Cumberland Advisors Market Commentary – The Bond Conundrum and How to Manage

The past couple of weeks have been breathtaking for bond investors and observers of the bond market. The yield on the 30-year Treasury bond is now at a record low – it dipped under 2% this week – and the 10-year Treasury is not far off its record low of 1.36% set in July 2016 – the yield now sits at 1.53%. With a little more than two weeks gone in August, we have seen the 10-year drop 47 basis points and the 30-year 53 basis points. This is more movement in two weeks than we sometimes see in six months.

 

There are many crosscurrents here. Most pundits are using the inversion of the yield curve as a forecast of a slowdown. But as we have noted in other pieces, economic slowdowns are far from synchronous with inversions. Growth continued for a year and a half after the yield curve inverted in 2006.

Looking at recent economic data, it’s pretty hard to find the slowdown:

– Retail sales advanced 0.7% month-over-month in July, versus an expectation of 0.3%.

– The Empire Manufacturing Index (New York survey of business conditions) advanced 4.8% versus an expectation of 2.0%.

– Core CPI is 2.2 % over the trailing 12-month level – right where it was at the end of December when the 10-year bond yield stood at 2.685% and the 30-year bond yield was 3.01%.

– The S&P 500 and the Dow Jones are still up double digits this year – even after this week’s turmoil.

– Second-quarter non-farm productivity is at 2.3% vs. a 1.4% expectation.

This does not look like an economy that is rolling over. Nor is it.

This is a bond market that has been buffeted by a number of factors that are not US-related.

Europe is mired in negative interest rates. The wisdom of having negative interest is strongly debated. One thing that is pretty clear to us is that negative rates have not helped the European banking system, and negative rates here do not help US banks, either – witness how poorly financials have done since the Federal Reserve changed its tune towards the end of last year.

The slowdown in China has pushed the yuan lower, and China’s growth rate has dropped. This has contributed to the rush into Treasuries. But we think there may be more playing out here, and it is symbolized by the protests in Hong Kong in recent weeks. Coming on top of the slowdown in Mainland China, the protests may herald the beginning of new freedom movements that the Chinese government will struggle to contend with.

How to manage bond assets
We continue to manage Cumberland total-return bond assets in a barbell method, accenting both shorter-term securities for liquidity and longer-term bonds to lock in yields, with what have been non-Treasury securities in the taxable world and longer tax-free bonds in munis. Indeed, with the fast rush down in Treasury yields, longer-dated munis, though at historical lows, offer value when you can get 3% higher grade in a world where long Treasuries are at 2%. We will take our chances with 160% yield ratios, knowing that defensiveness is built into the cheapness. The front end of the muni curve is VERY expensive relative to Treasuries, so even with a barbell and very low nominal yields, it’s been prudent to have exposure to the longer end of the market.The barbell strategy works less well when the Fed is at the end of a hiking cycle. We don’t believe the Fed is done yet: This is a pause in the Fed’s addressing the US economy. For all the change in talk from the Fed’s being on autopilot to now being data-dependent, the Fed has raised the fed funds target by 25 basis points in December and lowered it by 25 basis points last meeting; so from a fed funds target standpoint we are where we were last fall.

 

Equity markets are decently higher, and our economy continues to improve, yet the bond market has seen yields come down dramatically, in a manner that doesn’t square with US data but is more sympathetic towards the slower growth in Europe and China.

The trade war and concerns about slow growth notwithstanding, the US economy continues to do well. Our thoughts are that this race to the bottom in yields will slowly give way to a recognition that the US economy is on firm ground; the force of higher wages will push inflation higher; and the Fed will resume – albeit slowly – addressing the US economy. This is why Chairman Powell gave the markets a rate cut of only 25 bps last meeting though the markets were clamoring for 50.

Bond market yields here are high versus those in Europe, and that will keep a lid on things for a while. But the rush down has been overdone, in our opinion. My colleague David Kotok often likes to quote Herbert Stein, former chairman of the Council of Economic Advisers under Presidents Nixon and Ford. Stein’s commonsense “law” was that “If something cannot go on forever, it will stop.” We feel that’s true with long bond yields. The ride down in yields has helped portfolios. But backups can hurt, which is why we continue to get more defensive at the margin. The barbell is still in place.

John R. Mousseau, CFA
President, Chief Executive Officer & Director of Fixed Income
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentary – Markets During Apollo 11

This past week we celebrated the 50th anniversary of the Apollo 11 moon landing. Remarkably, only 1/3 of Americans today were alive when that happened.

Cumberland Advisors Market Commentary - Markets During Apollo 11

As a 12-year-old kid I was riveted by the space program and tried to digest the minutia of every flight. Like a lot of kids, we watched the moon landing in the late afternoon in the East on Sunday July 20th, and then our folks woke us up to watch Neil Armstrong set foot on the moon six and a half hours later. It was a remarkable culmination of technological excellence and perseverance that fulfilled President Kennedy’s promise that we would land a man on the moon. And for all Baby Boomers, it was another moment where everyone remembers where they were.

