Investment returns were positive in the first quarter (see chart on following page). Equities managed to end the period with solid gains, though off their highs as the Japanese earthquake took the wind out of the market’s sails. Large company U.S. stocks performed roughly on par with those of smaller U.S. companies, and there was little differentiation between the returns in growth and value stocks. Emerging markets continued to lag, and Japanese stocks led the way lower, no doubt due to the crisis facing that country.
Returns in the fixed income market were mixed. Of the three types of bonds—Treasury, corporate, and mortgage—the Treasury sector seems the least favorable. Facing continued issuance increases and an eventual rise of interest rates, 20- and 30-year Treasury bonds were modestly lower in the first quarter. Corporate bonds, which boast better fundamentals (i.e., better balance sheet health and more growth) managed a slight gain and remain attractive, although yields on a going-forward basis will likely not be as exciting as they once were.
Mortgage-back bonds represent the third leg of the fixed income stool. Before the credit crisis, roughly 90% of mortgage debt was rated AAA. After a wave of downgrades, the “natural” buyers of mortgages, which include insurance companies, pension plans and other well-heeled investors, own little of such debt.
Finally, municipal debt rebounded in the first quarter from the significant drubbing it took in the last half of 2010. Much of the stress on this market is due to suggestions that massive defaults are looming due to the weakening finances of America’s towns and cities.
I addressed this topic on a recent blog post. Specifically, a number of New York Times articles addressed these issues and came to some interesting conclusions. The first, Opportunity in a Muni Maelstrom, discusses opportunities in the market caused by the recent flows out of muni funds.
- Since November 2011, $38 billion flowed out of muni funds (7% of the tax-exempt bond mutual fund market).
- Outflows caused short-term price distortions, including high-grade credits.
- Article quotes a recent Moody’s study noting that every U.S. state is more creditworthy than 96% of corporate bonds.
- Quotes several market participants dismissing the possibility of widespread muni defaults.
The second, Broke Town, U.S.A., centers on the Vallejo, Calif. bankruptcy case and points to several characteristics of the muni market and local and state government to dismiss Meredith Whitney’s calls for significant, widespread defaults.
- Unlike banks, government entities are generally not dependent on short-term financing.
- Municipalities carry much less debt relative to the size of their economies than national governments, with annual debt service totaling less than 10% of revenues; quotes Moody’s: “State and local governments really don’t have a crushing debt problem.”
- On unfunded pension liabilities: Notes the cumulative liability is high, but that governments are addressing them; many states are reducing benefits for new employees and asking for higher contributions from employees.
- On municipal bankruptcies: Vallejo is cited as an example of “why bankruptcy for cities won’t work”—high costs and little benefits to filing.
Although this may not be a propitious time to exit the muni market, I also believe that this is not the right time to add to this sector. Based on market sentiment (which can be measured by the discount in closed-ended muni bond funds), there may potentially be more opportunities as the year progresses. We’ll continue to provide updates on muni valuations through our AdvisorOne blog.