Longer fixed income outperformed the short end as the yield curve flattened in the first quarter. Treasuries and agencies had strong returns followed by a rebound in high yield and corporate debt.
Fixed Income Return Summary
Tax Rates Are Going Higher
We wrote about the likelihood of higher marginal tax rates in the future in our last Newsletter in January. Since that time it has become an increasingly likely event. Both Democratic Presidential candidates are clearly arguing for higher tax rates so they can increase spending. We feel this is perhaps one thing investors can be relatively confident will happen. The following is an excerpt from last quarters newsletter:
Maximum Federal Tax rates in the United States have varied widely over the last century, from as low as 7% in 1915 to as high as 94% in 1945. After peaking in 1945, tax rates have trended lower against a backdrop of ballooning national debt. The following chart shows the maximum federal tax rate vs. public debt.
Maximum tax rates are now well below the 100‐year average of 59.6%, even as debt levels have climbed above 18 trillion dollars (100% of GDP). Tax rates are likely to go higher to pay for past spending, increasing entitlement programs, and massive infrastructure needs. The expiration of the Bush tax cuts in 2013 was likely a turning point in a new trend towards higher tax rates in the United States. Tax‐free municipal bonds continue to offer a safe haven from taxes and are relatively attractive compared to US Treasuries.
The table below shows interest rates for Sovereign debt for a variety of developed countries. Many of these rates are negative. The cells highlighted in red are maturities which have negative yields. Of the countries listed below, the U.S. is the only one that has positive rates for all maturities from 1 to 10 years. Interest rates in the U.S. are relatively attractive compared to rates in other countries. This should help cushion the effect of any Fed tightening which may occur this year.
Flattening of the Yield Curve
The yield curve has continued to flatten during the last several years. We expect this trend to continue as the Fed tries to normalize rates in a slow growth economy.
We have begun to see weakness in the 1‐year part of the Muni curve. We are able to get yields of about 70‐80 bp’s for maturities due in about 1 year. This is significantly higher than rates have been for these maturities during the last couple of years. We continue to believe a barbell strategy of bonds in the 1‐year part of the curve coupled with bonds in the 12‐15‐year part of the curve is a sound strategy for Muni bond portfolios.
The World Economy
We believe it is important to view our economy in a global context. One indicator which we follow to measure strength in the global economy is the Baltic Dry Index. This index measures the shipping rates for dry goods. The chart below shows this index for the last 25 years. When the economy is strong rates are high, and when the global economy is weak rates are low. We recently set a new low in this index which confirms the weakness in the world economy. It will be difficult for interest rates in the U.S. to increase much unless we begin to see more strength in international trade.
The U.S. Economy
The economy in the U.S. has been relatively resilient compared to the global economy. Growth is still subpar compared to trend, but we are seeing some signs of a pickup in Average Hourly Earnings which could lead to some inflationary pressures in the future. There are some at the Fed who may argue for an increase in the Fed Funds rate to keep inflation under control.
A Solution for Income Oriented Investors: CEF’s
Some investors choose to focus on investing in securities which provide them higher yields. The Fed’s zero interest rate policy has made this increasingly difficult in traditional investment grade securities. For some of these investors we have implemented a strategy of employing Closed End Funds (CEF’s) which generate taxable income. The collapse in oil prices and commodities coupled with fears of an economic meltdown in China created a unique opportunity in some of these funds. Emerging Market debt funds and High Yield funds were particularly hard hit. Several funds were trading at discounts to NAV of 15‐20% and had distribution yields of 8‐ 12%. Many of these were trading at levels near the lows experienced during the financial crisis in early 2009. We believe these funds offered a relatively low risk way to augment income in portfolios, and even though they have rallied we believe they still offer significant value for income oriented investors.
Credit Spreads: Taxable Munis vs Corporates
The first quarter of this year saw credit spreads for taxable munis compress significantly as the market for these securities rallied. During the same time period the spreads for corporate bonds briefly blew out (widened). This created a unique opportunity for us to sell some of our taxable munis and to pick up significant amounts of yield by moving into some corporates. This trade has worked well for us as the fears of credit deterioration have dissipated in the fixed income markets.