The financial markets looked a lot different back in 1969.

 

Inflation Inflation in mid-1969 was running about 5.5%. It had been around 4.35% the year before in mid-1968 and about 2.75% the year before that. The Vietnam War was still escalating and adding to inflation numbers. Inflation would turn down to 2.7% by mid-1972 – in part due to partial price controls imposed by the federal government – but this was short-lived, and inflation reignited, fueled by the Arab-Israeli war of 1973, which produced the first oil shock; and the inflation that followed climbed to over 12% by 1974. After a brief respite where inflation fell under President Ford (remember “Whip Inflation Now,” WIN buttons?), it resumed its advance again in the late ’70s, peaking at almost 15% before starting the decline to today’s relatively mundane 1.6%

Equity MarketsThe Dow Jones was at 846 at the time of the moon landing. Amazingly, for all the good will the moon landing generated, the Dow declined almost 5% from the time of the landing till the end of the month (buy the rumor, sell the news?). The moon landing came in the middle of a slide from a peak in the Dow of 995 in early 1966 to a bottom of 631 in May 1970. That represented a loss of 36.6% from the high. To put that in perspective, it would represent a loss of almost 10,000 points in today’s Dow Jones average. Clearly the market was reacting to the problems in Vietnam, the Cold War, and inflation. The market would rebound to a height of 1051 (a rise of 66%) in January 1973 as GNP and industrial production picked up markedly. And then there was a long slide to 577 in December 1974 – a drop of 45% from the high less than two years before. This fall correlated with the unfolding of the Watergate crisis that took down the Nixon administration, along with war in the Middle East and a pick-up in inflation. It was quite a time to start an investment firm, but that’s what David Kotok and his partner Shep Goldberg did, in June 1973.

Bond MarketsThe ten-year Treasury bond was yielding 6.65% in 1969 and had been yielding 5.50% the year before. It was in an upward trend that would peak at year end at 8% before declining to 5.5% in the spring of 1971 and then beginning the long climb that would peak in 1981 at almost 16%. To put this in perspective, if you had bought a ten-year Treasury bond at par in the middle of 1968, a year before the moon launch, a year and half later it was worth 85 cents on the dollar. One of the benefits – nominally – back then was that the higher coupons would offset some of the price damage. The more important thing is that the rise in bond yields during this period represented only part of the secular rise in interest rates that had been in effect since the end of World War II and that would end in 1981. We have been in a secular decline in interest rates since 1981, with the current low of 1.3% being reached in 2016 in the period immediately after the Brexit election decision. Are we now seeing another secular rise in yields? We won’t know until we have gone through an entire interest-rate cycle.

It’s very clear that the equity markets have reflected the country’s growth in population and technology and our general development as a society. It’s been 20+ years since we have been at the level of bond yields that were existing at the time of the moon landing. Now, NASA talks about going back to the moon in 2024 and to Mars beyond that. It’s remarkable that it has taken us 50 years to revisit the moon. That’s not to argue the merits of spending money on the space program, but the spirit that the country displayed during that historic period would be terrific to recapture.

John R. Mousseau, CFA
President, Chief Executive Officer & Director of Fixed Income
Email | Bio

Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentary – 2Q2019 Review: Total Return Taxfree Municipal Bond: The Big Squeeze

The muni bond market has been on a tear so far this year. Not only have yields dropped, but they have dropped relative to US Treasuries across the board.

Market Commentary - Cumberland Advisors - The Big Squeeze (Municipal Bonds)

The chart below shows where we are now and where we were at the start of the year.

The big squeeze has been caused by the twin tentacles of increased demand and decreased supply.

We know that the demand has been fueled by the provisions of the 2017 tax bill. The new tax code’s removal of the state income tax and local property tax deductions has left few other areas in which income can be sheltered from federal taxes and has pushed demand in high-tax states into high gear.

Here we compare a general market yield curve from October 31, 2016, to New York and California curves at that time and further compare them to the same juxtaposition recently. We can see that the difference between these high-tax states and the national curve has increased greatly as bond demand has grown (and bid down the muni yield curve across the board).

Muni Squeeze, 10-31-16
Muni Squeeze Spread, 10-31-16
Muni Squeeze, 06-17-19
Muni Squeeze Spreads, 06-17-19

 

The fact that the limitation on deduction of mortgage interest has been reduced to $750,000 from $1,000,000 has been another contributing factor, in our view. At the margin, a person thinking of buying a more expensive home, when confronted by the mortgage deductibility issue, would stay put and instead own more municipal bonds as opposed to buying more real estate with a mortgage that is not deductible.The supply sideHere are the monthly supply numbers for the last four years (2019 year to date)

We can see the large supply bulges in 2016 and 2017. Both were caused by large amounts of advanced refunding supply. Record low interest rates in the first seven months of 2016 (when the 10-year Treasury touched 1.30% after the Brexit vote) spurred on that year’s supply bulge, whereas the passage of the tax bill late in the next year expanded 2017’s bulge. The bill prohibited advance refundings going forward, so naturally municipalities started to price as many advance refundings as they could bring to market (starting before the bill was even passed in November and December of 2017). Issuance has been running roughly 25–28% less ever since. One result is that issuers are using 5-year calls instead of the standard 10-year call the market was accustomed to. In a market where yields have dropped, this has meant that durations have gotten shorter at a time when investors want them to be longer to capture price gains in a declining yield environment.In the graph below we can see that issuance from 2014–17 has changed significantly, trending lower.

