The Guarantors

The Insurers

There has been considerable attention devoted to the Sub-Prime Mortgage crisis and the exposure of insurers such as MBIA, AMBAC, FGIC, and XLCA to this sector. The stocks of these companies have been hit particularly hard during the recent flight to quality rally in the treasury market. The chart below shows the price activity for MBIA during the last year.

Click on the picture for a larger view.

The stock is down roughly 50% during the last month. The stocks of AMBAC and XLCA are down even more during this same time period. The negative news surrounding these firms due to the large losses they have taken and their large Sub-Prime exposure are causing investors to question the value of insurance and the ability of these firms to cover potential losses.

Muni Bond Insurance

The insurers play a major role in the Muni market. Over 50% of all financings come with credit enhancement such as insurance. Most retail investors have come to rely upon insurance when investing in tax-free bonds. The large scale deterioration in the credits of the insurers is causing investor anxiety and raising questions as to the quality of each insurer and their ability to pay. This problem is exacerbated by falling confidence in the rating agencies to properly rate these firms.

Rating Agency Review

Fitch released a special report on 9/2/2007 which outlined the current state of the insurers. In early November, they announced a further review of the guarantors’ ability to withstand the stress of continued deterioration in the Sub-Prime market. This study should be completed in about a month. The September study showed the Capital Adequacy Ratio for each of the major insurers. These ratios need to be met to maintain the AAA rating. The chart below shows these ratios. The only company that does not meet the minimum in this chart is Radian, which is already rated AA. Fitch and Moody’s are both doing additional reviews which will

Click on the picture for a larger view.

include further analysis of the insurers’ exposure to the weakening Sub-Prime market. The table below shows their preliminary findings of the likelihood that an insurer will need to raise additional capital or use reinsurance to reduce their exposure. CIFG and FGIC show a high likelihood of needing more capital to maintain their AAA rating. If it is determined that an insurer needs more capital, Fitch will give them 30 days to comply before downgrading them to AA.

Click on the picture for a larger view.

Click here for a PDF of this article

Munis: Kentucky vs. Davis Part 2

The Supreme Court

The Supreme Court will hear arguments concerning the Davis v. Department of Revenue of Kentucky next week on 11/05/2007, with a ruling expected in late spring of 2008. The Davis’s have challenged the existing system of preference given by the State of Kentucky to the ownership of in-state municipal securities whose interest is not taxed, while taxing the interest earned on out-of-state municipal bonds. The Davis argument is that the current practice of offering preference to in-state securities is discriminatory, and is a violation of the dormant commerce clause, which gives Congress the right to regulate interstate commerce. The Kentucky appellate court agreed with the Davis’s.

Supporting Opinion For Davis

Alan D. Viard from the American Enterprise Institute recently wrote an amicus brief in support of the Davis’s. This brief is an excellent example of the case in favor of the Davis’s. Mr. Viard’s brief is entitled, “The Dormant Commerce Clause and the Balkanization of The Municipal Bond Market”. We have provided a link to his paper for your convenience. The primary legal argument for the Davis position is that the tax is discriminatory because it favors within-state sales over interstate sales. Several cases are mentioned that support this argument. Each case quoted dealt with a corporation that was being taxed unfairly which impeded their ability to compete in a state. The trading of securities is a form of commerce, and since muni bonds are securities they should be subject to the dormant commerce clause. Since only Congress has the right to regulate interstate commerce, the current system of taxing muni interest in Kentucky is unfair and should be changed. Mr. Viard also attempts to make an economic case against the current tax treatment of municipal bond interest in this same amicus brief and concludes that “the U.S. Supreme Court can strike a decisive blow for free interstate trade in the nation’s financial markets”.

The Argument Is Flawed

The very title of the brief refers to the “Balkanization” of the municipal bond market. One normally thinks of Balkanization as the creation of a fragmented group of hostile or non-cooperative states. This is most certainly not the case here. In a coordinated effort, every state petitioned the court to overturn the Davis ruling. Even states that have no state income tax are in favor of maintaining the status quo with each state offering preferential treatment to bond interest earned from in-state muni securities. This case is not about a company being unable to compete in Kentucky because of unfair tax practices and, thus, suffering economic loss as an injured party. Rather, this case is about taxes, and the right of a state to tax bonds differently. One could say that the injured parties from Kentucky’s current practice are the other states. But these states claim no injury and support the current system. States exist to further the public interest of their region. They have taxing power and create laws to further the public interest. Taxes are inherently often discriminatory. For example, does it seem fair that single people pay higher tax rates than married people? We feel that this is also a case about the rate of interest paid on a local security. Most states encourage investment in local muni bonds, because this investment strengthens communities and benefits the public interest. Encouraging investors through economic incentives helps to lower the net interest cost paid by local borrowers.

