In 2013, the markets got their first taste of what I referred to in my last report as the post-post-crisis era. It was a year in which talk of “tapering” dominated the financial headlines – a reference to the U.S. Federal Reserve’s plans to scale back its purchases of long-term bonds, as a first step toward reducing its accommodative monetary policy. The Fed first floated the idea last May, and the rate on the 10-year U.S. Treasury note backed up by about 100 basis points (bps), leading the rest of the bond market in a sell-off. As it turned out, the Fed did not go through with the tapering plans – at that time – and Fed members went out of their way to assure market participants that it would not end the long-term bond purchases prematurely.
For us, the significance of the rate backup of 2013 was that it confirmed the beginning of the end of the Fed-managed market that had dominated the post-crisis era. Even though in May the Fed “walked back” its plans for the taper, the market only partially walked back its sell-off. The market was making a statement, in our view, that its own judgement on the economy was more important than Fed guidance, and that tapering at some point was inevitable. Indeed, the Fed has stressed for some time that its policy was “data dependent,” and on December 18 formally announced the taper’s start.
The "year of the coupon" wasn't quite that
A year ago, we anticipated that 2013 would be the “year of the coupon” in that total returns in various income sectors would approximate their coupons. A “coupon” is the traditional bond market term for the income issuers are obligated to pay on a periodic basis.) With no apparent end in sight to the flood of liquidity from the Fed and other central banks, many income sectors had recorded total returns in 2012 of roughly twice their coupons. For example, the total return for the high-yield sector, with a coupon of 7.8%, was 15.6%. At the end of 2012, with rates near historic lows and an outlook for continuing easy monetary policy, we anticipated a steady-state market for 2013 in which income investors would “earn their coupons.”
However, the Fed’s tapering talk and subsequent backup in rates upset the steady-state scenario. With the market decoupling from the expectation of unending Fed support, it resumed its traditional role of differentiation based on perceived relative value across income sectors – a stark contrast to the Fed-managed uniformly positive returns of 2012. In 2013, the sectors that were expected to benefit most from improving credit quality associated with the recovery – high-yield bonds and floating-rate loans – had positive total returns that were close to their coupons, while other income sectors never fully recovered from the rate backup and ended their year in negative territory, not earning their coupons (Exhibit 1). Emerging-market debt, both local and dollar-denominated, and municipal bonds were at the bottom of the pack.
Compelling values from 2013's volatility
The volatility of 2013 has created what we see as some compelling income investment opportunities for 2014, especially in “beat up” sectors like emerging markets and municipals. They may offer an attractive value cushion, with prices below what we view as a fair assessment of their worth. We believe sectors like high yield and bank loans continue to offer appealing investment propositions, though due to continued price gains in 2013, returns are likely to be limited to income distributions (i.e., their coupons). Relative to other sectors, both offer attractive yields and have been less sensitive to rising rates, and we believe they should benefit from an improving economy.
If we look at the past four years, emerging-market (EM) securities have lived up to their historically volatile reputation. Among major income sectors, local-currency-denominated EM bonds were first in total return in 2010, last in 2011, first in 2012 and last in 2013.1 In the past, EM bond prices have often been driven by changing technical factors (e.g., fluctuations in demand – especially from foreign retail investors – and supply of a nation’s currency or debt). The prospect of rising rates in the U.S., which accompanied the Fed’s tapering talk, proved to be a trigger for the exodus of foreign capital from local EM bond markets. Despite a coupon of 7.2%, emerging-market local debt had a total return of -8.9% in 2013.
This creates an opportunity, in our view, with one important qualification. While technical factors remain an important driver of emerging and frontier market performance, the varying fundamentals of regions and countries within both sectors have also grown to be significant factors. For example, Mexico’s reform efforts in education, labor and energy comprise part of what we see as attractive growth prospects for the country, while in Argentina, rising government intervention in the private sector helps make our views on that country more bearish. Investment strategies that don’t account for differentiation among emerging and frontier countries are likely to be suboptimal, in our view.