Municipal Bond Visible Supply

In our opinion, municipal bond pricing as well as supply has moved to a new normal. What could change this?One of the items would be an infrastructure bill. Right now, given the makeup of Congress and the focus on tariffs and trade, this outcome does not seem likely. We don’t believe that an infrastructure bill – if passed – would include an interest subsidy like the Build America Bonds (BABs), which enjoyed a 35% subsidy from the federal government. There is a lot of reluctance to replicate that model, given that the subsidy has fallen to the mid 20% levels due to various sequestrations. A more likely structure would have the federal government offering a direct subsidy on various projects.

Another item could be a return of advance refundings. Our own thoughts are that Congress did not save any money by prohibiting advance refundings, as the necessity to now do them with taxable bonds renders advance refundings much more expensive, if not impossible. We believe advance refundings were a tried and true way for municipalities to reduce debt-service costs and would like to see them return. We give this possibility a very low chance for passing anytime soon, but it can be brought up in other years. If it does come back, expect supply to explode – at least at these levels, where 4% bonds issued just last year could be candidates to be prerefunded to their first call date.

We remain cautious on the bond market for a number of reasons.

Inflation remains around 2%. It has not dropped markedly since yields have fallen from last October’s high. Below is a graph comparing the ten-year US Treasury yield to core CPI over the past five years. After breaching the 1% level last fall (when we expanded durations), it has since fallen to almost zero. Our premise is that the economy is NOT heading into recession, so we feel that some semblance of normalcy will return to this spread.

10 Yr Treasury with Core CPI – 5 Yr Period
Unemployment has stayed low, declining to 3.6%.
 Unemployment

We believe that some wage growth will pick up at these levels and eventually work its way into the general inflation rate. Though lower in the last two months, labor participation rates remain in an uptrend.The market is forecasting that the Federal Reserve will cut short-term interest rates a total of twice this year. Markets have a notably lousy record of forecasting actual Fed actions, and we think that is the case this time, too. We believe the Fed is happy to try to remain data-dependent, conscious of the fact that the economy is doing well and that there is not that much ammunition in the fed funds rate to cut short rates unless truly needed.

Summing up, munis are clearly in a brave new world from a pricing and supply standpoint. They are no longer as tremendously cheap as they were last fall. The low supply, combined with low rates, steady inflation, and low unemployment, keeps us in a cautious mode.

John R. Mousseau, CFA
President, Chief Executive Officer & Director of Fixed Income
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Sarasota financial advisor: Don’t panic over trade tariffs!

Sarasota financial advisor: Don’t panic over trade tariffs!

By Ray Collins | May 15, 2019

John Mousseau says it is important not to get caught up in concerns about a trade tariff war with China.

“If you’re sitting there and you read just the headlines, it looks like a cannon ball shot across the bow of the ship. In essence what it is, is just a shot in a longer term negotiation. I think it was long overdue to negotiate with some trading partners. The U.S. — in terms of being a world partner — has given up more than it has gotten in the last few years,” Mousseau said.

Mousseau said neither the U.S. or China wants a full-scale trade war.

Read and see more stories by Ray Collins here:  https://www.mysuncoast.com/authors/raycollins/

 




1Q2019 Review: Tax Free Municipal Bond – A Shining First Quarter for Munis

The first quarter of 2019 was a good one for the tax-free bond market, with yields falling during the quarter.

There are two main reasons that munis have had a good run so far this year.

Cumberland Advisors Market Commentary

Muni supply is down. The drop last year has carried over to this year. Remember, 2018 supply was down almost 25% compared to 2017 supply, in part due to the glut that was issued at year-end 2017 to beat the tax bill. The market has struggled with lower supply since. A great deal of the drop in supply can be traced to the 2017 tax reform act, which prohibited advance refundings of older, higher-coupon municipal bonds. Refundings were an important source of supply in past years, particularly in 2014 and 2016.

Demand is also higher, particularly in the high-tax states like New York, New Jersey, and California. Because of the SALT provisions of the tax bill, the cost (in terms of foregone yield) of owning out-of-state bonds in these states is much higher. We don’t see this demand factor changing. (See our February piece regarding the SALT conundrum: http://www.cumber.com/the-salt-state-and-local-taxes-conundrum/.)

In the past few weeks, longer-maturity munis have also declined in yield as investors have moved further out on the yield curve to secure incremental yield. Also, the more dovish stance by the Federal Reserve since year end, reinforced in the March Federal Reserve meeting, has seemed to ease retail investors’ normal reluctance to invest in longer maturities. The tax-free muni yield curve is also much steeper than the Treasury yield curve is, with the difference between 10- and 30-year AAA munis at approximately 80 basis points while the difference between 10- and 30-year Treasuries is only 44 basis points.

