Sleuthing Bonds

This leads us to the third phase of the cycle. Tender option programs have been among the largest issuers of short-term debt recently. These programs were created several years ago to provide a means of using leverage to amplify returns in the municipal bond market. They have been put together by hedge funds, proprietary trading programs, and some mutual funds (not ours). The basic structure is as follows: an investor acquires a large block of long-term bonds. Those bonds are placed into a trust, which sells floating rate securities with a tender option (they can be sold back to a remarketing agent) to money market funds and other short-term buyers. The investor holds on to a residual interest in the trust and earns a spread based upon the difference in yield between the variable-rate bonds and the fixed-rate bonds placed into the trust, magnified by the amount of leverage used. These programs produced double-digit yields for their investors when the yield curve was steep and when money market funds were willing buyers. However, with money market funds avoiding exotic structures and exposure to many bond insurers, the economics of tender option bond programs have been turned upside down. This has forced several large hedge funds and others to unwind the programs by selling billions of bonds into a market already suffering from a lack of liquidity. The enormous selling pressure overwhelmed the demand side of the municipal market, peaking with concentrated underperformance (particularly toward Treasury bonds) in late February. Since that time the market has recovered fairly significantly, although valuations are still relatively inexpensive and further selling pressure is still a distinct possibility.

Facing the Challenge

While short-term volatility has grabbed most of the headlines, long-term trends could prove to be more important going forward–28 states have announced projected budget shortfalls of $39 billion in fiscal 2009 according to the Center on Budget and Policy Priorities. The budget shortfalls are concentrated in states that were accustomed to very high growth rates in the housing-led boom that prevailed recently, but there are very few areas that are escaping weakness altogether.

Budgetary reserve balances are generally healthy and many states are implementing hiring freezes and other means of achieving balanced operations, but we expect the credit environment to be challenging for at least the next couple of years. Some of the weakness will also affect credit on the local level such as for school districts and housing authorities, but so far the damage has been relatively contained and upgrades are still outnumbering downgrades.

As always, it is very important to monitor bond portfolios carefully and maintain broad diversification. In years past, investors got into the habit of relying on rating agencies for surveillance and bond insurers for credit enhancement. However, rating agencies have recently done a very poor job of accessing credit quality in many cases–witness recent trades in highly rated mortgage-backed product below 50 cents on the dollar. At Thornburg, we utilize the rating agencies but do not always rely upon them. Even good analysts sometimes miss important points, and timely surveillance is very difficult for the rating agencies to provide on over a million different issuers of municipal bonds.

As for the insurers, we believe that cheap bond insurance was a key component of the “commoditization” of the municipal bond market. The insurance policies they wrote may ultimately prove to be worth something, but the market is currently treating them like scraps of paper. Bonds are trading and priced predominantly based upon the underlying fundamental quality (or lack thereof) of the underlying obligors. This is the kind of market where experienced managers with the time, ability and inclination can produce significant value for their shareholders. Hopefully that value will be recognized some day, perhaps after tax rates go up!

The other trend worth noting is the rapid steepening of the yield curve (see graph above). As you know, the Federal Reserve has some control over short-term interest rates, but market expectations generally control long-term interest rates. The Fed has aggressively eased monetary policy recently while the U.S. and the global economy are facing rising inflationary pressures. This turn of events seems to be feeding market expectations of higher inflation down the road, which is leading to a greater risk premium on long-term bonds relative to short-term bonds thus the steeper yield curve. Given that the Fed seems to be predisposed toward extending its easy money policy while the weak dollar and other factors continue to fuel inflation, we think that the steep yield curve may stick around for a while.

George Strickland is a managing director for Thornburg Investment Management and co-portfolio manager of the Thornburg Municipal Bond Funds and Thornburg Strategic Income Fund. He is responsible for overseeing the research, trading, and strategic positioning of municipal bond portfolios. He can be reached at [email protected].