Is There More Inflation In The Future?

Inflation Outlook
Recently, there has been much talk in the press about inflation. The argument is made that the recent rise in food and energy prices has to filter into the inflation numbers sooner or later, and that interest rates have to rise because inflation is so bad. Frequently this argument is further editorialized with comments such as “I don’t know why the Fed only looks at core inflation. After all, don’t we all have to eat and drive to work? Of course, if you take out everything that goes up, we won’t have any inflation at all!”. This is commonly followed by snickers, as if they are the only ones who could figure this out.

We pay close attention to inflation, which is a lagging economic indicator. Studies show inflation tends to peak at about the same time the economy is bottoming. It has been our opinion that we are in a temporary cyclical upturn in inflation, and we should see inflation come down as the economy slows. The chart below is a Fed model (Chicago Fed National Activity Index)

which shows economic activity and the likelihood of increasing inflationary pressures. The blue line is the value of the index and is charted against the axis on the left. We have added an index of inflation to the graph. The gray area is a graph of the year over year Personal Consumption Expenditures Index. This is the Fed’s preferred measure for inflation and the axis on the right shows the inflation rates. The CFNAI uses 85 different economic indicators as inputs which measure:

1. Production and Income
2. Employment, Unemployment, Hours Worked
3. Personal Consumption and Housing
4. Sales, Orders, Inventories

The Fed model uses a 3 month moving average to smooth the data. The index is designed to be 0.0 when the economy is growing at the long term trend rate. The index is positive when the economy is growing rapidly, and is negative when it is growing slowly. When the index is below –0.70 it is increasingly likely we are in recession. The index has been below –0.70 for the last 5 months. The current value is –1.25. This suggests a continued weak economy in the future. When the index is above 0.7 after the economy has grown for more than 2 years it is likely inflation will rise. This model shows the strong correlation between the overall strength of the economy and inflation. Since the index is in negative territory, this model shows it is likely that inflation will moderate in the future.

Conclusion
Investors should not become distracted by the chatter in the press about the need for interest rates to rise because of inflation. High oil prices and inflation are certainly today's problem, but the leading indicators show inflation is likely to moderate in the future, because of the weak economy.

The End Of The Muni Carry Trade?

Supply/Demand Imbalance
There has been steady growth in the assets held by Tax-Free Money Market funds since their inception. During the last 10 years the holdings of these funds have more than doubled in size as their assets increased by about 123%. Last year about $430 billion was invested in short-term Tax-Free funds. The chart above shows the “gap” between assets held by money market funds and the amount of issuance of short-term tax-free securities that are available for them to purchase. These securities have maturities of 13 months or less, or are longer maturities that have floating-rates and a put that gives short-term liquidity to the debt. Most of these floating rate securities are issued as Variable Rate Demand Notes. This money market supply gap has continued to widen over the last decade.

The Muni Yield Curve
The strong demand for short-term paper by money market funds causes munis to trade “richer” in the short-term part of the yield curve relative to U.S. Treasuries than in the longer part of the curve. This means that munis have a long history of having a positively shaped curve, even when treasuries are inverted by Fed induced tightening measures. The chart below shows the spread between a 1 year muni and a 30 year muni over the last 3 years. When the Fed was
in a tightening mode the curve flattened to a low of 40 bp’s on 2/27/2007. During that same period of time the Treasury curve was inverted. Since the muni yield curve has a history of having a positive slope even when money is tight, it works well for strategies that borrow short and lend long.

The Muni Carry Trade
Tender Option Bond programs (TOB’s) and leveraged Closed End muni funds both borrow short and lend long in the tax exempt marketplace. TOB strategies are funded by money market eligible instruments that allow the programs to purchase long muni bonds by employing leverage. The amount of leverage varies by the entity that is employing the strategy. The muni “carry trade” has become increasingly important over the last 10 year period. The chart below shows the holders of municipal debt as of 12/31/2007. Banks held about $193 billion at the end of last year and Closed End funds held about $92 billion of munis. During the last 3 years the growth in assets held by each category of investor can be seen below. Commercial Banks grew their holdings by about $50 billion since 2004. Much of this growth came from a few large banks that employed carry trade strategies in the muni bond market.


