Clinton Investment Management, LLC

Review

Economic activity contracted at a dramatic pace during the fourth quarter as US Gross Domestic Product fell at an annual rate of -6.30% according to the Bureau of Labor Statistics (BLS).  This weakness persisted well into the first quarter as the unemployment rate rose to 8.5% with expectations that this rate will move higher still.  Based on BLS labor reports, since December of 2007, when the current recession began, 5.1 million jobs have been lost.  Households continue to struggle with greater job insecurity, declining home prices, and limited access to financing for home mortgages, cars, and credit cards.  The implications of this can be seen in the dramatic increase in the national savings rate as it is now at the highest level in over a decade. The collective impact of these events has resulted in the precipitous decline in the Consumer Price Index (CPI).  The CPI is down -0.4% over the past 12 months,  the first time it has been negative since 1955.  

As it became more evident to the capital markets that deflationary forces would likely serve to keep inflation expectations low for an extended period of time, the value of various fixed income instruments began to rise during the quarter.  Treasury Bonds, however, were not as fortunate in this regard.  Investor fear of a cataclysmic collapse of the global banking system, during the latter part of 2008, drove Treasury yields to extreme lows.  This fear began to dissipate throughout the quarter, motivating investors to seek higher returns in investments which had been oversold during recent months and now were deemed attractive on a relative basis.

The municipal bond market benefited, not only from the risk aversion that persisted in the market, but also the recognition that tax rates are almost certain to be heading higher over time.  President Obama’s intention to roll back, in part or in their entirety, the tax cuts of the Bush Administration together with the massive Federal stimulus that will come as a result of the passage of the American Recovery Reinvestment Act of 2009 (ARRA) went further toward providing investors with sufficient motivation to reconsider the value of the tax-free cash flows offered by municipal bonds. Over $200 billion were set aside for the purpose of direct or indirect investment in our national infrastructure in addition to providing assistance to municipalities, such as California and New York, which are staggering under the weight of yawning budget deficits.  Furthermore, the willingness of the Federal government to come to the aid of the state and local authorities in their time of need,  further illustrates the essential nature of the services that municipalities provide.

As such, the municipal bond market enjoyed its best quarterly performance since 3Q 04 as measured by the Barclay’s Municipal Index which returned +4.22%.  Continued strong demand for high grade securities and the advent of the Build America Bonds (BAB)’s, authorized under the ARRA, was evident at the close of the quarter.  BAB’s will provide another avenue for municipal issuers to access the capital markets. In effect, BAB’s are issued by the same municipal entities that issue within the tax-exempt market, however, their yield is taxable.  A Federal subsidy, provided for in the ARRA, will reimburse municipalities for 35% of the interest due, providing municipal issuers with an alternative source of funding.  Given the dislocations that persist in the tax-exempt market, this could prove to be a cheaper source of financing for issuers.  Were this vehicle to be used extensively over the next two years, the period of time within which the BAB’s are authorized to be issued, it could have the effect of dramatically diminishing the new issue supply available in the tax-exempt market. As such, the implications of meaningfully lower supply, absent a commensurate drop in demand, could prove quite beneficial to the value of tax-exempt municipal bond holdings going forward.

CIM maintained a longer duration bias during the quarter benefiting client returns as the Barclay’s Municipal Long Index returned over +7.00% for the quarter, significantly outperforming long Treasuries which were down -13.45% during the same period.  Shorter maturities in the municipal bond market also underperformed longer-term maturities as illustrated by the Three Year Barclay’s Municipal Index which returned +2.33% for the quarter. CIM maintained its overweight positions in 10-20 years as this area of the curve participated fully in the municipal bond market recovery that ensued in the first quarter. The Pre-refunded/Escrowed and or government-backed sector of the municipal market was the worst performing segment for the quarter, returning a modest +1.77% according to Barclay’s market data. CIM chose to keep average portfolio credit quality high and sought opportunities to further diversify into the essential services sectors given the ongoing uncertainty surrounding the potential for further credit deterioration within the tax-backed sector.  CIM also chose to remain underweight in 3-5 year maturities given the unattractive absolute yield levels in this area of the curve in addition to the view that this area of the curve is likely to underperform longer maturities over time. 

Outlook

In the near-term, the municipal bond market is well positioned given a multitude of factors.  The relative attractiveness of the asset class, the potential for rising personal income taxes at both the state and federal levels, the markets persistent aversion to risk, moderating equity market return expectations, as well as diminished inflation risks all go further toward supporting a strategic decision to maintain a meaningful overweight position in municipal securities in CIM’s view.  Moreover, a significant increase in demand that may arise as a  result of the over $120 billion in coupon payments and redemptions that are likely to be reinvested in the municipal bond market over the next three to four months, provides additional support to the view that municipal bond prices could rally further. The curve slope is in excess of 400 basis points 1-30 years. 

As such, investors appear to be well compensated for extending into longer maturities.  Forces of supply and demand are likely to continue to influence municipal bond performance going forward.  As such, investors can expect seasonal fluctuations of the municipal market to play a significant role in determining portfolio returns for the foreseeable future. CIM remains committed to seeking out stable credits within this challenging environment.  If you should have any questions or concerns, please do not hesitate to contact Clinton Investment Management directly.

Important Disclosure Information

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter (article), will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.  Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this newsletter (article) serves as the receipt of, or as a substitute for, personalized investment advice from Clinton Investment Management, LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. A copy of our current written disclosure statement discussing our advisory services and fees is available for review upon request.

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