Turbulence returns and bonds do their job – protect, preserve and deliver that oh so precious income that is getting harder to find.  While we are keenly aware of the growing bubble in Treasury bonds (recall we are void of Treasuries), we frequently review the reasons for the record demand for Treasuries - to name just a few: slowing economic growth, greater Government regulation, the European debt crisis, looming financial reform, uncertain tax policy, November election jitters, public unrest in Greece and Thailand, a terrorist attempt in Times Square, growing tensions between North and South Korea, the Wall Street “flash crash”, BP’s environmental disaster, monetary tightening in China and other emerging nations and the one we hear most often, a growing distrust with politicians globally.  

Coming out of the first quarter, the ten year U.S. Treasury rate rose to a hair above 4% as it appeared the economy was on the mend. First quarter GDP grew 2.7%, nothing exciting after a severe downturn, but none the less a positive showing.   By late April, the growing problems in Greece began to spill over into Spain and other European countries.  Concern quickly mounted that a slowdown in Europe would create a double dip in the U.S.  This is having a two pronged effect on interest rates – 1) if the U.S. economy slows, the odds of lower inflation rise and thus, interest rates decline and 2) with sovereign debt concerns mounting, the U.S. remains a global safe haven, creating outsized demand for our debt and lower interest rates on Treasuries.    

Political leaders in most industrialized countries are finally racing to reduce headcount for public payrolls, restructuring pensions, reducing health care subsidies, deferring public projects, and cutting costs in numerous ways in an effort to illustrate to “institutional investors” that they are serious about reducing deficits and overall debt levels.  A simultaneous mass deleveraging by industrialized nations will create a slowdown in global GDP growth.  President Obama took this message to the G20 in

 

Key Interest Rates	06.30.10	12.31.09	06.30.09
Prime Rate	3.25%	3.25%	3.25%
Fed Funds Rate	0 – 0.25%	0 – 0.25%	0 – 0.25%
3 Month T-Bill	0.18%	0.05%	0.19%
10 Yr US Treasury Bond	2.94%	3.83%	3.53%
10 Yr AAA Municipal Bond	2.78%	3.26%	3.52%
10 Yr A Corporate Bond –                                                                         Industrial	4.04%	4.97%	5.10%

Source: Bloomberg & Vanguard

 

U.S. Capacity Utilization

 

 

Source: Bloomberg

Toronto in June, proposing that the G20 members follow in our footsteps and spend their way out of this problem.  An easy proposition for him, when our dollar is strong and our interest rates are at record lows (a result of perceived safety). Expanding government spending would theoretically enhance global GDP growth, which would benefit the U.S. more than any other country.  The President, focused on avoiding a Euro style loss of confidence in the dollar, recognizes the importance of maintaining a position of monetary power, and has indicated “the rising national debt is a real and legitimate concern”, “we’ve got to get our debt and our deficits under control”.  The U.S. Federal debt will stand at approximately 62% of GDP by year end 2010, the highest level since WWII.

G20 leaders didn’t agree with the President’s spending request; however, there was one unified agreement that we think is important for investors.  Leaders globally recognized that government spending is out of control and have jointly committed to cutting deficits by at least half by 2013 and capping GDP to debt ratios by 2016… all while aiming to preserve global growth prospects? This will remain a challenge for years to come as the leveraging of governments world-wide took decades to reach the tipping point and will take many years to work-out.  We are becoming concerned that a combination of spending cuts and tax increases could weigh on economic growth.  This is important to bond investors over the short term as global deleveraging will create slower global GDP growth and provide lower levels of inflation.  Longer term, we believe that 1) governments will use their printing presses to inflate their way to lower debt levels and 2) investors will demand greater returns relative to the risks (interest rate and credit) they assume.  Accordingly, with an outlook towards higher rates in the years to come, we remain focused on short duration, high quality portfolios.    

While we do not see a double dip on the horizon, we do anticipate a prolonged choppy recovery. With unemployment at 9.5% and consensus economic growth for the second half on the decline, the Fed has every reason to be aggressive with the Fed Funds rate. Indeed, with the year over year core CPI at 0.9% and capacity utilization still at low levels, the Fed is clearly more concerned about a double dip recession than the prospects of inflation.  The markets agree, with the first Fed Funds futures contract above 50 basis points being the June 2011 contract.

