January 2013 Market Commentary
Clinton Investment Management
By Andrew Clinton
February 22, 2013
The municipal bond market continues to perform well in the face of significant political, financial and economic uncertainty, once again, demonstrating the importance of consistent, competitive tax-free cash flow. Municipal bonds proved to be one of the best performing asset classes during 2012 (see Figure 1). For the year, municipal bonds meaningfully outperformed Treasuries returning 9.61% on a taxable equivalent basis relative to a return of 2.08% for Treasuries, according to Barclay’s Capital indices. The resolution of the Fiscal Cliff via the American Tax Payer Relief Act resulted in significantly higher Federal tax rates of 39.6% for individuals making more than $400,000 per year. Tax rates also increased for capital gains and qualified dividends, rising to 20% from the previous rate of 15%. In our view, these actions, together with the Obamacare tax of 3.80% on “unearned income”, which takes effect in 2013, significantly increase the attractiveness of municipal bonds relative to other taxable fixed income instruments and dividend paying stocks.
Clinton Investment Management (CIM) ended 2012 strongly. The composite returns we achieved on behalf of our Market Duration clients were higher than over 85% of the more than 125 municipal bond managers that make up PSN/Informa Municipal Fixed Income universe. Our composite returns continue to be ranked in the top 10% of the PSN universe since the strategies inception in May 2007. CIM also grew meaningfully during 2012 as assets under management increased by roughly 30%. Our growth is due, in large part, to the ongoing loyalty and trust of our clients and their willingness to refer others. Given the returns we have achieved on behalf of our clients on a 1, 3, 5 year and inception-to-date basis, we are optimistic that 2013 will be another strong year for our firm.
While we maintained a more cautious duration position on behalf our clients throughout the year, we sought to further diversify client portfolios from a credit perspective. We did so in an effort take advantage of what we saw as an improving credit environment. We spoke extensively in previous market commentary about our view that the municipal credit environment was not only beginning to stabilize but was also, in select situations, improving. We believe this trend is continuing and are of the view that a significant portion of portfolio return, given the currently low level of interest rates, will be derived from income as opposed to principle appreciation over time.
In light of our greater emphasis on maximizing cash flow through optimization of credit selection, we thought it would be insightful to provide a brief illustration of our credit research. CIM's municipal credit philosophy places primary emphasis on a solid economic underpinning. The financial management practices of the municipality also play a prominent role. The best credits have a strong tradition of solid financial management. However, a credit with a mixed record may also be attractive if it turns to the path of fiscal prudence. We focus on a comprehensive review of the political dynamics as a significant part of making this determination.
Two states have shown significant distress in recent years and undergone major credit deterioration-California and Illinois. The outlook for California has shown substantial improvement over the past year. The end of the home price meltdown has been a key factor. Governor Brown's efforts, perhaps to redeem the family name from his father's legacy of leaving behind a fiscal mess as governor, have proven successful, at least for the near-term, even against the reality of a dysfunctional system. The budget hemorrhaging has stopped. A reversal of years of weak finances may be developing. Illinois, on the other hand, is still failing to address its problems. Tax increases that have helped slow the decline are expiring and the state has not addressed its massive pension obligations which are among the worst, in terms of funding, of any state. No single reason can explain Illinois’ dysfunction. While California's supermajority requirement of 60% makes it extremely difficult to find a consensus, Illinois has no such problem in this regard. Perhaps the fact that two of the last three governors, from both parties, have been jailed offers a clue. In spite of the fact that Illinois has declined in price on a relative basis and is trading at a wide spread of well over +140 basis points over high grade credits, we do not currently see a buying opportunity. This is a significantly higher yield than those of similarly rated securities and serves as yet another indication of the high degree of credit risk associated with IL state general obligation bonds. We anticipate further declines for the Illinois credit going forward. We, therefore, do not believe current yields sufficiently compensate investors for the inherent risk of potential principle erosion due to declining credit quality. We will, of course, be monitoring this situation closely.
The media has raised questions surrounding the ultimate timing of a future rise in interest rates each year since 2008 and this year is no exception. While we are sensitive to investor concerns regarding the potential for a move higher in rates longer-term, we continue to believe that deflation, not inflation, remains the greatest threat to the US and global economies in the near-term. We, therefore, believe that the Fed will continue its accommodative monetary policy until such time as the Fed deems improvement in unemployment and economic conditions to be satisfactory. We do expect interest rates will, one day, rise again indicating that the US economy and financial markets have sufficiently normalized and are no longer in need of the intensive care the Fed has been administering. A deliberate tightening of monetary policy would be a clear signal to the markets that the balance of risk to the economy has shifted to an economy that could be overheating rather than declining. Having said that, as evidenced by Q4 2012 US GDP of -0.10%, growth remains quite weak when compared to previous economic recoveries. Moreover, given the increased likelihood of the implementation of Federal budget cuts resulting from the sequester and their associated negative impact on the economy, we believe inflation, employment, broader economic conditions, and interest rates will remain subdued for an extended period of time.
Regardless of the economic environment and the future direction of interest rates, up, down or sideways, it is important to remember that municipal bonds play an essential role in one’s overall asset allocation. Holding municipal bonds not only allow one to enjoy a consistent stream of income free from taxes, but they also serve as an uncorrelated asset class in volatile investment environments like the one we have experienced over the last several years. Since we have no way of knowing exactly when the current financial and economic storm will pass or when the next one will ultimately hit, investing in municipal bonds will continue to be a conservative and effective vehicle to manage one’s broader risk exposure.
If you should have any questions regarding the municipal bond market or this commentary in particular please do not hesitate to contact me directly.
Important Disclosure Information
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter (article), will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter (article) serves as the receipt of, or as a substitute for, personalized investment advice from Clinton Investment Management, LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. A copy of our current written disclosure statement discussing our advisory services and fees is available for review upon request.
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