Bennet Sedacca: Positioning For Slower Growth
...raising rates in a leveraged society is a self-fulfilling prophecy to slower growth.
Editor's Note: Minyanville is a community of people who share an interest in fiscal literacy. As perspective is an important aspect of our daily routine, we share this note from Bennet Sedacca, President, Atlantic Advisors, with hopes that it adds balance to your process.
Many months ago, Alan Greenspan opined that there was a "conundrum" in the long end of the bond market. In other words, he was surprised that long-term rates were not following their shorter-term brethren higher as the Fed was in the middle of their rate hiking campaign. In one of our quarterly newsletters some months back, we suggested that the reason the yield curve was flattening more quickly than usual was due to the "finance based" (leveraged) type of economy that now exists in the U.S. As individuals levered themselves to all sorts of exotic mortgages to move the housing frenzy along, they became more levered to the front end of the yield curve than normal. Coupled with rising inflation (including food and energy) and their higher ARM payments, it is no surprise that housing, and hence, the economy may slow noticeably in 2006 as the consumer digests these higher expenses. Considering that nearly half of all jobs created over the past four years have been housing and construction related, it should come as no surprise that GDP and wage growth could slow dramatically should housing slow as a result of these higher costs to consumers. We are of the belief that raising rates in a leveraged society is a self-fulfilling prophecy to slower growth.
So how does one position himself/herself for such a possible occurrence? Over the past six months, we have built positions in ARM pools (mortgage pools that adjust with short term rates such as LIBOR or 1 to 3 year Treasury Notes) whose coupons have just adjusted or will adjust by January, as we believe we are near the end of the Fed tightening cycle. Yields attained have been anywhere between 150-200 basis points above the underlying index. When one thinks about the impact of the higher short-term yields, it should equate to the flattening and eventual inversion of the yield curve. So we are creating "barbells"-a portfolio strategy in which maturities of included securities are concentrated at two extremes-whereby we buy high quality long-term municipal bonds at discounts. We will look to profit at both ends of the curve as the economy and inflation slow as a result of the Fed's actions. Why municipal bonds? Long-term, discounted municipal bonds (coupons in the 4 to 4 1/2% range) are currently trading 15-25 basis points ABOVE the long Treasury bond, a very rare occurrence, resulting in tax-equivalent yields nearly 300 basis points above Treasuries (we find this to be a conundrum!). And the November-January timeframe is the strongest seasonal period for municipal bonds in general, according to our good friends at Ned Davis Research, as supply wanes and large coupon payments occur on December 1st and January 1st.
While we are cognizant of the potential bursting of the real estate and other debt bubbles in our great country, our goal as portfolio managers is to construct the portfolio structure that will benefit our clients the greatest with the least amount of risk given the current environment. This is not meant as advice, just food for thought for those building bond portfolios for income in a tough fixed income environment. If our assessments are correct, we would look to unwind these positions sometime in mid to late 2006.
Bennet Sedacca - Atlantic Advisors LLC - Investment Advisory and Consulting
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