Top 10 Bond Market Lessons of 2013
1. Investment grade bonds can generate positive returns even in a rising interest rate environment
For all the discussion about Fed Tapering and rising interest rates, conservative investors who manage their portfolios for after-tax returns could have made money in short to intermediate maturity municipal bonds. As Exhibit 1 at right shows, municipal bonds with maturities up to 5 years generated returns well in excess of cash. Corporate bonds created opportunities for capital preservation oriented investors as well. Intermediate maturity financials generated a healthy positive return, well in excess of comparable duration industrials. Both financials and industrials, it should be noted, fared better than intermediate duration Treasuries as spreads on corporate bonds tightened throughout the year.
2. Risk free assets are not always so risk free
Treasuries were the worst performing sector in the investment grade universe. Not only were returns poor when compared to tax-exempt and other taxable sectors, but volatility was high.
3. You cannot always believe what you read about the credit quality of the municipal bond market
Despite all the gloomy headlines about Detroit and Puerto Rico, at the end of the day, municipals as a sector significantly outperformed Treasuries for the year. Credit quality improved for the sector as a whole and, despite the headline catching news from Motown and the Caribbean, many municipal issuers began to tackle pension reform in 2013. The State of Illinois, for example, passed important legislation that will put the state pension system on sounder footing in the years ahead. With property values increasing and tax collections continuing to rise, municipal credit quality is on an upswing in many areas.
4. You cannot always believe what you hear about tax reform in Congress
The tax exempt character of the municipal market is more valuable than it has been in years. Tax rates have increased and, despite all the rumors, there are no serious discussions in Washington that will change the tax exempt status of the sector. Yet, as shown in Exhibits 4 and 5 below, the size of the municipal market is actually falling on an absolute basis and on a relative basis to taxables. The tax exempt character of the municipal market has become more valuable over the past few years when viewed in this supply and demand context.
5. For value oriented investors, waves of selling pressure created tactical opportunities in closed-end funds
Mutual fund investors, following the headlines, liquidated their holdings of both open and closed-end mutual funds, creating opportunities for value oriented and tactical investors. As talk of tapering rose throughout the year and fears of rising rates worried investors, both taxable and tax-exempt open-end funds were swamped with large redemptions. This had a particularly notable impact on closed-end funds. As selling pressure accelerated, the share price of these funds fell sharply below the net asset value of the bonds they own. For clients comfortable with longer duration municipals and the closed-end fund structure, it was possible to create risk-managed baskets of closed-end municipal mutual funds trading at sharp discounts to net asset value with tax-free dividend yields of more than 6%.
6. Bond ETFs do not act like bonds
With the growing popularity of bond ETFs, 2013 served as a great reminder that bond ETFs are not bond substitutes and that marrying bond portfolios to an ETF structure is not a match made in heaven. The allure of a bond ETF is understandable: with the click of a mouse, investors can gain exposure to the broader municipal and taxable bond markets, or almost any bond market sector they desire. Using bond market ETFs as the building blocks of an investor’s asset allocation strategy seems like a simple, low transaction cost way to access bonds with the ease of highly liquid equity markets. Yet, most bonds are not as liquid as equities, and that is where an approach that is attractive in concept may break down in practice.
As Exhibit 8 at right shows, a number
of bond ETFs traded at meaningful discounts to NAV during periods of market volatility in 2013. These discounts often arose during periods of peak selling. When investors sell high quality bonds at a discount to their underlying value, it can be a signal that a bearish extreme has been reached. This behavior was particularly notable during the surge in interest rates that occurred in the late spring and early summer. A wide range of taxable and municipal ETFs traded at material discounts during that period.
If an investor was unfortunate enough to invest in these ETFs when they were at a premium and liquidated when they were at their deepest discount, these ETFs would have generated great disappointment to investors expecting market returns. The consequences of this can be seen in Exhibit 9 below.