Conclusion

It is always risky to predict the outcome of a Supreme Court case, because it is impossible to know how the court will rule. We believe states should have the right to tax their residents, and it is not the Supreme Court’s job to rewrite our existing tax system. Next week the oral arguments begin. Will the Supreme Court agree with us? We will find out by next summer.

Click here for a PDF of this article

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

The Case for Intermediate Treasuries

Taxable Fixed Income

For most conservative investors, an intermediate bond strategy represents a sound choice. There are advantages to this strategy compared with either holding cash or long-term bonds. Intermediate US Treasuries have offered significantly higher historical returns than 30 day T-Bills with little additional risk, and have provided annual returns that are only slightly less than long US Treasuries.

A History of Returns

Fixed Income and Equity returns are readily available for the last 81 years through data compiled by Ibbotson. The table below shows a comparison of returns for Intermediate (5 Yr) and Long (20 Yr) U.S. Treasury bonds for the period 1926-2006.

The Long maturity treasuries outperformed shorter bonds by .30% (5.60-5.30%) annually.

Intermediates, thus, captured about 95% of the return of the Long bonds. During this period, Intermediates outperformed the 20 Year bonds in 44 out of 81 periods or about 54% of the time. Long bonds had 21 periods of negative returns, while Intermediates only had 8. Thus, 5 Yr treasuries had positive returns 90% of the time. The duration or market risk of these bonds is compared in the chart below.

An Intermediate treasury has about 37% of the risk of a Long bond. This implies that the risk/reward of owning Intermediate bonds is very attractive when compared to Long bonds. The chart below shows that Intermediates have captured 95% of the return of Long bonds, while taking only 37% of the market risk during the last 81 years.

Conclusion

Portfolios consisting of intermediate maturity taxable securities are suitable for conservative investors’ fixed-income portfolios. These portfolios have generated positive returns about 90% of the time, are much less risky than portfolios of bonds with long maturities, and capture most of the return of a long bond portfolio. While we cannot guarantee that history will repeat itself, there is certainly a compelling case for investing in Intermediate Bond portfolios. This is a non-market-timing strategy that works well when combined with other riskier asset classes. The bonds provide income and dampen the volatility of the overall portfolio.

Why Not Manage A Bond Portfolio For Income?

Role of Bond Portfolio
Most investors own bonds to provide income and to dampen the volatility of the overall portfolio. We manage our bond portfolios for total after-tax return in order to accomplish both of these objectives. Some investors view their fixed-income portfolios solely as a source of income. The income approach to the portfolio often leads the investor to underestimate the additional risks that they take, and is a less desirable approach to managing bond portfolios. Income is only half of the equation. The total return of any bond is the income plus the price change. Income without consideration of the change in asset value is of particular concern when investing in low quality bonds. These bonds have a high correlation to equities. This means that an investor with a large position in these types of bonds has done little to dampen the volatility of the overall portfolio, because when stocks go down, high yield bonds go down as well. This is contradictory to the basic principle of diversification. The investor has added to his equity risk, rather than reduced his risk.

Increased Risks From Income Approach

Credit Risk
Lower rated riskier bonds generally have higher yields. Investors that are chasing yield often end up with these securities. It is similar to a bank robber who gets caught. When asked why he robbed banks his answer was, “because that is where the money is!” Junk bonds are like a magnet for investors who are only looking at the yield the bond might pay. There is no riskier strategy for most individual investors than to take too much credit risk. Why risk 100% of your money to get an additional 1% return? We advise investors to avoid credit risk, and put that money into a higher return asset class, such as equities, where the potential returns are much higher.

Inflation Risk
Some investors may say “when rates are at 5% I am going to put my money into long bonds and forget about them”. This leads to increased market risk and the risk that inflation will erode their future earnings stream. Economic conditions need to be monitored to make sure that inflation doesn’t become a problem again. A better strategy is to have some shorter maturities so that if rates rise maturities can be reinvested in higher yielding securities, and some longer maturities to help protect the income stream in case rates fall.

Reinvestment Risk
In the search for additional yield it is not uncommon for investors to ignore call features on the securities they purchase. This leads to reinvestment risk. A long bond with a short call is very undesirable. If rates rise you are locked into a long maturity at a low yield. If rates fall you have your bonds called away. Either way the investor loses. Who wants to play that game?

Tax Risk
Often muni bond investors will buy bonds that are subject to the Alternative Minimum Tax. These bonds pay a little higher rate than a regular muni, but the consequences of owning the AMT bond are disastrous if the taxpayer’s status changes and he/she finds themselves subject to the AMT. In that case, the interest is then taxed as if it were a taxable bond. We have found that most investors are better off not purchasing AMT bonds.

