2017 - Quarter 1

The high yield fixed income sector continued its outperformance in the first quarter of 2017. Intermediate municipal bonds, longer dated municipals, corporate bonds and treasuries/agencies all gained after a particularly volatile 4Q 2016.

Fixed Income Return Summary

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The 1st Quarter: A Conundrum

After the election last November, the bond market took a hit as both tax-free and taxable bond yields rose significantly. The chatter in the fixed income and equity markets was that the Trump administration was going to get the economy growing again and interest rates would rise. Taxes were going to go down, the regulatory climate would be good for business, and there would be big spending on infrastructure and the military. Deficit spending would drive the economy forward and deflation would become yesterday’s problem. At the same time, the Fed was committed to raising interest rates to combat possible future inflation and to provide breathing room to ease rates when the next recession comes along. It appeared there was nowhere for interest rates to go but up. However, to everyone’s surprise, after the Fed raised the
Fed Funds rate to 1.0% in March, the bond market rallied. The market was clearly too negative on interest rates. Fears of interest rates of 5.0% to 6.0% were clearly overblown. It will be difficult for rates to rise significantly higher since our interest rates are already very attractive compared to the rest of the developed world.

The Fed: Normalization of Rates

The Fed seems to finally be committed to normalizing overnight interest rates. There have been 25 basis point increases in the Fed Funds rate at each of the Fed meetings in December and March. This has brought the Funds rate up to 1.0%. Fed members are calling for two or three
additional increases this year. There is also talk by Fed members of possibly starting to shrink their balance sheet by year end. The balance sheet went from $900 billion in 2008 to about $4.5 trillion today because of quantitative easing. It will be interesting to see if the economy is strong enough for the Fed to follow through with raising rates and shrinking the balance sheet. There is no precedent for the Fed raising rates when the economy is growing below trend and inflation is below target. The Fed has had a history since the financial crisis in 2008 of overestimating the future growth rate of the economy. Their forecasts have been more representative of wishful thinking than reality. However, the markets have recently started to believe their forecasts. We have been monitoring economic developments for signs of faster economic growth, but the economy is still growing slowly.

Normalized Yield Curve

Our research shows the average spread between the Fed Funds rate and the 10 year UST is about 150 bp’s. Using our research, today’s fair value for the 10 year treasury is 2.50%. The 10 year is currently trading at 2.25% which is 25 bp’s less than fair value. Inflation is running at 1.7%.
If we add an additional 100 bp’s to the inflation rate we get a level of 2.7% for the 10 year. We still believe we are in a low interest rate environment for a long period of time. However, the current chatter from the Fed suggests they want to move rates higher. If we were to end the year with the Funds rate pegged at 1.50%, we might expect the 10 year UST to be closer to 3.0%. This scenario is based solely on comments from the Fed. Our forecast is for the economy to grow slowly and for inflation to be under the Fed’s target. If the economy does not strengthen and inflation remains subdued, it will be difficult for the Fed to raise rates much higher than they are now. An over indebted economy and negative demographics will create headwinds for the economy. Yet, relief from regulatory burdens will help the economy do better. We will be monitoring these developments to see how much reducing regulations will benefit the economy. Against the backdrop of possible higher short term rates in a relatively weak economy, a bear flattening trade should continue to be favorable. We continue to favor a barbell strategy for our portfolios.

Nuclear Power: Past and Present

Nuclear power seemed to be the power of the future in the early 1970’s. However, the nuclear accident at three‐mile island in 1979 changed the growth path of nuclear power plants. Many nuclear projects were canceled. The most infamous casualty of this incident was Washington Public Power Supply System (WPPSS pronounced like Whoops!) who abandoned 3 different nuclear reactors in the early 1980’s. After the accident at three‐mile island, there were no nuclear power plants started in the U.S. for almost 34 years. Finally, in 2012 the Nuclear Regulatory Commission approved the building of 2 nuclear reactors in Georgia at Vogtle Generating Plant, and 2 nuclear reactors in South Carolina called Virgil Summer Nuclear Generating Station. Construction of nuclear reactors is notorious for cost overruns and construction delays. These projects have encountered numerous delays and significant cost overruns. Recently things got so bad that Westinghouse (the firm constructing these nuclear reactors) declared bankruptcy because of these problems. The power companies that are having these projects built by Westinghouse are now confronted with a difficult decision: should they try to complete the projects or should they abandon them? They have already sunk billions of dollars into these reactors, but the projected increase in costs may make completing the projects a very expensive proposition. We feel the most likely outcome is for the projects to be abandoned. Low gas prices have made gas‐fired power plants a more attractive option for most utilities. Bondholders
for these projects should be ok, as the sunk costs have already been passed on to the utilities’ customers through rate hikes. We feel this is a significant setback for the future of nuclear power in this country.

Foreign Buyers of Munis

There has been increased interest in taxable Muni bonds from overseas investors. One reason for the increase in foreign investing in Munis is the relatively high rates in the U.S. compared to other developed countries. Another reason is the safety of Munis compared to Corporate bonds. The default rates on A‐rated Munis are practically zero, while similarly rated Corporate bonds have a cumulative default rate of about 2.5% over a 10‐year period. Finally, taxable Munis yield more than comparable Corporates. These factors combine to attract money from foreign investors into the Muni market.

We continue to believe we are in a low interest rate environment for a long period of time. Fed rate hikes against a weak economic backdrop may present investors with a good opportunity to add to their bond portfolios.