Presented by Windsor Financial Group
2006 Review
Our main product is advice. We believe we should make a fair assessment of our predictions and strategy recommendations to help you to ascertain the value we provide. The general theme we had for 2006 was that higher energy prices and higher interest rates will eventually have a negative impact on the economy. In other words, at some point during the year interest rates will peak and the economy will begin to slow. There will be attractive investment opportunities as rate rise. Portfolios should take advantage of the higher interest rates by extending maturities/durations with an emphasis on call protection. We also predicted the yield curve would invert slightly which it did. We missed the level on fed funds thinking they would top out at 4.50% but the fed felt 5.25% was more appropriate. Our predictions were for the most part very accurate. It’s interesting to note they were by no means in line with the consensus view. 2007 Outlook It’s very difficult to paint a landscape for 2007 that shows a strong economy. The housing sector is adjusting to bloated inventories, a lack of buyers and developers holding large quantities of undeveloped land. Many investors purchased properties expecting a quick profit only to find the market had changed. The days of rapid home price appreciation are behind us for a while. Having said that we also know periods of home price DECLINES are very rare. So rare in fact that one has to go back to the Great Depression to find a period when the national median home price declined. A slower rate of appreciation on a national level or regional price declines affects the rate at which homeowners tap into their equity and use it to fund current consumption. Billions of dollars of consumption have been funded by cash out refis. We will argue this stimulus to the economy will be significantly mitigated in 2007. Housing will not provide the economic stimulus in 2007 as it had previously.
There is a very high correlation between job growth and economic growth. If one looks back at the period from the beginning of 2000 to the end of 2001 you notice a significant contraction in the number of jobs created. Job growth was averaging 200,000 new jobs a month at the start of 2000 and by the end of 2001 the economy was losing 200,000 jobs on a monthly basis. That’s a difference of 400,000 jobs each month. Economic growth as measured by GDP declined from a 4% annual growth rate to a negative 1% rate of growth during this period. Our fear is the declining rate of job growth we are experiencing at the present time. We looked at a 6 month rolling average of the monthly non farm payroll increases and noticed a significant decline. The average was running at 175,000 earlier in the year but now stands at 125,000. If we see a continuation in this trend it will be a significant indication that the economy is slowing.
The last threat to the economy next year will be high energy prices. While we have experienced a decline in energy prices recently (crude has declined from $77/bbl. to $60/bbl.) the fact that we feel better off with oil at $60/bbl. is a concern. In 2005 crude oil was $40/bbl. Even though energy prices are lower that earlier this year we continue to believe they are high on a historical basis and will result in a reduction in consumer spending on discretionary items. I think about my own situation at the gas pump recently. I feel much better because the cost to fill up is lower by about $12.00 per tank but it is still high. At the end of the month I have fewer dollars left over because of it to spend on other items. We haven’t had a cold winter recently and if we do homeowners will be shocked to see the cost to heat their homes. We also worry about the risk to higher prices if there is another supply disruption in the Middle East caused by political or terrorist issues. Many oil analysts believe crude could be trading at $100/bbl. if we have another major terrorist event. The result of higher energy prices will be a small reduction in GDP.
The best way to summarize our economic outlook for 2007 is to describe it as a soft landing. The combination of a weaker housing market, a slowdown in the rate of new job creation and higher energy prices will result in weaker growth. GDP will be closer to 2.0% next year versus the mid 3.0% growth rate we have grown accustomed to having. The risk to our forecast is that we underestimate the impact from the items mentioned above and we have a mild recession. History is working against our forecast. There have been six recessions since 1970. All six were preceded by an inverted yield curve which is precisely the configuration we have today. They say history repeats itself. Let’s hope “they” are wrong this time. 2007 Investment Strategy While the theme for 2006 was to “increase the duration of the portfolio” the strategy for 2007 will be more accurately described as “maintaining duration”. The duration of the portfolio was increased this year and is in a great position to weather a mild economic slowdown next year. Given our interest rate forecast for 2007 we won’t want to purchase too many longer term fixed rate securities. The purchases completed at the beginning of the year will likely be much different from the securities we recommend at the end of the year. As interest rates decline we will adjust our advice to reflect a lower rate environment. We do expect to have a brief opportunity early in the year to obtain securities at attractive yields. That opportunity won’t last long. It’s interesting to note that on an annual cycle, rates tend to peak between April and June. We would argue the peak in rates will occur by tax time next year.
If we can achieve book yields of 5.50% or higher (to use a general target) then we will recommend you do so, especially since we expect a steeper yield curve and a 4.0% fed funds rate by the end of the year. The 150 basis point spread between longer term bonds and fed funds is attractive on a historical basis. Our theme of acquiring securities that have call protection and prepayment protect will continue as long as the cost (i.e. the reduction in yield versus a bond with poor structure) isn’t too great. Here is a good example. If we look at a callable Fhlb bond maturing in 4 years having a one time call in 2 years versus a continuous call after 2 years the difference in yield is less than 5 basis points. Why would I give up 2 years of call protection for less than five basis points? It doesn’t make any sense and we won’t recommend it.
Let’s look at some specific ideas for next year. It’s fairly easy to dismiss buying treasury notes unless the Investment Policy requires you to do so. We prefer you buy a bullet agency bond as a surrogate and get the state exemption as well as the additional yield (28 basis points additional yield for a 3 year term). Another asset class that in general isn’t attractive on a relative basis is corporate bonds. There simply isn’t enough additional yield for the assumption of the credit risk. A company rated single “A” has a yield spread of 42 – 55 basis points. If a AAA rated agency debenture has a spread of 28 basis points why would anyone buy the corporate bond for an additional yield ranging from 14 – 27 basis points? The financial incentive simply isn’t there. We may from time to time find a diamond in the rough but we can’t build a reliable strategy assuming that. The need for treasury notes should be dictated by your investment policy and corporate bonds are simply not trading at attractive valuations nor de we expect this to change anytime soon.
