troubles and the effects of the Federal Reserve’s “Operation Twist” (i.e. swapping short term FED holdings for longer duration holdings) may be a partial explanation for the current US Treasury market valuations. That said we expect municipals will out perform Treasuries going forward and while we see attractive opportunities in the municipal asset class, intraday volatility remains heightened.
Despite generally improving credit fundamentals, we do expect some issuer defaults to take place throughout 2012. Given the nature of the nascent economic recovery, and reduction in federal transfers to states, we expect continued credit pressures on certain state and local government issuers. However, states and municipalities are making difficult decisions regarding budgetary priorities and many have begun attempts to seek to reduce future pension and post retirement benefit payments. Interestingly, after all the uproar associated with municipal credits, we have seen investors returning to the space as high grade municipal bonds comprise a relative “safe harbor” given the travails of sovereign credits in Europe and surrounding the US Government credit. Actually, as we look forward, it appears that events unrelated to the fundamental and technical factors in the municipal market could conspire to change the current status of the market; please see our Fixed Income Market Outlook below.
When compared to other investing alternatives, we project that more investors will continue to be attracted to municipal bonds as a lower risk and higher yielding alternative. Keep in mind that following the negative returns generated by equities over the last decade, many investors have reduced equity exposures, some permanently. Historically, over the long-term, various studies show the average annual returns from equities are about 6%; excluding dividends, the annual return falls to about 1.7%. In the current market, high grade municipal bonds still yield 4.00% to 5.00%, with the prospect of generating incremental total returns due to price appreciation. If you “do the math”, even in this current “low yield” market, municipal bonds are capable of generating potential returns of 8-10% or more when compared to other investing alternatives on a taxable equivalent basis.
Fixed Income Market Outlook. The global credit markets remain volatile and continue to take guidance from potential solutions (or rather rumors of solutions) being crafted for the European sovereign debt markets. Lately, focus has been maintained on European bank exposures to the sovereign debt of member countries and the willingness (or even capability) of a member country to support its own banks. It’s clear that there will likely be no “grand solution” and this two-year old saga will continue to unfold well into this year (and beyond?), remaining a significant overhang to the credit markets until a solution is actually forthcoming. We note that both fundamental and technical factors have remained generally supportive for corporate credit; however we expect some deterioration in selected credits resulting from an increase in M&A activity and large shareholder-friendly stock buybacks.
We begin the year 2012 not unlike 2011 by focusing on a series of macro economic factors that can have a major impact on the fixed income markets:
Unemployment- For all of 2011, monthly payroll growth averaged 137,000 and total jobs growth was 1.64 million; however, even with the gains, the economy has made little headway in recovering the 9.0 million jobs lost during the recession. The unemployment rate stands at 8.5%. Recent unemployment data is encouraging, but we will not be surprised to see some downward revision to December’s job growth numbers and a potential increase in the unemployment rate.
Economic Growth- The US economy likely ended 2011 with GDP growth in the range of 1.5 to 1.75%. Europe is likely in recession, and China’s economy continues to show signs of weakness; as a result, GDP growth in 2012 for the US economy will likely be sub-3%.
Housing- Five years since the bubble, and where are we? Despite continued record low mortgage rates the housing market still shows no signs of recovery and potential programs to assist a meaningful number of homeowners remains problematic. The market seems cursed by decades of government subsidies, and there remain significant structural impediments to mortgage lending. Fed to the rescue?
Inflation- Given the extent of FED liquidity measures and its pronounced focus on “re-flating” the economy, we remain somewhat surprised that inflation has been held a bay. We remain quite willing to be early to the inflation trade. By the way, anyone who says there’s no inflation has not gone to the grocery store or filled a gas tank recently.
Fiscal/Tax policy- While Federal budget cuts starting in 2013 were part of the Debt Ceiling negotiation, entitlement and/ or tax reform seems well off. DC will be focused on the 2012 elections, so we expect no meaningful fiscal actions pre-election.
