Chairman Bernanke has started to turn the Federal Reserve’s liquidity spigot in the off direction and will continue this process through the remainder of this year and into next.  It will be a slow process, as the Fed remains concerned about the fragility of the economic recovery.  With unemployment at elevated levels, foreclosures a topic of daily conversation (approximately 25% of mortgages remain underwater – not in default, but underwater) and with banks still stingy about extending credit, the Fed seems focused on letting this economy gain its footing versus worrying about the potential risk of inflation.  Thus, the “extended period” language attached to the Fed statement continues.  

Many are suggesting that “easy money” (low Fed Funds rate) is what fixed most of the credit-crisis ills and now has the potential to create inflationary pressures.  We hope so!  Recall that we have been focused on investing in shorter duration bonds with the expectation that the trend in interest rates is a rising one.  As our shorter maturity bond positions are either sold (at stable prices) or mature, we anticipate that we will be reinvesting at higher rates.    

Easy money does not necessarily cause inflation. In fact, given high unemployment, low capacity utilization and continued weakness in the housing market, we do not see inflation as being a threat in the near term. However, expectations about future inflation, and more importantly, supply/demand imbalances can cause higher interest rates in the near term. With the massive borrowing needs engendered by the budget deficits at both the Federal and State levels, the supply of Treasury bonds may temporarily exceed the demand.  This imbalance, in and of itself, may cause interest rates to rise.  We have serious long term concerns about the current spending spree in Washington and its implication on the dollar, the economy, investment returns and our standard of living in a global world – but we will save that topic for another day.

     

Key Interest Rates	03.31.10	12.31.09	03.31.09
Prime Rate	3.25%	3.25%	3.25%
Fed Funds Rate	0 – 0.25%	0 – 0.25%	0 – 0.25%
3 Month T-Bill	0.16%	0.05%	0.23%
10 Yr US Treasury Bond	3.83%	3.83%	2.68%
10 Yr AAA Municipal Bond	3.08%	3.26%	3.43%
10 Yr A Corporate Bond –                                                                         Industrial	4.84%	4.97%	5.41%

 

Source: Cleveland Fed

The coming round of tightening – FYI, it has already started – will look different than many are expecting. Historically, the Fed simply increases the Fed Funds rate (the rate at which banks lend to each other on an overnight basis) to decrease liquidity.  While the Fed has many other arrows in its quiver to remove stimulus from the system, this is the most frequently used tool that is referenced by the media and Wall Street.  Given the magnitude of the stimulus thrown at the economy and the banks over the past two years, much is being done to unwind the stimulus without raising the Fed Funds rate.  To name a few:

• The $300 million U.S. Treasury purchase program has concluded
• The $1.25 trillion Agency and Mortgage   Backed Security purchase program expired on March 31st
• The discount rate (the rate at which banks   can borrow from the Fed) was increased on February 19th
• Most TARP recipients have repaid funding and the program is being scaled down
• The Term Asset-Backed Loan Facility is scheduled to close on June 30th
• The housing tax credit will expire in April

We believe the Fed is monitoring the economy and the commercial and residential real estate markets to see how they handle these actions before additional tightening occurs.

The chart above illustrates the size of the Fed’s balance sheet and the assets it holds. We anticipate that over time, the Fed will sell or let mature its Agency, Mortgage Back Security and U.S. Treasury positions.  When the Fed sells a bond from its balance sheet, an investor (bank) buys it, reducing the available public money supply.  These are dollars that could have been used to extend credit to a business, home buyer or a student seeking a loan.  Even if the Fed doesn’t sell any securities, over $200 billion of holdings will mature thru 2011, thereby reducing the Fed’s balance sheet.

At some point the Fed will raise the Fed Funds rate, but keep in mind that even a 1% rate is highly accommodating.   Our message today – the easing is over, the economy is slowly improving and the Fed will be removing the excessive liquidity injected over the past eighteen months, but it could take years.

Taxable Bonds

What a quarter… to nowhere.  The dollar weakens significantly, interest rates rise, then Greece falls off a cliff pushing global investors back to the safety of U.S. Treasury bonds, driving yields lower and the dollar higher.  At the end of March, the massive supply of new Treasury issuance finally caught up and pushed the 10 year U.S. Treasury to an intra-quarter high of 4.01%.

Going forward, it isn’t just Greece, the PIIGS

(Portugal, Italy, Ireland, Greece and Spain) all have long term structural problems and mountains of debt…sounds a lot like the U.S.???   While Greece is quickly addressing its structural flaws and extending maturities when it can (along with many other nations around the globe), these are long term problems that will require long term solutions, which we anticipate will result in increased global volatility for interest rates.  Even with all of the intra-quarter volatility, the 10 year U.S. Treasury ended the quarter at the same level that it started the quarter, 3.83%.