What does all this positive movement in the muni market mean?

Clearly there has been a reversal in bond market sentiment since last October, when the 10-year Treasury reached nearly 3.25%. The 10-year is back to a 2.45 yield, but the drop of 80 basis points has been accompanied by almost no drop in the rate of core inflation (nor any rise). And even though headline inflation has fallen (mainly due to oil), the drop in REAL yields has caused us to reassess bond markets in general and tax-free bonds in particular.

We think the SALT provisions are resulting in people – particularly in high-tax states – paying MORE this year in income taxes. In a market that has seen a resumption of bond fund inflows, we are concerned that the approaching tax deadline may see some bond selling, either directly or in bond fund form, to pay for the taxes.

We are also concerned that state and local governments – again, particularly those in high-tax states – will be under pressure from their citizens to cut taxes to make up for the extra taxes being borne because of the SALT provisions. If high-tax states oblige but don’t cut expenses, debt-service coverage could suffer.

Last fall, we thought REAL rates were high, bond selling was overdone, and the muni yield of 4%-plus was a giveaway. That yield bogey is VERY hard to find in a bond market that has done an about-face in the past four months. Thus, we are getting more defensive at the margin to make sure we are positioned to take advantage of any volatility accompanying April 15th. When it gets crowded at our end of the boat, we generally start moving to the other end.

John R. Mousseau, CFA
President, Chief Executive Officer & Director of Fixed Income
Email | Bio

____________________________________________________________________

Cumberland Advisors invites you to our third annual Financial Literacy Day, to be held April 11, 2019, from 8:30 AM to 4 PM at the Selby Auditorium of the University of South Florida Sarasota-Manatee.

Our focus is “Financial Markets and the Economy,” featuring:

Panels –
• The Stock Market
• Health Hunger and Philanthropy
• How the World Looks to Me – A Global Economic Outlook
Special Presentations –
• A Conversation with Susan Harper, Canada’s Consul Gen in Fla, on Trade/World Affairs
• Keynote by Gretchen Morgenson, Senior Special Writer in the Investigations Unit at The Wall Street Journal and Former Business and Financial Editor for the New York Times.
We welcome and encourage the participation of our friends, colleagues, and clients. The cost is only $50 to register, and includes coffee, pastries, catered lunch, and a light reception with Gretchen Morgenson. Please reserve your spot soon – we expect a full auditorium. Learn more: https://www.cumber.com/financial-literacy-day/

 




4Q2018 Review: Munis Turn It Around

Muni yields rose in the first six weeks of this quarter – mostly in sympathy with US Treasuries (UST). We saw the 10-year and 30-year Treasury bonds rise 20 and 25 basis points respectively. Since early November, AAA muni yields (AAA) have dropped across the board, and the 10-year Treasury yield has fallen a whopping 45 basis points in a matter of seven weeks.

 

The consternation and volatility in the stock market are the main reasons for yields doing a U-turn.

Some of the other themes affecting muni yields we discussed earlier this month:

(*) The housing market slowdown. Price gains have continued to slow for seven months in a row; and a number of Northeastern states and other previously “hot” markets have seen declines, especially at the higher end of the price range. This falloff is due to a combination of higher mortgage rates earlier this fall plus the specter of higher real estate taxes because of the lack of deductibility in the new tax bill.

(*) Concern about the rising level of debt and rising government debt service costs (see our piece “November Bond Market Bounce” from December 4thhttp://www.cumber.com/the-november-bond-market-bounce/).

(*) A general slowdown reflected by the price of oil. See graph below:

West Texas Crude per Barrel

(Source: Bloomberg)

 

The freefall in oil suggests that other prices may also be falling, so the combination of HIGHER yields earlier in November and stable-to-falling core CPI certainly made REAL yields seem much more attractive this fall.Now that yields have fallen, let’s survey the landscape.

37% Taxable Equivalent
(Source: Bloomberg)

The above graph shows the current muni AA curve and the Treasury yield curve. The curves demonstrate why we have used a barbell strategy, particularly on the tax-free side, where longer muni yields are CHEAPER than Treasuries yields. We believe those high yield ratios on the longer-maturity spectrum eventually go back to 100% or under – this outcome would be consistent with other Federal Reserve hiking cycles. For spread purposes we have also included a AA corporate bond yield curve and created a taxable-equivalent muni yield curve using the current top tax rate of 37%. This comparison demonstrates the advantage of munis over Treasuries for any level of taxpayer and the additional advantage of tax-free munis over corporates for high-tax payers, in the five-year tenor and beyond. The much lower default experience of munis versus corporates simply stretches this advantage.

The Federal Reserve last week raised the fed funds target yield range ¼% to 2.25%–2.5%.

