Market Review and Outlook 2nd Quarter 2013
The second quarter of 2013 was one of mixed economic data. The good news was that the economy showed signs of strength that we believe are likely to be sustainable. On the other hand, interest rates rose across the yield curve with the greatest impact on longer maturities. Our portfolios were not unaffected by the rise in rates, but given our focus on the short and intermediate part of the yield curve, our portfolios were less impacted by the change in rates.
The bond market opened the second quarter of 2013 with a continuation of the first quarter’s declining rate environment, only to reverse course dramatically in May. After peaking on March 11, interest rates moved slowly but consistently downward until May 2. For example, the 10 year US Treasury, which had been as high as 2.06% on March 11, bottomed at 1.63% on May 2. After that date, rates moved sharply and quickly upward, and the 10 year closed the quarter at 2.48%.
Two significant changes impacting the bond market’s outlook occurred in the second quarter. A sharp decline in expectations for inflation came first. After many months of anticipating that the Fed’s 3rd round of quantitative easing (QE) would be inflationary, the usual harbingers of inflation—gold, TIPs, and commodities—dropped sharply in price. This was favorable for municipal bonds as the “real return” increased.
Originally, QE3 had been presented as a more open-ended endeavor than previous QEs, which were undertaken with specified beginning and ending dates. The termination of QE3 differed in that it was tied to achieving specific economic targets regarding growth, employment and inflation. Although we are still some way away from these thresholds, the market began to question QE3’s longevity. And since markets are prone to anticipate, rather than await, the arrival of economic events, they began to act as if tapering were imminent.
As for US fiscal policy, fears of the negative economic impact from “sequestration” measures have yet to materialize, although hidden in July’s relatively good jobs report is the fact that jobs were lost at the government level. In contrast to the rest of the world, the US economy continued to show modest but steady progress on a number of important fronts. According to the Bureau of Labor Statistics, job creation continued to inch up and is now approaching 200,000 jobs per month. There are continuing indications of an improved housing market, although the recent spike up in mortgage rates has yet to be accounted for. Consumer confidence is at reasonably optimistic levels, while inflation remains low. Based on comments this month from Fed board members, it remains unclear whether these indications are, in fact, sufficient for the Fed to begin its tapering program.
The municipal market was influenced by a variety of factors. New deals continued to come at a modest pace and were usually highly oversubscribed. But for the first time in several years, municipal bond mutual funds experienced a quarter of substantial outflows. Credit spreads widened. A number of new deals that were announced for mid and late June were withdrawn. Yields rose and bond prices suffered. Although interest rates rose all along the yield curve, our focus on intermediate maturities avoided the larger losses of longer bonds.
Samson sought to walk a fine line between being too short and earning too little, and going out too long and increasing the volatility of the portfolio. Therefore, we tended to emphasize bonds in the 3 to 7 year range of the yield curve, an area which we feel will benefit from the Fed’s continuing maintenance of a near-zero Fed Funds rate. We also looked to buy opportunistically attractive blocks of bonds whose credit fundamentals remained strong, but whose prices had fallen in the recent market dislocations.
In general, the credit quality of municipal bonds remained firm, as tax receipts continued to improve in all major categories. One significant exception is the City of Detroit. Earlier this year Detroit’s finances deteriorated to such a degree that an emergency manager was appointed to oversee the city’s financial affairs. The manager, Kevyn Orr, released an initial report in June that depicted a dire financial situation. In an attempt to avoid bankruptcy, the manager proposed significant across-the-board spending cuts. He also presented a controversial plan that would put the city on stronger financial footing by asking creditors, including bondholders and retired public workers, to take a fraction of what is owed them. In June, the city stopped payments on debt and began meetings with creditors in an effort to avoid a bankruptcy filing. Perhaps the biggest surprise was the manager’s statement, which viewed Detroit’s general obligation (GO) debt as an unsecured obligation. All parties are clearly staking out negotiating positions. However, were this position to be upheld, it would be counter to the market’s perspective on the strength of a GO pledge and such an interpretation would impact other troubled issuers. Subsequent to the close of the quarter, on July 18, the City of Detroit filed for bankruptcy. Nevertheless, we believe municipal bonds remain an attractive asset class.
In addition to improving credit fundamentals and the diversification they add to portfolios more heavily weighted in risk assets, municipals continue to offer specific advantages for certain tax paying investors. Municipal bonds remain exempt from federal taxation, the maximum rate for which was increased in 2013, and they are also exempt from the recently added health care tax. As seen in the prior chart, on an after-tax basis, municipal yields are higher than those for comparable maturity Treasury and agency bonds, and higher than those for comparable quality corporate bonds. Furthermore, recent dislocations have provided buying opportunities. Therefore, we continue to recommend remaining fully invested, with durations roughly in line with the portfolios’ benchmark.
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.