Looking back over 2010, there has been no shortage of major developments affecting bond investors. The Greek debt crisis in May made its way across Europe to Ireland in November. The U.S. Federal Reserve embarked on a second round of quantitative easing (essentially printing money to buy debt) in October, believing that the U.S. economy was still quite weak and in need of more stimulus. Bond investors, who agreed with this assessment much of the year, decided that the economy was doing quite well on its own, thank you, and that the Fed’s actions were likely to lead to inflation.
With this backdrop, it is no surprise that bond yields have been on a roller coaster ride. Starting the year at 3.84%, the yield on the benchmark U.S. Treasury 10 year bond rose modestly through the first quarter to peak at 3.99% in early April. From that perch, it followed a long, slow decline all the way down to 2.38% in early October. The launch of the Fed’s “QE2” program, along with signs of a strengthening economy, caused yields to change course quickly. Today, the yield on the 10 year bond is all the way back up to 3.29%, having jumped more than 30 basis points in just the last two days.
The municipal bond market has been rocked by the developments affecting U.S. Treasury yields along with a few issues unique to that market. Over the course of 2010, the difficult budget problems facing states across the nation came into focus. In particular, the budget shortfalls shed light on the yawning gap between promises made to current employees and retirees for pension and health care benefits and the funds available to pay off those promises.
This fall, concern over the timing and nature of potential renewal of the Build America Bond (BAB) program caused many states to schedule large bond offerings before the end of the year. This supply glut add further downward price pressure in a weak market. This pressure will likely abate over the next couple of weeks.
Finally, announcement of an agreement between the Republicans and the White House to extend the Bush-era tax cuts to all income levels meant that municipal bonds were a little less attractive to investors than they would have been without the extension. There are many details yet to be worked out, including a final resolution of the BAB program an extension of which was not included in the agreed upon “framework”, leaving some uncertainty overhanging the markets.
In the fixed income portion of client portfolios, we had been reducing duration risk over the course of the summer and early fall with the decline in rates and concerns about muni credit quality. We have used the recent back up in rates to add to selected longer duration investments. In particular, discounts on many closed end municipal bond funds widened to attractive levels. A healthy stock market -- fueled by strong earnings -- is likely to help corporate bonds as credit spreads will likely tighten.
We will continue to be cautious as continued strength in the economy or excess Fed stimulus could cause rates to rise further. Credit quality among municipal issuers will be a concern for a few years as states struggle to put their financial houses in order. On the other hand, corporate credit is exceptionally strong as many companies have built large cash reserves and kept expenses under tight control.