Market Review and Outlook 3rd Quarter 2012
Demand for municipal bonds continued to outpace supply over the past three months. This technical pressure, along with increased concerns about global economic weakness and greater confidence in municipal credit quality, pushed municipal yields to near historic lows. As a result, the Barclays Capital 5 Year Municipal Index generated returns of 1.36% for the quarter, bringing year-to-date performance up to 3.18%.
The economy continues to show meager growth. A variety of factors, ranging from the uncertainty surrounding tax policy in 2013 to global geopolitical concerns, may be to blame. The two drivers of the economy, consumer and business spending, remain tepid and, although there have been subtle signs of progress, the economic data continues to be mixed. As a result, rates on Federal and Municipal debt are at their 45-year lows.
With such ambivalent economic data, the strength of the equity markets is surprising. The S&P has returned 16% year to date. This is partially due to the extraordinary return of Apple, which is up 65% as of September month-end; however, even indices which do not include Apple, such as the Dow and EAFE, generated double digit returns of 12% and 10%, respectively. What has driven the markets upward? We would guess that investors have nowhere to go and would rather invest in an equity index with a dividend yield of approximately 2% rather than a 10 year Treasury that is yielding 1.6%.
We are witnessing a search for yield in many sectors. Given that inflation remains subdued and the Fed has pledged to keep rates low even after the economy picks up, investors seeking yield are faced with the following choices:
- take on increased credit risk by investing in the high yield market,
- take on increased interest rate risk by investing in longer-dated bonds,
- all of the above.
High yield municipal bonds, for example, have had a stellar year, with the Barclays Capital Municipal High Yield Index returning 13.9% year-to-date. However, with all of the uncertainty surrounding the marketplace, any shift in investor sentiment could create a dire scenario for those taking on increased credit and/or interest rate risk.
As to technical factors, municipal bond funds marked the 43rd consecutive week of positive flows. Supply has been much greater year to date versus 2011; however, more than 43 % of the supply is refunding outstanding bonds that had been issued at much higher yields. Net new supply has actually been smaller than the amount of bonds that either matured or were refinanced. Other factors contributing to the rally in the municipal bond market may have to do with concerns over the potential for increasing tax rates and the possibility that interest rates will not be increasing significantly anytime in the near future.
High-profile bankruptcy filings in the state of California have increased concerns that more California cities might use bankruptcy as a method to rein in costs and avoid bond payments. While the potential exists, we do not suspect that this will become a major trend as the stigma of filing for bankruptcy creates an array of problems for municipalities, particularly restricted access to the markets moving forward.
It is interesting to note that over the first three quarters of 2012, especially the third quarter, there was a significant dispersion of returns in the performance of single state strategies. For example, the state of California has outperformed New York and Pennsylvania year to date. We attribute this dispersion to investors’ search for yield. The irony is that this outperformance is taking place in a state where the majority of local bankruptcies are occurring.
As mentioned earlier, Fed Chairman Bernanke is signaling low rates well beyond the expiration of his term. With or without him, rates may well be low for a long time -domestically and globally. We remain alert for any potential shifts in policy or market sentiment which might result in a meaningful rise in rates and are prepared to adjust the portfolios accordingly. For that reason, the portfolio is modestly shorter than the benchmark and does not have significant exposure to the greater than ten year part of the market.
The opinions expressed herein are solely attributable to Samson and should not be construed as an offer to buy or a solicitation to sell any securities. Inherent in any investment is the risk of loss. All factual information and statistical data in this document were obtained or derived from public sources. Samson makes no representations that such information or statistical data is accurate or complete. No person to whom a copy of this document has been delivered should rely on any such factual information or statistical data as being accurate or complete and should not undertake any investment program based on such information contained in this document. Any statements regarding future events constitute only subjective views or beliefs, are not guarantees or projections of performance, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond our control. Past performance is not indicative of future results. All estimates, opinions and analysis in this document constitute judgments made by Samson as of the date of this document and are subject to change without notice. Samson has no obligation or duty to inform any person to whom a copy of this document has been delivered of any change in any estimate, opinion or analysis in this document or to update the document on a going forward basis.