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Taxable Munis: A Relative Value Opportunity

October 21st, 2019

     Core bonds are a vital component of investment portfolios.  These bonds serve as a pillar of strength during risk off periods while other assets may be losing value.  Treasuries, agencies and very high-quality corporates fit this category and provide this benefit to investors.  We strongly recommend that investors include these bonds in their portfolios, but caution that a set-it-and-forget-it approach can leave money on the table.  Often, relative value opportunities arise, and active managers can add value by repositioning into more attractively priced bonds.  At United, we constantly search the bond market for relative values; particularly amongst high quality bonds.  Today, we feel that we’ve found one in taxable municipals.

2017’s Tax Cuts and Jobs Act made it more difficult for municipal issuers (states, towns, school districts etc.) to refinance debt.  The act eliminated issuers’ ability to ‘advance refund’ older, high interest debts with new tax-free bond offerings.  As a workaround, municipalities have recently been issuing taxable bonds to refinance older tax-free bonds.  As a result, the anticipated supply of taxable bonds has risen dramatically.  30-day visible supply recently hit the highest level since 2010 (per Bloomberg data).  We feel the market has not been completely prepared to absorb this unusual amount of supply, and the resulting imbalance has pushed yields higher on a relative basis.                 

Today, Bloomberg’s 10-year taxable AA yield curve indicates a yield of 2.55%.  Since the 10-year US treasury sits at 1.79%, taxable munis offer a greater than usual 76 basis points of spread.  Meanwhile, 10-year AA corporates offer 2.4% representing a tighter than usual spread.  Considering this, investing in taxable munis offers a rare 15 basis point yield advantage over corporates.  This is particularly attractive as AA corporates typically offer higher yield than AA taxable munis.*  In our view, taxable munis represent clear value as the uptick in supply has made them particularly cheap relative to corporates.  As a result, we have increased exposure to taxable munis in our clients’ IRAs and tax deferred accounts.

 

*Bloomberg Taxable Municipal AA+ AA AA- 10 year Index BV2TAG10, Bloomberg AA+ AA AA- Corporate Bond 10 Year Index IGUUDC10, spread data since taxable index was created 1/4/16.

 

Matt DeLorenzo, Fixed Income Strategist

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What You Don't Know About Medicare May Hurt You

Medicare Enrollment Periods & Special Rules
 

Medicare Enrollment:

When you are first eligible for Medicare, you have a 7-month Initial Enrollment Period to sign up for Part A and/or Part B:

  •  Begins 3 months before the month you turn 65.
  •  Includes the month you turn 65.
  •  Ends 3 months after the month you turn 65.

If you are not automatically enrolled, you can sign up for free Part A (if eligible) any time during or after Initial Enrollment Period starts. If you have to enroll in both Part A and Part B, then you can only enroll during valid enrollment period.

If you wait until the month you turn 65 or enroll in 3-month window after your Part B coverage will be delayed.

In most cases, if you do not enroll in Part B when first eligible you will have to pay a late enrollment fee/penalty. The penalty is 10% additional for every 12 months you wait and will have to pay that additional fee for life. This may also cause a gap in coverage.

If you do not sign up during your Initial 7-month Enrollment Period, you can enroll for Part A and Part B during the General Enrollment Period between January 1st-March 31st if both below apply:

  • You did not sign up when first eligible.
  • You are not eligible for a Special Enrollment Period.

Your coverage starts July 1st if enroll during General Enrollment Period.

 

Special Rules: (Special Enrollment Periods)

Once your Initial Enrollment Period ends, you may be able to sign up for Medicare during a Special Enrollment Period (SEP). If you are covered under a group health plan based on current employment, you have a SEP to sign up for Part A and/or Part B anytime as long as:

  • You or your spouse (or family member if you’re disabled) is working.
  • You are covered by a group health plan through the employer or union based on that work.

You may have an 8-month SEP to enroll in Part A and/or Part B that starts at one of these times-whichever happens first:

  • The month after the employment ends.
  • The month after group health plan insurance based on current employment ends.

Usually do not have to pay a late enrollment penalty if you enroll during SEP.

 

*COBRA and retiree health plans are not considered coverage based on current employment. You are not eligible for a Special Enrollment Period when that coverage ends.

*If your group plan has fewer than 20 employees you need to enroll in Part B when you turn 65 and Medicare will be primary and group secondary. If group plan has 20 or more then group primary and can utilize special rules.

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US Treasury Floaters – A Contrarian Opportunity for Cash

April 2nd, 2019

Fed induced selloffs are exciting times for bond pickers, as credit spreads tend to widen out while treasury rates move higher. This was the case in October 2018. Interest rates increased while spreads on many bond types began moving to their widest levels since 2016. The opportunity was short lived though, as the fed changed its message and fostered sharp bond appreciation from the 2018 lows. As a result, many investors are currently struggling to locate value in today’s market. While yields on most bonds are indeed lower, we feel a unique bond type is presenting relative value; US Treasury Floating Rate Notes.

