December Investment Commentary
Despite a volatile month that witnessed a post-election stock market slide and uncertainty caused by ongoing budget negotiations in Washington, investor sentiment improved in late November and the resulting market rally pushed stocks back into the black in the closing days of the month. Both large- and small-cap U.S. stocks returned around 0.5%, while mid-caps gained 1.6%. Growth did better than value across all market caps. International markets also finished November in positive territory. As worries about a euro-zone breakup lessened, both the broad international and regional European benchmarks gained around 2.5% for the month, and emerging-markets stocks rose 1.3%. Year to date, U.S. and international stock returns are in the low- to mid-teens.
Domestic investment-grade bonds edged up 0.2% in November while developed foreign bonds slipped 0.1%. Both indexes have low single-digit gains for the year so far, trailing the performance of many of our active bond fund managers. Emerging-markets local-currency bonds also continued their positive year, rising 1.4% in November, bringing their year-to-date return close to 15%.
The Elections Are Behind Us, But Significant Challenges Remain in Front of Us
We don’t make our living predicting macroeconomic or political outcomes, and if we had to, we’re not confident we’d consistently be able to put food on the table. We do make our living understanding how a range of outcomes—macro, political, or otherwise—can impact our investment strategies. To that point, the recent election and the fiscal cliff negotiations may take attention away from the underlying longer-term problems the global economy faces, but those deeper problems will remain the driver of how things unfold in the years ahead. We’ll use this commentary to update readers on a central component of our risk-management strategy—our portfolios’ fixed-income allocations, particularly municipal bond holdings. Before getting to that we want to remind readers why risk management remains a high priority for us.
Issues like Europe’s debt struggles, our longer-term fiscal issues, and a potentially sharp slowdown in growth in China create risks that can shake markets at any time. Moreover, in our view, there isn’t a strongly credible counterpoint on the positive side, where these issues are decisively resolved resulting in an unexpectedly positive outcome. A fiscal cliff agreement, for example, may replace a painful short-term dose of budgetary medicine with a more measured and economically better tolerated regimen. But any solution by definition will have to reduce the dangerous gap between revenues and spending that is being plugged with ever increasing amounts of debt, and this will create economic headwinds likely to suppress growth for a number of years to come. The same holds true for Europe; there is no game-changing solution that replaces the difficult adjustments that must occur. So it’s not an issue of whether there will be painful economic consequences, it’s an issue of when, what form they take, how well managed they will be, and whether a very negative outcome can be avoided—and, equally important, the extent to which financial asset markets are discounting (i.e., pricing in) the potential range of outcomes.
Against this backdrop, the most plausible positive case is one where in the years ahead policymakers manage to avoid a crisis, allowing us to muddle along with modest economic growth (ideally) until things gradually get better, and eventually (perhaps later in this decade) we return to a more historically normal growth rate. We believe we can still earn decent returns in that sub-par growth environment, with the potential to add to stocks and other riskier assets if we do experience shorter-term panic-induced market sell offs that drop prices to levels that result in far better prospective returns than from current levels.
The Risk-Return Equation for Bonds
The idea of being patient as we ride out a higher-risk, lower-return environment sounds straightforward, but it is a real challenge to earn acceptable returns in this kind of climate. The bond portion of our portfolios, in particular, demands a lot of care because yields across most fixed-income sectors are exceedingly low, and, in many cases, are at historically low levels. High-quality bonds (such as Treasurys) tend to offer offsetting gains during sharp stock-market downturns as investors flock to “safety.” But with interest rates at record lows, the ability for Treasurys to provide positive returns is limited. The only way to increase the protective value of bonds in such an environment is to extend duration, which is another way of saying “take on more interest-rate risk,” to achieve higher returns as rates fall. But with rates so low, there is significant likelihood that rates will instead rise over our five-year investment horizon, and this will hurt bond prices. Investors are thus forced to choose between trying to protect against a severe recession and stock-market declines, and protecting against rising rates.
Our approach has been to reduce exposure to core bonds—the kind that provide the most recession protection—in favor of higher-yielding, shorter-duration, and/or unconstrained strategies that have less risk if rates rise and that should generate better returns along the way. In fact, we are highly confident that over a full five-year span we will earn higher returns from these funds versus the core bond index in almost any scenario, even while they would temporarily under-perform the benchmark in a fear-driven market sell off.
In thinking about the impact of this trade-off on portfolio risk, it’s helpful to consider risk in the context of time. We expect less very-short-term protection, such as during a steep and rapid stock market decline, but are confident that over a period of quarters instead of days or months, this will even out as a result of the higher yields we are earning and as market confidence comes back. In other words, the bond strategies we own might not rally in a bear market, and might even suffer modest losses in the shorter term, but it will be temporary rather than permanent. It’s important for investors to understand that trade-off so they know what to expect in a scary market.
The Fiscal Cliff, Taxes, and Muni Bonds
We have written at length about our strategy on the bond side in many of our recent commentaries, and our focus has been almost exclusively on taxable bonds, addressing investors for whom taxes are not an issue, either due to tax bracket or account type (retirement assets for example). The fiscal cliff negotiations have brought taxes to the forefront of people’s minds, and we want to update readers on our thinking about the municipal bond asset class. Regarding munis specifically, though, our take may well be different than what you’d expect based on the headlines.
