Fed Notes-The Twist 
The Federal Open Market Committee (FOMC) held a two-day meeting September 20-21, resulting in the decision to keep interest rates unchanged. This was not a surprise to us. Also as expected the Fed adopted a policy of extending duration on its holdings of treasury bonds. By holding more long-term bonds, the Fed hopes to hold down bond yields which is expected to provide an incentive to banks to lend more freely. The Fed did not decide to set explicit targets for unemployment and inflation nor did it lower the rate it pays banks on overnight reserves. 

• We doubt the move to extend duration will have much impact on the real economy. The Fed will shift $400 billion of securities from short-term maturities to longer-term maturities, but it is not increasing the size of its balance sheet. The move will shift securities the central bank holds on its balance sheet from under three years in maturity to six years and beyond.
• The Fed also announced that they would reinvest the proceeds of maturing mortgage-backed securities back into new mortgage-backed securities instead of treasuries.They have not purchased mortgages since March 2010. This move is most likely aimed at supporting the housing market. However, we don't believe that the primary problem with the housing market is the level of mortgage rates. Problems in that sector have more to do with falling home prices, high unemployment and that many buyers are not qualified under more stringent mortgage writing standards.
• We do look for long-term rates to continue to trend lower. The Fed has indicated that about 30% of the buying will be the 30-year maturities, which is longer duration than many expected, so we think long bond yields are likely to continue to fall.
• Look for a flatter yield curve—the spread between short and long-term rates to narrow—which is actually negative for banks who earn money on the spread. Given all of the pressure currently on the banking sector, a flatter yield curve is just another negative. If banks' borrowing costs remain the same, but the amount they earn on longer-term loans declines, then profit margins or the "spread" they earn falls.
• The Fed did not lower the rate it pays banks for holding excess reserves. This is as we expected, since many of the banks holding reserves at the Fed are European banks that are going through a period of stress. The Fed may have decided that a change in the interest earned by banks would disrupt the European credit markets. Also, domestic banks currently earn 0.25% on deposits of excess reserves and the Fed may not want to reduce that margin.
• A downbeat assessment continues to be the Fed's view of the economy. Although there were three dissenting votes again over the decision to extend bond maturities, the overall tone of the Fed's statement reflected its concerns about the slow pace of economic growth, high unemployment and the downside risks to the economy.

Bank Bonds… plus Extraordinary Calls on Trust Preferred Securities 
It's been a rough stretch for the banking sector in the US and overseas. A recent lawsuit against several large banks by the federal government relating to mortgage losses along with a lagging economy have weighed heavily on bank equity and debt. We'll also provide context on preferred securities—in particular, recent calls on trust preferred securities (TruPS) due to provisions in the Dodd-Frank Bill. 

• Banks remain a leveraged play on US economic growth. Even in the post-bailout era, the profitability and stability of large US banks remain dependent on US economic growth. Bank profitability relies on borrowing and lending at a profit margin. This is more difficult to achieve in a high-risk, low interest rate environment.
• Euro-land concerns decrease the appetite for financial risk. The crisis in Europe and, at its core, the potential threat to European banks, appears separated from the banking sector in the US. But they aren't completely disconnected. US and European banks lend short-term funds to one another and often have investments in similar securities or loans to the same borrowers. In a global financial system, when investors become nervous, they tend to reduce holdings of similar securities across the board, often without differentiating between issuers.
• Moody's downgraded ratings on several large US banks on September 21. The effected issuers include Bank of America, Citigroup and Wells Fargo. Moody's was careful to say that the downgrades reflected a "decreased probability that the US government would support [these banks,] if needed" and that the downgrades did not reflect "a weakening in the intrinsic credit quality" of these issuers. Moody's announced that they were conducting these reviews months ago. Still, the change increases uncertainty about bank credit quality.

Source: Barclays Capital U.S. Corporate Investment Grade Index and U.S. Corporate Investment Grade Financial Institutions sub index using daily observations from September 20, 2008 to September 20, 2011. Option-adjusted spread (OAS) is a measure of return over the comparable Treasury after accounting for the cost of any embedded options.

• Federal lawsuits and balance sheet questions increase concerns about bank credit quality. In early September, the Federal Housing Finance Agency (FHFA) sued 17 large US banks over possible defects in mortgages sold to the housing agencies. With or without the lawsuits, there are still major questions about the scope of potential mortgage exposure on the books of big banks. This could continue to weigh on confidence.

 

 

Source: Barclays Capital US Corporate Bond Index (investment-grade). YTM = average yield to maturity by sector for all ratings/maturities as of September 20, 2011.

• We continue to recommend diversification by industry sector when investing in corporate bonds. US bank debt accounts for roughly 34% of the market for US investment-grade corporate debt, as shown in the chart below. But these issuers tend to make up a disproportionate share of corporate bond holdings for many individual investors. The volatility, for some, is compensated by higher yields compared to other investment-grade corporate bonds. But the higher yields tend to come with more headline risk and volatility as well.
• How much bank debt to hold in one's portfolio, or whether to be a buyer or seller now, should hinge on personal tolerance for volatility in this sector. We believe that the risk of systemically widespread credit stress or defaults is low. But there are still risks to consider when building a well-diversified portfolio.
• A note on bank trust preferreds securities. A side note is the relatively small, but still widely followed, market for bank preferred "stocks." Individual investors hold many of these securities. Over the past few months, several large US banks have exercised "extraordinary" calls on a trust preferred securities a niche form of bank preferred debt at par. The reason is changes in the rules for how banks can treat these securities as part of their capital requirements in the Collins Amendment to the Dodd-Frank Bill. Investors should be aware that more trust preferred securities could be called at par by other banks in the future.