Another topical question we are frequently asked regards tax policy for 2011.  We know taxes are going to go up, we just do not know the timing, the magnitude, or the degree to which each bracket will be impacted.  It is safe to say that if you are single and make over $200,000 or a couple making over $250,000 in adjusted gross income – your taxes will be going up. Additionally, come 2013 the new Medicare tax will also kick in.  Democrats have been delaying the tax conversation in Washington in hopes the economy would be stronger and a tax increase would be more palatable.  With concerns of a double dip front and center and the November elections approaching quickly, leading Democrats have recently stated that “spending cuts would have to outweigh tax increases”.  We anticipate the Democrats would love to address this important issue after the election.

 

Taxable Bonds

Corporate bonds meaningfully outperformed Treasuries until late April when the European sovereign debt crisis erupted and investors flocked back into Treasuries.  The ten year Treasury yield crested just above 4% as the first quarter ended and fell back to 2.94% as the second quarter concluded.  This is the lowest level for ten year Treasuries since April of 2009.  This swing, led to a strong performance for Treasury bonds during the 2nd quarter.

Corporate America has “de-leveraged” at a quick pace, building large cash balances, paying down debt, extending maturities at record low rates, and overall having leaner balance sheets.  This is providing a more positive outlook for corporate credit.  While spreads have rallied over the past year, they are still wide by historical standards indicting room remains for further tightening.  We believe that when the Fed finally starts to raise rates, corporate credits will outperform Treasury bonds as Treasury yields rise faster than corporate yields.  Additionally, we believe the increasing supply of U.S. Treasury debt and a contracting supply of corporate bonds will be a positive factor in the performance of corporate bonds.

We continue to remain overweight investment grade corporate bonds and have reduced our exposure to Fannie Mae (FNM) and Freddie Mac (FRE) paper.  Since the government took over Fannie and Freddie under conservatorship in September of 2008, we have reduced our exposure to these agency bonds. 

 

U.S. Unemployment Rate

 

Source: Bloomberg

 

President Obama and team have pledged to cover them thru 2012. Many investors are assuming that agency bonds are as safe as Treasury bonds due to the implied backing.  We do not assume anything and therefore, no longer hold any FNM or FRE bonds with maturities over three years as we have become unclear on the governments long term intentions.

We are staying short, focusing on high quality, being opportunistic and looking at total return!

 

Municipal Bonds

 

The municipal bond market extended its rally during the 2nd quarter of 2010. Yields grinded lower as the demand for high quality fixed income securities were reminiscent of the "flight to quality" environment experienced during late 2008. Municipal bonds continued to benefit from a favorable technical backdrop. The key positive drivers were relatively light supply, strong demand, and heavy seasonal reinvestment of maturing principal and coupon payments.

 

The Build America Bond (BAB) program continues to be a major player in the primary market with total issuance of over $115 billion since the program’s inception in April of 2009. This program allows municipalities to issue taxable bonds for qualified projects and receive a subsidy of 35% from the Federal government. The supply of taxable BABs has reached nearly 25% of total municipal issuance which has led to a “crowding out effect” for traditional tax-exempt municipal bonds.  This contributes to the supply / demand imbalance that has helped generate positive price returns.  It should be noted that the BAB program is scheduled to expire at the end of this year, but will probably be extended, most likely with a reduced subsidy. Depending upon the final form of the program, we may see the balance shift back to more traditional tax-exempt issuance in 2011.

The fundamental credit picture for the municipal market continues to play out in headlines. State and local governments are challenged to aggressively cut spending while raising taxes and fees in an effort to balance budgets and stave off revenue declines.   Pension funding remains a long term concern for most states and municipalities.  However, there has been evidence that many municipalities have begun to enact measures to close the gap such as increasing employer and employee contributions, raising the minimum retirement age and capping cost of living adjustments for current and future retirees. 

Within the municipal market, steady demand for high quality essential service revenue bonds and general obligation bonds has helped to aid positive price returns in the quarter.  Moreover, short-to-intermediate maturities were in demand as a result of the flight-to-quality trade.   The expectation for higher tax rates has also bolstered demand for tax-exempt municipals.  The highest marginal Federal tax rates are expected to climb to 39.6% from 35%.  Additionally, the recently signed health insurance reform law applies Medicare taxes to virtually all investment income except interest from tax-exempt municipal bonds.  On top of all of this, state tax rates will continue to increase and many investors may ultimately surpass a combined tax rate of 50%. 

 

Despite much improved market liquidity, strong demand, and cautious optimism, it is clearly a time for careful diligence and diversification.  We will continue to diversify portfolios with regard to issuer, sectors, geographic areas, and maturities. Our focus remains on preservation of principal, positive cash flows, and reinvestment opportunities.

 

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 goals 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).

 

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www.carret.com