2015 - Quarter 2

Municipal and corporate bond markets were down in the second quarter against a backdrop of global volatility and fears of rising rates.

Municipal Return Summary

Long tax‐free municipals and investment grade corporates were the worst performers, while shorter tax‐free municipals and high yield bonds were only slightly negative. A variety of Merrill Lynch Bond Indices can be found below.

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Capital Controls and a Potential Greek Exit

The debate surrounding a potential Greek exit from the Euro seems to be shifting from “what if” to “what now”. Monday morning (June 29th) brought with it a myriad of capital controls, including bank closures, in a last ditch effort to stem the tide of capital leaving the country. Greek Prime Minister Alexis Tsipras also called for a referendum on July 5th to either accept or reject the bailout conditions set by Greek creditors. The chart below shows the recent volatility of the Greek 10 year, including a 300+ basis point shift higher in yields after the announcement of capital controls on June 29th.

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Puerto Rico In Financial Crisis

“The debt is not payable. There is no other option. I would love to have an easier option. This is not politics, this is math.” – Governor of Puerto Rico, Alejandro Garcia Padilla According to Governor Padilla, Puerto Rico might potentially seek concessions from debt holders in an attempt to avoid an inevitable “death spiral.” Whether these concessions come in the form of bondholder haircuts or a payment restructuring remains to be seen. As we have discussed at length in previous newsletters, a combination of unsustainable debt levels and a declining population continues to be a strong indication of future credit pressure. Below is a historic price chart of the 3.5 billion Puerto Rico general obligation bonds maturing in 2035, a benchmark often used to gauge the health of the Puerto Rico bond market. These bonds are now trading at yields of more than 12%.

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Similar…But on Different Continents

Negative credit events for countries and municipalities share some common characteristics. First, their politicians are usually either corrupt or inept. These leaders are chosen to run the government in a way that is beneficial for their citizens. Unfortunately, they are not willing to address difficult issues. Instead of making tough budgetary choices they look for the easy way out and borrow money. When this is done over a long period of time the problem becomes so great that it may only be resolved by defaulting on their debt. Next, the citizens feel a sense of entitlement. This causes them to vote for inept politicians who promise benefits that are not sustainable. The cost of these entitlements continues to grow until they become such a large part of the budget they crowd out other services the government should be providing. Third, public employees and pensioners are unwilling to take haircuts to their benefits until they are forced by some external event. Fourth, the creditor becomes the “bad guy” and the inept politicians and citizens become the victim. Finally, the government seeks protection from creditors as it defaults on their obligations.

This situation is normally compounded by an inability to print money in the debtor’s currency. This is certainly the situation in Greece because their currency is the Euro. It also applies to Puerto Rico because their currency is the dollar. These types of financially distressed situations become very political and the “mean” creditors don’t come out very well. It is best to avoid these situations, because bondholder protections are often ignored.

We do not have any exposure to Greece or Puerto Rico. We also avoid debt of large cities and municipalities which have large unfunded pension and OPEB obligations.

Rising Rates?

There has been considerable chatter about when the Fed is going to raise the overnight cost of Fed Funds from zero to 0.25%. Most of this discussion has little value for investors. The Fed has a dual mandate of keeping inflation at targeted levels and economic growth at a rate which is consistent with their inflation target. Inflation has been below their target of 2% for the last 3 years and economic growth has been below trend since the financial crisis. An increase in the Fed Funds rate of 0.25% ‐ 0.50% during the next several months would be consistent with a more neutral Fed policy. The chart below shows the market expects the Funds rate to be about 0.35% by year end. It is also projecting a rate of less than 0.75% a year from now. It is important to remember rate increases are data dependent, and there is no guarantee the economy will be strong enough to warrant changes in the Fed Funds rate.

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Secular Stagnation?

Larry Summers has argued world economies are suffering from secular stagnation caused by aging populations, over indebtedness, and limited investment in capital goods. We have been in agreement with this argument, and believe this will cause rates to be low for a long period of time. Mr. Summers’ hypothesis has led to a lively discussion in academic economic circles. There are some who believe technological advances will lead us out of this problem of subpar economic growth. We will be watching for signs the economy can grow at faster rates. The recent increase in employment in the U.S. is an encouraging sign for the economy, but has not led to inflationary pressures.

Greece and Puerto Rico are credits that should be avoided. In the U.S., inflation is under control and the economy is struggling to find its legs.

We believe interest rates are likely to remain well below their historical averages for a prolonged period of time.