The chart below shows the increase in holdings by the 7 largest holders of muni debt by commercial banks over the last 3 years. The 5 largest holders were all significant purchasers of munis during this time period and accounted for about 50% of the growth in holdings by all the commercial banks. The addition of these large positions of muni debt in such a short time period can only be explained by the use of leveraged TOB strategies. In addition to the TOB’s issued by the commercial banks, there was considerable growth in the number of these strategies employed by hedge funds/arb accounts. It is estimated that Merrill Lynch’s TOB is about $40 billion. Many of these strategies were offered as Alternative Investments or as Fund of Funds strategies. Data on the size and number of these programs is not readily available, but the amount is impressive. Closed End muni funds had little impact and did not experience much growth during this time period. These funds are leveraged through the use of Auction Rate Preferred securities which are not money market eligible, because their liquidity is not guaranteed.

Filling The “Gap”
The leveraged strategies employed by TOB’s are primarily funded by the tax-free money market funds. For example, La Salle Bank would purchase a large block ($15-$50 million) of long muni bonds and deposit them into a trust. The trust splits these bonds into 2 different parts:
1. The short-term holder gets a weekly floating rate security that is money market eligible and can be put back to the marketing agent on 7 days notice.
2. The residual certificate holder (La Salle Bank) receives the difference between the rate paid on the short-term piece and the rate received on the long bonds that were purchased.
This is a “carry trade” for the Bank, because they borrow short and lend long. The steepness in the yield curve has made this a desirable trade for the Bank and the shortage of money market eligible paper has made it beneficial for the tax-free money market funds. The residual holder assumes the market risk of the bonds, and the short-term holder assumes the credit risk of the securities. The credit risk is minimized through the use of insurance or guarantees. The market risk for La Salle Bank is hedged with derivatives. Historically, this strategy has worked well for both money market funds and TOB programs. This type of funding has been useful in filling the “gap” between demand and available supply for the Money Market funds.

Auction Rate Securities
Closed-End funds and Municipalities both issue auction rate securities. The Closed End funds primarily fund their leverage through the issuance of Auction Rate Preferred (ARP’s)securities. These are high quality securities that are secured by the assets of the fund. These are not money market eligible securities, because their liquidity is not guaranteed by anyone. Instead, the rates and liquidity are set by an auction process. Auction Rate Preferred’s are purchased mostly by individuals and corporations. Municipalities issue Auction Rate securities (MAR’s) that are also not money market eligible for the same reason as the ARP’s. These securities are usually either credit enhanced by an insurer or bank, or are of very high quality.

Crisis In Confidence
The huge write downs by municipal insurers of CDO’s with sub-prime exposure has called the creditworthiness of the insurers into question. The rating agencies are imposing tougher rating standards and are calling for more capital from the insurers of municipal credits. Moody’s has downgraded FGIC from AAA to A-3 and Fitch lowered XLCA from AAA to A. This has led to serious disruptions in the short term muni markets. Money Market funds are only able to hold securities (Variable Rate Demand Notes) that are AA rated or better. These funds are not able to hold weaker underlying credits with an insurance wrap that might get downgraded below AA. This has caused Money funds to “put back” weaker credits whose insurers are likely to get downgraded.

In the Auction Rate market, many auctions have recently failed. This is due to liquidity concerns, rather than credit concerns. Dealers have been unable to provide enough liquidity for all of the auction rate securities. Roughly $10 billion of auctions failed during the last 2 weeks. The sudden lack of confidence in the auction process has led this market to unravel. This is causing financing costs to increase for issuers of these types of securities, because when an auction fails the holder of the security gets the maximum rate payable according to the original documents. These rates have been as high as 12-20%. This is causing issuers to look for alternative modes of financing instead of using the Auction Rate marketplace.

Recent Developments
We have noticed these developments due to the distortions in the short-term muni market:

1. There is extreme pressure on banks, dealers, and hedge fund TOB programs due to downgrades of securities that can no longer be funded in the short-term markets. There is constant fear that these programs will be or are unloading long munis to unwind trusts due to downgrades. There is also pressure caused by increased financing costs for these programs. Cheap funding in the money market arena has given way to much higher financing costs. This increase in costs has made the carry trade unprofitable for some hedge funds, which has led to liquidation of some of their long bond holdings. This has caused the long end of the market to underperform relative to Treasuries.
2. Issuers are searching for ways to lower soaring financing costs of Auction Rate securities. Some of these will be converted to VRDN’s and will be bought by the Money Market funds. Others will be reissued as long term debt. Since rates are low on an absolute basis, we expect many of these loans to be converted to long term bond deals.
3. There is now a severe shortage of acceptable money market eligible paper for the funds to purchase. This has led to short-term rates for quality paper falling rapidly to levels around 1%. This is below levels that are justified by current tax rates for taxable accounts. Money has continued to flow into Money funds during this recent scare. Assets are now up close to $500 billion.
4. The Auction Rate market has suffered a serious setback from the large number of failed auctions. Some investors, who are not concerned with liquidity, have been attracted by the high rates currently available in this market.
5. The muni yield curve has continued to steepen which will provide an incentive to investors to extend to pick up yield when the market returns to normalcy.