The strong case for munis
The case for munis is even stronger, in our opinion, especially at the intermediate and long end of the yield curve. The negative headlines concerning the troubles experienced by Detroit and Puerto Rico, combined with the Fed’s talk of tapering, dragged down the whole sector, as investors pulled large sums out of muni bond funds (Exhibit 2). In so doing, we believe that investors have ignored several key strengths:
Taxes – At tax time this April, millions of Americans will come to grips – perhaps for the first time – with the fact that federal tax rates have gone up for 2013 (Exhibit 3). In our view, it is hard to see how this could not bolster the demand for munis, which, as of December 31, 2013, were yielding 4.9% on a pre-tax basis. Under the 2012 maximum tax rate of 35%, that is equivalent to a 7.5% taxable instrument2 – already a very generous yield, comparable to high-yield bonds. But under the new 2013 maximum rate of 43.4%, the taxable equivalent rate jumps to 8.7%.3The investor would pick up an extra 120 basis points, relative to a comparable taxable bond, without increasing risk. It is rare in the investing world to receive an extra benefit without also boosting risk, but that is the case here, courtesy of rising tax rates.
Relative value - As of December 31, AAA, 30-year municipal bonds were yielding 106% of comparable U.S. Treasury bonds, higher than the 102% 10-year average for that ratio, based on the Barclays U.S. Aggregate Local Authorities Index.4 Investment-grade corporate bonds were yielding just 52% of municipal bonds, on an after-tax basis, as of December 31, 2013.5 Compared with other options for yield in today’s markets, munis are attractive.6
Credit quality – The summer of 2013 saw Detroit file for bankruptcy and the downgrading of Puerto Rico’s general obligation bonds. We believe that the overall credit trends of state and local municipalities show that such problems affect just a relative handful of governments, and are not representative of the market as a whole, which comprises more than 60,000 issuers. In a recent study, Moody’s looked at 10-year cumulative default rates between 1970 and 2012 and found there has not been a meaningful increase in default rates. For example, at the high-quality, AAA-rated end, there was a 0.00% default rate among issuers, and a 0.05% rate for A-rated. Further, Moody’s revised the outlook for both states (in August) and local governments (in December) from negative to stable, five years after the financial crisis. Moody’s noted that while conditions are not expected to achieve pre-2008 peaks, most governments have successfully adapted to a “new stable” environment of constrained resources.
Closed-end funds enhance the muni value picture
While we believe the current prices and yields on municipal bonds offer a significant “value cushion,” that cushion can be increased even further, based on the pricing of muni closed-end funds as of December 31 (Exhibit 4). Because closed-end funds trade on the secondary market, share prices may reflect a premium or discount to the net asset value (NAV) of the underlying bonds. For example, the Morningstar U.S. Closed-End Muni National Long category on December 31, 2013 traded at a 6.7% discount to NAV with a yield of the same amount. However, at a 43.4% federal tax rate, the taxable-equivalent yield would be 11.8%. Obviously, share prices of closed-end funds could get cheaper still, but the investor would still be compensated by the same attractive yields. The bottom line for us is that when a beat-up sector like munis is offered in a beat-up vehicle like closed-end funds, it may be a potentially double-barreled value opportunity that we believe deserves consideration.
Looking beyond the Fed-managed market
With the Fed finally moving ahead with the taper, what does this tell us about the course for interest rates in 2014? At the short end of the curve, rates are likely to be anchored near zero “well past the time that the unemployment rate declines below 6.5%, especially if projected inflation continues to run below the [Federal Open Market] Committee’s 2% longer-run goal,” according to the Fed’s December 18 announcement. Fed officials have been quoted as saying that tightening at the short end of the curve is not expected until 2015 or even 2016.
At the longer end of the curve, rate direction is likely to be data dependent and more volatile. The Fed has described its $10 billion lowering of monthly bond purchases as a modest step, with further incremental reductions to be decided at future meetings. The recovery continues to be characterized by mixed signals, like the higher-than-expected initial jobless claims number in December, coming after a series of positive economic readings in the fourth quarter. Inflation has been running well below the Fed’s 2% target and unemployment falling slowly, so we continue to expect a slow advance in longer-term rates in a “sawtooth” pattern rather than the kind of 100bps spike of 2013.
For us, this kind of volatility provides opportunities to better manage portfolios as rates drift up from their historical lows, as shown by recent experience in the municipal and emerging-market sectors. As the economy continues to move from its Fed-managed moorings in the new year, we look forward to helping you identify value opportunities across income markets.
