The municipal bond market is currently a story of tightening credit spreads and a rare victory for bondholders in California of all places.
We are the Champions!
Bankruptcies have been comparatively rare in the municipal bond market. Whereas bankruptcies have been fairly common in the corporate credit market, municipal bond investors have rarely had to deal with worrying about coupon payment disruptions and principal return haircuts. Recent bankruptcies, such as Detroit have not gone well for bondholders as the courts have elevated other parties (such as pensions) over bondholders and other creditors, in spite of established capital structure and credit laws. Recent precedents did not bode well for creditors of Stockton, California.
To see a list of high yielding CDs go here.
On Wednesday, Judge Christopher Klein, the federal judge overseeing Stockton’s bankruptcy, ruled that Calpers and Stockton general obligation bondholders are both unsecured creditors. Payment of claims to Calpers will not take priority over those of bondholders in a plan of adjustment; they will be equally secured on the same basis. This more traditional (and, in our opinion more logical) verdict is refreshing. Some municipal bond experts are taking Judge Klein’s ruling to mean that state and local fiscal matters are within the jurisdiction of the Federal government. We are not legal experts, but the Stockton decision does open a new chapter in the story of municipal bankruptcies. Calpers has argued that agreements bound by state law and state constitutions cannot be altered or broken by the federal government. However, the “Contracts Clause” of the 10th Amendment of the U.S. Constitution gives the government the power to amend, modify, and break contracts. The ruling will undoubtedly be appealed, but for now it is a victory for Stockton bondholders and could set a precedent for municipal bankruptcies of the future.
The Contract Clause reads:
“No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility.” (3)
Back in Black
What a difference a year makes. During the summer of 2013, it seemed as though retail investors could not sell their municipal bond holdings fast enough. Whereas the pre-tax yields of investment grade municipal bonds would normally trade significantly inside U.S. Treasury yields, it was not uncommon at the time for A-rated and even AA-rated municipal bonds to trade with credit spreads of 100 or more basis points above U.S. Treasury yields on the intermediate and long end of the yield curve. Today, A-rated and AA-rated 10-year municipal bonds are trading right on top of 10-year U.S. Treasury yields.
Although many of our readers are focused on bond yield and income generation, understanding and observing credit spreads is important as that is how volatility and perceived credit risk are measured. This was evidenced in the summer of 2013 when investors raced to reduce their exposure to municipal debt. Investors were concerned that higher interest rates and a spreading credit contagion from Detroit and Puerto Rico would negatively impact their municipal bond investments. In our opinion their fears were unwarranted.
We used last summer’s municipal bond rout to pick up high-quality bonds at attractive yields. One of our strategies we use to enhance yield returns for investors who can tolerate volatility is to consider the higher quality issuers in beaten-up sectors of the economy. Last year’s municipal bond rout might have been the epitome of that situation as an entire segment of the fixed income market was roiled by problems among a relatively small subset of that market segment. These credit fears were augmented by a misunderstanding of Fed language by investors. Understanding what was happening gave many market participants a decided advantage.
Last year’s municipal rout was probably a good precursor for the kind of volatility we can expect throughout the capital markets for the foreseeable future. Last week, we wrote that volatility is back. In fact, in 2013 (and 2012) we warned readers that when the Fed began to remove accommodation, volatility would return to the capital markets. We saw it last year (the taper tantrum) and we have seen it during the past few months as a response to less dovish Fed language and decent economic data. As such, we believe that a reassessment of risk by market participants should be a benefit for investment grade municipal bonds (particularly essential service revenue bonds and state G.O.s). As we construct and manage portfolios of actual bonds, we see volatility as more of an opportunity than a concern. We have the ability to hold until the volatility has subsided or to maturity if necessary.
Over the weekend, Cumberland Advisors founder, Chairman and CIO, David Kotok, mentioned the following in a letter to investors:
“Cumberland is ONLY a separate account manager. We do NOT manage any mutual fund. ETFs aside, we do NOT use traditional bond mutual funds in most cases. All of our clients have 100% transparency regarding their own accounts. All client accounts are private when it comes to any information about their holdings. We wouldn’t have it any other way.”
We are very much in the same camp as Mr. Kotok and Cumberland Advisors. We are believers that investors should know what they own and own the actual assets in which they seek exposure. This leaves investors less subject to the actions of others and less affected by market volatility than they might be otherwise.
Make no mistake, volatility is back and it should be here to stay. The days of all assets performing well are probably over. This is true even of investments within an asset class. Investing by gaining broad exposure might not be the best way to proceed for many investors. We believe that it is time to be tactical. Tactics are what we do at Bond Squad. (1) (3)
We would like to make a side trip from municipal bonds to the international arena. As expected, incumbent president, Dilma Rousseff gained the majority of the popular vote in yesterday’s Presidential election in Brazil. However, she did not win enough of the vote to avoid a runoff election versus Aceio Neves. Mr. Neves (the most pro-business and pro-growth) candidate was running in third place, but had recently gained ground in recent weeks. As the result of Mr. Neves’ stronger-than expected showing, Brazilian bonds and equities are trading higher today. Although we are hopeful that Mr. Neves might win the runoff and institute pro-business policies, we are not betting on his victory. As such, we are not constructive on Brazil or much of the EM markets for that matter.
Economic data coming out of Europe today is not encouraging. German Factory Orders came in -5.7% MoM and -1.3% YoY. German Construction flat-lined at 50. German Retail PMI came in at 47.1 and the Aggregate Eurozone Retail PMI came in at 44.8. Readings below 50 indicate contraction. We see little that ECB President Mario Draghi can do to reignite growth in the Eurozone without fiscal help. Making Sense co-creator, Bill Malle commented:
“It’s the same old problematic mismatch come back to haunt Mario for Halloween: Monetary responsibility without fiscal authority- A witch’s brew & recipe for disaster …”
Investors looking for treats in the Eurozone should not be tricked into believing that monetary policy alone can cure all ills.
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
Director of Fixed Income
Wealth Strategies & Management LLC