Here at home, we continued to see an improvement in economic activity.  Household net worth increased for the third consecutive quarter, primarily attributable to the improving stock market and stabilizing home values.  The University of Michigan’s March consumer confidence index hit a 15 month high and retail sales, while not exciting, have improved.  While small businesses are still struggling, Corporate America is feeling much better and the bond market reflects these improvements.

The Treasury yield curve remains historically steep, indicating investors expect the economy will continue to improve and interest rates will be higher in the future.  We continue to see opportunities in the 2 to 7 year range with an average portfolio duration of approximately 3.  Lower quality (BBB+) investment grade corporate bonds spreads have tightened relative to Treasuries as the economy has improved and corporate earnings snap back. We continue to remain void of U.S. Treasuries favoring Government Agency bonds and maintain an overweight exposure to investment grade corporate bonds.  We remain invested in a larger than average position in BBB+ bonds as we anticipated an economic recovery would benefit this sector.  We have enjoyed meaningful appreciation in most of these issues.

We remain optimistic that our short duration (maturity) structure will benefit our clients in the years ahead!

 

U.S. Treasury Yield Curve

         

           Source: Bloomberg

Municipal Bonds

 

The municipal bond market continued to weather the headline risk and supply storm in the first quarter of 2010.  Some of the risks appear to be warranted while others appear to be sensational.  An obvious disconnect exists between risk perception and performance.  Moreover, the disconnect between perceived risk and demand for municipal bonds continues to widen as tax rate increases start to take hold.  The municipal bond market is currently benefitting from mutual fund flows, strong underwriting activity, and the extension of the Build America Bond (BAB) Program.

 

Increasingly, investors are looking to the municipal bond market for preservation of principal that is exempt from taxes.  The resulting strong demand has allowed municipal yields to remain near historically low levels.  This increased demand and low interest rate environment has facilitated strong underwriting activity that is generating near-record supply.  It should be noted that a large portion of this issuance came to market in the form of taxable Build America Bonds, where 35% of the interest cost will be subsidized by the Federal Government.  Thus, as total supply increased, the tax-exempt portion of the supply was limited and met with growing demand.  The BAB program will continue into 2011 with potentially lower levels of subsidy and more focused purposes of funding.

While there are many indications that the U.S. economy has begun to show signs of improvement, many municipalities continue to experience fiscal and political challenges.  Many states are projecting further declines in tax revenues as unemployment rates remain high and consumer spending continues to be sluggish. 

Headline risks highlighting the municipal market continue to rollout with little signs of slowing.  Obviously, there are challenges that will affect the market for years to come.  At this point, most of the debate is over the risks involved with mounting pension obligations.  It is our belief that these obligations will not lead to an increase in municipal defaults.  Keep in mind that pubic pensions are not like corporate pensions.  Rating downgrades may occur as a result of these challenges.  However, gradual economic improvement has started to occur leading to a firming of the credit story for general Obligation Bonds and Essential Service Revenue Bonds.  More financial transparency and governmental reform are the anticipated positive byproducts resulting from the critical evaluation of the municipal landscape.  

 

We remain cautiously optimistic in regards to the municipal markets.  Our focus continues to be on preservation of principal and cash flow.  Demand continues to be strong and is expected to increase as tax rates rise and the national and local economies improve.  Curiously, demand from overseas for BABs occurred in a meaningful way in March of 2010.  If the trend continues – this should be a net positive for the municipal marketplace as a whole.  We understand that municipal credit generally lags the broader U.S. economy by several quarters.  It is our expectation that in the midst of deafening “noise”, the municipal market will continue to evolve and be resilient.

 

Carret Bond Strategies

 

Municipal Bond: An Investment-grade intermediate duration portfolio focused on preservation of capital and cash flow.  Each portfolio is customized to meet individual client goal and objectives.  Our strategy is designed to generate tax exempt returns with strong risk controls.

Taxable Bond: An investment-grade intermediate duration portfolio focused on corporate, government agency and U.S. Treasury bonds coupled with select opportunities in preferred securities. Utilizes top-down and bottom-up fundamental credit research with the goal of generating high current income with the preservation of capital.

Past performance may not be indicative of future results. Different types of investments and investment strategies involve varying degrees of risk, both short-term and long-term, including principal loss and fluctuation. No client or prospective client should assume that any material in this document serves as the receipt of or a substitute for, personalized advice from Carret Asset Managment, LLC or from any investment professional. Due to various factors, including the passage of time and changing market conditions, such content may be outdated and no longer reflective of current holdings or position(s).

(c) Carret Asset Management

www.carret.com