Third Quarter 2009

Carret Credit Insight

Senior Portfolio Managers

Jason R. Graybill, CFA

  212.207.2339

  jgraybill@carret.com

Neil D. Klein

  212.207.2340

  nklein@carret.com

Save, Pay Down Debt, Save Some More… What a Novel Concept !

The consumer remains the key to an economic recovery... as they always do, making up 65% - 70% of the overall economy.  Believe it or not, consumer sentiment rose for the fifth straight month in June even as unemployment increased to 9.5%.  How can this be?  U.S. consumers are being financially prudent, paying down debt, saving and examining family budgets to identify where cuts can be made.  These frugal moves will set the stage for not only an economic advance, but for an advance built on stronger fundamentals.  When Americans act financially prudent and are employed, confidence can go in the right direction in short order.  While unemployment remains at elevated levels - and going higher - those with jobs are feeling more confident that they have weathered the worst of the storm.  We expect that as unemployment crests above 10% and confidence stabilizes, we could very well see early signs of a recovery.  However, consumers will not resume spending until they shore up the household balance sheet and that requires – knowing what their house is worth, confidence that the stock market has bottomed, restructuring expenses relative to incomes and feeling secure with their employment. 

As we have discussed before, the Administration and the Fed need consumers to do the opposite of what they are doing, they need us to - spend, borrow and spend some more.  The economic drag from lower consumer consumption has left a massive hole in the economy. A hole that the Government is working hard to fill by going into ever greater debt.  A few interesting statistics… the personal savings rate rose to 6.9% in May, a number not seen since 1993. Household debt has shrunk for the past two quarters – this is a first since this statistic has been recorded.

From an investment perspective, the credit markets have returned to a state of normalcy – if ever this state exists. The TED spread is at pre-crisis levels and high quality corporate bond spreads have tightened to the wider end of historical ranges.  Municipal Bond supply was robust with solid institutional demand keeping rates mostly stable.  The Treasury yield curve is sloping in an upward direction with 2-10 year spreads indicating that investors expect the economy to revive – although, one can’t infer this as they have in the past due to the Fed’s effort to keep rates near 0%.

We are listening to the Fed’s words and watching their posturing as we remain in unprecedented times with the Fed essentially holding rates at 0.0% and buying back $300 Billion of Treasuries in an effort to keep financing rates low. The Fed’s “Extended Period of Time” language remains intact and we believe this will be the first set of words to change prior to any increase in rates. Demand for Treasuries remains strong; however, demand is not keeping in check with supply as 10 year rates have drifted from 2.06% on the 1st of January to close at 3.53% at quarter end.  The Fed has completed more than half of the announced open market purchase commitment and many are expecting them to announce a second round.  We believe the Fed is in a wait and see position. They need rates to stay low and yet the Treasury needs to issue a record supply of new bonds to finance a rapidly escalating deficit.  At some point, we are going to reach an imbalance when the Fed will not be able to manipulate rates. Remember, the Fed can only control / manipulate short term rates and over a cycle, rates will drift to natural market levels.

The Economy, Interest Rates & Inflation

The economy continued to contract (backward looking indicator) during the 1st quarter of 2009, with the final GDP report coming in at -5.5%.  We anticipate this could be the low point for 2009 as the government’s stimulus plan seeps into the economy. We would point out that less than 10% of the stimulus funds from the $787 billion Obama plan have actually been put to work. 

We continue to hear concerns about inflation from clients, prospects, colleagues and industry contacts. While we are well aware that the markets will move in anticipation of inflation, we must say…. what inflation?  While oil, commodities and emerging markets equities have risen materially in the past 3 months, the latest year over year CPI numbers came in at -1.3% in May (the lowest rate since 1950) and the Core number came in at +1.8%.  Wages and unemployment are the two biggest variables to Core inflation, so - with wage growth contracting, unemployment rising and manufacturing capacity at 65%, the lowest level since recordkeeping began in 1948, inflation will not be a serious concern until unemployment not only peaks but starts to decline and the output gap narrows. 

The Fed’s Open Market Committee meetings were a non-event with rates remaining unchanged and the Fed indicating that inflationary pressure is not a near-term concern – note the wording near term.  The CPI figures remain within Bernanke’s Band of 1.0% to 2.0% inflation. 

