Past, Present and Future of Bond Markets
Long-term municipal bonds are, in my opinion, the best value that exists in our bond market
One thing I have learned since 1982 is that there are no 'certainties' in the markets-stocks, bonds or commodities. For some sense of perspective, my career started with Fed Chairman Paul Volker madly fighting double digit inflation rates and interest rates across the yield spectrum. This included Treasury, corporate, agency and municipal securities. In fact, I recall that in my first job as a retail stockbroker, the first trade ticket I wrote was for AAA rated 30 year municipal bonds with a 13% coupon at par. Mr. Volker eventually fought off the double digit inflation rates with very restrictive monetary policy - I would call 15% short-rates rather restrictive. Note that historic hedge fund investor Michael Steinhardt took a huge position in intermediate term Treasurys believing that inflation would eventually be beaten (he almost lost many clients in the process - see the wonderful book Wall Street Wizards for a recap).
Soon after, inflation ebbed as the recession of 1981-1982 greeted us. Keep in mind that while recessions are certainly no fun, back in the days of what I would call the 'normal business cycle,' recessions were considered healthy as they kept inflation in check and acted as a Darwinism-type mechanism. In other words, recessions weeded out the weak players and companies, encouraging healthy competition and a new, healthy economic expansion. Note that the great secular bull market in equities began in August 1982 and ran through the bubble top of March 2000-albeit with the Crash of 1987 and some other problems along the way like the real estate crunch of the early 1990's and the near-disaster crated by the demise of Long Term Capital Management in 1998. Which leads me to where we are now in terms of yield, risk and opportunities that confront all of us going forward (both professional and retail alike).
The Long Trip Down in Yield
By the time the real estate credit crunch arrived in 1990-1991 (along with RTC bailout of many failed Savings and Loans and major bank failures, like Southeast Bank), Treasury bill yields had crumbled to approximately 3%. This was at the hands of Fed Chief Alan Greenspan, who had already been greeted with and dealt admirably with the stock market crash of 1987, whereupon he flooded the system with cash and yields fell precipitously. As it turns out, in my humble opinion, this was the 'new way' of managing monetary policy. Every crisis was greeted with a flood of new currency and a flood of new debt.
These policies have continued unabated until this very day. In fact, money supply as measured by M3 (the broadest of all measures of money supply) rose from 1984-1994 at a 3.8% rate or so, only to be followed by an annual increase of nearly 8% per year since then. We have had a stock market bubble and bust since that period (money has to go somewhere when it is created) and then, depending upon your point of view, a real estate bubble. That bubble, by most anecdotal and statistical measures is showing definite signs of slowing. Things got so bad in 2002-2003, that Fed officials began uttering the dreaded 'D' word, deflation. Without a doubt, deflation is the worst virus that can affect an economy and financial system - just ask Japan. So the long journey from 15% rates ended with the Fed Funds target rate at a meager 1% in 2003 and remained there for a bit. Fortunately, stocks recovered beginning in March 2003 with simultaneous dramatic increase in real estate prices around the world. Both savers and investors were starved for yield, and had no choice but to take more risk to earn excess returns. As economies around the world began to recover due to this dirt-cheap cost of funds and forced risk-taking takes me to where the world is now in terms of yield and opportunities to invest in bonds (or lack thereof in some cases).
Our New Leader-Ben 'Boom Boom' Bernanke and his Conundrum
As you know, Fed Chairman Greenspan handed over the reins to former Princeton Professor Ben Bernanke on January 31, 2006. As I have written, it is my opinion that Chairman Bernanke is faced with a difficult task to keep the balances of our economy in check. As M3 ballooned for years and years, we have managed to create a system that is loaded with both inflated assets and inflated debts. As I have written many times, equity can disappear, while the debt is a constant, along with increases due to debt service. During the new Chairman's testimony to Congress last week, he was peppered with questions about the 'inverted yield curve.' Inverted curves have generally (not always) preceded economic slowdowns or outright recession. Mr. Bernanke's answer to the questions was that he basically had no issues with the shape of the curve and that all is well in our economy. I have been writing for a long while why the curve would invert and why there is no conundrum. There is so much short-term debt from the perspective of HELOC's (home equity lines of credit) from real-estate speculation and increased installment debt. So when rates increase in the front end of the yield curve, the economic slowdown could have a more dramatic impact on the economy. In addition, foreigners have an increasing appetite for our long-term debt - of every kind. See below.
