By Peter Coffin
A discussion of three investment objectives in the context of high-grade bond investors.
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Hi, welcome to the Breckinridge podcast. This is Sara Chanda. I am a portfolio manager here at Breckinridge, and I am joined today by my colleague Eric Haase, also a portfolio manager with me on the tax-exempt desk, and in similar fashion to recent months, we are going to be discussing several key themes in the month of October that we feel are relevant for folks in the field. And the themes we’ve selected today include tax loss harvesting, relevant we think given the most recent jump in rates over the month, hospital spreads and the tightening vice that has recently reversed in the last several weeks, and lastly cash yields, the benefit of holding bonds versus cash when yields are fairly comparable. So while these themes may not seem related, what we think ties them together is how the rise in rates has affected various segments in the muni market. So Eric, let us get started on tax loss harvesting.
Sure, so last month, one thing we did discuss in the podcast was the effect of the rising yield environment on performance within a portfolio. We have seen, obviously, the longer end selling off slightly more. So you look at longer bonds within your portfolio, you may have some fairly larger losses in them. So one thing you can do to take advantage of those losses is tax loss harvest.
Right, so just for folks in the field, by definition, tax loss harvesting is really the practice of selling a security that has experienced a loss and by realizing or harvesting that loss, investors can offset taxes on both gains and income, so that sold security is replaced by a similar one that maintains, again the optimal asset allocation that we think would make the most sense, and expected returns. So this is relevant now because we have seen this pretty significant rise in rates.
Right. And you think about the construct of a well-diversified portfolio overall you should have uncorrelated assets which move independently. So they move independently in response to various market factors and technicals. Generally, people think about equities and fixed income as being uncorrelated assets. If you look at that has happened, again, with fixed income on a year-to-date basis, you have losses in your portfolio. Rates on the AAA municipal bond curve are up between 50 and 80 basis points depending on where you are in the interest rate curve. That is negative for fixed income, so the result is that you are going to have bonds in your portfolio which are probably carrying losses and you can realize these losses to offset gains you have in other parts of your portfolio.
Right. So those are the benefits actually, offsetting those capital gains resulting from selling securities at a profit and you are actually able to carry forward $3000 in losses. If you have more losses to take, only $3000 can be carried over. Some of the factors that we think of when we are looking at tax loss harvesting, first of all it only applies to taxable investment accounts, so tax-deferred accounts like 401(k)s and IRAs, they grow tax-deferred so they are not subject to those capital gains taxes. Some other things to consider is this wash sale rule. Really, it is a technicality of tax loss harvesting, so when you purchase a like security for something sold, you need to ensure you do not trigger that rule and really the rule was enacted to prevent an investor from buying and selling something very similar. And so, if a security that is purchased is deemed too similar, you actually do not get the benefit of those losses. They are no longer deductible.
And alongside that, internally one thing we look at is the potential cash drag. So if you want to lock in that loss right away you want to make the sale on the asset now and then it may take time to actually find a suitable replacement. So due to that, you are sitting in cash and there is some cost to that, some opportunity cost. So we are very cognizant of that as we look to harvest in the portfolios.
Right, and then some of the other things we are doing, so when we are looking at a portfolio, we certainly, we are going assess losses not just on the percentage loss but obviously the corresponding dollar amount as well for that client.
So now we can go on to our next theme which is talking about the change in spreads that we see in the hospital sector in the muni space. In the low yield environment, investors are looking to pick up yield any way they can, and a lot of times that involves going in to riskier sectors of the market and hospitals are generally seen as a riskier part of the muni market. So result is that with that increased demand, we have seen dramatic spread compression over the last number of years. We actually have a more negative outlook on the sector and we are highly selective on names based on market pricing and the fundamentals available.
Right, we have actually been, as you mentioned, very selective and in fact if you think about what where hospital spreads were five years ago, AA hospitals at 70 basis points over the AAA scale. We opened up 2018 to see some of those same names trading a +35 or 40 over scale, so clearly a pretty dramatic compression. But now in the recent weeks, we have actually seen that rebound a little bit and seen some spreads now in the 55 or 60 basis points camp. And again, what is the result of that? Obviously, there may be some changes or shifts that we are seeing. Is it fundamentals, Eric?
It is not currently fundamentals. We have the same themes that are playing out that we have seen all along so we have seen thinning margins, increased leveraged, and strained liquidity metrics, so that, again, on the fundamental side makes us be a little more constructive and a little more selective as we look at names. Really what it boils down to is it is more of a technical issue. So over the last, call it, 6 to 7 weeks, we have seen a lot of outflows from high-yield funds and the result is that has helped push spreads wider.
Right. So thinking about just rates in general, kind of getting into our final theme of just cash versus bonds, so again the curve has been flatter as the Fed continues to normalize, and we have actually gotten a lot of questions here just regarding cash versus bonds, and why would you take interest-rate risk if you are getting the same yield in cash versus a bond?