The Fed also made mention of two possible increases next year and did so with less flexibility in the language, which helped to spook the equity market after the announcement last Wednesday. Our thoughts are that if core inflation remains where it has been, at 2.0–2.25%, and if there are more Fed hikes next year, the Fed will finally have gotten Fed funds to a positive spread over core inflation – where it has not been for 10 years. That would appear to be a good place for the Fed to pause. And as we get to that pause, we will begin to pick up the pace of moving very-low-duration assets out somewhat further on the yield curve to lock in rates, as shorter to intermediate rates most likely slowly work their way down.

Happy New Year to all our readers!

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio

Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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The Cumberland World Series Theory of the Bond

Most investors have heard of the “Super Bowl Theory of the Dow.” This theory, first proposed by sportswriter Leonard Koppett in the 1970s (source: Wikipedia), posited that when a team from the “old” NFL (the current NFC plus the Colts, Browns, and Steelers, who joined the AFC in 1970) won the Super Bowl, the Dow Jones Industrial Average would advance in the year following the Super Bowl.

 

If a team from the AFC won the Super Bowl, the Dow would decline. Amazingly, this theory has worked out almost 80% of the time, though the February 2017 Super Bowl, won by the Patriots (AFC), did NOT accurately predict the stock market (up in 2017). The correlation, of course, is just a coincidence: There is no connection between a conference winning the Super Bowl and subsequent returns in the stock market, and thus there is no reason to think that the Super Bowl can be used to predict markets.

But we decided to have a little fun; and since it’s World Series time, we wanted to see whether there was any tie-in to how the BOND MARKET did in the calendar year following a World Series win by either the American League or National League. The easiest data to use was the 10-year US Treasury bond and its return in a calendar year. We measured TOTAL return (coupon and price) and then took away headline inflation (CPI). (By the way, we have this data in our bond models, so it was easy to deploy for a “fun” topic.) We went back to 1966 to have a similar time period to the Super Bowl.

Our results are below:

How the BOND MARKET did in the calendar year following a World Series win by either the American League or National League

What do the results tell us?Frankly, not as much as we hoped.

Some notes: We used the full calendar year AFTER the World Series. And we ignored 1995, which followed a year when there was not a World Series due to the players’ strike. In the bond market, 1995 was a big year because the market rebounded after the carnage of 1994.

In the 51 years that we measured, the American League won the World Series 27 times and the National League triumphed 23 times. The bond years following an American League winner had a positive return 15 years and a negative return 12 years. The AVERAGE bond market return following an American League winner was 2.39%. The average UP year for an American League winner was 9.12%, and the average DOWN year following an American League winner was -6.03%.

The National League numbers look a bit more promising. In the 23 years that the senior circuit won the World Series, the AVERAGE return was 3.06%, 67 basis points higher than the average American League return (remember, these are total returns, inflation-adjusted). The average POSITIVE return for the National League was 9.18%, fairly comparable to the American League’s 9.12%. But the average DOWN year for the National League was -4.88%, considerable less than the American League’s -6.03%.

At some point we may go back another fifty years to add to the study, since we have a much longer record for the World Series than we do for the Super Bowl (which started after the 1966 season).

But the results would suggest that the bond market on average does better after a National League win in the Series, with a slightly better upside number and a considerably better downside number. What does 2018 hold? Well the American League Houston Astros won the World Series last year over the Los Angeles Dodgers. But wait – the Astros were a National League team until 2013! So with this mixed history, the 10-year Treasury to date has a total return of approximately -3% through the end of the third quarter, with inflation of approximately 1.4% through the first nine months. That’s a total return through nine months (after inflation) of roughly -4.4%. If we have a flat quarter, that should suggest that a down year this year would be more like a National League return (and Houston was an National League team for all but six years of its 56-year existence). Of course the returns will change between now and the end of the year. The volatility in the equity markets, slowing housing markets in a number areas of the country, and possible worries about SALT provisions in the tax bill may start to push more assets into a bond market that has been oversold in general – particularly given that trailing headline inflation has dropped from 2.9% to 2.3% in the past three months.

As for next year, we know we fare somewhat better with the National League, but GO RED SOX!

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio

Gabriel Hament
Foundations and Charitable Accounts
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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The Tale of Two Ratios: Shorter and Longer

In a year when we have seen commentators talking about the relative flatness of yield curves, we have a conundrum when we look at the US Treasury yield curve and the US muni yield curve (shown here as the Bloomberg AA general obligation yield curve).

Market Commentary - John Mousseau

Curve 1 below is from the beginning of 2017. Curve 2 is from September 2017. Curve 3 is from September of this year.

Curve 1
Source: Bloomberg

Curve 1, at the beginning of 2017, shows a very cheap muni yield curve across the board. Muni yields were at or above Treasury levels at EVERY POINT ON THE YIELD CURVE. This reflected the entire uncertainty surrounding the presidential election. There were questions as to whether we would see a tax bill and how munis would be treated, fear of a big infrastructure bill (and uncertainty over how that would affect munis), what the president would do regarding a new Fed chair, and whether Fed policy would change. All in all, it was an extraordinarily cheap moment for muni bonds. The long end was particularly cheap, as the market had undergone a selloff in the wake of the Trump election, with extreme bond-fund selling.

