Yesterday kicked off a busy week for economic data (both at home and abroad). This week we will get manufacturing data, The Fed’s Beige Book report and (probably most importantly) employment data. If we are going to see volatility in June, this will probably be the week we see it. However, before we discuss economic data, we would like to dive into “Municipal Monday.”
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In the City (county and state) Ah Ha
Last week, a major story in municipal bond circles was the four consecutive weeks of capital inflows to municipal debt investments by retail investors. The financial media treated this as a major development for the direction of municipal bond valuations. However, fixed income watchers have observed capital inflows to the municipal bond space since last summer, albeit from institutional investors.
Average yield of 10-year AAA-rated G.O. municipal bonds (source: Bloomberg):
As the chart indicates, municipal bond yields spiked early last summer as rising Treasury yields and credit concerns regarding Detroit, Puerto Rico and various other municipalities frightened many retail investors out of the municipal bond space. By late last summer, institutional investors (including hedge funds) began picking up values in the municipal bond market as sales driven by investor panic left some high quality and very solid municipal bonds trading at very attractive yields. It was not until a few weeks ago that retail inflows shifted to a net positive. Last year AAA-rated municipal bonds were attractive to even low-tax bracket investors and investors which did not pay income taxes. These investors now have to seek opportunities in AA-rated and A-rated municipal bonds to find value versus taxable fixed income. Some investors are inclined to gain exposure via a macro-investment in municipal bonds. Our view is that the best opportunities can be had by intelligently selecting individual bonds. Understanding credit stories and having the ability to hold onto viable bonds if interest rates rise is, in our view, the best way to invest in municipal bonds (and fixed income as a whole).
It is not just AAA-rated municipal bonds which have experienced impressive recoveries. Troubled issuer, Puerto Rico has also seen the yields of its G.O. debt fall significantly in recent months.
Puerto Rico G.O. 5-year yields (source: Bloomberg):
After spiking last June and July, Puerto Rico debt has shown signs of recovery as the territorial government has begun to implement reforms. However, the situation in Puerto Rico remains shaky. We do not recommend investing in Puerto Rico beyond three years and then only if one has a high degree of risk tolerance. For aggressive and speculative investosr looking to gain exposure to Puerto Rico debt, it might be better to do so via territorial G.O.s and sales tax revenue bonds (Cofinas).
Municipal bonds remain among the more attractive asset classes within fixed income. At the present time, 10-year AA-rated and A-rated municipal general obligation bonds are (on average) yielding about 110 basis points over the yield of the 10-year Treasury note. We are referring to pre-tax rather than after-tax yields. This is a drastic departure from the historical norm of municipal bonds trading with pre-tax yields inside U.S. Treasury yields. Even more interesting, 10-year AA and A-rated municipal G.O.s are both yielding in the mid-3.00% (see charts on our website). To put this into clearer perspective, A-rated corporates (which offer no tax advantage and, because of different ratings methodology, can be somewhat less creditworthy than similarly-rated municipal bonds), are yielding about 3.30%, about 30 basis points less than A-rated and AA municipal bonds.
The sweetest spot of the municipal curve appears to be in the seven to twenty year area. We see little value, on a risk/reward basis, in extending out beyond twenty years in municipal bonds (or corporates for that matter). In fact, we would prefer to stay inside 15 years. Some “experts” remind (frighten) investors that bond prices fall when rates rise and that there is probably not much upside in bond prices. Although this is probably true, it is our opinion that fixed income should not be used with price appreciation as a primary goal. Income is the true purpose of fixed income. If price appreciation and total return potential are your primary objectives, there are better places to accomplish this than in fixed income at the present time.
Here, There and Everywhere
There has been a heated debate on the Street regarding why long-term bond yields are so low. Explanations range from modest economic growth and weak inflation pressures to reduced issuance of long-dated Treasuries, demand from pensions and short covering (just to name a few). The truth is that all of these potential factors are playing a part in holding down long-term rates. Low foreign sovereign debt rates can be added to the list. Some of these downward pressures (such as short covering and moderate growth) could very well abate after a time. However, the supply of new Treasuries might not increase. Changing demographics should result in strong demand for fixed income for the next decade or two. Changing demographics could also keep global inflation fairly low. This could keep long-term rates from rising precipitously. However, we believe that long-term rates should trend higher over time, just not very high. If one understands global demographics, central bank policy responses and the benefits of technology on prices (and downward pressure on wage growth), one should be able to construct a workable fixed income investment strategy.
Burning (room) for You?
Investors have expressed fear over rising rates and inflation, but have few concerns regarding liquidity. Liquidity should be of particular concern to junk bond investors. New financial regulations limit the ability for Wall Street firms to make markets and hold inventory. If there is a correction in the junk market, there might not be enough bidders to support the market. If you are investing in high yield debt, make sure the issuer is financially strong enough to service its debt for an extended period of time (making holding to maturity a viable option). We do not find much value in junk debt from a total return aspect at the present time.
Come and face the changes
Yesterday’s manufacturing data was encouraging. Markit’s final read of May manufacturing PMI came in at 56.4 versus a prior 56.2, an April reading of 55.4 and a Street consensus of 56.2. Readings over 50 indicate improving conditions. The production gauge rose to 59.6 in May, the highest since February 2011, from 58.2 a month earlier. Orders and factory employment were little changed from April. The data indicate that the economy continues to rebound, but hiring (albeit improved) remains lackluster.
ISM reported its manufacturing index. In fact, it reported it three times today (so far). The initial report from ISM was 53.2. ISM then announced there was a calculation error within its software. Then ISM announced an error in its correction and amended the number to 55.4. Assuming that 55.4 is correct, it appeared that May manufacturing activity increased moderately from April (54.9). Production surged to 61.0 from a prior 55.7. New Orders climbed to 56.9 from a prior 55.1. However, Inventories were unchanged at 53.0 and Employment fell to 52.8 from a prior 54.7. Prints over 50 indicate improving conditions.
This manufacturing data indicates that the economy continues to expand, but that the pace of economic growth, job creation and wage growth should be moderate. We believe that this is setting the stage for long term rates which are higher than today’s levels, but not rates which would be considered particularly high from an historical perspective. The long march forward continues.
By Thomas Byrne – Director of Fixed Income – Investment Consultant
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.
- November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
- December 2011 – November 2012 – Bond Squad, Kunkletown, PA
- April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
- June 1986 – March 1988 – E.F. Hutton, New York, NY
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