At a high level, our objectives for the bond portion of our tax-sensitive portfolios are the same as for our tax-exempt portfolios. We are trying to improve returns while not entirely trading off the modest risk-management benefit we get from high-quality core bonds. Muni bonds carry generally the same challenges and problems as their taxable counterparts. Yields are dismally low, but in a fear-driven market they would likely rally to some extent along with Treasurys, so their role in providing ballast to a portfolio is similar to that of high-quality, core taxable bonds. But at the same time, with taxable equivalent yields very low, our analysis convinces us that it is unlikely, across almost all scenarios, muni returns will match those of some of their taxable counterparts, such as those we use in place of core bonds in our tax-exempt portfolios. (In other words, at current price levels, potential muni returns set a fairly low bar that at least a few of our taxable bond funds should be able to exceed even on an after-tax basis.) Osterweis Strategic Income and PIMCO Unconstrained serve as good examples. The annualized returns for these funds over the next five years will likely range from 3%–6%, depending on the economic scenario, and for munis to achieve those returns from current price levels, it would require 10-year Treasury rates to drop from current levels of approximately 1.6% to approximately 1%. That’s a pretty dire scenario. This has been the situation for a while, and as a result, we have been using some of our preferred flexible and absolute-return-oriented bond funds—alongside muni funds—in our tax-sensitive portfolios.
Although we have added some credit risk by shifting part of our fixed-income exposure away from high-quality core munis, we have reduced our exposure to the threat of higher interest rates. This is consistent with the fixed-income allocations in our taxable models. We are willing to accept greater credit risk and less short-term downside protection in exchange for protecting against what could be a more painful, rising interest-rate scenario. In other words, there appears to be an asymmetric risk/reward scenario among most fixed-income asset classes. The upside is limited because of the absolute low level of rates, while there could be significant downside should rates rise. We also include floating-rate loan funds in our bond-heavy conservative models to further reduce interest-rate risk. In both taxable and tax-sensitive strategies we are very cognizant of downside loss thresholds and take these into account in our overall portfolio allocations, including our exposure to credit and interest-rate risk.
One other option for managing muni bonds’ interest-rate risk is to shift from intermediate-term munis to short-term munis. However, short-term muni yields are paltry. For example, the one- to three-year segment of the muni market is yielding 0.5%, compared to 1.6% for an average 10-year muni bond. Meanwhile, going farther out the muni yield curve and investing in longer-maturity bonds does get us higher yields, but doing so further increases risk from rising rates. We believe the intermediate part of the muni curve, where we are currently positioned, currently offers the best risk-reward tradeoff.
Stronger Demand From Expected Tax Increases May Be Overblown
Supply and demand forces also play a role in determining muni returns. Since the muni market collapse in late 2008, due to concerns over substantial defaults, strong investor demand has pushed muni returns higher by more than 25%. We suspect much of the potential demand tailwind that contributed to this rally has already played out. Individual investors typically account for roughly two-thirds of the muni market, and we expect that most high-tax-bracket investors already hold munis. Therefore, an increase from 35% to 39.6% in the top bracket isn’t likely to result in a significant swing to munis and increase demand for tax-exempt bonds. So where has the recent demand come from?
One source has been taxable investors making a tactical play by crossing into the muni market as yields in certain parts of the taxable fixed-income markets (such as high-quality corporate bonds) have been less attractive than munis even on a pretax basis. Some of that is from taxable mutual funds, including PIMCO and others. Some of these “crossover” investors are investing in the longer-dated, higher-duration maturities, and in the riskier high-yield segment of the muni market, which has rallied strongly, but seems quite vulnerable to a pullback that could be made more painful if and when this shorter-term money rushes for the exits.
On the supply side of the supply-demand equation, net new municipal bond issuance has been minimal, with the majority being municipalities refinancing at lower rates. With a lack of new bonds in the muni market, existing demand also contributed to bond prices rising and yields dropping to record lows.
State and Local Government Fiscal Problems Have Improved
We are likely to continue to read about fiscal problems at the state and local level, including threats of defaults, union strife, pension abuse and reform, etc. This headline risk could contribute to periodic weakness in the muni market, and, as noted above, could contribute to “hot money” heading for the exits. But this isn’t a driver of our thinking, as there have also been encouraging signs relating to generally improving fundamentals.
While municipalities are not clear of their fiscal challenges, they have made progress in improving their fiscal credibility. We have seen many examples of higher taxes, pension reforms, public sector layoffs, and significant spending cuts (several hundred billion in expenses have been cut at the state level over the past three years) that are to varying degrees helping municipalities correct gaps between what they take in and what they spend.
Where Does That Leave Us in Terms of Owning Munis?
We make investment decisions at the asset-class level based on a five-year analysis of risk and return across multiple broad, macroeconomic scenarios in concert with each portfolio’s 12-month downside risk threshold. Based on that analysis, we view munis as marginally unfavorable relative to other selective options in the taxable bond universe, even for investors in the highest tax bracket. Our rationale is not driven by concerns about state and municipal finances, but rather is comparable to our rationale on the taxable side in that Vanguard’s Intermediate-Term National and California funds (for example) each have yields comparable to Treasurys and we are confident they will trail, even on an after-tax basis, other taxable vehicles we can own. As with core taxable bonds, what little yield you get with munis comes with risk of price declines if and when we see rates moves higher. But also like core taxable bonds, if we see fear drive stocks lower, munis are likely to follow Treasurys higher in a flight to quality.
Our preliminary analysis leaves us seriously considering a small reduction in munis. We don’t feel urgency to move aggressively or quickly, but it’s possible that we could start to incrementally decrease our muni exposure over time, provided we identify more compelling options that can be substituted appropriately (including potentially higher allocations to funds already in our portfolios). These could include vehicles such as flexible municipal strategies; higher-yielding, shorter-duration funds such as Osterweis Strategic Income; floating-rate loans (which would benefit from higher interest rates); and other options on the taxable side. Importantly, we will be assessing how any potential changes impact the risk profile of our portfolios, and any changes will take our downside loss thresholds into account just as we do on the taxable side. This analysis is among our higher research priorities, and we expect to complete our work in the near future.
—Francis Financial and Litman Gregory Research Team (12/3/12)