Curve 2
Source: Bloomberg

Curve 2 is from September of 2017. What happened? Short-term muni yields dropped. The trend really started in the first quarter when then-Chair Janet Yellen made it clear that the Fed would continue on its path of raising short-term interest rates gradually (read: not at every meeting) but would need to keep raising rates to reflect an improving economy. Thus the shorter end of the market essentially began to go lower in yield to reflect the tax structure, and the ratio moves were dramatic for paper inside of five years. Longer munis continued to exhibit cheapness of yield relative to Treasuries. We believe this was related to market knowledge that there would be a change in the tax code coming with the tax bill and to the uncertainty as to how municipal bonds would be treated under that bill. The expectation was that municipal advance refundings (which allowed municipalities to defease older, higher-coupon bonds in advance of their call dates) would be eliminated. Bond markets also expected that private-activity bonds – issued by charter schools, private universities, state housing agencies, and airports among others – would be prohibited. In the end the tax bill eliminated advance refundings but allowed private-activity bonds. The cheapness in the long end of the muni market was due to the expectation that SUPPLY would bulge at year end to beat the tax code changes, and indeed that is what happened.

Curve 3
Source: Bloomberg

Curve 3 is from this September. Two observations jump out. The long end remains absurdly cheap. One factor is some erosion of the buying base. Banks have been smaller buyers of munis because of the lower corporate rate; and individual demand for long munis has been good, but bond funds have not recouped the outflow of funds that they saw in the wake of the 2016 election. The more dramatic move has been the continued drop in ratios inside of 10 years – in some cases to lower than the break-even rate if we assume an average marginal tax rate of 25%.

One of our thoughts is that investors are expecting a possible change in the makeup of Congress this fall and possibly a change in the White House in 2020 and a potential revision of the tax code again. The current individual rates expire in 2025. Therefore, investors are turning over muni portfolios faster and paying more for short-dated securities. They would therefore have money back faster if there if a tax law change in the wake of a switched Congressional majority.

However, we believe the longer end of the bond market remains an extremely good value. A 4% tax-free yield is the taxable equivalent of 6.35% if an investor is in the 37% top tax rate bracket. For states with high income taxes that are no longer deductible, a 4% in-state bond yield is worth even more. At the top state tax rate, a 4% New Jersey tax-free bond is worth 8.97% taxable equivalent; a 4% New York bond is worth 8.82% taxable equivalent; and a California 4% tax-free yield is worth 8.04% taxable equivalent. This is for AA or higher-rated securities. To position the 4% in-state bond correctly credit-wise, it compares to high-grade corporate and long, taxable municipal bonds at the 4.0–4.5% level or a BB junk bond long yield index of 6.5% (source: Bloomberg).  In general, the muni yield curve drifted up 20 basis points during the quarter, across from 2 years out to 30. This is in sympathy with the treasury yield curve, which also experienced slightly higher yield movements across the board.

Curve 3 also is a way to understand Cumberland’s current barbell approach to tax-free bond portfolio management. We want shorter-term securities turning over faster as the Fed raises short-term rates, but we want the longer end locked in because we believe the current cheap yield ratios will eventually go to 100% or below. This happened during the Fed’s hike cycle of 2004–2006, when long muni/Treasury yield ratios fell from 103% to 85%. Our approach should give long munis a great deal of defensive value if overall interest rates rise. It is this defensive quality that causes us to include some longer tax-free bonds in the management of taxable bond portfolios of clients such as pensions, foundations, and charitable trusts. The total-return characteristics of owning a tax-free bond at these levels is very compelling when the expectation is for lower yield ratios over time. Certainly it will take some time for the strategy to work out, as longer Treasury yields are somewhat anchored to the general low level of longer bond yields in the Eurozone countries.

As the Federal Reserve continues to raise short-term interest rates (and we believe they will continue to do so to get the fed funds rate decently above the level of core CPI [currently 2.2%]), we will eventually move some of the shorter end of the barbell out somewhat longer, some of the longer end (where most bonds are callable) to more noncallable structures, and some bonds to the “belly” of the yield curve (where we don’t want to be now but will certainly want to be if we get to a point where the economy slows).

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio


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Tax Free Munis Continue to Perform

The tax-free bond market has continued to benefit from the drop in supply so far in 2018. To recap, the end of 2017 saw a bulge in supply as issuers tried to beat the tax-cut bill that Congress was still massaging through joint Senate/House committee work.

Cumberland Advisors - Tax Free Munis Continue to Perform

The final results of the bill were an elimination of advance refunding bonds but a continuation of private activity bonds. With the lack of clarity about aspects of the final bill, the supply of both advance refundings as well as private activity bonds mushroomed in early December, leading to a record amount – $63 billion[1] of municipal bond issuance – in the last month of the year.