Consumer Price Index

Global economic conditions appeared to be stabilizing in the 2nd quarter.  At the very least, certain sectors of the worldwide economies have ended their sharp economic contraction.  Fed Chairman, Ben Bernanke, was quoted as seeing the “green shoots” of early economic improvement.  Initial jobless claims may have peaked in March and moved lower to begin the 2nd quarter.  The decline of non-farm payrolls has slowed. Many of the leading indicators have also stabilized and some are moving slightly higher.  Mortgage rates dropped dramatically in the early days of the 2nd quarter creating another massive round of refinancings.  Nevertheless, the economy still faces some meaningful challenges

Taxable Bonds

We continue to underweight U.S. Treasury and Government Agency bonds, favoring Investment Grade Corporate bonds with a focus on short duration (less than 5 year) issues in anticipation of rising rates into 2010.  We remain diversified by industry, sector and company but are focusing shorter duration issues in the lower end of the high-grade universe (BBB+ to A-) as yields present attractive opportunities at this time.    

Many recently learned that Treasuries are not always the safe haven that many believe them to be. As the fixed-income markets have improved from the panic levels of the 4th quarter of 2008 and the 1st quarter of 2009, the “flight to quality” trade has reversed.  10 year Treasury bonds are in negative territory for the year as rates have risen – the Merrill Lynch Treasury Master Index is down 4.5% for the first half of the year. Rising rates have been influenced by a host of issues – below, we identify a few of the key items: 

• Less risk aversion as evident by rising global equity markets - specifically emerging markets
• Declining concerns about deflation
• Increasing inflationary concerns
• Increasing Treasury supply
• A potentially improving global economy
• A potentially bottoming domestic economy
• Concerns about the credit risk of the U.S. Government
• Rising commodity prices

Municipal Bonds

The change in municipal yields were mixed in the 2nd quarter. In particular, yields on the longer end declined while yields on the shorter-side were more stable.  For the first half, as a whole, yields on the shorter end of the curve declined more than yields on the longer end, meaning the yield curve has steepened so far this year.  High quality bonds have held price value while some non-general obligation and non-essential purpose revenue bonds have declined in price.  

Issuance during the first half of 2009 was $194 Billion, or approximately 16% below the first half of 2008. Issuance in the 1st quarter of the year was about equal with that of 2008.  Thus, the entire decline has occurred in the second quarter. New money issuance should be helped this year by strong demand and the incentives in the stimulus package passed in February.  Taxable municipal bond issuance is actually up this year due to the Build America Bonds (BABs) provided for in the stimulus bill. BABs allow municipal bond issuers to sell taxable bonds and receive a 35% direct payment from the Federal Government.

The percentage of bonds coming with bond insurance was cut in half so far in 2009. We would expect bond insurance to remain below 25% for the year, especially with additional questions being raised recently about the remaining insurers with high credit ratings. 

Municipal bond holdings, by household, continued to rise in the 2nd quarter according to the most recent data available from the Federal Reserve. At the end of the first quarter of 2009, households owned directly 35.7% of all outstanding municipal bonds. 

State tax revenues continued to shrink in the 2nd quarter.  The growth in tax revenues began to slow in 2007, and that continued throughout the entire 2008.  This should not be a surprise given the combined impacts of increases in unemployment, which decreases income, as well as increases in the overall savings rate in the U.S. Increases in personal savings means that consumers are spending less, and thus generating less sales tax revenues.

California’s travails were much in the news during the first half of the year, with the State finishing the second quarter rated “BBB” by Fitch and potential downgrades by Moody’s and Standard & Poor’s into the “BBB” category possible in the near future.  The current issues were touched off when California voters rejected some ballot propositions that had been part of the budget package that was passed earlier this year to plug the State’s then budget gap.  Since the time of the Governor’s May revision, state revenues have continued to decline.

Because of the impending cash shortfall, the Controller will begin paying some bills with IOUs (technically registered warrants) in the first week in July. This will give the Governor and the Legislature some time to come up with a plan to tackle the budget and cash issues.

It has been our belief that - as the US economy faltered – so would state and local economies.  Moreover, we have planned for this point in the economic cycle for some time; accordingly, our municipal bond portfolios (California included) have a defensive bias.  Specifically this relates to structure, duration, quality, and coupon and bond type.      

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.

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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