MainLine West Monthly Market Review – December 2012

Municipal Market Review:

The Municipal market was fooled with a simple Washington, D.C. head fake. The uncertainties cited last month, surrounding the fiscal cliff and potential changes in allowable tax-exempt income levels finally caught up with the high evaluations on municipal bonds. The result, was one of the worst year-end sell-offs ever for the municipal bond market, aside from the Meredith Whitney induced sell-off in December 2010. More specifically, after a slight year-end rebound of 2-5 bps monthly yield changes were as follows: 

  • 10 year muni rates increased 25 bp, underperforming the Libor market which sold-off 14 bps,
  • 25 year muni rates increased 35 bps, underperforming the Libor market which sold-off 18 bps.

The trend for municipal credit quality during 2012, looks to be on track for solid improvements. As of December 18, 2012, Municipal Market Advisor Default Trends Analysis (data from MMA) shows the pace of defaults in 2012 continues to lag 2011 by a large amount. More specifically:

  •  91 issuers for a par amount of $1.62 Billion have defaulted. This is .46% of issuance to date in 2012.
  • 128 issuers for a par amount of $6.53 Billion this same time last year. This represented 2.17% of issuance to date in 2011.

Investment Strategy Review:

 It goes without saying, we are now more interested in looking for value after the recent sell-off. Going forward we remain defensive for some investors, and will release our 2013 Market Outlook within a couple of weeks to discuss strategy ideas for 2013. We start the discussion off this month with a review of municipal floating-rate bonds.

The municipal market has been a top performer since the economic crisis began in 2007, and has earned the respect of financial advisors and their asset allocation models. Depending on what happens over the coming year, regarding budget cutbacks, financial reforms, and tax policy changes, munis should remain an important piece of the investment puzzle. It just remains to be seen exactly how important.

A Review of SIFMA Floating-Rate Municipal Bonds:

As we approach the end of another great year in municipal bond performance and lifetime low interest rates. What is an investor to do for 2013, how about getting more defensive?

A simple one year total return analysis shows at these low coupon levels, it does not take much to turn a bonds total return negative.  The current low yield levels create such a low coupon payment that it does not take much of a market move to lose its value. This is not a very good risk and return profile. As a buy and hold investor, with a laddered portfolio, the impact of purchases in 2013 at these levels would be muted, as the rest of the portfolio will still be enjoying good yields from prior years. Hopefully, the bonds not maturing in 2013 will get reinvested over time at higher rates. However, what if you want to make a new allocation to munis, or due to bond calls and refinancing you are sitting uncomfortably on too much cash?

There are several traditional defensive strategies, for example:

  1. Stay in cash and earn a .15% to .20% tax-exempt 7 day variable rate yield, with no price risk.
  2. Purchase a short-term municipal bond portfolio of 1-5 years earning .60%, with minimal price risk.
  3. Cushion bond strategy, which now has the same ugly risk/return profile as the 5 year analysis above shows.

Strategies 1 & 2 are very liquid, and market price risk is low, unfortunately, they do not provide a lot of income. How about an investment strategy that could earn twice as much income if interest rates rise, have a relative stable price close to par in any interest rate environment, and have excellent liquidity in the final 12 months of its investment term?  May we introduce you to municipal floating-rate bonds!

Municipal Floating-Rate Bonds:

Background:

Floating-rate municipal bonds are not a new investment vehicle. The first ones I remember were issued in 2006-2007, and have been big underperformers. This is not surprising, as rates have decreased; their coupons have decreased, making fixed rate bonds bought at the same time better performers. These early bonds also were mispriced as spreads were too tight, issued with long-term maturities, and were usually priced as a percentage of 3 month Libor.

In the last couple years, a much more efficient SIFMA rate market with better pricing mechanics, and spreads have emerged. Couple this with a perceived increased risk of higher rates in the future; it may be time to take another look at this asset class.

Municipal floating-rate bonds come in 2 styles, SIFMA based, and 3 month Libor based floaters. For this analysis we will focus on SIFMA based, since they are most prevalent and do not introduce the concept of basis risk.  Here are the SIFMA floater basics:

  • Bond’s coupon changes weekly priced off the 7 day SIFMA rate, plus a fixed spread.
  • Coupon payments, in most cases are made monthly.
  • Most bonds are 10 years and shorter in length, with call dates 6 months from maturity. This allows the issuer some flexibility when refinancing the debt.
  • Same credit quality as fixed coupon bonds from the same issuer.
  • Floating-rate bonds pay out tax-exempt income.

Performance Analysis:

The idea is to see what the income impact would be versus the standard fixed rate bond investment under each interest rate environment. It is important to quantify the income difference versus the defensive advantages of the bonds.  There are a few assumptions made for this analysis:

  • Bonds are purchased at par and held to maturity
  • I do not assume any reinvesting of coupons.
  • Rates rise marginally until 2016 (cumulative increase of 75 bps). They then begin to rise at the historical averages for the given time period.
  • The relationship between SIFMA and 3 month Libor averages 70% over the life of the analysis.
  • No scenario is provided for interest rates going down. This would most likely mean the floating-rate bonds underperformed, and the assumption the investor wanted a defensive strategy was a bad one.

The four scenarios are as follows:

    1. “No Chge” – There is no change in SIFMA from the current .20% over the life of the investment.
    2. “Avg Chge”– Rates go up marginally for the first couple of years, and they increase at a rate that represents the average historical change in yields over a one, two and three year basis. This is an increase of 1.06% in one year from 2016-2017, 1.81% in two years from 2016-2018, and 2.38% over three years from 2016-2019.
    3. “1/2 Avg” – Rates change half the average that is defined in scenario #2.
    4. “+1Std – Rates go up faster than average by 1 standard deviation. . This is an increase of 2.06% in one year from 2016-2017, 3.32% in two years from 2016-2018, and 4.07% over three years from 2016-2019.

Conclusion:

It may now be time to add some SIFMA floaters to a diversified municipal portfolio, especially if an investor is looking to invest in the 5 to 10 year. The risk/return profile looks somewhat favorable for this asset class to finally be in favor. If you can buy a like rated and maturing bond, without giving up income, and get income/price protection in an increasing rate environment, I think that’s a winning plan. The ability to sell the floating-rate bonds may be tough as the market is still developing. These bonds should not be bought with plans to sell them until they approach 1 year left to maturity. When they get to be 13 months from maturity, they become money market eligible and there should be a good bid for them by the money market funds. As the different results from each floater above shows, an investor needs to be selective on which bonds are bought and at what spread. Not all floaters are created equal, but if selected properly, and rates go up, they just may be the star performers in your portfolio.

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