The offset to the huge uptick in supply in December 2017 has been a drop in supply this year. Through the first five months of the year, new-issue supply has dropped from $161 billion at this time last year, to $126 billion. We have also seen demand pick up, particularly in high-tax states. Many states are seeing an increase in demand because, under the new tax bill, state income taxes as well as local property taxes are no longer deductible on federal taxes; thus the taxable equivalent yield for high-tax state bonds from California, New York, Minnesota, and other high-tax states has risen.

The relative improvement in the tax-free bond market can be seen in the table below.

Cumberland-Advisors-Tax-Free-Munis-Continue-to-Perform-Table01

As the Federal Reserve has continued to hike short-term interest rates, we have seen improvement in the tax-free muni/US Treasury yield ratios. The second quarter so far has continued a trend we saw in the first quarter, with yield ratios in the short end of the curve moving lower. Longer-term yield ratios have also moved lower, but the effect has been a little less dramatic than in the short end.All of this makes a lot of sense in an environment where shorter-term interest rates are moving up because the Federal Reserve is raising rates in the face of an ever-improving economy. If the average tax rate in this country is close to 25%, then only a 75% move in a muni tax-free rate is needed to equal whatever the equivalent rise in Treasury yields is. We believe the longer-maturity muni/Treasury yield ratios will trend lower as the Fed’s hike cycle continues into next year.

In addition, most tax-free yields are NOT on the AAA curve but usually decently above it, with most AA and A-rated bonds trading 40–80 basis points or more above the AAA curve. Thus the longer end of the tax-free bond market still offers superior value in our view. This is why we continue to employ a “barbell” approach to our fixed-income management, particularly on the tax-free side.

Below is a graph showing the US Treasury yield curve and the Bloomberg AA tax-free yield curve:

We can see that the muni yield curve is fairly well behaved from a ratio standpoint out to 7 years, then it cheapens and crosses the Treasury curve and yields continue to rise, even though the Treasury curve is lower – and flatter. One factor here is that longer Treasury yields have stayed lower ever since President Trump was elected. One of the reasons is that inflation has continued to be stubbornly low, and low inflation has been reflected in long Treasury yields, which have also stayed low. Another factor is that US government yields continue to be much higher that sovereign debt yields in other developed countries. In our view, the longer tax-free yields with yield ratios well over 100% provide a safe haven for bond assets if this ratio moves LOWER over time (as it did during the 2004–2006 period – the last time the Fed raised short-term interest rates). Thus we have the two parts of the barbell – on the one hand, owning shorter-term assets that can roll over quickly and be reinvested in higher-yielding short-term bonds as the Fed raises short-term rates. And, on the other hand, owning long-term munis, which provide much higher incremental yield than longer Treasuries do as well as short-term taxfree bonds. In addition, the cheap muni/Treasury yield ratios provide a life jacket to the duration risk of longer bonds. In other words, even if long Treasury yields rise, a return to a more normalized 100%-or-below yield ratio will buffer price erosion of longer tax-free munis.

Finally, a quick word about the Internet Sales Tax Decision announced late last week by the Supreme Court. The Supreme Court found that businesses did not need a physical presence in order for states to levy a sales tax in their respective states. Thus, sales of goods on the internet will now be able to be taxed, generally by the states in which they are purchased. The fact that we have Justices such as Justice Ginsburg and Justice Thomas on the same side of an opinion suggests that common sense prevailed here. Certainly, states that are more highly dependent on sales tax revenues will benefit from this ruling. The fact that the Supreme Court superseded its earlier ruling on this (Quill case) is also refreshing in that the Justices now recognize that technology has changed the original premise of the Court’s thinking. At Cumberland, we think this decision means greater debt service coverage for various sales-tax-backed bonds, and we would expect to see an improvement in their trading values.

And lastly, as we go to press, the US Supreme Court has ruled that government workers who choose not to join unions may not be required to help pay for collective bargaining.  Though this case was decided on First Amendment issues, it has broad positive implications for state and local governments to craft solutions to the pension issues facing them.  We will write more on this important decision in the next few days.

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio


[1] Figures pulled from Decade of Muni Finance, published by Bond Buyer.

 


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US Hurricanes and the Bond Market

As Hurricane Irma churns through the Caribbean, the United States is faced with something that it has not experienced before: two hurricanes of category 4 or higher hitting the country in the same year (http://www.aoml.noaa.gov/hrd/hurdat/All_U.S._Hurricanes.html).

Cumberland Advisors Market Commentary

As we write, Irma’s path is still in doubt, with possibilities ranging from the east coast of Florida and the Miami area to the west coast of Florida, possibly impacting our firm’s home city of Sarasota. All of this happening as the citizens of Southeast Texas are recovering from the devastating effects of Hurricane Harvey.

There has been much written over the years about the effects of hurricanes on equity markets. Clearly, such calamities have caused drop-offs in economic activity, followed by upticks in spending and consumption as affected areas rebuild. There is also considerable literature on the effects of large storms on property and casualty (P&C) companies. Generally speaking, these companies pay out substantial claims after the storms but usually benefit down the road as they obtain pricing power for future insurance premiums.

