Municipal Bond Market 2010 Q&A
Clinton Investment Management
Andrew Clinton
September 10, 2010
For those of you accustomed to reading Clinton Investment Management’s (CIM) quarterly commentary, for this issue we have chosen a Q&A format in order to directly address many recurring questions that we have been receiving regarding issues such as general municipal bond market conditions, the direction of interest rates and the potential impact a move in yields would likely have on the market going forward.
Q. “I do not want to assume the risk associated with investing in equities and I don’t want to invest in cash given that yields are effectively 0%. What should I do now?”
A. When weighing whether to put more money to work in the municipal bond market in the near-term, recognize that although rates are low by historical measures, relative yields remain attractive in our view. Considering that the Bush tax cuts are almost certain to expire in January 2011, at least for those in the highest tax brackets, additional investments now could prove advantageous as it does not appear that current market yields reflect a potential increase in demand for tax-exempt bonds should tax rates rise. In addition, given the seasonal aspects of the market, i.e. technical conditions, that typically persist in the latter part of the third and fourth quarters, the next several weeks could present a good entry point as municipal yields may rise temporarily in order to accommodate additional issuance. States like New York and California, historically late in their budget approval cycles, cause the new issue calendar to temporarily swell, putting upward pressure on yields during the fourth quarter. Having said that, inflation expectations appear quite subdued at the moment. The unemployment rate remains stubbornly high and, given the likelihood of ongoing budget cuts by state and local governments, our expectation is that the economy will grow at a more moderate pace, constraining any rise in interest rates over the next several months. Municipal credit conditions are likely to remain challenging at least into fiscal 2012-2013. As such, we continue to be extremely sensitive to issuer selection as we seek opportunities to increase exposure to stable essential service names, i.e. water, sewer, and power related issuers. We continue to monitor economic conditions closely for signs of acceleration or change in inflation expectations.
Q: “If interest rates do rise in the future, should I be committing additional assets to the municipal bond market now given the historically low level yields?”
A: Much has been written, of late, regarding the probability of a move higher in interest rates. Unfortunately, little has been written regarding several important factors investors should consider before taking action in this regard. First and foremost, many of the most astute investment strategists have demonstrated, over time, that consistently predicting the direction of interest rates is very difficult if not impossible. Yet, with short-term interest rates at extremely low levels, it is our view that as the US economy stabilizes, higher interest rates will likely follow. That is not to say, however, that investors should avoid fixed income, let alone municipal bonds. As an asset class, fixed income, and tax-exempt bonds in particular, have proven to be a stabilizing force in our clients’ overall asset allocation during what has arguably been one of the most challenging three year periods in financial market history. In order to fully address the concerns raised by this question, the ultimate direction of interest rates cannot be considered in isolation. Therefore, a discussion of other relevant questions must follow.
Q: “What is duration and what does it mean as it relates to fixed income investments?”
A: Modified Duration is a measure of a given bond’s and or bond portfolio’s sensitivity to changes in interest rates. The longer the duration, the more sensitive the bond or portfolio is to changes in interest rates. When interest rates are falling and prices are rising, a longer duration bond or portfolio will benefit more from a total return perspective. When rates are rising and prices are falling one would prefer to maintain a fixed income position that is less sensitive to changes in rates, thus, a shorter duration is more appropriate.
Q: “To what degree will interest rates rise if they do move up?”
A: Should interest rates rise less than the cataclysmic move suggested by some, the associated income generated by a given bond will offset some portion of principle loss that may occur from a rise in rates. Therefore, investors must ask and answer the following questions before positioning portfolios accordingly.
Q: “When will interest rates be higher?”
A: If rates rise slowly over a two year or perhaps even a five year period, a significant amount of income could be lost as the opportunity cost of remaining invested in low yielding short-term bonds could be very high.
Q: How will the shape of the yield curve change affect my portfolio if rates do rise?
A: A bear flattening of the yield curve occurs as short-term yields move higher by a greater margin than long-term yields. Many investors have made the mistake, during prior periods of rising interest rates, of not recognizing the potential risks associated with a “twisting” yield curve. For example, an investor, believing that interest rates are heading higher, might liquidate all of his or her existing long-term holdings while purchasing short-term bonds with the proceeds under the assumption that the yield curve would shift in a parallel manner. This would be an appropriate strategy for preserving principle were interest rates to rise by the same number of basis points in every maturity. If, however, short-term interest rates rise by a higher degree than long-term rates, investors, having expressed their view on interest rates by investing in short-term bonds, may ultimately lose more value than if they had held the bonds that they sold. This second scenario is entirely possible given the degree to which the Fed has cut short-term interest rates to date.
Q: “With all of the news surrounding the uncertainty of municipal credit quality and financial soundness, what is a municipal bond investor to do?”
A: We firmly believe that a tactical rather than passive investment strategy will better serve clients, over time. Passive buy and hold or what we affectionately refer to as “buy and hope” strategies are, in our view, a simple means for accruing income with little prospect for growing principle value. Through our active oversight, we track individual credit developments on a real time basis in an effort to avoid the fundamental credit deterioration that has plagued select municipal issuers to-date. We fully understand and appreciate that our clients seek out the safety and security of municipal bonds in order to preserve principle and generate tax-free income. Thus, our role is not only to oversee the individual positions within our clients’ portfolios but also to rigorously manage our clients’ risk exposure. We do this through the disciplined application of a unique investment methodology and process which segments risk into several key investment criteria. We then monitor our clients’ overall risk exposure and seek opportunities throughout the life of their investments to reduce portfolio volatility while optimizing the portfolios’ potential for total return.
In closing, it is our sincere hope that these responses deliver both insight and a sense of confidence regarding our views on the municipal bond market and active portfolio management. We recognize that the questions above are not comprehensive. Therefore, we invite you to contact us directly if you would like to discuss the municipal bond market in more depth. We truly appreciate our clients’ ongoing loyalty and support and look forward to speaking with you soon.
Andrew Clinton
President
Clinton Investment Management
(c) Clinton Investment Management
