October 2014 Monthly Summary – Why Wait?
Another month and, once again, the market ends with lower yields than it started. Yields were initially pushed lower in October, due to international economic growth concerns and US Treasury short covering. By month’s end, municipal bonds had retraced roughly 2/3rds of their gains from earlier in the month, due to a pickup in supply and an easing of concerns. Yet, October finished as another month where investors continue to wait for higher yield levels. Unfortunately, during this wait, cash is building and income is lost. This wait may continue, but that does not mean an investor needs to stay in cash and earn nothing on their capital.
In this month’s credit review, we look at four different cash strategies and highlight their risks and returns. The threat of the muni curve flattening is still high, and longer-term fears that municipal yields are relatively low are creating a tough investment landscape. A solid cash investment strategy in this current market needs to protect against these concerns and still provide investors with income. Think we can find one?
October 2014 Municipal Market Review:
The municipal market started the month off strong, thanks to a flight to quality from international economic concerns. By month’s end, the muni market had given back roughly 2/3rds of the month’s rally. More specifically:
- Municipal yields decreased slightly by 5 to 14 bps, with taxable Libor rates decreasing 23 to 16 bps.
- Issuance continues to increase and is now trailing 2013 by only 6%. This looks like it will continue to decline as issuance runs higher into year-end.
- Municipal to Libor yield ratios continue to highlight the strong performance of the muni market in 2014. More specifically (chart & graph in Appendix 3):
- 10-year ratio is tighter by 10%, at historical averages.
- 5-year ratio is tighter by 24%, and is now the richest part of the municipal curve.
- 25-year ratio is tighter by 15%. Small relative value versus long-term average ratio.
Muni industry news:
- Stockton Bankruptcy plan has been approved by the courts. After two years, the city of Stockton, a poster boy of pension neglect, can finally move forward. The city’s high salaries, free healthcare, and worker bonuses for items such as learning to operate the back of a fire truck, were examples of benefits above and beyond the norm for a public entity. The high costs of its city employees, combined with it being “demographically challenged” led to its bankruptcy. The exit plan protects pension pay, cuts some benefits (no more free health care) and appears to pay investors in lease obligations of the city only 1 cent on the dollar. This exit plan highlights the growing trend of pension liabilities taking a higher priority to other creditors.
- Municipal issuance is growing. For the 1st nine months of the year, the 30-day average supply was $6 billion on a weekly basis. Since September, this average has been $9 billion. As of the first week of November, the level is at $12 billion. Is this finally the issuance we are waiting for, or just a short-term rush by bankers to get deals in before the holiday season and year-end?
- Detroit’s Bankruptcy is nearing finalization. The City has finally reached a settlement with its last creditor FGIC (the monoline insurer who has insured $1.1 billion of the COP’s issued to fund the pension plan). The settlement includes a $150 million in cash, some tax credits, and real estate in downtown Detroit. FGIC will need to recoup its losses by becoming a real estate developer.
- Disappointment with Chicago’s 2015 budget proposal. It appears the initial budget does not identify a source of revenue to help it meet a state mandated pension payment in 2016. If you remember our analysis on the City in the June 2014 Credit Review, this was a point of focus for the credit trend of the City going forward. We had hoped they would have proposed an increase in property taxes or identified a new source of revenue to begin fixing their pension problems.
Investment Strategy Review:
What to do if you are a municipal investor and have cash? Relative and historical value on municipal bonds is not ideal at this moment. We recommended staying defensive and staying patient. This month’s credit review will analyze four different types of cash investment strategies that can help fill the “muni void”.
October 2014 Credit Review – Where to Wait?
So you have cash, and you have been waiting for interest rate to rise for the last year. In the meantime you are earning single digit returns on your cash. Why? Just because you are concerned with higher rates, and a flattening yield curve, does not mean you need to give up short-term income. What are your options, what are your costs, and what are your risks? We feel the ideal cash investment at this moment should do the following:
- Protect against rising rates, both short and long-term.
- Provide liquidity when value returns to munis.
- Provide tax-exempt income.
The municipal market has several different types of cash investment strategies that we will review:
- Variable Rate Demand Notes (VRDN’s). This is the benchmark for all cash investments. 7-day variable rate floaters are puttable at par with a 7 day notice.
- Fixed rate short-term bonds with maturities from 1 to 5 years.
- Cushion bonds – Premium coupon short call bonds from 3 to 7 years.
- Floating rate notes (FRN’s) – short to intermediate maturing bonds that have floating rate coupons.
1) VRDN’s – 7 Day Variable Rate Demand Notes are the safest in cash investments. Investors are guaranteed par with a 7 day notice to the remarketing agent on these notes. This is as liquid as you can get in the municipal market. These notes have been earning on average 5 bps in 2014. There is no price risk, so once investors decide to invest in long-term bonds, they will not incur losses “selling” them. In the meantime they may earn enough money for a cup of coffee.
2) Fixed rate short-term bonds from one to five years for AA-rated bonds are currently yielding the following:
These bonds will pay the investor par at maturity. But if interest rates go up in the next year, the bonds with maturities of 3 to 5 years will show price losses. For a 3-year bond, a 30 bp increase in rates will cause it to have a 0% total return as market losses will offset the income earned. For a 5-year bond, this break-even change in rates is 35 bps.
3) Cushion bonds are bonds with premium coupons (for example 5%) that are trading to a short call date (3 to 7 years). They have limited price risk over the short-term, while earning higher income than fixed rate short-term bonds. This was our main cash investment strategy in 2013 when we were booking yields of 2% to 3% for investors. Now AA-rated bonds with intermediate final maturity dates (13 to 20 years) are earning the following yields:
These bonds do display some price risk, and if interest rates were to go up 50 to 55 bps in the next year, market price losses will offset the income earned and the strategy would have a 0% total return.
4) Floating rate notes (FRN’s) combine features of both fixed rate term bonds, and 7-day variable rate demand notes. They earn a rate based on the 7-day floating rate index, plus a credit spread for the issuer. Depending on the term of the final maturity, these bonds are earning the following yields:
This yield will change as interest rates change. If interest rates go up, the yield will go up. This creates a feature which allows the price of the bond to adjust to changes in interest rates and trade around par. The investor is not guaranteed par, but if the credit quality of the issuer remains unchanged, transaction history shows pricing to be +/- 1/2 % from par.
Which strategy is best for an investor with cash, and still anticipating higher rates? Below is a table with the above analysis results:
Only the FRN strategy provides investors with income, and price protection if the yield curve flattens, and rates increase. The 7-Day VRDN’s strategy earns next to nothing, but have no price risk. Also, at these low yield levels, duration risk is greatly magnified elevating price risk for the cushion and fixed rate short-term strategies. Floating rate notes provide an investor the opportunity to “straddle” the return/risk profile. Not the best of income, but not the worst. Not 100% liquid at par, but pretty close. FRN’s fit well for someone concerned with higher rates, but unwilling to earn nothing waiting for them.