Some of the best value can be found in agency bonds containing a one time only call feature. Bonds having call protection as long as five years can easily be found. Liquidity is excellent and it is easy to diversify among FHLB, FNMA, FHLMC and FFCB. Analysis shows that the yield spreads are generous. For example, a one-time callable agency bond maturing in 5 years with a call option in 3 years is priced to provide a yield spread of over 60 basis points. Recall our earlier comment where we discussed an “A” rated corporate bond has a spread of 42 – 55 basis points. Granted it isn’t an exact comparison but the value is easy to discern.
Mortgage backed securities(MBS) provide an attractive yield, are pledgible and have prepayment protection and a variety of terms(balloons, 10, 15, 20 and 30 year fixed rate securities as well as 1/1, 3/1, 5/1, 7/1 and 10/1 hybrid arms). Add to that a range of coupons (4.0% - 8.0%) which implies a wide range of market prices that includes deep discounts to high premiums and you have the ability to purchase a security that perfectly matches your interest rate risk position or your interest rate outlook. There is also the opportunity to move into the non agency or “whole loan” sector to maximize yield. The amount of issuance has increased dramatically over the past 5 years resulting in excellent liquidity. The regulators recognized this fact years ago and changed the risk based capital weighting to 20% which is the same as agency issued securities. Given our interest rate outlook fixed rate MBS securities will be emphasized early in the year and we will probably migrate to hybrid arms later in the year because they have a short duration (and we expect interest rates will be much lower). The credit quality of the whole loan deals we have analyzed is very good. The options for the MBS sector are the broadest of any asset class and will be used extensively throughout the year.
As most of the banks in the top performing quartile participate meaningfully in municipal bonds, we continue to recommend a significant allocation to municipal securities for those institutions that can use the tax-advantaged income. From a high-level vantage point we are suggesting that some portfolio cash flows should be redirected towards taxable securities as they will tend to outperform in a falling interest rate environment and are more efficient trading vehicles in the event rates become poised to rise in the next 24 to 36 months. Should the economy become positioned for rising rates, we would skew reinvestment cash flows towards municipal securities as their tax-exempt nature often results in out performance versus taxable bonds in such environments. In general terms we are advocating that clients with municipal bond exposure focus on improving call protection and credit quality. Specifically, we are suggesting that clients holding municipal bonds with call dates starting in 2008 and 2009, and have maturities longer than 10 years, cull these positions during market rallies. In a falling rate environment, these positions could get called away from portfolios, producing reinvestment cash flows at an unfavorable time. If not called, the market value of such positions rarely exceeds par and in a rising rate environment, these positions could cause portfolio duration to extend, potentially amplifying market value losses.
Although Windsor manages credit risk through annual credit reviews of non-rated and lower-rated credits, we would suggest that financial institutions with exposure to holdings of weaker municipal issues reduce such exposure. The market yield premium (credit spread) for holding low-quality municipal issues is historically low. In the event of an economic slow-down, we expect the strain on corporate obligors of certain municipal issues (hospitals, nursing homes, multi-family housing projects etc…) will result in deteriorating credit characteristics and potentially wider credit spreads. Additionally, more traditional municipal issuers could come under pressure if tax collections drop or, if the cost of fully funding public pension liabilities increases overall debt burdens. Banks with long-term exposure to lower-rated credits or deteriorating credits should consider reducing these holdings in to the strength of the current credit environment.
In this uncertain interest rate environment, there are few glaringly compelling additions to be made to fixed-income portfolios. More from a risk and cash flow management standpoint, we are proponents of intermediate duration (6-12 year maturity) non-callable and good quality municipal bonds. Our goal with this focus is to push reinvestment cash flows beyond what we expect will be a falling interest rate scenario, without taking excessive interest rate risk. In the event that a housing-related economic slowdown is met with Fed easing, we are concerned with extending portfolios in the face of a developing interest rate picture. Additionally, if the majority of the yield curve shift is realized in the short and intermediate segments of the yield curve, the maturities mentioned above should enjoy additional performance or price support as they “roll down” the yield curve (in a normal yield curve environment, investors are willing to accept a lower yield –or pay a higher price - as the number of years to maturity for a particular issue decreases).
In the event that loan demand slows and if investment portfolios increase, we would suggest that client’s look to enhance asset yields through the use of good quality short-term (3-5 year maturities) non-rated and privately-placed municipal issues. The short-term nature of these holdings would serve to somewhat insulate them from wider credit spreads. The maturities mentioned would also serve to extend reinvestment cash flows beyond what we feel will be the near-term depression in interest rates. In the current environment, these quality non-rated issues can produce between 20 and 60 basis points of additional yield as compared to more traditional insured municipal bonds. Conclusion: Odds favor a soft landing in 2007 over a recession or a robust economy. The impact from a weaker housing sector, a lethargic job market and higher energy prices will cause a slowdown next year. Inflation will be contained due to global pressures on wages as well stabilization in commodity prices. We expect the fed will be compelled to lower the fed funds rate by 25 basis points at the end of the first quarter. The yield curve will migrate to a more normal configuration from its present inverted shape. We don’t want the duration of your portfolio to get too short so our goal will be maintain the duration at a reasonable level. The steeper yield curve will finally provide opportunities to realize security gains on a limited basis. Depending on how steep the curve gets it may also prompt a hard look at leverage ideas. It will be a year of transition from above average GDP to a soft landing. |
