Back in January, we predicted a “watershed year” for bond investors in 2007. It’s been all of that and much, much more. Let’s briefly review how things played out in 2007 so we‘ll have a better understanding of what to expect and the where to invest for income in 2008.
At the beginning of this year, the Treasury yield curve - that imaginary line depicting rates paid on governments sorted by maturity - was inverted. Very simply, short-term rates were higher than long-term rates. While many of our peers attributed this anomaly in rates to heavy buying of long-term maturities by Asian and oil-producing central bankers, we suggested the market was anticipating slower growth ultimately requiring reductions in short-term rates by the Federal Reserve. Rate inversions have occurred about a half dozen times over the last thirty years and almost always are resolved by the Fed lowering short-term rates to reinvigorate the economy as opposed to longer term rates moving higher on concerns of stronger growth and/or higher inflation.
When long-term rates temporarily spiked this spring (10-year Treasury yields touched 5.20% at one point) amid concerns of stronger growth, higher inflation and Fed tightening, we reiterated our belief the housing sector wasn’t out of the woods yet and our heavily financed-based economy wouldn’t support higher rates. We recommended more conservative buyers position themselves for the looming rally and purchase bonds that outperform in such a scenario, long-term, high grade, fixed rate taxable and tax free bonds. Because spreads (the yield premium over Treasuries) on lower rated corporate debt were historically narrow and, we believed, likely to widen as the economy slowed, pressuring prices, we suggested total returners invest more defensively.
While our macro calls on both the economy and rates this year proved correct (although past performance doesn’t guar-antee future results), we must admit our surprise at the severity of the market reaction to a downshifting economy during the last several months. Given the fact certain members of the Federal Reserve were framing the seemingly endless stream of bad financial news as recently as early November as a “rough patch” and dismissing the need for aggressive rate cutting by policymakers, we aren’t the only ones likely confused and concerned with the ongoing market turmoil.
December Trends Likely To Set The Tone For 2008
Like the stock market, the bond market has experienced a gut-wrenching “flight to safety” resulting in a decline in Treasury yields (short-term rates falling further than long-term rates) and spread widening on higher risk/higher return bonds. With 10-year Treasury rates hovering near 4% - the lowest yield in five years - and spreads on lower rated high yield corporate debt pushing 600 basis points - having doubled since spring - the bond market is obviously priced for much slower growth in 2008.
What makes this slowdown unique and therefore difficult to predict on how things play out, is the associated “credit crisis” which has developed because of problems created by falling home prices and rising mortgage defaults. Many fear commercial banks, which serve as the engine that drives sustained economic growth through loan creation, will stop lending money to corporations and consumers because they are overwhelmed with too many bad loans.
The Federal Reserve, which reduced short-term rates another 25 basis points last Tuesday for a total of 100 basis points in easing since mid-September, continues to talk and act in the context of a soft landing. Clearly, if it expected a full-blown credit crisis, especially heading into a presidential election year, we expect new Fed chairman Ben Bernanke to be more aggressive in addressing ongoing growth and liquidity concerns in the credit markets.
While the last month of the calendar year is often a non-event, December 2007 sets up as extremely important. In addition to fresh economic data, especially job creation and consumer spending, keep a close eye on trends in the financial markets. Should the ongoing “flight to safety” become more pronounced, reflected in weaker corporate bond and underlying equity prices and declining longer term Treasury yields, it would increase the probability of recession and necessitate more defensive investment strategies. Conversely, better-than-expected economic news, corporate developments or additional help from the Fed would likely begin to reverse the extreme negative sentiment dominating investor emotions now and set the stage for a gradual “flight from safety” in the stock and bond markets in 2008.
FDIC-Insured CDs Still Offer The Highest Returns For Low-Risk, Short-Term Income Needs
For safety-conscious investors interested in low risk, short-term, income-generating alternatives offering a defined maturity, one investment clearly outshines the competition right now – FDIC-insured certificates of deposit (CDs).
A CD, of course, is a type of deposit account offered by commercial and savings banks that carry federal deposit insurance (up to $100,000 per institution per owner and $250,000 for qualified retirement accounts). Because you agree to keep your money at a bank for a certain period of time, CDs usually pay higher rates than money market or regular savings accounts.
Although conditions will likely change if the Federal Reserve continues to lower short-term rates as we expect, bank CDs currently offer a meaningful yield advantage over Treasuries, government agencies as well as investment grade corporate and municipal debt with comparable short maturities. For example, 3-month and 6-month CDs are currently yielding between 4.60% and 4.85%. These returns compare very favorably with 3-month and 6-month T-bills - now yielding 2.90% and 3.25% respectively, which have experienced tremendous demand in ongoing flight to safety in the financial markets. The fact CDs offer very comparable and sometimes higher yields than shorter term (one to three years) investment grade munis or corporates reinforces their value as a sensible option for safe money right now. Given our expectation closely-indexed long-term Treasury rates are bottoming, we see no reason to extend maturities past three years at this point in the rate cycle.
