Fixed-Income Markets: Economic Turning Point Is a Positive Sign

Nov.19.09 | About: E*TRADE Financial (ETFC)

Key Points

  • At the end of last month, new supply and gross domestic product (GDP) data put pressure on Treasuries.
  • The Treasury Department plans to lengthen their average maturity before the economic data gets much better and as the quantitative easing (QE) program ends.
  • Also, a soft month for Municipal Bonds is another reason to like the asset class.

As the month of October drew to a close, Treasury bond prices were under a bit of pressure when the market absorbed yet another record week of auctions, this round totaling $123B in new supply spread out over various maturities. It is not easy selling record amounts of ultra-safe Treasury bonds at the same time economic data are being released showing the expansion of the economy and business cycle. The final leg of the auctions ($31B in 7-year Treasury notes) occurred on the same day that the much anticipated advance GDP numbers were released. The GDP report confirmed what many had forecast -- the economy has turned the corner from negative to positive growth. The debate now centers on how long the recovery will last, how significant it will be and even whether or not this will be a double-dip recession. For the time being though, we will take the positive economic news.

The good news to be taken from the data is that taxpayers are starting to see something in return for their money that the government has been spending on various stimulus programs (e.g. cash for clunkers and first time home buyer incentives). The positive GDP report suggests that efforts to pull the economy out of recession have been effective, at least on some levels.

I find it interesting that earlier in the month we learned the Treasury Department has plans to extend the average life of its outstanding debt. The plan is to extend the average maturity of Treasuries to 72 months. This extension to six years is up from the current average of just over four years. What is the motivation? To lock in lower rates before they begin to creep up with the improving economic picture. According to Bloomberg News, almost 25% of the Treasury’s existing debt will mature in 2010.

One final word on the Treasury market involves the Federal Reserve’s purchases of Treasuries at various spots along the curve. The “quantitative easing” program, which was initiated with the intent of forcing interest rates lower saw the Fed buy as much as $300B in Treasury debt. The Fed has also been buying large amounts of mortgaged-backed securities as well. The plan has been successful to the degree that interest rates, especially home mortgage rates, have remained low. Now that the program has ended, it does not necessarily mean that Treasury yields will spike up without the Fed’s support, though we could see some additional volatility in trading. Treasuries remain in significant demand from buyers, both domestic and global.

The municipal bond market pulled back a bit last month with the primary index down 2.1%. Longer maturity components of the index were down even more. It is not too surprising that the market has taken a breather after turning in a 14% return for the first nine months of the year. The good news is that the pull back added a little more value back into the asset class in certain areas, so take advantage where you can. Even though many of the high quality names on the short end of the maturity scale may be seen as fully valued, that area is still appealing to many. Investors can find bonds with tax-exempt yields of 0.50% to 0.80% on maturities between six months and a year. I have pointed out in the past how these levels may not be appealing in absolute terms, however, on a relative basis, they are fair. Relative to what? Money market rates at 0.01% to 0.25%. This remains an area where many individual investors prefer to invest as opposed to the total-return managers that tend to look further out. If you don’t require daily liquidity and can lock-up your money for six months to a year, then this is worth a look.

I was recently asked why munis are so popular among individual investors. The answer is a straightforward one. The primary appeal is the tax-exempt interest income they provide. Also, this is an asset class made up of predominately higher quality issuers with either tax-supported revenue streams or fees from essential purpose utilities to meet debt service. They also have low historical default rates and are seen as relatively safe.

Those who joined our latest web-seminar heard me explain why it is my belief that there is a greater probability of income taxes going up as opposed to staying flat or even going down at the Federal level. The government simply needs more money to pay the increasing size of its bills. Several states this year have already increased income tax levels or added new top brackets. Potential tax increases are just one more reason for the municipal bond asset class to continue being popular among upper income earners or with anyone who wishes to shelter some income from taxation.

Now that I referred to the overall safety and low defaults on munis, let me not overlook the fact defaults do occur. Several months ago I mentioned a California based wine museum (Copia: The American Center for Wine, Food and the Arts) that is in default on ~$77M in debt. This issuer accessed the muni market through the California Infrastructure and Economic Development Bank. According to an article in The Bond Buyer newspaper, legal proceedings are moving this bankruptcy toward the liquidation phase, so if anyone is searching for 17 acres in the Napa area here is your chance. The land comes with a 78k square foot building. It looks like they have a bid for the property of $37 million and that translates into roughly 48¢ on the dollar.

What went wrong with Copia? The museum’s bonds are backed by “gifts, grants, bequests, donations, admission fees, parking fees and other operating revenues”. In the end it was simply not enough to meet their obligations. More traditional muni borrowers (states, cities, towns, municipal agencies and utilities) have the option of cutting spending or raising taxes and user fees. This adds a layer of safety that has proven to be dependable and attractive to investors.

The more traditional munis are the types of individual bonds that I invest in for our clients at Kobren Insight Management. We do have exposure to the more risky kind as well, but we look to mutual funds to gain that exposure and I fully recommend that retail investors do the same.