Recovery Stalls; Fed Responds
Quantitative Easing Debate Dominates
As economic data revealed a stalled recovery, discussions heated up in October on whether the Fed should embark on a program of additional Treasury purchases known as Quantitative Easing or QE2. During the month, several Fed speakers, economists and market pundits debated the issue. Investors were left with a near-certain belief that the Fed would pursue QE2 and, after its November 3rd meeting, the Fed announced its plan to buy $600 billion of Treasuries concentrated mostly in the intermediate part of the yield curve.
The QE2 debate caused increased volatility in the Treasury market during October and the yield curve steepened. Short and intermediate yields declined in response to the Fed’s intent to keep rates low. Yields on long maturities of 10 to 30 years rose as investors began to price in expectations of higher future inflation. This trend, supported by a declining dollar, continued immediately after the Fed’s announcement.
Tax-Exempt Market Review
Heavy Supply Dampens Returns
In a reversal from previous months, tax-exempt municipal issuance increased sharply in October and supply outstripped demand. Intermediate- and short-maturity municipal bonds declined in value. Higher quality bonds underperformed lower quality as investors continued their search for yield.
As in the Treasury market, longer maturities underperformed shorter maturities and the yield curve steepened sharply. If the Build America Bond program is not extended by Congress we can expect to see more tax-exempt issuance in longer maturities next year, causing the yield curve to steepen further.
The cheapening of municipals has resulted in historically high municipal/Treasury ratios. Short maturities are particularly cheap relative to Treasuries, as Treasury yields have declined to extraordinarily low levels and investor resistance to low yields has reduced demand.
Taxable Market Review
Uncertain BAB Future Prompts Heavy Issuance
Issuance of taxable Build America Bonds reached a record monthly high of $13.3 billion in October. If Congress fails to act to extend the BAB program, we expect this heavy issuance to continue as the program’s year-end expiration date nears.
The heavy supply and uncertain future are weighing on yield spreads, resulting in historically high spreads relative to corporate bonds. We continue to view the spread widening in taxable municipals as a buying opportunity and are targeting an overweight position.
Although corporate bonds have performed well and yield spreads are at narrow levels, there is an increasing amount of event risk in the sector. Stock buybacks, dividend increases, LBOs and high coupon-bond buybacks through make-whole calls are now daily events. All of these events generally have negative implications for the bondholder.
Source: Barclays Capital
Breckinridge Strategy
Slightly Defensive Given Legislative Uncertainty
Breckinridge continues to target a relatively neutral duration due to uncertainty surrounding federal legislation that could have a significant impact on the municipal bond market. The Bush tax cuts and the Build America Bond program are both due to expire at year-end. Each could meaningfully impact the supply/demand equation in the municipal bond market next year.
For this reason, we are slightly more defensive in structuring portfolios; targeting a neutral duration and level-funded maturity structure. We are focused on bonds that are undervalued relative to particular points on the yield curve or specific issuers.
Our Perspective on the Election Results
Implications of the Republican Sweep
The Republican sweep of the House of Representatives and the state governorships is striking and portends a more fiscally conservative framework in both federal and municipal government. The following maps illustrate the enormity of the Congressional election results.
Sources: Barclays Capital, The Washington Post, The New York Times, Politico, RealClear Politics, The Cook Political Report and The Economist
Republicans picked up 12 state governor seats in the elections, resulting in 29 Republican governorships. In addition, Republicans now control both legislative houses, as well as the governors’ office; in 20 states (previously they controlled only 9 states). The party’s emphasis on reducing the size of government and resistance to adding more debt will have many implications for municipal government and finance. In general, fiscal conservatism should be a positive for municipal credits. However, it could also produce more economic austerity, which could further delay economic recovery. Resolving the problem of unfunded pension liabilities may become more contentious in discussions with unions and we expect to see more headlines on this issue.
Wide Divergence in Ballot Initiatives across States
More than 160 ballot questions appeared on state ballots, many relating to taxes and fees that could significantly impact state budgets. In several instances, taxpayers voted for measures that will help maintain or even strengthen the fiscal condition of the state. Other measures were passed that could hinder the situation.
The election results highlight once again the great divergence between issuers and the difficulty in drawing general conclusions regarding municipal credit quality. The following are examples of some significant legislative ballot results from the election.
voted on several questions and had mixed results. An important ballot question was approved that will now allow the budget to be passed with a simple majority instead of a two-thirds majority. This is a positive development in this politically gridlocked state. However this could be offset by the approval of Prop 26, which requires a two-thirds vote for new fees and charges, and Prop 22, which prohibits the state from borrowing from local governments and transportation funds for other cash flow needs. These two initiatives could have a negative impact on the already stressed budget situation in California.
voters struck down two proposed amendments and a proposition that would have limited the state’s ability to borrow, reduce property and income taxes, and reduce other fees such as motor vehicle taxes. Many had feared that if these measures had passed, it would set a negative precedent for other states.
voters rejected a proposition to reduce the sales tax to 3 percent from 6.25 percent. Approval of this measure would have had a significant negative impact on the budget due to the loss of revenues.
These are just three examples of state election results that will have a significant impact, both positively and negatively, on state finances. It underscores the necessity of thorough credit research on an issuer-by-issuer basis. With an experienced team of credit analysts, Breckinridge has always evaluated issuers independently and maintains a strong focus on fundamental credit research.
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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