7. Bond sector ETF underperformance relates to sector specific liquidity characteristics
In 2013, there was a noticeable link between the underlying liquidity of a bond market sector and the likelihood that a meaningful discount would occur during a period of market turbulence. For example, even though the iShares Treasury ETF traded at a discount at times, it was generally small relative to the discounts for ETFs investing in other sectors. The ETFs discounts for Corporates (CFT), GNMAs (GNMA), Municipals (MUB), International Inflation Linked Securities (IGOV), and corporate debt issued by finance companies and banks (MONY), were all larger at varying moments than the discounts experienced by the Treasury ETF.
Bond related ETFs experienced performance that differed from benchmarks and meaningful discounts for understandable reasons that relate to the mechanics of ETFs. A simplification: When investors buy an ETF, new shares may be created if demand is sufficiently large. Then, the ETF may buy bonds, often by sampling the market.* When cash is invested in an ETF, the investment manager has to purchase bonds from the solution set available on that day – which may not be the best choice in all cases. As bonds are an over-the-counter market, and all issues do not trade every day, ETF investors are exposed to a potential adverse selection process when shares are created. In the case of mortgage-backed securities, pools with favorable prepayment characteristics may simply be unavailable on the date that investors buy ETF shares.
Yet, cash must be put to work, regardless of the character of the bonds available. When ETF investors sell shares, bonds most be sold. If investors redeem during a time of market turmoil, selling pressure may actually drive the price of the ETF stock beneath the net asset value of the securities in the ETF portfolio.
8. Caveat Emptor: Should the Puerto Rico meltdown have surprised anyone?
Puerto Rico has been a declining credit for years and it has been public knowledge for a very long time that the Commonwealth’s pension funds have been woefully underfunded. Yet, 2013 was the year that the market decided that it cared. As a result, municipal bonds issued by Puerto Rico fell in value by about 20% in 2013 according to Barclays’ index data. Since many municipal mutual funds are purchased by retail investors based primarily on yield, higher yielding Puerto Rico bonds, triple tax exempt, were distributed across the industry. More than 60% of all municipal funds had exposure to one of the many credits that are directly related to Puerto Rico. This is another good reason why conservative investors should know what they own and should construct sector exposures with separately managed accounts when possible.
9. A great year for taxable high yield, but low quality municipals were left in the dust
As investors reached for yield, and as corporate balance sheets continued to mend, junk bond spreads tightened throughout the year. The Barclays Corporate High Yield Index generated a 7.4% return for the year. The Barclays Municipal High Yield Index, a basket of fallen angels, toxic tobacco bonds, and sectors that are overlooked and illiquid, like charter schools, generated a negative return for the year of -5.5%. Certain Puerto Rico credits are now also in the high yield index. Municipal and corporate high yield usually correlate and it is rare for one sector to post a meaningful positive return, when the other posts a significant negative return.
10. And, the baby was thrown out with the bath water…..
The investor exodus from municipal bond funds
meant that lower quality investment grade municipals were oversold. As a result, A-rated and BBB-rated municipals significantly underperformed comparably rated corporate bonds for the year as shown in Exhibit 11 to the right. For value-oriented investors with a fundamental approach to credit analysis, there are good opportunities to add value to municipal portfolios with a careful review of the issuers in these credit buckets.
When we look at the yield curves for A-rated and BBB-rated municipal securities, on a pretax and tax equivalent basis, it should be noted that the pretax yields across almost all maturities are in excess of the dividend yield of the S&P 500, and the taxable equivalent yields, particularly in the 10-15 year part of the curve, are notably attractive. After the bull run in stocks, many strategists have more muted expectations for domestic equity returns, and the pretax and taxable equivalent yields seen in Exhibit 12 are not only competitive with that more modest outlook for stocks, but, given the lower volatility and historically more modest drawdowns of municipals, more attractive. For investors who are now overweight stocks after a bull run in 2013, it may be an appropriate time to revisit the role of municipals in that framework.
Chief Investment Officer
January 6, 2014
*Authorized participants can create shares when demand is large. They can deposit securities that are generally in alignment with the ETF strategy into the fund. They can also deposit cash. Only an authorized participant can create or redeem shares.
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 which we believe to be reliable, but Samson cannot guarantee the veracity of the information.