Unless you were short growth stocks, long Treasuries or sitting in cash, 2007 ended on a very disturbing note. As every investor knows, mounting concerns that the well-publicized problems in the mortgage/housing sector would ultimately undo the overall economy resulted in a gut-wrenching “flight to safety” throughout the financial markets – selling risk and buying high-quality – during the final three months of last year.
We intentionally delayed publishing our 2008 outlook on the bond market, normally written at the end of December, deciding instead to wait to see how the markets performed in the first few weeks of the New Year. Extreme market volatility, the extraordinary circumstances surrounding a potential credit crisis and unrelenting negative media spin made it more difficult to determine perception from reality. On the one hand, the Federal Reserve was telling us that the economy had obviously hit a “rough patch” but that the mortgage mess appeared contained. In speeches and interviews, some policymakers even questioned the need for further reductions in short-term rates. On the other hand, the financial markets were telegraphing a very different, less-sanguine message of recession and more paper losses for holders of risk assets.
Although two weeks doesn’t establish a trend, 2008 has unfortunately begun on a disappointing note. Stocks are off to one of their worst starts ever. Spreads – the yield advantage over riskless Treasuries – on high yield corporate bonds have more than doubled since last spring, now exceed 600 basis points and seem headed higher. And despite multi-year lows in rates, it seems investors can’t get enough of safehaven Treasuries, reinforcing expectations of slower growth and continued principal erosion on risk assets. So much for a “January Effect” or rally in stocks and bonds sold at year-end for tax selling purposes and repurchased early the following calendar year for potential capital gains.
Present Economic Conditions Represent New Territory For Everyone – Fed Included
What makes the current economic slowdown more challenging than normal to analyze is the accompanying credit crisis. Mounting defaults in their mortgage portfolios have forced banks to reduce lending and stockpile cash on fears of rising bankruptcies. Tightening credit standards, should they continue, could spell trouble for both consumers and companies that need to borrow money and ultimately push the economy into a recession.
Fresh data such as the December employment (only 18,000 jobs were created last month, pushing the jobless rate to 5%) and manufacturing reports (export activity, once a strength, has begun contracting) indicate growth is downshifting big time and reinforces the “flight to safety” fears dominating investor sentiment now.
Hopefully - and we hate to use that adverb in any investment report - the Federal Reserve is not behind the proverbial curve regarding monetary policy and the economy slows down during the first half of 2008 but recovers, along with the credit markets, during the second half of the year as policymakers predict.
However, because the current situation in the credit markets is so unique, uncertain and potentially dangerous, bond investors must be proactive regarding their portfolios. Holders of more cyclical high yield corporate, emerging market and municipal debt tied to housing as well as certain types of mortgage bonds should reduce undue exposure to any one credit and/or asset class. In the past, we’ve talked extensively about the importance of diversification and the virtues of this investment strategy are being reinforced during this unnerving correction.
No one likes taking losses, although above-average current income received should help offset some of the pain. But realizing the current situation in the credit markets is so unprecedented and the outcome so uncertain regarding potential defaults, bond investors must err on the side of caution entering 2008. Our guess is there will be a better entry point for investors who want to become more aggressive, taking advantage of the potentially heavy discounting in more speculative, cyclical issues, later in the year.
Sensible Suggestions For Three Popular Investor Profiles
Complicating the decision-making process for income investors is the fact benchmark Treasury yields have declined to five-year lows. With the annual inflation rate pushing 3%, we see little value in purchasing 10-year governments paying only 3.75%. It’s important to understand plenty of bad news is already priced into the Treasury market. Amazingly, 2-year Treasury rates have fallen to 2.50%, suggesting investors expect the Federal Reserve to reduce its overnight borrowing rate (the fed funds rate is currently 4.25%) another 175 basis points before it’s done. While government bond yields could decline further in the coming months, we think patient investment grade buyers will have a much better entry point in the future to lock in longer term rates. Having painted a picture of markets fraught with uncertainty and trading at extremes, we’ve probably left many of you in a quandary as where to invest. Based on our expectations for slower growth and further recession pricing in the first part of 2008, we’ve identified what we believe to be some sensible options for three popular investor profiles. Please contact your J.P. Turner advisor for additional information on these investments.