Right, and just to put in perspective how flat the front end of the curve is, a 1-year AAA muni is yielding around 2% right now and if you looked at a 3-year AAA muni, it is around 2.25% let us call it, so cash becomes more attractive in that world.
Right, so cash, in general, why hold cash if you think a high-quality asset is more likely to provide liquidity when needed. Capital preservation is clearly important to a lot of investors. And thinking about that, there are obviously mechanisms in place like a money market fund, a government money market fund right now yielding just under 2%, 1.82% or so. After tax though, for a high tax investor that is going to get you down to just over a percent or so, but there are other options as well, right?
Right, so other options in the, call it cash space are prime money markets, and these are vehicles that generally have higher yields but additionally that is due to higher credit risk. And really, it boils down to what should your cash be? And a lot of people prefer to have that liquidity and safeguard of owning something like government money market or sweep vehicle.
Right, so then the question becomes, why a bond? So bonds obviously provide diversification, we talked about correlation earlier. Bonds have historically been less correlated to other risk assets, provide stable income, deflation protection, then the question becomes why bonds versus cash?
Right, so the benefit of holding bonds or if rates drop, say there are geopolitical issues or growth concerns in the world, high-grade bonds have the potential to provide capital appreciation over cash whereas cash will not appreciate in value. So while a client will take on some interest rate risk or duration risk, high-grade bonds can provide capital appreciation opportunity over cash. Which you can, again, generally will offset your, the kind of losses you will have in your equity or other risk assets in your portfolio.
And what about if rates increase?
Yes, so if rates increase, you do have some duration so bonds will underperform cash, but most likely in most scenarios, based on your asset allocation you are going to be earning additional returns from your equity or riskier asset classes.
Right, so then you think about, so if you do not want to be in cash, maybe an intermediate portfolio does not quite suit your needs, you can also look at maybe more of a limited structured portfolio for folks that do not want to lock up their cash for 4+ years or so. There could be another alternative, like a limited type of portfolio where you have got duration less than three years. The yield to worse there is about 2.25% so a better yield duration relationship from what we have seen in the past given the rise in rates.
And just some disclosure regarding the tax loss harvest discussion that we had today. The effectiveness of the tax loss harvesting strategy is largely dependent on each client's entire tax investment profile, including investments made outside of Breckenridge's advisory services. Clients should consult with their tax professionals regarding tax loss harvesting strategies and associated consequences.
We hope you found this information interesting and we would love to hear from folks in the field. If you have any feedback, please email us at CR@Breckinridge.com. Thank you for joining us.
In the municipal recap:
At 5:30 the fund referenced is the Fidelity Government Money Market Fund (SPAXX) as of November 8, 2018.
At 7:10 yield is from Breckinridge Capital Adviors, Limited Tax Efficient Composite, October 30, 2018
Welcome to the Breckinridge podcast. This is John Bastoni, I am a trader here at Breckinridge and today I am joined by Khurram Gillani, a member of our portfolio management team. Today we are going to review some key topics from the corporate and securitized bond markets over the month of October. In October, we saw higher rates and weakness in the equity markets. How did that translate over to the credit markets?
So it did spill over to the credit markets as correlations between equity volatility and credit volatility have increased over the last several years, so corporate spreads during the month were 12 basis points wider. Interestingly the yield to worst on the corporate index is a 4.3% now and that is actually the highest level it has been since mid-2010. The volatility was broad-based across all sectors, so no sector was tighter during the month and excess returns were negative for all maturities, and most negative especially for long bonds, long bonds being bonds maturing in 10+ years.
Another thing we should talk about is supply and demand for the month of October. Usually in the Fall, we tend to see a spike in new issuance as issuers look to get deals done before year end. This month seemed a little bit different. Why was that?
Yeah, so supply was actually down this month versus October of 2017, so supply came in right around $100 billion and so that is down 29% versus the same time last year. And then overall, supply is down about 25% year-over-year, but just remember that 2017 was a record year for issuance and we are still over a trillion in gross issuance in the corporate market year-to-date. The fact that supply was down actually although equal, did support credit spreads during the month. However, fund flows from investment-grade corporate bonds were negative during the month. It was actually the first month of redemption since January of 2016 so that is one of the reasons why corporate spreads were wider during the month.
Turning to some credit stories, specifically GE. We noticed that they were downgraded in the first week of the month to BBB.
That’s right, so GE bonds were downgraded by S&P earlier in the month to BBB, and then Moody’s followed suit on the last day of the month and downgraded their bonds also from A to high BBB as well. This adds about $50 billion of new debt to the BBB corporate index. That is going to be reflected next month. So GE has really been struggling. They have reported several quarters now, consecutive quarters, of lowered earnings and cash flow, especially due to the fact that sales in their power business have gone down pretty significantly. They have also had to take a very large goodwill impairment charge on their balance sheet which the Department of Justice is currently investigating. This has led to concerns over corporate governance around inadequate financial disclosure and transparency in the company.