Euro-Zone Debt problems- It’s hard to believe that the continuing “Greek debt saga” has now been influencing the markets for TWO YEARS, let alone listening to market observers describe “waiting to take directions from upcoming votes by the Greek parliament”. Volatility in the credit markets will continue to be influenced by the debt travails of Greece, Italy, Portugal, Ireland, etc. as this Euro ebb and flow contributes to the daily “risk on, risk off” taking place in the markets. Of late, the municipal market has been insulated from the daily ebb and flow of the Euro debt problems. That said, should a highly unattractive outcome take place, we can expect there will likely be some impact on certain municipal positions.
US Politics- The election season is off and running. It remains to be seen if the Republican nomination will be in hand sooner rather than later, but one thing is clear. We are about to witness one of the ugliest campaigns ever. That said, we will look for any guidance from the campaigns or from Congress itself concerning potential “rewrites” of federal tax law that could have an impact on municipal bonds. We also expect to follow closely the Supreme Court review of ObamaCare and the implications should the law be found to be unconstitutional.
As indicated above, we expect the US economy to muddle along at a growth rate below 3%. We may sound like a broken record, but until we see a recovery in the housing market, economic growth will likely remain muted. We highly discount any concerns for a near-term recession; however given that we believe Europe is already in a recession and we see continued softness coming from China, any further “Euro-Area” contagion could inflict pain on the US economy. The Fed’s Beige Book release on Wednesday indicated growth is “modest to moderate” across most of the US; albeit economic growth is seen improving while hiring is limited and the housing market remains sluggish. Chairman Bernanke seems to be growing restless in his attempt to “re-flate” the economy as evidenced by his calls for the Administration and/or Congress to try new programs in an attempt to revive the nation’s housing market. QE3 (or is it QE4?) seems in the offing, particularly with the trial balloons being floated for the potential purchase of more mortgage-backed securities, as well as the likelihood that the federal funds rate will be maintained at ZERO perhaps into 2014. It appears likely that Fed “incursions” in the markets (i.e. “Operation Twist”, potential MBS purchases, currency swap arrangements with the ECB, etc.) will continue. However we expect to keep an eye on the Fed’s “exit strategy” because we remain convinced that the Fed will not be able to unwind its various programs on a timely basis.
The Fed has also continued to focus on measures to increase “transparency” concerning Fed actions. For example, Chairman Bernanke initiated press conferences post certain Fed meetings to enable the media to ask questions regarding Fed actions. This aim to add transparency is now morphing into the Fed likely making public its forecasts of economic growth, interest rates and inflation targets. Do we really think that the Fed and its staff will be any better in making forecasts than any number of private sector market observers? What happens when forecasts prove to be wrong? Will there be a specific menu of options that will be implemented to correct the data to adhere to a new base-line forecast? It’s interesting that in the recent release of Fed meeting transcripts from 2006 that the Fed and its staff clearly underestimated the extent of the oncoming housing crisis. At his first meeting as Chairman, Ben Bernanke noted that he agreed with the view that “a decline in housing will be cushioned by strong fundamentals in terms of income, jobs, and continuing low interest rates.” He also noted “strong fundamentals support a relatively soft landing in housing” as “residential investment represents just 6% of the economy. I think it would take a very strong decline in the housing market to substantially derail the strong momentum for growth that we are currently seeing in the economy.” Boy did they get that right! One thing is true as it relates to the markets; that is with more data being released, we will see more market volatility. That’s the way the markets work. So while the aim may be to provide “transparency” associated with Fed actions, it will frankly be all about the politics as such devices can be used to deflect Fed criticism by members of Congress and presidential candidates. We suggest the market gets enough information already; that is in regard to both content and timeliness.
Qualified Investors may contact us for our part Market Commentary and Letter to Investors. infor@cedarridgepartners.com
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