These securities have cheapened in 2019 while the market moved to price in future interest rate cuts. Currently, market implied odds of one or more rate cuts by January of next year sit at 63.4% (CME Group FedWatch Tool). On the surface, it doesn’t seem sensible to own floating rate bonds if rate hikes aren’t on the horizon. We take a different view and believe these bonds are an interesting opportunity for the following reasons.
 

  • Yield – The 1/31/21 US Treasury Floater outyields all treasuries out to 11 years. With a current coupon of 2.528% (it pays the 3 Month T Bill rate + 0.115%) and a price of 99.95, these notes offer YTM of 2.555% given the current T-Bill rate. While the coupon can indeed change, the notes currently provide a 25 basis point yield advantage over two-year fixed rate treasuries and a 14.5 bp yield advantage over three-month bills.
     
  • Rate Outlook – While the fed appears likely to be on hold for a while, we see an unchanged fed funds rate as a possible outcome. In this scenario, we project the floating notes to outperform. Further, albeit less likely, we see future interest rate hikes as a possible scenario. In this case we feel the floaters will also outperform.
     
  • Historical Value – Since the treasury started selling floaters in 2014, buyers had to sacrifice yield. One example; when issued on 1/31/18, the US treasury two-year floaters offered 1.506% yield given the three-month bill rate at the time. This was 63.4 bps less than two-year fixed rate treasuries. Investors paid up for these due to the rate protection they offered. Today, these securities offer the same rate protection at a much better price point.

 

Matt DeLorenzo, Fixed Income Strategist

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January FOMC Minutes Review #FOMC

The market’s initial response to the FOMC minutes implies a mildly dovish interpretation. Some investors found comfort in the idea that the balance sheet runoff may conclude this year. Others are unconvinced that this is what the fed intended to signal. The rationale is that the fed only signaled that an announcement would take place this year, rather than a firm 2019 end date. Considering the following quotes from the minutes, I think it’s clear that they do indeed intend to end QT this year.

Page 10 “Against this backdrop, the staff presented options for substantially slowing the decline in reserves by ending the reduction in asset holdings at some point over the latter half of this year and thereafter holding the size of the SOMA portfolio roughly constant for a time so that the average level of reserves would fall at a very gradual pace reflecting the trend growth in other Federal Reserve liabilities.”

Page 11 “Almost all participants thought that it would be desirable to announce before too long a plan to stop reducing the Federal Reserve’s asset holdings later this year.”

Another interesting point is that some participants may prefer to continue reducing the portfolio’s MBS holdings while reinvesting in treasuries only. This could push mortgage spreads wider over time.

Page 12 “Participants commented that, in light of the Committee’s longstanding plan to hold primarily Treasury securities in the long run, it would be appropriate once asset redemptions end to reinvest most, if not all, principal payments received from agency MBS in Treasury securities.”

To me, the biggest question from here is; WHEN in 2019 will QT end? While the fed has communicated its willingness (and perhaps its intention) to end QT this year, a whole 10 months remain in 2019. Given the current cap of $50B/month, the amount of reduction can actually wind up exceeding that of 2018. Remember, the cap (max monthly reduction) didn’t hit $50B until October 2018. There hasn’t been a big market response to the minutes, but this may not wind up being as supportive as it seems on the surface.
 

 

Matt DeLorenzo, Fixed Income Strategist

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LIBOR to SOFR – Preparing for Changes #LIBOR #SOFR #bonds

Largely due to its history of scandal and manipulation, LIBOR is being phased out. While this isn’t new information, we’ve been tracking updates here at United. The rate is being replaced with SOFR, or the Secured Overnight Financing Rate. Since many financial obligations with floating rate structures are tied to LIBOR, we feel this transition and the accompanying details is very important. Some details remain to be hammered out, but we note some of these relevant points:

  • LIBOR is expected to be completely phased out by Q4 2021. SOFR is the replacement rate.
  • The transition will primarily impact longer dated bonds and obligations. Many will mature before Q4 2021 and thus won’t be impacted.
  • SOFR is naturally a lower rate than LIBOR. This is partly due to the fact that SOFR is a secured rate, while LIBOR is supposed to reflect the credit risk of financial institutions.
  • SOFR can only be observed back to 2014, but it tracks fairly close to the fed funds rate.
  • Given that LIBOR is a higher rate than SOFR, a direct replacement would abruptly change the rate on many financial instruments. Since this would be very problematic, there is likely to be a ‘spread adjustment’ of about 10 basis points. An obligation that previously paid 3 Month LIBOR + 100 basis points would in theory be converted to SOFR + 110 basis points.

While the transition will impact many types of financial obligations, we are most interested in its impact on LIBOR linked bonds, preferred stocks and bank loans. We find that in situations like this, refining our understanding ahead of time helps us to identify value for clients when dislocations occur.
 

Matt DeLorenzo, Fixed Income Strategist
 

https://www.newyorkfed.org/arrc/governance.html

https://www.isda.org/a/g2hEE/IBOR-Global-Transition-Roadmap-2018.pdf

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