“Negative nominal interest rates are contradictory in an expectations-driven liquidity trap, unless they are able to eliminate deflationary expectations altogether…This paper has shown that negative interest rates are likely to make things worse in an economy plagued by liquidity traps…”.[1]

 

On July 31, 2019 the Federal Open Market Committee (FOMC) met and in a split vote (8 for, 2 against) decided to lower the federal funds rate to 2.00-2.25%.  Since the decision, the 10-year U.S. treasury bond yield collapsed – dropping from 2.05% to as low as 1.49%. It currently sits at 1.74%.

Present day credit markets are complicated and vexing at times, presenting potential risks and opportunities for investors.

Federal Reserve Board Member disagreement on the direction of monetary policy is a contributing factor to prevailing market uncertainty. Several members question the sensibility of our central bank following the easy monetary policy used for many years by both the Bank of Japan and European Central Bank (ECB), which has done little to spur growth or inflation in their respective economies. Nonetheless, just this morning the ECB cut rates further into negative territory in what could be a last-ditch effort to spur growth.

Boston Fed President Rosengren and Kansas City Fed President George voted (in the minority) at the July meeting to keep interest rates unchanged with a federal funds target rate of between 2.25%-2.50%. These two officials disagree with the majority opinion that believes lower interest rates will spur economic activity in the U.S.

It will be interesting to see what consensus opinion decides to do with rates at the September FOMC meeting. The market is currently ascribing a 100% probability of another 0.25% cut on September 18th. Since we are not formally trained economists, we will leave the theoretical discussions on monetary policy effects to the central bankers.

Instead we offer these observations as to how to navigate the current volatile market dynamics.

 

1. We manage the “mattress money” portion of investment portfolios and believe a quality separately managed (SMA) bond portfolio serves these purposes:

    • it offers safety of principal- 41 states are rated AA or better and rainy-day funds are higher than 2007
    • it provides a steady stream of tax-exempt income- offsetting coupon payment dates + the ladder structure enables constant and consistent cash flows
    • it anchors the overall investment portfolio during recessionary, deflationary, and volatile market periods- one reason we target essential purpose bonds, rather than more economically sensitive revenue sources

Our Tactical Ladder and High Income strategies demonstrated this during the last two bond market “tantrums”. First during 2013’s Taper Tantrum and following the 2016 Presidential election. As shown below, the largest municipal bond ETFs underperformed these two strategies during these events.  This could be attributed to security selection, but we also believe the SMA is mechanically superior during dislocated markets due to the “rush to exit” scenario that often befalls bond fund and bond ETF structures when the market experiences a significant sell-off.

 

 

 

 

 

 

2. Do not stretch for yield by lowering credit quality standards.  In an economic downturn, lower credit quality bonds will get hurt the worst. Our foundational analysis looks at underlying credit quality, deal purpose, and issuance structure. The bond rating metric is complimentary information to our analysis.

3. Avoid structured investments and those using derivative strategies. We remain wary of bond investments advertised as “yield plus”, “yield enhanced”, etc. These products may make sense in an overall asset allocation strategy, but they are substantively different and potentially more volatile (due to the use of leverage) than a fixed rate, fixed maturity, quality SMA bond portfolio. In a volatile market sell-off, it often ends badly for investors in derivative products. As a reminder, many Auction Rate Securities (ARS) products (marketed as a higher paying alternative to money market funds) failed to perform as advertised during the 2008-2009 financial crisis.

4. Maintain a laddered portfolio structure, build a bit of cash, target 3.5%-5% coupons for a portion of the portfolio and sell positions if solid bids are received on lower quality and/or lower yielding issues.

5. We continue to rely on our time-tested market expertise and a value management approach to find attractive relative values within the market. They remain available in the municipal market.

 

Bond prices have risen (yields have fallen) significantly during the first eight months of 2019 for a number of reasons. Over the last several weeks the decline in bond yields has been exceptionally rapid. If we reach a breakthrough in trade talks with China, or if recessionary fears dissipate from current levels, we likely will see a reversal of the powerful bond market rally of recent weeks. So, a bit of caution and patience at this point is a reasonable approach.

In the interim we will adhere to our time-tested elements and strategies to bond market investing. We continue in our efforts to offer our clients a portfolio management platform that is transparent, efficient, and provides investors with choices.

Thank you for your continued confidence in our bond portfolio management process and team. Please call us should you have any questions or wish to review your portfolio.

 

Sincerely,

Ronald P. Bernardi

President and CEO

September 12, 2019

 


[1] Excerpts from “ Negative Nominal Interest Rates Can Worsen Liquidity Traps”- Andrew Glover, Senior Economist at the Federal Reserve Bank of Kansas City, August 26, 2019 http://andyecon.weebly.com/uploads/5/1/3/8/5138005/nirp_liquidity_traps.pdf