Market Review & A Prudent Approach
Investor Sentiment Improves
In January, investors focused on positive economic developments on the domestic front despite a murky near-term economic outlook and mixed market activity. Home sales extended gains and the ISM Manufacturing Index increased 4.7 percent. The economy also marked 35 consecutive months of private-sector job growth, but the unemployment rate inched up to 7.9 percent. Negative GDP growth during Q4 2012, which could possibly be revised upward in coming weeks, served to remind investors that a full recovery remains elusive.
Some investors took on more risk following Congressional approval of legislation to permit the government to continue borrowing money through May 18. The 10-year Treasury note ended the month 19 basis points higher at 2.02 percent. The intermediate part of the yield curve outperformed, in part due to the Federal Reserve Bank's commitment to purchase securities in the five-to-eight year range.
Economic forecasts suggest growth will remain weak in the first quarter. Higher taxes, including the increase in payroll tax, may lower consumer spending and hinder consumer sentiment in the coming weeks. Looming political battles – such as the March 1st deadline to avoid automatic defense and domestic budget cuts, known as Sequestration, and the risk of a government shutdown unless another Continuing Resolution is passed by March 27th – could curtail growth.
Tax-Exempt Market Review
Munis Start Strong
The municipal markets got off to a strong start in January. Long-term municipal bond issuance increased almost 39 percent relative to January 2012. Bonds issued to refund prior debt and combined refunding and new-money deals accounted for nearly two-thirds of volume. Given historically low rates, we expect this elevated level of refundings to contribute significantly to new supply in 2013.
In a reversal from December outflows, municipal bond mutual funds posted robust inflows in January amidst strong reinvestment from coupons and maturities. Given high demand relative to supply, municipals outperformed Treasuries, especially in longer maturities. Ratios dialed back to their lowest point in a year perhaps in part because retail and institutional investors realized that the American Taxpayer Relief Act would not affect their holdings of municipal bonds. Federal tax expenditures, including the exemption for municipal bond securities, may be targeted as part of future tax reform efforts in Washington. However, in the meantime, higher marginal tax rates on top earners should promote a high-demand environment for municipals.
Taxable Market Review
Shareholder-friendly activities increase
All spread product outperformed Treasuries in January. Taxable municipals outpaced corporates on low supply and high demand. The outperformance was more pronounced for taxable municipals, which likely benefited from heightened fears of corporate M&A activity as well as the S&P rating upgrade on California municipal bonds. In our opinion, taxable municipals continue to represent value versus comparably rated corporate bonds due to higher spreads and lower default risk.
Higher rated investment-grade corporates underperformed lower quality corporates. Spreads on Financials, which contributed the bulk of investment-grade supply, tightened more than non-Financials resulting in marked outperformance.
Activist shareholders and rising shareholder enhancements, such as debt-funded share buybacks and special dividends, continue to pose a risk for corporate bondholders. An increased level of large-scale leveraged buyout (LBO) activity among high-grade issuers is another potential concern. As reports surfaced that Dell, Inc. intended to go private in the largest LBO since 2007, spreads more than doubled on average, driving underperformance in the Technology sector.
LBOs can be very destructive to holders of long-term bonds. Through in-depth credit research, Breckinridge aims to avoid firms that are likely candidates for an LBO. Targeting issuers with high market value and purchasing bonds with change-of control covenants can help mitigate this risk.
In late January, S&P upgraded California’s bond rating to A/stable from A-/stable. The rating applies to $73 billion in California GO bonds and reflects the state’s improving fiscal metrics.
As recently as 2010, the state faced a $28 billion deficit. Additional revenues were off the table, as a sufficient minority existed to block any increases. General fund spending dropped by $17 billion as steep cuts were made. Now California budget officials project annual general fund surpluses through 2017. An uptick in economic activity and recently enacted tax hikes underpin the new estimates. In November with the aid of turnout for the presidential election, California voters approved a 0.25 percent increase in the state sales tax and income tax hikes for households with income in excess of $250,000. The measure is expected to raise more than $6 billion annually.
The state’s volatile revenue structure remains an issue. Roughly 37 percent of the state’s income-tax receipts are paid by the richest 1 percent of earners. These taxpayers report wide fluctuations in income and tax liability from year to year, which makes it challenging to predictably finance the cost of state operations. However, Breckinridge views the potential effects of tax policy as a long-term issue.
A Prudent Approach
In tax-exempt and taxable accounts, we are holding a neutral-duration posture. Our target 4.25-year duration remains as is, slightly longer than the benchmark. Existing barbelled portfolio maturity structures will be more bulleted to offset the longer term risk of a steepening in the Treasury curve.
We believe tax-exempt municipal to Treasury ratios are currently more attractive in the intermediate range of the curve, which presents buying opportunities on a relative basis. Lastly, we infer that the corporate bond markets are becoming more differentiated. Given a prolonged period of spread compression and increased likelihood of idiosyncratic risk, we are not only being more prudent with our sector selection, but also with individual purchases of corporate bonds.
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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