Market Review & Uncertainty is the Only Certainty
Uncertainty is the Only Certainty
Investor focus shifted in the fourth quarter from continued weak economic conditions in Europe to historic political and monetary-policy developments in the U.S. The November election cycle, Hurricane Sandy, the fiscal-cliff showdown and other events created a cloud of uncertainty that permeated the markets. Accordingly, fourth-quarter GDP data are expected to be lower than third quarter, as the pace of the recovery cooled. Construction spending and manufacturing slowed in response to global economic weakness. However, the unemployment rate fell to 7.8 percent and housing, auto and non-auto retail sales showed further improvement despite decreased consumer confidence. For the year, several key measures of economic activity showed mild to moderate improvement.
Fourth quarter also brought unprecedented changes in U.S. monetary policy, which the Federal Reserve announced in December. Specifically, the Fed will initiate a new program of monthly outright Treasury purchases of $45 billion, adding to its ongoing monthly mortgage purchases of $40 billion. The end-date target for holding rates to zero, which had been mid-2015, was in effect changed to numerical thresholds of a 6.5 percent unemployment rate and an inflation rate at or below 2.5 percent. While these actions raised long-term inflation fears for some investors, current inflation measures such as the Consumer Price Index have thus far remained relatively steady.
As a result of the cloud of uncertainty and monetary-policy changes, the Treasury market exhibited elevated volatility in the fourth quarter. The 10-year Treasury note traded in the range of 1.58 percent to 1.86 percent, ending the year at 1.78 percent. The yield curve steepened as intermediate- to long-term rates increased. The municipal and Treasury markets diverged during the quarter, as shown in the following chart, with long-maturity tax-exempt bonds significantly outperforming long-maturity Treasuries.
Tax-Exempt Market Review
Still Under a Cloud
Tax-exempt market performance varied widely in the fourth quarter. In November municipal bonds performed particularly well, bolstered by heavy inflows into mutual funds, high reinvestment of coupons and refunded debt, and low new-issue supply. Demand for longer maturity debt was strong and lower quality bonds outperformed high quality bonds, as investors sought higher yields.
In a sharp reversal, December was a very difficult month for municipals with all investment-grade sectors and maturities posting negative returns. Several factors contributed to the underperformance. Heightened speculation surrounding the outcome of fiscal-cliff negotiations and possible changes to the municipal tax exemption weighed heavily on investor sentiment, as did increased tax-related selling such as estate planning activities in anticipation of changes to the estate tax. Additionally, heavy new-issue supply was concentrated in the first two weeks of the month – a period of sharply reduced investor and dealer appetite given the uncertain outcome of negotiations in Washington. Municipal-bond mutual funds may also have been impacted by Moody’s downgrade of Puerto Rico to Baa3 – the lowest investment grade rating. All of these factors and increased price volatility led to a sharp reversal of the sustained trend of net inflows into municipal-bond mutual funds. For the first time since August 2011 municipal-bond mutual funds reported net outflows.
Taxable Market Review
Taxable Munis Outperform Treasuries; Corporates are Top Performers
Aided by the overall high demand for spread product together with light supply – a demand/supply balance that is unchanged from 2011 – taxable municipals outperformed Treasuries.
One hurdle for taxable municipals in the coming months will be the overhang related to Build America Bonds, which were primarily issued in 2009 and 2010, as shown in the above chart. Included in the automatic budget cuts called Sequestration is a reduction in the federal subsidy for BABs. If Congress fails to meet the March 1st deadline to address Sequestration or there is a cutback or withdrawal of the federal subsidy, BABs could underperform in 2013.
Corporate bonds, especially low quality issues, outperformed taxable municipals in the fourth quarter. Spreads on taxable municipals did compress but not as much corporates.
Extraordinary monetary accommodation encouraged investors to take on more risk, which led high quality corporates to rebound from November's negative returns. Yield spreads to Treasuries narrowed and strong mutual funds inflows demonstrated demand for spread product. A more detailed review of the corporate bond market can be found in our Quarterly Corporate Bond Commentary.
Fiscal Cliff “Resolution”
What Lies Ahead
The American Taxpayer Relief Act of 2012, passed by Congress in January to avoid the fiscal cliff, increases several tax rates, making tax-exempt municipal investments more attractive to high-income taxpayers. The act made Bush-era rates permanent for individuals earning less than $400,000 and married couples earning less than $450,000. The marginal tax rate for top-earners, those individuals and couples earning more than these limits, was raised to 39.6 percent from 35 percent. The top rate on dividends and capital gains was also increased to 20 percent from 15 percent. These rates exclude a 3.8 percent Medicare tax on net investment income for taxpayers with income in excess of $250,000. The estate-tax rate increased to 40 percent from 35 percent for amounts over $5 million. The law also contains provisions that limit itemized deductions and personal exemptions for individuals making over $250,000 and married couples making over $300,000. These limits increase the marginal federal tax rates and the state income tax rates for taxpayers who deduct state and local income taxes. The totality of these changes makes the tax-exemption for municipals more attractive going forward.
Missing from the deal was definitive action on Sequestration. Legislators have postponed scheduled cuts in federal spending until March. This new time line coincides with the deadline to increase the debt ceiling and pass a new federal budget. Also, missing from the deal was an elimination or cap on municipal interest income. While some of the uncertainty related to the tax status of tax-exempt bonds has subsided for the moment, much remains in question. Congress still has to grapple with spending cuts and future sources of revenue as well as overall tax reform. The municipal-bond tax exemption remains on the table and will continue to overhang the municipal market in the weeks ahead.
Breckinridge Strategy and Outlook
Steady as She Goes
In light of political and economic instabilities, we remain cautious moving into 2013. Our tax-exempt portfolio targets a neutral to slightly long duration relative to the benchmark. We continue to target new purchases in the longer intermediate maturity range given the relative steepness of the yield curve. Our taxable portfolio also targets a neutral to slightly long duration relative to the benchmark, given the Fed’s accommodative stance and the dampening economic impact of potential fiscal austerity measures. We continue to focus on intermediate maturities due to strong technical support in the intermediate part of the yield curve and we maintain our emphasis on high quality issues despite the “search for yield” environment. A widespread deterioration in corporate credit quality would be surprising in the near-term and any downgrades should remain localized to particular issuers. Nevertheless, we remain highly selective with corporate bond purchases.
DISCLAIMER: The material in this document is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Nothing in this document should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. Factual material is believed to be accurate, taken directly from sources believed to be reliable, including but not limited to, Federal and various state & local government documents, official financial reports, academic articles, and other public materials. However, none of the information should be relied on without independent verification.
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