Risk premiums decline, liquidity returns… for Quality that is.
The 1st quarter of 2009 was another volatile quarter, though high quality, intermediate maturity fixed income investors
were rewarded with positive returns while many markets continued to decline. During the quarter, the credit markets for
high quality investments improved significantly after the credit implosion of October rocked all areas of the bond market.
Credit spreads tightened, money market liquidity returned, the commercial paper market is functioning and the TED
spread is below 100 from a peak of 480. Investment grade corporate bond issuance totaled $868 billion in the Quarter,
significantly greater than the 1Q of 2008 – a sign that investors are seeking lower volatility asset classes. As a comparison,
junk bond issuance was only $10.2 billion during the Quarter. Not to be upstaged, the municipal bond market saw
California bring a huge state GO issue to market with demand far exceeding the $4 billion capital raise that was bumped
to $6.54 billion in a days effort.
While we expect the economy to continue to deteriorate (as measured by unemployment and wage growth) into the summer,
we are seeing signs of improvement in the major problem areas – consumer spending and housing. Core retail sales
rose in January and February and with mortgage refinancing at high levels, household cash flow is anticipated to rise,
which should benefit consumer spending. On the housing front, exiting home sales increased 5.1% and new home sales
increased 4.7% in February – both upside surprises.
As we have said before, housing (mortgages) and leverage were the primary culprits for the implosion of the banking
system and thus the beginning of the economic downturn. We believe these two factors will also be the primary catalysts
for a resumption of economic growth. As household balance sheets are deleveraged via modest consumer spending,
debt reduction and increased savings (not a recipe for robust economic growth since the consumer is 70% of GDP),
the fundamentals of the consumer will be stronger when the turn arrives. However, as we said last quarter, the Government
is the one going further into debt in an attempt to “spend our way out of this spending problem.”
The household savings rate has increased to 5%, the highest level since 1995, versus a negative rate of 2.7% prior to the
economic decline. This one seemingly positive data point alone resulted in a household savings swing of $846 billion
and a contraction to GDP of 6.0%. It is easy to understand why the government encourages us to spend when confidence
is declining and the economy is contracting.
The median single-family housing price in February was $165,000 down 29% from the peak in 2005 – 2006 of
$231,000. As we know, when prices go low enough, buyers will emerge (for any good or service) – housing is no exception.
Mortgage rates declined during the quarter, stimulating refinancing and bringing the housing affordability index
to record highs in many markets. All markets, housing included, adjust in price on the upside and downside faster than
they did twenty years ago – Nationally, we believe we are close to a bottom. Economists, in general, expect it will take
6 - 10 months to reduced excess housing inventories and another 2 - 6 months for home prices to stabilize.
We fielded a recurring question during the quarter from both clients and prospects:
How do we manage portfolios in an inflationary environment?
We are the first to admit that record amounts of government stimulus will eventually lead to some inflation and higher
interest rates; however, higher interest rates are a good thing for bond investors in properly positioned portfolios. First,
we need to agree that inflation will not appear until unemployment peaks and wage growth resumes (two items that we
do not see in the near future) and the global imbalance for goods and services needs to tighten (supply goes down or demand
goes up). Accordingly, investors should position portfolios toward higher coupon, premium bonds with shorter
maturities (we are at a 3.1 average duration). Short maturities will provide a weapon in future years if rates rise as we
expect. TIPS (Treasury Inflation Protected Securities) can provide an inflation hedge; however, a short maturity portfolio
offers more inflation fighting flexibility if structured properly.
One final comment – many money management firms specialize in managing a single asset class which is creating opportunities
for multi asset class investment firms like Carret. A trading pattern has emerged that has become known as
the “Negative Feedback Loop” - equity investors are looking at debt / cds widening and debt investors are watching equity
prices decline and everyone is assuming there must be a problem without talking to the other side. At Carret, since
we manage both equities and fixed-income, we are cross researching our holdings from both the credit and equity perspective
and focusing on the fundamentals of our work and not the noise on Wall Street trading desks.
The Economy, Interest Rates & Inflation
Global economic conditions continued to weaken in the first quarter. In fact, many key indicators found new bottoms.
The broader markets have reacted as one would expect as various stimulus packages grab the headlines. Ten year Treasury
yields traded wildly within the quarter ending at a rate of 2.71%. The payroll reports have become “market moving
events” on the first Friday of each month. The February and March payroll reports showed losses above 650,000 per
month and brought the overall jobs lost number to almost 5 million since the recession began in late 2007. We were encouraged
to see that the number of jobs lost was lower than the 700,000 whisper number. The unemployment rate
reached 8.5%.