J.P. Turner is actively involved in the CD market and has access to a wide range of structures and rates offered by banks around the country. Since regional banks will sometimes boost rates temporarily to quickly attract deposits to fund loans through the brokerage community, it’s worth checking with your J.P. Turner advisor for the latest rates as well as additional information on how CDs work.
Municipal Bonds Offer Great After-Tax Value For High Net Worth Income Investors
Concern of a spreading credit crisis and the inevitable slower growth it would bring has resulted in yields on municipal bonds, typically one of the least-volatile sectors of the bond market, rising relative to benchmark Treasuries this year. As their name suggests, municipal bonds are issued by states and cities to finance capital projects such as schools and road improvements. Munis are exempt from federal taxes and most state and local taxes in the state the bond was issued in.
Over the years, higher quality (A rated and higher) municipals have offered about 90% of the yield paid on benchmark federally-taxable Treasuries. But this percentage will fluctuate. A reading below 90%, makes munis less attractive to investors in the higher tax brackets because the yield advantage in owning municipals over taxable bonds is less and vice versa.
Today, high grade municipals offer very close to 100% of the yield paid by taxable Treasuries, making the securities very at-tractive for investors in the higher tax brackets. 10-year high grade munis are currently paying about 4.25%, very close to the same rate as 10-year Treasuries. For investors in the higher tax brackets, the after-tax return is actually much greater than 4.25% because the investor pays no federal taxes (and usually no state liabilities) on municipal bond income. In doing the arithmetic, someone in the 33% federal tax bracket would actually have to find a high grade taxable 10-year taxable bond paying 6.35% to beat the return on 10-year 4.25% munis. We wouldn’t spend too much time looking for 10-year high grade taxable bonds in the corporate or government agency sector paying 6.35% as they simply don’t exist today.
We anticipate the yield spread between municipals and Treasuries to begin narrowing to more traditional percentages next year as the potential for higher taxes in a new administration (to fund mounting entitlement and deficit requirements) increases.
A Reminder On Year-End Bond Swaps
The dramatic “flight to safety” which has gradually snowballed since summer has resulted in big winners and big losers in the bond market in 2007. Higher quality debt, led by Treasuries, has outperformed higher risk/higher return debt including lower rated corporate, convertible, emerging market and certain mortgage-backed securities by a wide-margin.
For clients with bond or preferred stock positions trading below their cost basis, market developments have created a double-barreled opportunity to claim some tax benefits and at the same time reinvest in today’s market. Stated in simpler terms, an in-vestor declares a capital loss today in exchange for a potential capital gain tomorrow.
The strategy we’re referring to is known as a tax swap. A tax swap, very simply, is the sale of one depressed bond for the purpose of establishing a tax loss and the simultaneous purchase of another similar security to maintain market position. Under the current tax code, an investor may write off short-term losses – the breakpoint is one year for long-term losses – against other losses, dollar-for-dollar. In addition, another $3,000 in net losses can be deducted from ordinary income with any additional amounts carried forward to future years.
To avoid the IRS’ infamous “wash sale” rule, be aware investors can’t declare losses if substantially similar bonds are bought within thirty days of the sale. Bonds are not considered to be substantially the same if one, and preferably two, of the following features are changed on the new purchase, coupon rate, issuer or maturity. Since J.P. Turner does not provide tax advice, we recommend clients considering tax swaps to check with their accountants before making any decision intended to generate any tax benefits. Investors have until Monday December 31st to settle tax swaps for 2007.
In addition to tax benefits, tax swaps can help investors achieve other goals such as: improving credit quality, increasing annual income, consolidating positions, modifying average maturities and/or switching to tax free or taxable income. Given the current economic and market uncertainty, investors may understandably want to declare losses this year and sit in cash until clearer investment trends develop in early 2007.
Although the information included in this report has been obtained from sources we believe to be reliable, we do not guarantee its accuracy or complete-ness. This report is for informational purposes only and not intended as an offer or solicitation to purchase or sell any securities. Sources used to compile this report include Bloomberg, bondmarkets.com, fidelity.com, investinginbonds.com, wikepedia.com. and realmoney.com. More complete information is available upon request. Yields and prices quoted are as of 12-14-07. Peter Conroy - Bond Trading Desk - JP Turner & Company LLC.
Compliance ID #JPT121707-530M