Current economic conditions entering the 4th quarter of 2009 could easily remind one of the old joke that says what the world really needs is a one-handed economist, someone who can’t say “now, on the other hand” after making a forecast. Chances are that is not going to happen anytime soon. It is also not uncommon to see well-respected economists and market strategists look at the same potpourri of information and come to very different conclusions and forecasts. Some economists have been predicting an uptick in inflation from the massive amounts of stimulus money that is hitting the system; there is certainly some logic to this if you follow the Milton Friedman thesis that all inflation is monetary at its core. Others are looking past the money supply to the continued weakness in the economy and see deflation as a bigger risk. They point to evidence of businesses from many sectors and regions of the world lowering prices to move the inventories and create cash flow; they also point to the decrease in housing prices. There has also been talk of what is called stagflation, a combination of a stagnant, recessionary economy combined with rising prices; the United States hasn’t really experienced stagflation since the early 1970s, when wage/price controls as well as an oil crisis combined for rising prices and rising unemployment. Lastly, many economists have stated that the recession of 2008-2009 is over, and we are now experiencing the beginning of a slow, but steady recovery.
One thing is sure; not all of them can be right. Another thing for all of us to consider is that we cannot accurately predict the future any more today than we could last year or the year before. We can only make decisions based on current information and solid time-tested practices such as asset allocation. Investors also need to consider their risk tolerance and time horizon as they make decisions.
Current Conditions in the Bond Market
What we do know for sure with respect to the bond market is this: the range of interest rates from short to long-term (yield curve) continues to be somewhat steep. The Federal Reserve has indicated that the quantitative easing policies instituted during the fall of 2008 that have kept short-term interest rates near zero percent will stay in place for the foreseeable future. Ten-year Treasury bonds are currently yielding around 3.20%, almost 300 basis points higher than 26 week T-Bills. Investment-grade corporate bonds in the 10-year maturity range are currently trading around 4.37%, over 100 basis points more than comparable Treasuries. Intermediate term investment-grade municipal bonds, which offer investors interest payments that are federally tax-free, are yielding around 3%.* To an investor in the 28% marginal bracket at the federal level, that is the equivalent of earning 4%. While the risks of investing in bonds include the financial condition of the issuer and potential changes in interest rates, the steepness of the yield curve has many investors allocating larger portions of their portfolios to bonds or bond funds. The latest data from the Investment Company Institute supports this trend, with large inflows into bond-oriented unit investment trusts and mutual funds. However, economic and financial conditions can change, and investors should always consider their individual circumstances before investing.
Build America Bonds—Update
Last month we explored the background and features of a new type of bond called Build America Bonds (BABs). BABs are a new type of taxable bond issued by state and local governments that entered the marketplace with the passage of the American Recovery & Reinvestment Act of 2009, also known as the “Stimulus Bill.” The BABs market continues to grow at a rapid rate since the program began in April 2009. According to sources such as the Bond Buyer and Citigroup Research:
- Over $35 billion in BABs issued through end of September
- 17% of total municipal bond market new issues were BABs
- In August alone, BABs represented 92% of all taxable municipal issuance
- 40 different states have issued BABs
- Non-US buyers have shown strong interest
- Some predict annual BABs issuance of $50-75 billion through 2010
- BABs issuance could represent 25-30% of all municipal bond issuance
Many individual investors, domestic and foreign, have embraced BABs for their portfolios. Many BABs offer higher interest rates than comparable corporate bonds, which have added to the market’s growth. Under the terms of the Stimulus Bill, the government will only issue BABs through the end of 2010.**
Summary—Consider Intermediate Maturities
Despite historically low short-term rates and an uncertain economic outlook, opportunities are there for suitable investors interested in a fixed income allocation for a portion of their portfolios. Rates available on investment-grade paper in both the taxable and tax-free arenas, particularly in the intermediate maturity range, may present an attractive risk-reward proposition. However, investors should weigh the potential rewards of the current market (interest rates relative to short-term securities, historical performance of bonds as an asset class, etc) with the fact that nominal interest rate levels are lower than a year ago or even earlier this year. Many investors with established positions in bonds, fixed income unit trusts, or bond funds are enjoying higher rates of interest as well as unrealized capital gains on their original investment.
In conclusion, while we seek the emergence of the proverbial one-handed economist or an accurate crystal ball, let us keep a close eye on the economy and make solid decisions for our portfolios based on the best information available at the time of investment. Over the long run, that is a plan worth following.
The opinions referenced above are those of Jack Tierney and are subject to change at any time, due to changes in market or economic conditions, and may not necessarily come to pass. These comments are not necessarily representative of the opinions and views of the firm as a whole. The comments should not be construed as recommendation, but as an illustration of broader theme.
As performance is no guarantee of future result, the material is for educational purposes only, and does not contend to address the financial objectives, situation or specific needs of any individual investors. It is not a solicitation or an offer to buy or sell any security or investment products. This is not, and you should not consider it to be, legal or tax advice. The tax rules are complicated and their impact on a particular individual may differ depending on the individual’s specific circumstances. Please consult with your legal or tax advisor regarding your specific situation.
