Current Credit Crisis Compared to Long Term Capital Management

Long Term Capital Management

It is interesting to compare the current credit crisis to October 1998 when Long Term Capital Management created a similar predicament in the credit markets. The table below shows the Fed in a tightening mode prior to September 1998 when LTCM exploded.

(Click below to Enlarge)

The Fed quickly cut rates 3 times during September-November, reducing the funds rate from 5.50% to 4.75% until the crisis was averted. The chart below shows the rise in yields after the Fed began to ease.

(Click below to Enlarge)

Yields continued to rise into January 2000. During this time, the yield curve steepened and the economy continued to grow. The Fed had to reverse gears and tighten again beginning in June of 1999. The premature easing that took place because of LTCM proved to be an ill founded decision for the Fed.

The Current Economic Cycle

Fixed income investment returns are closely tied to inflation and economic growth. We monitor the Index of Leading Economic Indicators (LEI) as a barometer of future economic strength, and the GDP Price Deflator as a measure of inflationary trends. The chart below shows the LEI for the period from December 1995 to the present.

(Click below to Enlarge)

The index showed no signs of slowing until early 2000. This would have been a red flag that the Fed was easing prematurely. The current situation is somewhat different. The LEI has been moving sideways since the end of 2005. We will be monitoring the LEI closely for signs of future strength or weakness. If the index begins to rise, this would be a negative for bonds. Inflation has weakened somewhat, but is still near the upper end of the Fed’s target of 2%. Recently, inflation has been showing signs of slowing. If it begins to accelerate, we would view this as a negative for bonds. Gold and oil have both been rising, which is a red flag that the Fed is easing while inflationary pressures may be building.

Conclusion

The Fed has made a pre-emptive strike by lowering rates. It is unclear if this is good for bonds. The initial reaction is not encouraging, since the long bond has sold off about 1.5 points since the announcement. The bond market is concerned that the Bernanke Fed may be lowering rates when inflation is still not under control. Time will provide us with the data to see if this was a wise decision. Hopefully it isn’t an over-reaction to the current crisis similar to October of 1998 when the Fed eased because of Long Term Capital Management even though the economy was strong.

Muni Exchange Traded Funds vs. Mutual Funds

ETF’s

Exchange Traded Funds have become increasingly popular in recent years. These funds are for the most part passively managed, track indices, and have low expense ratios compared to the average mutual fund. ETFs can be traded intraday, shorted, and bought with margin. Mutual Funds do not offer the same features. There are no size minimums to invest in ETFs. This makes them popular with smaller investors. Exchange Traded Funds are usually a more tax-efficient vehicle than mutual funds because they don’t realize gains or losses when selling securities. ETF’s can be concentrated to give an investor exposure to a specific segment or market, such as precious metals, single countries, foreign currencies, and U.S. Treasury Bonds. It should be no surprise that the ETF has finally discovered the Muni market.

The Muni Bond Market

The Municipal Bond market is a highly fragmented market of over 50,000 different issues. Last year, there was total issuance of $388 billion from 12,706 different deals for an average size of $31 million per deal. The market is a collection of regional markets. Each state has different tax rates and different infrastructure needs. The Individual Investor (as a whole) is the largest investor class of muni bonds accessed via individual securities, separately managed accounts, mutual funds, and closed-end funds. These investors typically purchase munis because of the tax advantages of owning tax-free bonds.

Historical Problems Creating Muni Indices

The fragmentation of this market has caused problems in the past with the creation of a viable index for munis. Due to the wide bid/ask spreads and tax consequences of trading, individuals tend to buy and hold muni bonds to maturity. This strategy means that after a bond deal is issued, the amount of trading in that security diminishes rapidly over a short period of time. This makes price determination difficult for any individual security, because actual trades do not take place. It is this lack of actual price determination through trades that has caused problems with Muni indices in the past. This was evident with the Muni bond contract. The CBOT finally stopped trading this contract in 2006, because of problems with the index that led muni dealers to look for alternative hedge vehicles to hedge their inventory.

There are currently several indices money managers use to measure performance which work well for their purposes. These indices are priced daily and are meant to reflect changes that have taken place in the market. The CBOT muni index was a live index that needed to be priced continually. The current plan is to price the relevant ETF index on a daily basis. Most ETF’s in other markets trade continuously and can be compared to a transparently priced index which also trades continuously, such as the S&P Index. Without transparent continuous pricing, muni ETF’s may be subject to some of the same issues that brought down the CBOT muni contract: manipulation by hedge funds and lack of pricing relevancy.

Portfolio Construction And Performance

The ETF faces constraints which will affect its ability to offer good value to its shareholders. The ETF must only purchase bonds from large deals. The table shows the different size limitations of the deals they may purchase. This will limit their ability to invest in any cheap smaller regional issues that may come to market. The purpose of this restriction is to make sure they are investing in liquid names. There are also limitations as to the issue’s purpose. For example, some ETF’s can’t invest in tobacco bonds, hospitals, or housing bonds. Neither one can invest in AMT bonds.

ETF Advantage May Not Apply to Muni Investor

Marginal tax rates determine the attractiveness of muni bonds for any given investor. High Net Worth Individuals with significant levels of taxable income find munis especially attractive. These investors normally have large sums of money to invest and don’t benefit from the ability to invest small sums of money in an ETF. There may be adverse tax consequences of selling holdings in these funds, so it is unlikely that the ability to liquidate holdings intra-day would offer much benefit to these investors. When we compare the tax free ETF to Vanguard mutual fund, we see little benefit to purchasing the ETF, and our guess is that the ETF will have difficulty generating higher returns than the mutual fund because of its constraints.

Conclusion

It will be interesting to see how successful the muni ETF is in the future. We expect this success to be somewhat dampened due to difficulties in index construction and the nature of the muni investor.

Click on the table for a larger view