So how did spreads react on this news?
Yeah, so GE spreads have been widening all year. During the month their bonds maturing in 2021 were about 70 basis points tighter and then their long bonds maturing in 2044 were over 60 basis points wider during the month, but they were over 100 basis points wider year-to-date.
The other credit-specific story we should talk about is Ford. It seems like they had a rough month as well. Can you elaborate on any specifics there?
Yes, so they actually reported earnings on the last week of the month. They were pretty ambiguous in terms of their commitment to an investment grade rating. They did not provide disclosure on the cost breakdown or timeline of their very large restructuring plan, and they did abandon their margin targets for 2020. Ford has been struggling over the last several quarters as auto sales have peaked. So their sales and margins have deteriorated and they are also undergoing this very large restructuring program which like I mentioned earlier, they haven't really given investors much information or data on, and so that's why Moody’s currently has a Baa3 rating on them with a negative outlook. S&P currently rates them BBB with a negative outlook and there is a risk of material additional spread widening with the name should one or more rating indices downgrade them to speculative grade, which is a possibility.
And how do their spreads react on this news?
So, during the month the auto sector underperformed led by Ford, so their 3-year bonds are 35 basis points wider during the month and their 10-year bonds are over 40 basis points wider during the month.
That is very helpful insight. We will be keeping a close eye on these names going forward.
Okay, so let us switch gears and talk about the securitized market. We will start with MBS. So they had a pretty rocky month. Volatility was up as interest rates rose.
Interest rates ended the month higher but over the course of the month, the observed range of rate movements was high on any given day. It was not uncommon to see moves anywhere between 5 and 10 basis points on any given day over the month. This led to mortgage underperformance over the course of the month. We had been in a pretty tight 10 or so basis point range for most of the year. We are significantly wider than that now. That has led to one of the worst months we have seen since the 2016 election. Mortgages produced negative 37 basis points of excess returns.
So mortgages look relatively cheap on a historical level.
That's right, yes.
So why were excess returns negative? Is that because the main buyer of MBS, which is the Fed, has dropped out of the market? This is the first month that they bought net zero mortgage-backed securities, right?
Yes, we mentioned higher rates, but the real issue facing the sector over the month was just a general lack of demand. The Fed is effectively net buying zero right now and will be for the foreseeable future. This is the first time since the financial crisis where they have not been reinvesting some of their paydowns back into the market. Banks have historically been one of the largest buyers of mortgage-backed securities. Their demand has largely underwhelmed so far this year and October was really no different. This has led to asset managers being the marginal buyer of the sector and typically what we see when asset managers are the main buyer, is an increased correlation with other risk assets. Typically, we look for mortgages to have a negative correlation in terms of spreads and returns with other risk sectors but when asset managers are buying those correlations tend to increase.
Interesting. And then turning to the ABS market, so we have low employment, steady GDP growth, that has been one of the best performing sectors in fixed income as a result. How did it to do this month?
ABS did underperform slightly from an excess return perspective, down six basis points over the month but compared to other more volatile spread sectors, that was that was relatively calm. We just really continue to see the sector exhibiting some defensive, safe haven flows over the month. So far this year we continue to see pretty attractive risk-adjusted returns to the tune of positive 26 basis points on an excess return basis.
And just to remind people out in the field, that even though Ford Motor credit corporate bonds have been struggling and they are kind of on the verge of high yield, the Ford auto ABS continues to be rated AAA and their spreads have actually held up very well relative to the senior unsecured debt of Ford Motor.
We did not see any material spread movements on Ford's auto ABS. It is important to remind our listeners that these are bankruptcy remote trusts that have their own levels of excess spread and over collateralization that support their own AAA rating on their own.
Well, thank you, John. Thank you everyone for listening to our Breckinridge podcast this month. We hope you join us next month.
The effectiveness of a tax loss harvesting strategy is largely dependent on each client’s entire tax and investment profile, including investments made outside of Breckinridge’s advisory services. As such, there is a risk that the strategy used to reduce the tax liability of the client is not the most effective for every client. To the extent that a client’s custodian uses a different cost basis/tax lot accounting, tax efficiencies may be greater or lower than Breckinridge’s estimates. Tax loss harvesting may generate a higher number of trades in an account due to our attempt to capture losses. Further, a client account may repurchase a bond at a higher or lower price than at which the original bond was sold.
Federal and local tax laws and rates can change at any time; changes to tax laws and rates can impact tax consequences for clients. Further, the IRS and other taxing authorities have set certain limitations and restrictions on tax loss harvesting. The tax consequences of Breckinridge’s tax loss strategy may be challenged by the Internal Revenue Service (IRS). Clients should consult with their tax professionals regarding tax loss harvesting strategies and associated consequences.
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By Peter Coffin
A discussion of three investment objectives in the context of high-grade bond investors.
Podcast recorded June 11, 2018
In this podcast we cover the month’s market movements.