The Muni Bond Rout and the Fed's QE2 Conundrum

Includes: CSJ, MYI, NUV, NVG, VGM
by: SL Advisors

While U.S. treasuries yields have been steadily increasing over the past few days, activity in municipal bonds is looking more like a rout. The reach for yield and the eager anticipation of a large non-economic buyer (the Federal Reserve) of treasuries rendered bonds an exceptionally poor investment. Now that the Fed has disclosed its hand, shorting treasuries is no longer reckless, and poor value combined with spreading credit concerns in munis have shown that few potential investors remain at current levels. The activity in closed end municipal bond funds is particularly poor, with funds such as Nuveen Municipal Value Fund (NYSE:NUV) dropping 6% at one stage. Many other funds have experienced dramatic falls (NIO, VGM, MYI amongst others).

While today’s prices are the most attractive in several months, closed end funds still trade too close to NAV to be compelling and ten year treasuries still don’t look like a good ten year investment. In our Fixed Income strategy we maintain a bias towards short maturity high grade debt. Our biggest holding is iShares Barclays 1-3 Year Credit Bond (NYSEARCA:CSJ). Recent increases in bond yields haven’t been caused by signs of growth – indeed recent events such as last week’s tightening in China have caused the opposite concerns, and shipping rates (highly sensitive to shifts in supply and demand) remain weak. But even though a growth pick-up doesn’t appear to be driving bonds down, on balance bond yields still aren’t high enough to be attractive.

The increase in yields does create some interesting questions around QE II. How is the Fed to respond to rising inflation expectations? Since one of their objectives is to raise inflation, does this mean QE2 is already enjoying some success, perhaps reducing the need to invest all $600BN? Or do higher yields require even greater buying of bonds from the Fed, since their objective of lower borrowing costs is moving away from them? It’s never been done before, so nobody knows. Perversely, weak bond prices could justify a curtailed QE2 program, or even a larger one. However, a falling bond market might not react well to the departure of its least price sensitive buyer. Having embarked on this program the Fed is going to have to see it through and make mid-course adjustments as required.

We continue to maintain some non-US$ exposure through ETFs such as CEW and BZF. Higher yields have provided support for the US$, but we think the fundamentals for a weaker currency remain. Further pressure on commodities may create an opportunity to invest in the Canadian dollar as well.

Disclosure: Long CEW, BZF, CSJ,