Components of Total Return That Are Ignored

Yield Curve Shifts
Prices in the bond market change daily. We call these changes in market value due to changes in yield for each maturity, yield curve shifts. When the bond market is volatile, these shifts are a significant part of total return.

Changes in the Composition of the Yield Curve
When money is tight, the yield curve normally flattens. When the Fed eases, the curve normally steepens. These changes are important aspects of the portfolio’s return. Sometimes the best strategy is a barbell strategy. This works well in a flattening curve environment.

Credit Quality Spreads
After tightening during the last 3 years, quality spreads were recently blown out to more traditional levels. Holders of virtually all high yield bonds saw significant declines in the value of their holdings. While these bonds declined in value, high grade bonds rose in value. We experienced a flight to quality rally in the U.S. Treasury market.

Conclusion
Bond performance consists of two parts, income and price change. It is a mistake to manage a portfolio only for income, because income is only half of the story. This approach often leads to higher levels of portfolio risk, and poorer relative performance than a total return approach. This is not the style of most professional bond managers. So, who would take this type of approach? We see this style primarily when an individual is managing his/her own portfolio and is working with a broker who is selling them securities. These individuals are captivated by the higher yields, and don’t know that there is more to managing a bond portfolio than clipping a big coupon.

Bond Insurance:MBIA

Insurance Risk
Last year, over 60% of all Muni Bond issuance was credit enhanced by either insurance or bank LOC’s. Since a guarantee is only as good as the one who guarantees it, the credit-worthiness of an insurer is very important. Last month, Barron’s ran an article about MBIA insurance. In the article, Pershing Square Capital Management justified their short stock position in MBIA by saying the insurer has significant exposure to the sub-prime mortgage market, delinquencies are on the rise for these loans, and MBIA’s insurance exposure is much greater than the rating agencies would like for you to believe. As fixed income money managers, we are less concerned about how well the firm’s stock does. What matters to us is the company’s ability to pay claims as well as the likelihood they would be required to pay these claims.

Breakdown of Insurance In Force

Insurance exposure can be broken down into the following categories:

U.S. and Non-U.S. Public Finance
U.S. and Non-U.S. Structured Finance

The chart below shows the amount and the relationship of this exposure. Default studies would suggest that the exposure to Public Finance is quite manageable. Total Public Finance insurance in force was $706.3 billion at the end of 2006.

The insurance in force for Structured Finance was $254.5 billion for the same period. This includes:

Collateralized Debt Obligations (CDO's)
Mortgage-backed Home Equity
Mortgage-backed Other
Mortgage-backed First Mortgage

The next chart shows the breakdown percentages for Structured Finance. According to a recent S&P report, MBIA has $5.78 billion of sub-prime exposure in Mortgage-backed securities, and about $431 million is speculative.

The chart shows 62% of their Net Insurance for Structured Finance is in CDO’s. The same S&P report said MBIA has $16.605 billion of Insurance Exposure to CDO’s with sub-prime exposure, and $2.059 billion of this is for sub-prime mortgages. If we combine this total with the $431 million of speculative Mortgage-backed, the total is $2.49 billion of sub-prime insurance written by MBIA.

Ability to Pay

S&P calculates the ability to pay this insurance exposure by looking at the following:

$13.3 billion in claims paying resources
$6.6 billion in qualified statutory capital
$819 million in earnings last year

S&P argues that any future claims are likely to be less than 1 year’s earnings. Their reasoning is that the firm’s exposure to $431 million of speculative grade sub-prime mortgages is about 6.6% of total statutory capital ($6.6 billion), and less than half of 2006 earnings. We find some problems with this analysis because:

1. None of the $2.059 billion in CDO sub-prime exposure is included in their analysis
2. Default rates for higher quality sub-prime Alt A mortgages are also rising. Currently, 2.9% of these mortgages in CDO’s are 60+ days delinquent and 1.08% are foreclosed.

Conclusion
It is easy to see how MBIA’s earnings may be negatively affected in the future due to increasing default rates in the sub-prime area. However, as bond holders we are more concerned about the firm’s ability to pay and maintain their AAA rating. We still have confidence in MBIA’s ability to pay, but feel deteriorating credit conditions are much worse than S&P’s report would suggest. The rating does not appear to be in danger at this point, but we would rather invest in underlying securities unlikely to ever need the insurance. We feel bond insurance is good when there is a localized event, such as Hurricane Katrina. Investing in junk and relying on insurance to bail you out if something goes wrong is not a formula for success. Insurance is no substitute for research if global credit conditions worsen.