FDIC-Insured CDs Continue To Offer Solid Returns For Low-Risk, Short-Term Needs
Based on our bearish Treasury outlook (we were bullish this time last year), we see little value in extending maturities on rate-sensitive, higher quality bonds. When the economy begins to show signs of stabilizing, we believe longer term Treasury rates will start moving higher (ahead of any Fed activity) resulting in price discounting on closely-indexed, higher quality, longer term bonds.
Among the various low risk, shorter-term, income-generating alternatives, FDIC-insured certificates of deposit continue to offer strong value. 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 accounts).
While conditions will likely change as the Fed continues to lower short-term rates, bank CDs currently offer a significant yield advantage over short-term government and agency paper. For example, 3-month and 6-month CDs are now yielding about 4.50%, almost 150 basis points more in yield than 3-month and 6-month T-bills and a significant increase in income. On larger deposits, we recommend clients ladder maturities – staggering maturities three months to three years – rather than trying to guess where the best returns might be on the CD yield curve.
Municipal Bonds Offer After-Tax Value For High Net Worth Investors
Concerns ranging from shrinking tax bases to the ability of insurers such as MBIA and Ambac to cover principal and interest obligations should default rates increase dramatically, resulted in municipal bonds underperforming Treasuries in 2007.
Today, yields on many higher quality tax free munis offer almost 100% of the yields paid on taxable Treasuries, making the securities very attractive for investors in the higher tax brackets. For example, 10-year A/A rated municipals are paying 3.75%, very close to the same rate as 10-year Treasuries. But for investors in the higher tax brackets the after-tax return is actually much greater because no federal (and in some cases no state) taxes are paid on municipal income. The 5.60% after-tax return for investors in the 33% federal bracket on 10-year munis paying 3.75% is far superior than anything available in today’s high quality taxable marketplace. The yield advantage of munis over Treasuries should narrow to more traditional spreads (90%) when economic conditions start stabilizing.
Once again, we recommend that investors in the higher tax brackets who agree with us that long term Treasury rates are bottoming that (the Fed will continue to trim short-term rates for a while), limit any new muni purchases to ten years and less.
Total Return Opportunities Available In Selected Crossover Credits
Income investors willing to assume greater credit risk in exchange for potentially higher returns than available on CDs or Treasuries should consider selected corporate crossovers.
Crossover credits are best described as corporate and municipal bonds straddling the ratings gap between investment grade and speculative. Bonds rated Baa3 and higher by Moody’s and BBB- and higher by Standard & Poor’s are considered investment grade while debt rated Ba1 and lower by Moody’s and BB+ by S&P are known as high yield or junk bonds.
Total return opportunities can develop when lower-tier investment grade corporates and munis post poor operating results, increasing the likelihood of a speculative credit rating. Many institutions and funds are restricted from owning lower rated debt which sometimes can result in portfolio managers being forced to sell bonds they otherwise would continue to hold on expectation of recovery longer term.
We’re keeping a close eye on the debt of Sallie Mae, a major provider of education financing for students, as a potential new crossover idea. Sallie Mae has come under severe pressure in the last year on a slew of bad news relating to the credit crisis (i.e., higher funding costs and loan losses). Although the company, which recently announced a well-received management shakeup, still possesses an investment grade rating (Baa1/BBB+), its corporate debt is now trading at junk-type yields between 7.50% and 10.50%.
While one can argue the business has been mismanaged, we don’t believe Sallie Mae is going away given the growing need for education financing. The company is scheduled to report 4Q 2007 results shortly and we’ll keep you posted on developments.
Although the information included in this report has been obtained from sources we believe to be reliable, we do not guarantee its accuracy or completeness. 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 Bear Stearns, Bloomberg, bondmarkets.com, fidelity.com, investinginbonds.com, realmoney.com, USA Today, valubond.com and wikipedia.com. More complete information is available upon request. Yields and price information as of
1-12-08. Peter Conroy - Bond Trading Desk - JP Turner & Company LLC.
Compliance ID #JPT011408-028