Market Review
Geopolitical Risk, Deficit Concerns Drive Volatility
Economic activity improved in February, yet optimism was tempered as turmoil erupted in the Middle East. A sharp rise in oil prices caused many market observers to reassess economic growth and inflation forecasts amid fears that rising commodity prices will stall the tenuous recovery.
In addition to global geopolitical risks, investors are contending with unresolved budget deficits on both a national and state level. Congress passed a temporary budget that expires March 18th and the current plan is to pass another short-term spending measure that will last just four weeks. Bipartisan agreement on spending cuts remains elusive. Failure to pass a budget or continuation of short-term measures could have a significant negative impact on the bond market. At the state level, tax revenues have increased, enabling some states to reduce deficit estimates for FY2011. It is however a slow and modest recovery. States and local municipalities are currently engaged in very difficult budget and policy decisions for FY2012. Highly publicized events in Wisconsin have clearly illustrated the challenges involved in closing budget gaps and reforming pension plans.
Escalating geopolitical risks, increasing oil prices, unresolved budget deficits and a tenuous economic recovery drove increased market volatility in February. Last month, the 10-year Treasury note traded in a wide range from 3.40 percent to 3.745 percent.
Municipal Bond Market
No Supply, Continued Mutual Fund Outflows Dominate
The municipal bond market continued to be dominated in February by two overriding factors: ongoing outflows from mutual funds and sharply decreased new-issue supply. Selling pressure decreased as the volume of withdrawals and the size of the bid lists declined. Reduced supply helped provide firm support to the municipal bond market. As a result, munis outperformed Treasuries despite fund outflows. Nevertheless, investors continue to reduce their exposure to tax-exempt bonds as illustrated in the following chart. It is interesting to note that intermediate maturity funds have experienced fewer outflows.
Taxable Bond Market
Spread Sectors Outperform Treasuries
Intermediate-maturity Treasury yields rose in response to positive economic data. At the same time, long-maturity yields declined, reflecting concerns that higher oil prices will limit future growth. As a result, most sectors outperformed Treasuries. The termination of the Build America Bond (BAB) program drove a lack of supply, which supported longer-maturity taxable munis. A continued search for yield and improving credit fundamentals supported corporate bonds. We expect these trends to continue over the near term.
Breckinridge Strategy
Stay the Course
Our portfolio strategy remains focused on high quality and intermediate maturities, with a barbelled maturity structure. We believe this is the appropriate strategy given the many uncertainties in the municipal market at this time. The challenging fiscal environment reinforces our commitment to target high-quality issuers. At the same time, the tenuous economic recovery and an uncharted Federal Reserve policy support a barbelled portfolio structure as a prudent strategy for protecting our clients’ assets.
It is important to note, however, that this portfolio structure is unlike the structure of the Barclays 5 Year Municipal Bond Index or the Barclays 1 to 10 Year Blended Municipal Bond Index. Important distinctions include the quality composition (Breckinridge portfolios are of much higher quality with little exposure to BBB-rated credits), the large overweight position in the indices of California and New York, which comprise more than 30 percent of the indices (these overweight positions drive much of the performance volatility for the indices as market perceptions of the fiscal condition of these two states change rapidly), and lastly, the maturity structure of the Barclays 5 Year Index is bulleted in the four- to five-year maturity range, while Breckinridge portfolios are well distributed along the maturity spectrum. These differences will at times result in a sharper divergence between the performance of Breckinridge portfolios and the performance of the indices in various market scenarios.
Despite the recent strong outperformance of municipals, we continue to believe that municipal bonds are attractively valued. Given the lack of new issuance, we are concentrating on finding opportunities in the secondary market. We continue to monitor closely our holdings in this challenging environment and will not hesitate to sell holdings that we believe are deteriorating from a credit quality perspective.
Mission-Related Investing
Aligning Beneficial Purposes with Investor Interests
The termination of the BAB program and intense media scrutiny of municipal bond credit quality offer an opportunity to examine the underlying and very beneficial public purpose of municipal bonds.
One of the critical elements in analyzing the creditworthiness of a municipal issue is to evaluate the “essentiality” of the project being financed. The more essential a project is to a community, the greater the willingness of taxpayers to support payment of debt service on the related bonds even in difficult times. In addition to strengthening the security of a municipal issue, a project that serves an essential purpose is also likely to represent a very compelling mission for portfolios with a mandate for social responsibility.
Conversely, financings for non-essential projects are more susceptible to default. A strong legal structure may help, but in the past these have proven vulnerable when local politics come into play. The default of the Washington Public Power Supply in the early 1980s is the best-known example. Harrisburg, PA may soon provide another. As a result, Breckinridge tends to be skeptical of “enterprise-type” financings in which a municipality ventures beyond its core function.
We strongly favor municipal bonds that are issued to finance capital projects related to education, the environment and vital infrastructure. Our motive in doing so is driven by the benefits to bondholders’ security. The fact that the bond finances socially responsible projects that may fit with an investor’s mission is simply an added benefit.
In broader terms, all investors should understand the important role the municipal market plays in facilitating the flow of capital to essential projects at the local and state level. The ability of municipalities of all sizes to efficiently access affordable capital in the municipal market has been critical to our nation’s success in terms of both productivity and competiveness. It is a bottom-up approach that stands in stark contrast to the central planning used in other countries. The municipal bond market represents a vital investment in the future of communities across the U.S. and that’s a mission most investors readily support.
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.
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