2015 - Quarter 3

High yield corporates were punished during the third quarter as they tracked broad based declines in equities and commodities.

Return Summary

Safe haven assets including treasuries and agencies saw strong positive returns followed by gains in investment grade corporate and municipal bonds.

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Finding Value In Municipal Bonds

While the media has been fixated on when the Fed might raise the Fed Funds rate from 0.0% to 0.25%, we have been quietly finding value in tax free and taxable Municipals bonds. Investors would be wise to avoid the noise created by a steady stream of pundits trying to guess when the Fed will begin to normalize the overnight rate charged to banks. Worrying about when rate normalization occurs and using terms like “lift off” is akin to the panic generated by discussions of Y2K fifteen years ago. That turned out to be one of the biggest non‐events of our lifetimes, and we continue to believe rates will remain low for a prolonged period of time regardless of when the Fed begins to raise rates. We have found value buying yields around 3.00% for A‐rated tax free bonds in the 10‐12 year part of the curve and as much as 3.50% in 15 years. We have also been able to find A‐rated taxable Munis at yields of 3.00% plus in 5 to 6 years, and up to 4.00% in 10 years. We believe these types of yields offer value in an economy where both inflation and economic growth are below the Feds targets.

Affordable Housing Sector

Affordable housing loans, including section 8 housing projects, provide a unique yield opportunity in this low interest rate environment. Tax‐free yields on recently issued A‐rated multifamily bonds have reached 3.80% for ten-year maturities, and historical default rates on rated projects remain well below 1%. The credit strength of individual projects in this sector can vary widely, and numerous credit factors must be analyzed and continuously monitored. Some of the factors we monitor include:

  • Level of Government Support – The project should benefit from a high level of government support, such as low income housing tax credits and section 8 housing subsidies.

  • Demand Factors– Special consideration should be given to the project location, population growth, and the project rents vs. market rents.

  • Occupancy – High current and historical occupancy rates are extremely important. Low occupancy is often the result of low demand, poor management, inferior asset quality, or a combination of all three.

  • Owner/Sponsor – Concern should be given to the owner/sponsor, including years of experience, the number of units owned, and track record.

  • Financial Factors – Traditional measures of financial strength, including Loan‐to‐Value and projected debt service coverage ratios are fundamental to any affordable housing analysis.

We believe the affordable housing sector offers significant yield opportunities for diversified investors after proper due diligence. The credit factors above are just some of the many elements that should be analyzed on an ongoing basis.

Economic Stagnation: An Aging Global Population

Economic Stagnation is occurring in spite of low interest rates and easy credit conditions because of high debt levels and negative global demographic trends. Fed policies designed to encourage current consumption extend the period of time required to deleverage the high levels of debt in the economy. We are in a classic liquidity trap and these policies only make the leverage problem worse over time. Japan has been pursuing these policies for the last 20 years without success, and in the process has accumulated enough debt to make their Debt to GDP ratio roughly 275%. This should be a clear warning to the rest of the world.

Aging populations in many developed countries are also creating economic headwinds. The table below shows the age distribution for some developed countries compared to Emerging Market countries.

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In the Eurozone there are more people over the age of 65 than under the age of 15. Japan is the country with the greatest demographic headwind since they have twice as many people over 65 as they do under the age of 15. This is very negative for future economic growth and is one of the reasons they have been fighting deflation for 20 years. The U.S. is in better shape than Japan and Europe which might explain why our economy has been doing better than either of their economies. A healthy economy has a large number of workers in the 16‐55 range. These are the ages traditionally associated with the most consumption. They buy new cars and homes and are “accumulating” things. As workers get older their primary expense is for healthcare and recreation. Healthy demographic trends are beyond the control of the Fed.

The Strong Dollar

The chart below shows the strength of the dollar since the Fed ended the last round of Quantitative Easing (QE.) The stronger dollar has had a devastating effect on Emerging Market countries.

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These countries are seeing their revenues fall and the cost of paying back USD denominated debt rise. U.S. GDP growth has also been weak as the strong dollar dampens demand for our exports.

Low commodity prices are a sign of economic weakness in the global economy. The key variables that drive interest rates are the pace of economic growth and expected inflation. These are both below the Fed’s targets. The markets normally lead Fed rate action, and they are telling us any significant increase in rates is currently unwarranted. As long as inflation and economic growth are subdued there is little reason to be concerned about rising rates.

Rates are likely to be low for a long period of time due to economic stagnation.