Municipal Market Review:
Municipal bonds outperformed their taxable equivalents during the month of October. Treasury and Libor swap rates both increased by 4 to 10 bps over the month, while municipal yields increased on average 1-2 bps. This is due in large part to the perceived credit quality improvement of municipal issuers and moderate new issue supply. Credit default spreads (CDS) on municipal bonds continue to tighten during the month, reflecting investors’ increased comfort with lower default rates for municipal bonds. Overall, CDS levels are 25% lower than they were at this time last year. Although we feel credit quality is improving, this seems a bit optimistic given the current economic and political uncertainties.
- Municipal Market Advisor Default Trends Analysis (data from MMA) shows the pace of defaults in 2012 continues to lag 2011. More specifically:
- 64 issuers for a par amount of $1.18 billion have defaulted as of October 30, 2012. This is .39% of issuance to date.
- 81 issuers for a par amount of $1.74 billion this same time last year. This represented .82% of issuance in to date in 2011.
- Although municipal issuance is up 45% year-to-date, new money is up only 11%. The bulk of the issuance growth has been used to refund current outstanding bonds. This type of issuance does not create new supply to the market and, therefore, does not require an increase in demand.
We continue to recommend being cautious when purchasing new municipal bonds at these current yield levels. The economic and political uncertainties surrounding the markets and municipal bonds does not give us reason to lock-in long-term investments at these yield levels.
Investment Strategy Review:
We continue to advise investors on executing a defensive cushion bond strategy, buying 4-7 year callable premium coupon bonds. In the short-term, short call premium coupon bonds can provide a 2.0%-2.5% tax exempt yield, and have low price duration if rates do go up. We highlight the performance of this strategy in this month’s market review.
The Cushion Bond Strategy:
As many of our investors are familiar with, we have been big advocates of investing in “cushion bonds” for some time now. What is this strategy and how has it worked?
The “Cushion Bond Strategy” is a defensive investment plan used when investors are concerned with rising interest rates in the future. Its objective is to provide an investor a comparatively higher “short-term yield”, while accepting minimal market price risk versus other traditional short-term bullet bonds. More specifically, if the strategy is successful, it allows an investor to clip a high coupon, while minimizing market value losses. Then, when long-term rates increase, bonds can be sold and reinvested into long-term higher yielding bonds. If the investor does not want to sell the bonds, or rates move up too quick to avoid losses, the bonds can be held with the unrealized market losses. They are now earning a higher yield (4-4.5%) as they “have kicked” and are now trading to their maturity date.
More specifically, the MainLine West cushion strategy is designed to allow an investor to earn 2-3% over the next 2 to 5 years, and minimize the risk of market price declines. This strategy calls for the following types of bonds:
- Purchase 5% coupon bonds providing good extension risk protection. Yields would need to rise over 200-300 bps for the bonds to extend duration and become priced to the maturity date. This keeps bonds from having a lot of price volatility. The plan is to clip the coupon as the bonds amortize to the call date.
- Purchase bonds priced to a 2-7 year call date, giving them low price volatility and fitting in well with our expected rising rate time frame.
- As value returns to the municipal market, and yields increase, these bonds may decline a bit in price, but as a 2-7 year municipal bond and not as a long-term bond. Bonds can be sold and the proceeds used to buy new long-term maximum yield bonds at new higher levels of interest rates.
Having reviewed a majority of our investor’s bonds purchased under this strategy, and comparing them with indexed bullet bonds maturing on the same day as the call date, the cushion strategy has shown strong performance. Depending on when the bonds were bought, credit quality, call date, and state of issuance, we show the following annualized and averaged results (Period ending 10/08/12):
Hang in there, our investment time frame and strategy is for the next 2-5 years, as we wait for higher long-term municipal rates. Returns to date make the strategy look pretty successful as many other investors have begun executing more recently therefore, driving up prices. We are still confident in the objective of the strategy, and feel it is off to a great start!