On The Right Track

In an era of seemingly low to no interest rates, we see an increase in opportunities in municipal bonds.  Despite continuing Quantitative Easing by the Federal Reserve, asset prices are weakening, yields are rising and long-term assumptions should be questioned.

Last summer, almost one year ago, the bond market appeared to adopt the assumption that interest rates would remain low across all maturities, seemingly forever.  With the Federal Reserve ramping up its bond purchases from Quantitative Easing (QE2) to Quantitative Easing Infinity, only a fool would believe rates would not remain low.

Money poured into Bonds.  Not only was the Fed buying Bonds and lots of them, so was everyone else it seemed.  Yet despite all this buying and despite all the confidence that Bonds would be THE place to be, forever, Bonds reversed their trend.

On July 25th, 2012, Ten Year Treasury Notes traded at an all-time low yield of 1.38%.  What this also meant was that the price of Treasury Notes were at an all-time high and other assets that are priced off of Treasury Notes were also priced at all-time highs or close to it.  Last week, Treasury Notes traded as high as 2.23%.  Higher yields mean lower asset prices.  Similarly, the Thirty Year Treasury Bond traded at an all-time low of 2.44% on July 26th, 2012 and last week at a high of 3.36%.

Heading into May, US Treasury markets had given the Bond bulls plenty to be optimistic about.  Sure rates had eased higher since last summer, but as recently as May 1st Treasury yields were within striking distance of their all-time lows, at 1.61% and 2.81% respectively.  Then, all of a sudden, wham!

Does this market movement remind you of another asset class of late?  Gold, peaking at $1921 in September 2011 had weakened and strengthened to nearly $1800 in October 2012 and $1603 as recently as April 2nd before plunging in a matter of weeks to $1322 in April 2013.  Silver prices showed a similar, yet more exaggerated fall from $49.80 in April 2011 to $20.34 in May.

The dominoes are falling, albeit slowly at the turn, gaining steam over time and then wham!  One may choose to ignore the movements of precious metal prices but a falling US Treasury market cannot and should not be ignored.  Of even greater concern is the large segment of the Bond market that prices off of US Treasury yields.  Rising yields means declining asset prices, not only for US Treasuries but Corporate Bonds, Mortgage Bonds and Municipal Bonds.

Municipal Bonds peaked later than the July 2012 peak for Treasuries.  Municipals peaked in November 2012 and I declared that market to be in a bubble in my December 2012 Letter.  Like Treasuries and precious metals before them, Municipals are only slowly retreating in price (the first movement) and I expect the move to accelerate to the downside significantly in the months to come.

I bid for Municipal Bonds every day, day in and day out.  Sometimes it is difficult to discern a changing big picture when dealing with a multitude of individual bonds each day.  But over the past several weeks I have become quite excited.  The bids for bonds, particularly long-term Bonds are both dropping and disappearing.  Liquidity is leaving the market and as someone with liquidity, as well as advising clients with great liquidity, this situation brings an excitement that has only been fleeting the past several years.  The longer this lasts the greater the odds we are able to find more of the bonds we look for.

Our strategy has been consistent.  We believe long-term bonds to be a short-term play.  We believe the days (years) of buy (a long-term bond) and hold has been long over.  Instead, we have pursued short-term bonds which are self-liquidating, by a call or by maturity, in which we could earn 1%, 2%, 3% or more.

A short-term portfolio with high turnover due to calls and short maturities amounts to a near-Cash strategy focusing on wealth preservation, high liquidity and yield without principal volatility.  With tens of thousands of different issuers and issues, we have plenty to choose from.

As the Stock market moves from a this-is-as-good-as-it-gets market to a market that begins to ask where-is-the-support-for-this market, we will continue to find more worthwhile Municipals.  The dominoes are falling but until Stocks join the other falling price assets there will be plenty of doubters.  I am okay with that.  Watch the markets.  First Commodities with Silver and then Gold and now US Treasuries are moving lower.  Municipal Bonds are next in line with Mortgages and Corporate Bonds as well.  When falling asset prices finally get in synch to the downside, watch out below.

Am I worried?  I am not worried because this is investment environment for which we are prepared and have been preparing.  Our strategy has not only worked in a rising price, bubble environment for Municipal Bonds, it works better in a declining, bubble-popped environment.  This is because liquidity in the Municipal Bond market is thin and subject to the readiness of traders to bid and buy.  Already, in the month of May, we are seeing municipal bond dealers pull back on their bidding for bonds because they have a plethora of underwater (price-wise) long-term bonds on their inventory shelves.  Dealers worry about their inventory levels; I worry about finding you excellent bonds that fit our strategy.

With the downturn in US Treasury market prices, Municipal bond prices are following.  Our strategy remains the same but I expect our opportunities to increase.  We are prepared for this change in trend.