The Administration’s fiscal stimulus packages are expected to produce benefits down the road. The latest initiative is
the Public-Private partnership to help remove “bad” assets from banks to free capital and to make new and beneficial
loans. Of course, TARP and TALF are still very much in the picture. Unfortunately, there may be more questions than
answers about these programs at this point. We know that the plans will produce large deficits with the benefits occurring
in the future. Up to this point, the financial system and housing markets have been resistant to policy fixes.
The final fourth quarter 2008 GDP number declined a worse-than-expected -6.2% quarter over quarter on an annualized
basis. The forecast of first quarter growth is mixed with year-end estimates improving and, in some cases, moving back
into positive territory. Obviously, a lot remains to be seen before true improvement should be factored in to any economic
models.
There was some good news as the Conference Board’s [forward-looking] index of Leading Economic Indicators jumped
0.4% month over month in January. The manufacturing numbers and leading indicators were positive for two consecutive
months this quarter. On the other hand, personal consumption expenditures have been negative for two consecutive
quarters signaling that consumers appear to be saving rather than spending at this point. January retail sales jumped a
surprising 1.0%. However, auto sales continue to fade and are almost non-existent.
Treasury yields were extremely volatile during the quarter as the battle waged between flight-to-quality demand and
huge new issue supply. The Treasury’s $1 Trillion buy-back program appears to have won the latest battle as yields
moved lower even as supply flooded the market. Short rates remained constrained by a near-zero fed funds rate.
A pick-up in the inflation rate is not a growing concern at this point in time. The latest CPI report had the rate at 0.3%
month over month and 0.0% year over year. Bear in mind that the Fed’s target range is between 1.0% and 2.0%. Producer
prices were down 1.0% year over year helping to emphasize that inflation is not a serious problem at this point in
this recession.
Taxable Bonds
We remain overweight corporate bonds as corporate credit spreads continue to be extremely attractive by historical standards.
We have increased our short term Agency exposure utilizing callable bonds to capture yield opportunities. We
have sold most of our remaining Treasury paper during the Quarter and continue to avoid this market.
We continue to make shorter maturity investments as we expect rates to rise in future periods. We are focusing on Aand
BBB+ credit on the short end of the portfolio with higher quality credits on the longer end. We continue to remain
underweight financials but continue to invest selectively in this area.
We continue to focus on senior debt with nominal exposure to subordinated debt. Our fixed-income investment philosophy
is to own the highest tranches of the capital structure. On March 5th, we were interviewed by Business Week journalist
Lauren Yong and offered the following insights: “With the major banks, you really don’t want to have exposure to
common stock, preferred stock or subordinated debt,” Graybill says. “The government has quasi-nationalized the banking
system, putting good money after bad to support the financial infrastructure in this country,” he says. “As senior debt
holders, we are multiple steps above the government on the capital structure ladder – a position we find attractive.”
Municipal Bonds
Intermediate maturity municipals posted strong returns in the 1st quarter as demand continued to push prices higher.
The municipal market rally was driven by compelling absolute yields attracting stronger demand from both institutional
and high-net-worth investors. The ratios versus Treasuries remain historically wide as 10 year municipals yielded 130%
of Treasury Bonds at quarter-end.
The supply/demand dynamic appears to be favorable as new issue supply continues to be absorbed into the marketplace.
March’s more than $37 Billion in issuance, including over $6 Billion in California state General Obligation (GO) bonds,
lifted issuance in the first quarter to nearly $84 Billion. Issuance in March was the fifth highest for that month on record,
but still trailed last year’s nearly $44 Billion bonds sold in that month. Many of the new issues “came to market” without
bond insurance. In fact, the percentage of bonds coming with bond insurance was cut in half (27% last year to 13%
this year).
On the insurance front — MBIA Inc. announced that it had established a new U.S. public finance financial guarantee
insurance company by restructuring its principal insurance subsidiary. MBIA hopes this operating structure will facilitate
both transparency and future capital-raising efforts. MBIA Insurance Corp. of Illinois is expected to be renamed National
Public Finance Guarantee Corporation.
We are watching developments out of Washington D.C. that may have a direct impact on Municipal Bond buyers and
the overall Municipal Bond marketplace. The issues of note include; Tax Credits for State and Local Governments,
changes to AMT tax regulations, Safe Harbor exceptions for interest expenses, improvements to bond transparency, and
possible oversight changes for the entire municipal bond industry (SEC / MSRB).
Carret Bond Strategies
• Municipal Bond: Utilizes top-down and bottom-up fundamental research with the goal of generating high after-tax
returns coupled with the preservation and growth of capital. Focus on investment grade municipal bonds with an
intermediate duration.
• 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.
Strategy Allocation
Carret Update
Total Assets Under Management: $1.37 Billion
Equity Assets: $737 Million
Fixed-Income Assets: $633 Million
Total Empoyees: 32
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 Management,
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
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