1Source: Morningstar, as of December 31, 2013, based on performance of the JPMorgan Government Bond Index-Emerging Markets (GBI-EM) Global Diversified, versus other comparable income sector indexes. See end of report for index definitions. Past performance is no guarantee of future results. It is not possible to invest directly in an index.
2Taxable-equivalent yield refers to the yield an investor in a particular tax bracket would have to earn on a taxable investment to have the same after-tax yield as on a given tax-free security such as a municipal bond. For example, an investor in the current maximum Federal tax bracket of 43.4% (which includes the new tax from the Affordable Care Act) would need a taxable yield of 5.3% to match the after-tax yield on a municipal bond of 3%. A portion of income may be subject to federal income and/or alternative minimum.
3The after-tax return for the investor may be even higher when the municipal exemption from state taxes is also included.
4See end of report for index definitions.
5Based on comparison of the BofA/Merrill Lynch AAA-A US Corporate Index and the BofA/Merrill Lynch Municipal Index, as of December 31, 2013. See end of report for index definitions. Past performance is no guarantee of future results. It is not possible to invest directly in any index.
6See discussion of relative risks of Treasury, municipal and corporate asset classes on p. 7.
7Unlike open-end mutual funds, closed-end funds have a fixed number of shares and typically trade on a stock exchange. Closed-end fund shares frequently trade at a discount to the fund’s net asset value per share. Premium/Discount is the amount by which the market price trades above or below NAV.
BofA/Merrill Lynch U.S. High Yield Index is an unmanaged index of below-investment-grade U.S. corporate bonds.
BofA/Merrill Lynch U.S. Floating-Rate High Yield Index is an unmanaged index of the institutional leveraged loan market.
BofA/Merrill Lynch U.S. Mortgage-Backed Securities Index is an unmanaged index of the U.S. mortgage-backed securities market.
BofA/Merrill Lynch AAA-A US Corporate Index consists of U.S. dollar-denominated investment-grade corporate debt securities rated between AAA and A.
BofA/Merrill Lynch Treasury Index is an unmanaged index of U.S. Treasury securities with remaining maturities between 7 and 10 years.
BofA/Merrill Lynch Municipal Index tracks the performance of U.S. dollar-denominated investment-grade tax-exempt debt publicly issued by U.S. and territories, and their political subdivisions, in the U.S. domestic market. Securities must have at least a one-year term remaining to maturity and a fixed coupon schedule.
JPMorgan Government Bond Index Emerging Markets Global Diversified (GBI-EM) is an unmanaged index of local-currency bonds with maturities of more than one year issued by emerging-market governments.
JPMorgan Emerging Market Bond Index + (EMBI+) is an unmanaged free float-adjusted market-capitalization-weighted index designed to measure the debt market performance of U.S. dollar-denominated emerging markets.
Barclays U.S. Aggregate Local Authorities Index measures the performance of U.S. investment-grade fixed-rate debt issued directly or indirectly by local government authorities.
An imbalance in supply and demand in the income market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer’s ability to make principal and interest payments. As interest rates rise, the value of certain income investments is likely to decline. An imbalance in supply and demand in the municipal market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a
lack of price transparency in the market. There generally is limited public information about municipal issuers. As interest rates
rise, the value of certain income investments is likely to decline. Investments involving higher risk do not necessarily mean higher
return potential. Diversification cannot ensure a profit or eliminate the risk of loss.
Elements of this commentary include comparisons of different asset classes, each of which has distinct risk and return characteristics. Every investment carries risk, and principal values and performance will fluctuate with all shown substantially asset classes shown, sometimes substantially. Asset classes shown are not insured by the FDIC and are not deposits or other obligations of, or guaranteed by, any depository institution. All asset classes shown are subject to risks, including possible loss of principal invested.
The principal risks involved with investing in the asset classes shown are interest-rate risk, credit risk and liquidity risk, with each asset class shown offering a distinct combination of these risks. Generally, considered along a spectrum of risks and return potential, U.S. Treasury securities (which are guaranteed as to the payment of principal and interest by the U.S. government) offer lower credit risk, higher levels of liquidity, higher interest-rate risk and lower return potential, whereas asset classes such as high-yield corporate bonds and emerging market bonds offer higher credit risk, lower levels of liquidity, lower interest-rate risk and higher return potential. Other asset classes shown, such as municipal and investment-grade bonds, carry different levels of each of these risk and return characteristics, and as a result generally fall varying degrees along the risk/return spectrum.
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