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As interest rates fell, Puerto Rico yields did as well, propelling them to higher prices along with other bonds. This was not because of credit, it was despite credit. In a bond Bull market credit makes little difference!

Slow Moving Bond Bear To Quicken

October 16th, 2017 by Kurt L. Smith
  • The trend is indeed your friend and the only friend one has needed these past few years has been the one in stocks. Despite the fact that municipal bonds were the best performing asset class in 2014 (yeah, that long ago), stocks are where the action is. Enjoy it, because trends change.

    When it comes to bonds, only two words are needed: low rates. Forget trend change; forget even a price or yield change. When it comes to bonds, low rates is all you need to know. Spoken by stock market pundits, why would anyone be concerned about bonds? Stocks are where the action is.

    Rates are indeed low, but they have been lower. The reason we care is because the trend is your friend and when it comes to bonds, the trend has changed. You know it because I keep telling you. Sure it’s a lonely proposition, but the market continues, albeit v-e-r-y slowly, that I am indeed correct.

    In June, I believed a 2.13% low on the ten year treasury completed the bond market’s correction of the 1.32% to 2.64% initial move up. Yep, I tried to hurry the market. In September the market hit 2.02%. But last week we were back to 2.40%. I like my proposition!

    At rates of 2-this or 2-that, every stock investor will continue to claim the low rate mantra. But after a 1,000 or 5,000 point decline in the Dow, the perspectives will change. The story will change.

    Trend is important because, it dictates what we should (and should not) invest in. These decisions are hugely important. When a thirty-plus year bull market ends, it should be more than obvious that the repercussions will be nothing short of earth shaking.

    You got an early start on trend change with respect to bonds. We called the end of the Bond Bull in 2012, with longer-term maturities following in July 2016. Did I need to work you over back then to sell items in your bond portfolio? No, you were prepared. We have worked a Bear market strategy for years.

    What you buy is as important as what you do not buy. When it comes to bonds, the most important decision has long been the most overlooked. Credit is, and will always be, the most important determinant in a bond portfolio. You may be able to ignore credit in a bond Bull market, but as the Bear continues to assert itself, there will be no place to hide.

    Puerto Rico bonds are instructive in the way bond prices behave as a result of credit. A poor (at best) credit for most, if not all, of my thirty year career, Puerto Rico bonds did have a positive shared with other bonds: a thirty year bond market Bull. As interest rates fell, Puerto Rico yields did as well, propelling them to higher prices along with other bonds. This was not because of credit, it was despite credit. In a bond Bull market credit makes little difference! Excuse me, as is often the case, a bond Bull often makes the credit worse!

    A Bond Bull makes credit worse because it allows issuers to become over-leveraged. This is not just a municipal bond problem, it is a government bond problem, a corporate bond problem, a mortgage bond problem. Over-leveraged issuers is the bane of a bond portfolio that fails to focus on credit. Usually it takes a Bear market for a festering situation to become dramatically apparent.

    The situation in Puerto Rico is so bad the prices of their bonds have plunged all the while the general consensus regarding bonds is low rates. One of Puerto Rico’s bellwether bonds is their 8% of 2035 general obligations. Issued in February 2014, also a time of low rates, the situation in Puerto Rico had already become so acute that bonds could only be marketed to qualified investors buying $100K minimum denominations. Credit? Look at the yield!

    If you want to see what a Bear market in bonds looks like, pull up a chart of these Puerto Rico 8%’s. Issued at 93, the bonds never traded over 96, and broke below 90 several months later. One year later they had gravitated around 70, were they remained for two years until this spring.

    Notice how in a bond Bear, you keep score not by yield, but by price. Why? At some point it is not about the return on your money, but rather the return of your money. Folks may argue where or when this occurs but one can strongly argue it occurs just below 70. This usually means there is no such thing as a bond selling in the 60’s, or 50’s or 40’s. The next stop for a bond in trouble will be low(er). Last week the 8’s traded at 30 1/4.

    Why didn’t investors sell earlier? The critical question is why buy at all? The credit quality of Puerto Rico hasn’t been worthwhile, let alone improving, for decades. Seems so easy and simple in the rear-view mirror, doesn’t it. Unfortunately, in the world of municipal bonds, credit takes a back seat whether the investor realizes it or not (look at the yield!).

    The bond Bear Market has its own time frame, but the importance of credit has always been paramount. Just like in June, I continue to believe the next leg of higher interest rates will be whatever it takes to throw doubts on the low rates mantra that stocks take for granted. I don’t know when or how high, but it will shock. Not just the bond market.

    Texas A&M University

    Permanent University Fund Revenue Refunding

    Moody’s Aaa  Standard & Poor’s AAA   Fitch AAAe

    Due 7/1 Dated 10/1/17 Maturity: 7/1/2047

    Sale Amount: $90,365,000

    1 2018 4.00% 0.97%
    5 2022 5.00% 1.45%
    6 2023 5.00% 1.55%
    7 2024 5.00% 1.70%
    8 2025 5.00% 1.85%
    9 2026 5.00% 2.00%
    10 2027 5.00% 2.13%
    11 2028** 5.00% 2.24%
    12 2029** 4.00% 2.28%
    13 2030** 4.00% 2.38%
    14 2031** 3.00% 2.70%
    16 2033** 3.00% 2.80%
    17 2034** 3.00% 2.90%
    18 2035** 3.00% 3.00%
    19 2036** 3.00% 3.10%
    20 2037** 3.00% 3.15%
    21 2038** 3.125% 3.25%
    22 2039** 3.25% 3.30%
    23 2040** 3.25% 3.32%
    24 2041** 3.25% 3.34%
    25 2042** 3.25% 3.36%
    26 2043** 3.25% 3.40%
    27 2044** 3.25% 3.42%
    28 2045** 3.375% 3.43%
    29 2046** 3.375% 3.44%
    30 2047** 3.375% 3.45%

      *Yield to Worst (Call or Maturity) **Par Call: 7/1/2027

    Source: Bloomberg

    This is an example of a new issue priced the week of 10/11/17

    Prices, yields and availability subject to change


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