Obama Job Bill Questions Tax Exemption on Muni Bonds 
In muni-land, we've been watching a provision in President Obama's American Jobs Act of 2011 that includes a proposal to limit the exemption on interest for single taxpayers with incomes above $200,000 and households above $250,000—in short, for any exemptions taken above the 28% tax bracket. If you’re a muni bondholder, should you be concerned?

• We don't expect that the bill will pass as proposed. However, we expect that that the muni tax exemption will be one of many issues on the table as the debate about deficits, taxes and the economy continues.
• Removing the exemption would likely result in a higher cost to municipalities to borrow.In our view, this would be counter-productive to the administration's efforts to support job growth. If the tax exemption for municipal interest is removed, it would almost certainly result in an increase in interest rates paid for state and local governments to sell new bonds. The Jobs Act also includes a number of other measures designed to increase this investment, including $38 billion in support to fund construction. An increase in financing costs would work against these programs.
• A reduced exemption would amount to a tax increase on affluent investors. Nearly 60% of the interest paid on munis, according the IRS, flows to households above the 28% tax bracket. The change, as proposed, would result in an immediate impact for many wealthy investors, not just on newly issued bonds. It’s likely that an immediate tax increase would be opposed by the Republican and anti-tax wing of congress.
• Lobbyists have successfully opposed prior efforts to remove the muni tax exemption.We've almost never faced such a contentious and difficult debate about spending and taxes. But there's a strong, mostly affluent voting block—along with active state and local government lobbyists—who are lobbying against this change in tax law.
• Don't change investment strategy based on a proposed, not realized, change in tax code. Since the bill was introduced, we've seen virtually no impact on muni yields. Passage of this portion of the bill might result in a roughly 50 basis point (0.5%) increase in muni yields, by some estimates. Even if the bill is passed, we think the impact on muni prices—all else equal—would be manageable.

Liquidity—Ignore at Your Peril
During times of market volatility, investors often flock to the safest, most liquid investments. Over the last few months, investors have fled to US treasuries. Meanwhile, higher risk bonds or bonds that trade in smaller quantities have under-performed. Lack of liquidity is one major reason and an important factor to consider for investors in higher-risk or more thinly-traded corporate and municipal bonds. 

• Liquidity or lack thereof, is a risk factor that is often overlooked by many individual investors. The importance of liquidity is well-known by institutional bond investors, but less appreciated by investors who may trade less regularly, trade in small blocks or hold bonds with higher credit risk in exchange for yield. While this may not be an immediate concern for buy-and-hold investors, it is a factor to consider for those who may need to sell unexpectedly, worry about changes in credit quality or who closely watch the reported value of individual bonds in their portfolio.
• Unlike the stock market, there is no centralized exchange for individual bonds. Again, this is well known by active investors. But for individual investors who may change their views on individual bonds in their portfolio, understanding the lack of a centralized exchange can be even more important. While you may choose to hold more thinly traded bonds, its worth considering that liquidity can evaporate during the times that it might be needed most, such as when markets are falling and investors want to raise cash.
• Issuers with higher credit risk and lower ratings tend to be least liquid during periods of market stress. This periodic drop in liquidity has been one factor that has driven dramatic swings in price and widening or tightening of spreads in higher-risk or more volatile sectors such as high yield or financial sector bonds. This volatility may matter less for investors who choose not to sell, but investors concerned about swings in market value should be more careful when holding bonds for liquidity as well as returns.
• It's easy to forget about the importance of liquidity when low interest rates push you to search for yield. This is especially true in niche sectors, such as closed-end funds, high yield bonds or preferred securities. While these sectors often offer yields well above the rate on treasuries, the price is higher volatility during periods when risk-aversion turns "on."
• The price investors do receive if they sell will depend on market demand. Prices that you will see listed for the bonds you hold are estimates, usually based on previous sales or bids and offers. When conditions change, you may find that there will be a different price at which the security trades.
• Some investors may be willing to stomach lower liquidity for higher yield. High-yield bonds are an obvious example, but so are bonds with lower credit risk such as—for sake of illustration—a small local town or school district municipal bonds. These smaller issues can be appealing for slightly higher yield. But understand when doing so that it may be difficult to count on a set price in a thinly traded, un-centralized market if you need to sell.

Please visit www.schwab.com/onbonds for more fixed income perspective from the Schwab Center for Financial Research. If you have questions or concerns about the issues raised in this publication, please speak to your Schwab representative. 

Important Disclosures

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Preferred securities are hybrid securities, have volatility, credit risk, call risk and are typically concentrated in financials which may make them more volatile than securities that are more broadly diversified. 

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. We believe the information obtained from third-party sources to be reliable, but neither Schwab nor its affiliates guarantee its accuracy, timeliness, or completeness. 

 

The Barclays Capital U.S. Corporate Bond Index covers the USD-denominated investment grade, fixed-rate, taxable, corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody's, S&P, and Fitch. This index is part of the U.S. Aggregate. 

The Barclays Capital Financial Institutions Bond Index is a sub-sector index of the U.S Credit index, which includes publicly issued investment-grade U.S. corporate bonds in the finance sector. 

Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly. 

Past performance is no guarantee of future results. 

Investing in sectors may involve a greater degree of risk than investments with broader diversification. 

International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks. 

The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice. 

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager. 

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc. 

 

 

(c) Charles Schwab

www.schwab.com