Conclusion
Guarantees of liquidity and credit are an integral part of the short term muni market. The current disruptions have been caused due to concern about the credit-worthiness and dependability of these guarantees. This has led to a contraction in the supply of capital as a funding mechanism for carry trades. We do not expect this shift in supply to be reversed any time soon. This will make it much more difficult for TOB’s to do carry trades in the future.

Ambac Insured Auction Rate Securities

What Do I Own?
Some investors have become concerned because they own securities that are AMBAC insured and Fitch recently downgraded the insurer to AA from AAA. We are not particularly concerned about munis that are strong credits on their own. However, there may be instances when an investor should be concerned.

The example below is for Arizona Public Service Company and is in a weekly Auction Rate mode. It is important for the investor to understand what this security is in order to determine if it is a suitable investment for him/her. A weekly Auction Rate security has a rate that resets weekly. This rate is determined by an “auction” process. The stated maturity is shown to be 6/1/2034. This security is not deemed to be Money Market Fund eligible because a money fund can normally only invest in maturities out to a little over 1 year. It is possible, but highly unlikely, in the event of a failed auction that the investor would end up owning a security with a maturity in 2034, instead of a money market alternative. The underlying credit quality of APS is BBB-. This is shown in the Bloomberg screen shot below. While it is normally unlikely for an auction to fail, the current stress on the guarantors (in this case AMBAC) and the weak underlying credit quality of APS increase the possibility of this unlikely event occurring.

We have avoided these securities and invest in Variable Rate Demand Notes instead. These securities are money market eligible because the liquidity to put them back to the dealer on 7 days notice is guaranteed.

Conclusion
We would caution investors to be aware of the risk of a failed auction on a weak underlying security that is guaranteed by an insurance company that cannot maintain their AAA rating.

Variable Rate vs. Auction Rate

Auction Rate Preferred’s
Many individuals and corporations use Auction Rate Preferred’s (ARP’s) instead of money market funds. These securities are typically viewed by most investors as a money market substitute, but there are some important characteristics that make them different from a true money market instrument. In fact, these securities are not money market eligible securities for money market funds.

Most money market funds invest in Variable Rate Demand Notes. These trade in $100,000 denominations. The rates normally reset weekly by the service provider who is the dealer that has the floating rate securities. The investor has the option of putting back these floaters to the dealer by giving 1 week’s notice. The security is normally credit enhanced by either an insurer or a bank. The liquidity (ability to put back the security) is normally guaranteed by a bank. These VRDN’s are bought and sold at par (100).

An auction rate security is reset by an auction process. The dealer does not set the rate on the security. It is possible (but highly unlikely) that there could be a failed auction. In the event of a failed auction, the investor would own the security to whatever the stated maturity might be. It is this possibility that makes ARP’s ineligible for money market funds.

VRDN’s are normally sold by institutional sales people who trade them in large size. ARP’s are normally sold by middle market and retail sales people in smaller-sized pieces than VRDN’s. The sales credits paid to market ARP’s tend to be higher than those for VRDN’s. This helps to explain why the yields on the Auction Rate products have tended to be lower than those for Variable Rate securities. This is shown in the chart below. The average spread has been about 4 bp’s in extra yield for the VRDN’s. Recently, this situation has changed. This change and the absolute level of rates is shown in the table below. ARP’s are now yielding about 80 bp’s more than VRDN’s. We believe there are 2 reasons for this change in the spread. First, there is a high degree of uncertainty in the money market at the present time. Investors are attempting to reduce risk in all their money market holdings. They are now realizing there is “auction” risk and are commanding more of a premium for holding


ARP’s. Secondly, many corporations desire to reduce their holdings of ARP’s over year end, because they are treated as longer maturity investments on their books. This has resulted in dealers carrying unusually high amounts of these securities coming into year-end.

Conclusion
We would expect many of these corporations to repurchase the ARP’s they have sold after the first of the year. However, we would expect the spread between these two short-term instruments to be greater for the ARP’s than VRDN’s into the foreseeable future.

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.

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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

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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.

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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.

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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.

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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.

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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.

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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.