Market Review
The Flight to Quality Continues
The flight to quality continued in May and risk aversion reigned. Treasuries benefitted and yields declined sharply. Fears centered on European sovereign default risk, the long-term viability of the euro, and most importantly, the negative impact of European austerity measures on the global economy. Despite the fact that U.S. economic data began to show slow growth, investors focused on the uncertainty of financial reform, which exacerbated risk aversion. Low inflation data and Federal Reserve Board commentary reinforced the view that the Fed will keep short-term rates low for a very long time.
Tax-Exempt Market Review
Risk Aversion Benefits High Quality
High quality municipal bonds outperformed lower quality bonds in May. Credit spreads widened to limit returns on lower quality bonds. While overall municipal supply was ample in May, tax-exempt supply was relatively low since a higher percentage of municipal debt was issued as taxable Build America Bonds (BABs). The chart below illustrates this trend. Low supply, combined with a steady inflow of funds provided support to the tax-exempt market. In a search for yield, funds continued to flow out of low-yielding money-market funds and into intermediate-maturity funds. Yield ratios relative to Treasuries also rose as Treasury yields declined significantly. On a relative basis, tax-exempt bonds continue to look attractive.
Taxable Market Review
Taxable Munis Perform Well Despite Headline Risk
Rampant risk aversion drove widening yield spreads in all spread sectors in May. Corporate bonds, especially financials and energy bonds, were sharply impacted by the financial reform bill and the failure to contain the BP oil spill. Yield spreads on Agencies and taxable municipals widened modestly compared with corporate bonds. As in the tax-exempt market, higher quality outperformed.
The BAB program was the subject of several recent announcements out of Washington. The House of Representatives approved a jobs bill that included an extension of the BAB program for two years with a reduced subsidy. Additionally, the city of Austin, Texas and the state of Maryland announced the IRS withheld funds from a BAB subsidy payment for fees owed to the federal government. Finally, the IRS announced audits of some of the BAB deals to determine if there were any irregularities in the initial pricing.
We believe these issues will be resolved as the program evolves and regulations are clarified. Over the near term, however, uncertainty created by headline risk may put pressure on BAB yield spreads. We view any spread widening as a buying opportunity.
Breckinridge Strategy
Moving Out the Curve
It is becoming increasingly evident that the Federal Reserve intends to keep short rates low for as long as possible. Benign inflation data, a weak labor market, and weaker global growth support this position. With relatively steep Treasury and tax-exempt yield curves, we are buying in the intermediate part of the yield curve, and in some cases, swapping out lower yielding, very short maturities. This will result in a less barbelled portfolio structure. We are maintaining our emphasis on high quality given the uncertain economic and budgetary outlook.
The Unfunded Pension Liability Overhang
Breckinridge Webinar Available on www.bondinvestor.com
Breckinridge recently outlined its strategy for navigating state and municipal pension risk in a webinar entitled “Pension Risk and Municipal Bond Investing.” A recording is available on our website. Key points made in the webinar include:
- Breckinridge believes pension obligations will contribute to significant divergence in the credit quality of municipal issuers in the next several years.
- Funding ratios for major state and local pension funds are approximately 83 percent now and projected to decline to 72 percent by 2013, an inadequate level according to actuaries. Additionally, typical assumptions of 8 percent annual investment returns may be too aggressive.
- However, most plans remain years from insolvency, which means there is time to pursue needed pension reforms. In Colorado, lawmakers recently passed legislation reducing annual payments to current retirees. In other states and municipalities, employees must contribute more for the same pension benefits or wait longer to be eligible to retire. Pension reform has in fact become politically popular.
Assessing the diverging pension risk and credit quality of municipal issuers requires thorough, independent research. Breckinridge applies its proprietary credit rating system and individualized approach to assess pension risk – selling bonds that fail to meet our rigorous investment guidelines and buying only what we consider to be safe municipal credits.
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 paper should be construed or relied upon as legal or financial advice. 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, such as 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.
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