We wanted to look at some of the major storms in the United States to see if we could discern any trends or effects from these meteorological events on the bond markets – both the Treasury market and the tax-exempt municipal bond market. My colleague Gabriel Hament and I looked at the most damaging storms of the past thirty years, taking us from Hurricane Hugo, which ravaged South Carolina and Charleston in particular in 1989, to Hurricane Ike, which hit Galveston, Texas in 2008. The haymaker of all hurricanes, of course, was Katrina in 2005, which devastated New Orleans and Louisiana. The relatively docile period of the past nine years has now come to a vicious close with the twin punches of Harvey and Irma. And though figures are not in yet, it is likely that the cost of Harvey will be even greater than that of Katrina.

In the charts at the end of the piece you’ll see that we list twelve of the most destructive hurricanes of the past thirty years, including the date of landfall, the regions affected, and the estimated cost of damage, which is adjusted to 2010 dollars. We then report the ten-year US Treasury yield as well as the ten-year Moody’s municipal bond yield the week before the storms, the week of landfall, three months after landfall, and six months after landfall. We also look at changes in the Treasury and muni 10-year yields from the week of landfall to three months after landfall, as well as changes from the week of landfall to six months after landfall. For comparison purposes we look at the PERCENTAGE of yield changes, so that periods with different interest rate levels can be compared.

Note that we didn’t include Hurricane Ike in our review of interest rate changes, because the economy was in free fall in September 2008, and Ike made landfall the day after Lehman Brothers declared bankruptcy.

What did we find?

The story is somewhat mixed. On the 10-year Treasury side, in six out of twelve storms the result was higher 10-year bond yields three months after landfall. In the six storms with lower yields, the average drop was 18 basis points or an average drop of 2.9% of total yield (since we are comparing yield drops in different interest rate environments). For the six periods where there was a rise in rates three months later, there was an average rate rise of 20 basis points, or an average rise in overall total yield of 4.45%. This higher percentage is due to the fact that four out of the last five storms we examined occurred in 2004 or later, when we were in a lower interest rate environment than in the ’90s or early ’80s.

Six months after landfall, there is a bias towards higher Treasury yields. Of the twelve storms, four saw lower 10-year Treasury yields six months after landfall, and eight witnessed higher ones. Of the four storms with lower yields, the average yield drop was 38 basis points, for an average percentage of total yield drop of 7.18%. Of the eight storms that saw higher yields six months later, the average rise was 40 basis points, an average total percentage yield rise of 8.7%. The last six storms chronologically saw higher yields six months later.

On the muni side, for the three-month period after landfall, seven out of twelve storms saw lower yields, with the average drop being 13 basis points in the Moody’s 10-year AA scale and an average of 3.02% drop in total yield. On a six-month basis, five storms saw a drop in 10-year muni yields, with the average drop being 26 basis points or an average percentage drop of 6.01% of total yield. Seven storms saw a rise in yields six months later, with an average rate rise of 19 basis points or 4.8% of total yield. The last six storms all saw a 3-month rise in muni yields (albeit some of them small), and the last five all saw rises on a 6-month basis.

What to make of all this? Without being overly scientific, it is clear that in more recent times we have experienced a yield rise more often than not as we moved six months out past a serious hurricane. The fact that this happened during periods of generally declining interest rates is also important. The muni yield drop or rise is more muted than that of Treasuries, and that is explained by the fact that because of the tax exemption you need less of a change in munis to match that of Treasuries on a taxable equivalent basis. We think it also points to the overall quality of municipal debt and the fact that areas tend to rebuild (particularly more recently), although that can take months or years in severely damaged areas. We observe RISING yields, particularly in the Treasury area, after eight out of twelve storms and the last six storms in a row. We think that points to overall better insurance coverage as well as quicker response by Federal agencies with relief dollars. This response translates, of course, into a higher level of economic activity in the years after a storm, and the bond markets perceive a potentially higher level of inflation.

With Hurricane Harvey hitting Texas and Irma now bearing down on Florida, we think there could be a sizable amount of insurance money and federal dollars at work in rebuilding the affected areas. From a portfolio management standpoint, we have sold some selective credits ahead of Irma, the idea being that the lower-rated, uninsured bonds of smaller coastal areas are more vulnerable to headline risk than other credits that are larger or higher-rated. We have practiced this approach for years.

As for the future path of interest rates, we look to the more recent history of bond yields after storms, combined with the fact that we are in a period of the Federal Reserve’s slowly pushing up short-term rates and getting ready to gradually reduce their balance sheet. Add in the impact of rebuilding after two massive hurricanes with insurance proceeds and federal dollars – particularly after what has been a longer time period since the last category 4/5 hurricanes – and common sense leads us to believe that higher rates lie ahead of us in 2018.

We pray for the safety of all of folks in the affected areas, and we’ll be back to inform readers on the impact of Irma.

John R. Mousseau, CFA
Executive Vice President & Director of Fixed Income
Email | Bio

Gabriel Hament
Foundations and Charitable Accounts
Email | Bio


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