The Long End of the Yield Curve
Is it a sucker bet to buy long-term bonds with short rates being lower? Or are they really a long-term bargain because foreign and domestic investors smell eventual severe economic weakness in this country as a result of the 'debt bubble' created under Greenspan's watch? To me, this is the $64,000,000 question. We are all aware of the fact that foreigners own a gigantic amount of our Treasury debt - 52% at last count. What is not talked about very much is that foreigners also bought a monstrous $392 billion of our corporate bonds last year, making us more and more dependant on their movements. Some investors say that foreigners have a way of 'top-ticking' our markets whenever they buy en-masse. Only time will tell, but my guess is that their purchases of long term corporate debt at historically low spreads to treasuries will be ill-timed. Why? Mostly because spreads are at historical lows and the increase in spreads and hence loss of value has a better chance of occurring than a further tightening. It explains why we are severely underweight corporate securities for our clients and intend to stay that way until spreads widen out in whatever the next inevitable crisis will be.
I may have misunderstood or mis-heard our new Chairman, but to me, he seems to be endorsing an inverted curve, which to my knowledge would be a first for a Fed Chairman. As our readers know, we closely track the CFTC data on COT (Commitments of Traders). For weeks, the supposed 'smart money hedgers' have had an abnormally large long position in long-term Treasury futures which on the recent rally in long term bonds, one might have expected would be liquidated. But as of this Friday's data, just released, they have maintained their positions - at least for now. We will be watching this data closely as a clue if they smell deflation too. As for the 10 year note, they are basically neutral, as they have been of late, even though it is our opinion that 10 year Treasury note rates have a better chance for a short-term move to interim highs before settling into lower levels later in the year as economic weakness actually does rear its ugly head. To me the rhetorical question is: if real estate is slowing, and the number of purchase applications as measured by the Mortgage Bankers Association has broken the multi-year uptrend line started in 2001 recently (see chart below), what part of the economy will pick up the slack? Please note that nearly 50% of all jobs created during this recovery have been real estate related.
With savings rates hovering at zero, how much more will an already stretched consumer be able to spend? So while we are, for the short-term, avoiding long-term bonds, we expect to add duration to portfolios later in the year as seasonality improves and economic weakness shows itself. This should also allow for corporate bond spreads to widen out, and we would look to add exposure in that sector too.
Click chart for full size version
What on Earth is wrong With Long-Term Municipal Bonds?
Long-term municipal bonds are, in my opinion, the best value that exists in our bond market today. Long-term Treasury yields hover around 4.52% while long-term municipal rates are in the 4.60-4.70% range. This is indeed an unusual occurrence as municipals have averaged 85% or so of long Treasurys over a long period (that would equate to a 3.85% yield). Our opinion, from experience, is that retail investors just don't get excited about 3.85% yields-tax-free or otherwise - to lock up funds for 30 years. For some reason, 5% seems to be the 'magic' level for retail investors to get excited about long munis. We were able to buy some bonds back in November around that 5% level but have exited those securities at handsome profits and will again consider those securities if we get the chance at the right level. As for short-term (2-5 year) municipals, their tax-equivalent yields are unattractive to us at this time and we are not favorably disposed to them. They trade at approximately 70% of similar Treasury yields, providing not much value, not to mention their lack of liquidity when compared to Treasuries of similar duration.
Odds and Ends-Extreme Complacency Could Lead to Higher Yields Near-Term
According to the highly respected Tony Crescenzi of Miller Tabak and Company, implied volatility of march and April options on the 10 year note has reached 4%, its lowest level since just prior to the Asian Financial Crisis. This suggests that market participants expect almost no volatility, a situation that usually preceded sharp sell-offs. The same situation exists in the equity markets. This has us on our toes to expect high volatility in both markets after very tight ranges in equities and bonds during 2005. So we are 'staying on our toes' for signs of higher volatility. If we got that move to the downside (if 10 year notes break important support at 4.65% or so), we would watch for negative sentiment to rise and an attractive entry point as positive seasonality takes over in May and lasts through year-end.
What To Do Now?
We have been actively adding to 2 year Treasurys as they approach 4.70-4.75% and continue to add to short-term, seasoned GNMA's until better opportunities present themselves. We have been avoiding new purchases of Fannie Mae (FNM) securities (but not selling existing holdings) until their new CEO can provide us with their new game plan, not to mention their audited financials that we have all waited so long to see (I recently read in the New York Times that it could be another year until they sort out their accounting mess). And, Chairman Bernanke, in his testimony last week before Congress, indicated that both FNM and Freddie Mac (FRE) have both grown too large and pose systemic risk. In a nutshell, we are playing it 'close to the vest for now' and waiting for better opportunities as they arise. Again, after 26 years, and mistakes and battle wounds to prove it, we will wait until low-risk opportunities arise.
One last comment -a 'wild card' if you will. We must keep an eye on the dollar. With foreign interests controlling so much of our debt, a precipitous drop in the dollar could cause them to both cease buying our bonds and supporting our deficit or to demand higher yields. Both of those cases are hyper-inflationary, and while a statistical outlier, must be considered by the prudent bond manager. I hope you have found this commentary useful and I look forward to questions or comments.
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