Annual Market Review
Fed Policy Anchors Yield Curve
A stalled economic recovery shaped both monetary and fiscal policy in 2010. The Federal Reserve maintained an extraordinarily accommodative policy, anchoring short-term rates at historically low levels. The Obama administration renewed its focus on stimulating the economy through fiscal measures following the Democratic Party “shellacking” in the November elections.
However, the combination of monetary and fiscal stimulus ultimately failed to keep interest rates at low levels. Yields rose and the yield curve steepened in the fourth quarter in anticipation of higher growth and inflation.
Taxable Municipals Outperform Treasuries; Tax-Exempts Diverge
For the year, Treasury yields declined, with short and intermediate maturities declining the most. Taxable municipal bonds outperformed Treasuries and agencies, although performance was held back by credit concerns. In contrast, tax-exempt municipal bond yields rose for the year with most of the increase coming in the fourth quarter. The divergence in performance is due to several factors unique to the municipal market.
Municipal Market Developments
BAB Impact Dominates
Tax-exempt municipal yields rose in the fourth quarter prompted by the spike in Treasury yields. The rise in short- and intermediate-maturity municipal yields was fairly consistent with the rise in Treasury yields. However; the muni curve steepened substantially, with longer maturity yields rising more than 100 basis points. The steepening of the muni curve beyond 10 years is shown in the chart below. The rise in longer muni yields reflects the market’s concern over the loss of support from two key sources of demand.
First, the Build America Bond (BAB) program was not extended. Institutional buyers were a critical source of demand for BABs. Rather than rely entirely on tax-free investors, BABs allowed municipalities to redirect some supply and tap into demand from institutional investors across the globe. With Congress’ decision not to extend BABs, the municipal market lost that long-term demand and once again must rely entirely on the tax-free market. Since retail investors normally shun long-term bonds, traders now expect longer maturities to underperform.
Second, mutual funds are no longer attracting new money. While retail investors don’t purchase long-term municipals directly, mutual funds do. Over the past several years, mutual-fund investors have been the other key source of demand for long-term munis. The funds are now in net redemptions, so instead of supporting the market, they’re actually a burden. This has caused long-term rates to rise further.
In anticipation of uncertain demand in 2011, municipalities rushed to market in fourth quarter 2010. This is expected to create a lull in supply in early 2011, which has allowed the market to stabilize. Still, the municipal bond market enters 2011 on a shaky footing – without BABs and without demand from mutual funds. On top of these technical factors, muni investors remain very nervous about muni credit quality and the potential for a sudden spike in interest rates in general.
The Advantage of a Steep Yield Curve
In regard to interest rates, there is a great deal of uncertainty and fear about higher rates. Bond investors are not oblivious to that risk. In fact, a significant rise in rates is already discounted by the market and reflected in the steepness of the yield curve. The unusually high degree of steepness in the curve means the additional yield earned as an investor extends maturities is quite large. Or, put another way, it means that as each bond gets closer to maturity over time its yield declines significantly.
Last year provided a great example of how the steepness in the yield curve can benefit bond returns. There was very little change in the yield curve when comparing
years to maturity for short- and intermediate-term municipals. However, as the above graph illustrates, when comparing
actual maturity dates, short- and intermediate-term yields fell by a meaningful amount. For instance, according to MMD the market yield on an eight-year AAA bond at the end of 2010 was 2.62 percent, which is exactly where it was at the end of 2009. Yet an eight-year bond purchased a year ago was due in early 2018, and now it is a seven-year bond. The market yield on a seven-year bond according to MMD is roughly 25 bps lower – or 2.37 percent. As its yield declined, the bond has appreciated in value, adding to its total return.
For this reason, Breckinridge pays very close attention to the incremental pick-up in return for each maturity. For a direct investor in municipal bonds, value is added with the passage of time as a bond rolls down to a shorter maturity and lower yield or higher price. This “roll” effect increases the total return of the holding in a steep yield-curve environment.
Credit Concerns
Credit concerns remain in the forefront as states and municipalities grapple with near-term budget deficits and long-term pension and health care liabilities. Negative headlines and misperceptions abound, and we expect this will result in “choppy” market performance in 2011. Breckinridge remains confident that the vast majority of muni issuers will do a capable job managing through these difficult times. Our objective remains to invest in the most credit-worthy isssuers. We address these concerns in detail in the
Special Commentary.
Breckinridge Strategy
Caution Reigns
Due to uncertainties regarding economic growth, interest rates and inflation, Breckinridge is targeting a neutral duration relative to the benchmark, with a slightly barbelled structure. We remain cautious in regard to credit quality and are focused on investing in very high quality general obligation and essential service revenue bonds.
Disclaimer: The material in this document is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Nothing in this document should be construed or relied upon as legal or financial advice. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. Factual material is believed to be accurate, taken directly from sources believed to be reliable, including but not limited to, Federal and various state & local government documents, official financial reports, academic articles, and other public materials. However, none of the information should be relied on without independent verification.
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