Recovery Stalls and Bonds Benefit
“Double-Dip” Fear Reigns
Interest rates declined in August in response to weak economic data and indications from the Federal Reserve that it is determined to keep interest rates low. During the month, it became evident that the economy began to slow in the second quarter and has stalled in the third quarter.
The housing sector posted particularly weak data. Despite historically low mortgage rates, sales dropped following the end of the Federal tax credit. Additionally, mortgage delinquencies remained extraordinarily high. Most importantly, disappointing unemployment data confirmed the weakness in the overall economy and solidified the Fed’s intent to remain accommodative.
Yields declined across the curve. The two-year Treasury note again achieved a new milestone, hitting an intra-month all-time low yield of .46 percent. The 30-year Treasury bond yield declined the most, returning 8.00 percent for the month.
Tax-Exempt Market Review
Low Supply and Heavy Inflows Produce Strong Returns
Municipal bonds posted strong returns in an environment of low issuance and heavy demand. Flows into mutual funds out of money-market funds remained strong as yields declined to miniscule levels. Sub-1.00 percent yields in maturities less than four years pushed investors further out the yield curve in search of higher yields.
These technical factors, combined with sharp declines in Treasury yields, enabled municipal bonds to post returns that are typically seen in the taxable market. Negative headlines regarding specific credits were in abundance; yet for the most part, investors did not distinguish amongst strong and weak credits. The search for higher yields dominated investor sentiment as lower quality bonds outperformed higher quality bonds. The same phenomenon resulted in outperformance of longer maturities versus shorter maturities.
Taxable Market Review
In a Market Full of Gloom, Treasuries Outperform
With market sentiment dominated by fears of a weakening recovery and a possible dip back into recession, investors fled to Treasuries. Both taxable municipal and corporate bond yield spreads widened. In contrast to the tax-exempt market, higher quality bonds outperformed lower quality bonds.
Uncertainty over the future of the Build America Bond program (BAB) continued to plague taxable municipals. We believe it may be difficult for Congress to pass new legislation before the program’s expiration at year-end given the upcoming elections and fractious political environment. We are confident the BAB program will be extended, although the timing remains uncertain.
This uncertainty has produced historically wide yield spreads between taxable municipal and corporate bonds. Corporate bond event risk has risen due to the recent increase in merger and acquisition activity. Accordingly, we view this as an extremely opportune time to invest in high quality taxable municipal bonds.
Breckinridge Strategy
Taking Advantage of a Firm Market
With supply low and demand high, the opportunity currently exists to sell weaker credits. We have taken this opportunity to further refine our portfolio holdings and sell issuers we believe may be at risk for rating downgrades or spread widening. In particular, we have focused on underfunded pension liabilities and the impact they could have on already stressed municipal budgets.
In today’s fiscally challenged and uncertain economic and political environment, Breckinridge is even more vigilant in reviewing municipal credits. Recent and future improvements in municipal financial disclosure rules such as GASB 54 are benefiting investors. In addition to analyzing the financials, other factors are also considered when reviewing a municipal credit. Credit reviews also include more subjective factors such as: assessments of the local political climate, government leaders’ ability or willingness to make difficult decisions, the presence and influence of unionized employees and state specific laws. We then act opportunistically to refine our holdings based on these well-informed reviews.
Disclaimer: Any references to credits, sectors, municipalities or other specific securities reflect Breckinridge Capital Advisors Inc.’s opinions and are in no way recommendations or solicitations to buy or sell securities. Actual client portfolios managed by Breckinridge Capital Advisors, Inc. may or may not continue to hold and purchase credits, sectors, municipalities or other specific securities mentioned above. All factual material is believed to be accurate, taken directly from sources believed to be reliable – including, but not limited to – the U.S. government, official financial reports, academic articles, and official trade organizations. However, none of the information should be relied on without independent verification. An investor should consult with an investment professional before making any investment decisions. All investments involve risk, including the loss of principal.
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