Commentaries

OCTOBER MARKET COMMENTARY

By: admin / October 17th, 2012

Handicapping the Presidential election through the various opinion and voter polls reminds us of the greased pig contest at the County Fair. Every time some young 4-H’er had the pig in their grasp the crowd would clap and then groan as the pig slipped away. With only weeks to go before one of the most definitive Presidential elections in modern history, markets seem to react like the crowds at that County Fair. We clap as the outcome – read certainty in financial markets – seems more clear but groan as the outcome slips away like a greased pig. From Gallup to Hart, Ohio to Florida this race increasingly confounds the odds makers. What is clear, however, is change is coming to the tax code regardless of the party in power.

As discussed in many financial and political circles the combination of unsustainable Federal deficits and the divide between how to correct those deficits creates the intense focus emerging on the U.S. Tax Code. Not since 1986 has there been such a focus on deductions, preferences and marginal rates.

The Municipal markets, much like the “one percenters”, are gearing up for the debate but we feel like that poor fella at the County Fair. Every time we think we have the pig in our grasp, certainty slips away. What we do feel certain of, is that there is no substitute for in-depth credit analysis and eye-on-the-market pricing opportunities. If confusion and chaos breed opportunity then the next few months could bring unique opportunity to position investment portfolios for the change that’s coming. Eventually the pig tires and the reward goes to the fellow whose perseverance prevails. We know. We’ve been in a few greased pig contests.

• As the 2012 U.S. Presidential Election moved into its final weeks with the first of the Presidential and Vice Presidential debates concluded, conflicting views on tax reform and the related municipal market tax exemption emerged.
• Moody’s Investors Service, one of the three major credit rating agencies, has proposed a plan to modify its reporting of U.S. pension liabilities and the impact on municipal governments’ credit ratings.
• According to a report released by the National Conference of State Legislatures (NCSL), nearly three-quarters of U.S. States are reporting expected increases in tax collections of between 1% and 4.9% for the first three months of fiscal year 2013.
• Treasury yields moved in a narrow trading range entering the 4^th quarter as Euro Zone issues continued but on a more positive note. Additional action through the Fed’s “new QE” also added to the narrow Treasury trading range

 

Presidential Candidates Have Differing Views on Taxes; Impact on Muni Market Possible

As the 2012 U.S. Presidential Election moved into its final month and the first of three Presidential debates was held in early October, the candidates’ views on the municipal bond market tax exemption and tax codes in general appear to vary. APA does note that either candidate’s focus on tax reform could have an impact on the $3.7 trillion municipal bond market. While Governor Romney has yet to disclose many of the details for his tax reform proposals, both candidates seem to agree on one thing: The U.S. Tax Code is too complicated and is in need of a major overhaul. Romney would like to reduce overall taxes, increase the size of the tax base, reduce federal spending and let free markets grow the economy. The Bond Buyer reports that Romney plans to close various loopholes and eliminate certain tax preferences to pay for his lowering of marginal tax rates by roughly 20%. He would eliminate the alternative minimum tax. Specifics as to what loopholes he would close or which tax preferences would be eliminated were not immediately clear as he deferred to Congressional authority over tax legislation. Other key proposals from the Romney plan include permanently extending all of the 2001 and 2003 Bush tax cuts, scheduled to expire in 2013. He also would eliminate the taxation of investment income for individuals making less than $200,000 and cap individual tax deductions at $17,000. Analysts at the nonpartisan Tax Policy Center estimate that the revenue losses from Romney’s proposed tax cuts would total $480 billion by 2015.  

President Obama’s tax plans are different. He has proposed extending all the 2001 and 2003 Bush tax cuts only for individuals making less than $200,000 yearly and for families making less than $250,000. He would return the top tax rate to 39.6% as a way to boost economic growth and reduce the Federal deficit. The President is also advocating for the “Buffett Rule”, which would impose a minimum 30% tax rate on those taxpayers with adjusted gross income exceeding $1 million, including capital gains and dividends. The Bond Buyer reports that market participants believe that increasing tax rates and placing a minimum 30% tax rate on wealthy individuals could potentially make municipal bonds more attractive than other forms of investments.

APA reported in our September 2012 Commentary, while neither the Democrats nor the Republicans addressed the municipal tax exemption issue in their respective party platforms, there has been discussion of the potential for elimination of the once sacrosanct ability for state and local governments to issue bonds exempt from Federal taxes. Governor Romney has not specifically mentioned eliminating the tax exemption, but a senior economic advisor in his campaign stated in a Wall Street Journal editorial in August 2012 that eliminating the tax-exemption on municipal bonds is “on the table”.  The Obama Administration has not specifically mentioned the tax exemption issue but is in favor of resurrecting the Build America Bonds program and placing a 28% cap on the value of tax-exempt interest for wealthy taxpayers. Municipal markets participants have vowed to fight vigorously for the tax-exemption of muni bonds and recently formed the “Municipal Bonds for America Coalition”, created to promote and defend the municipal market’s Federal tax-exemption.  

Moody’s Investors Service Proposes Adjustments to U.S. Public Sector Pension Data

Moody’s Investors Service, one of three major credit rating agencies, recently proposed a plan to modify its reporting of U.S. pension liabilities, asset and cost information. Moody’s believes that this modification will improve transparency and provide improved comparability of pension information across municipal sectors. Moody’s does not expect to see significant rating adjustments on state governments, but does expect certain rating adjustments for smaller local governments. To date, Moody’s has completed data collection on 8,500 local governments and 14,000 individual pension plans. Moody’s adjusted fiscal 2010 state and local unfunded pension liabilities were more than $2 trillion or three times more than the figures reported by state and local governments. Their explanation as to why they made changes to pension reporting was due to the belief that recent rating downgrades caused by underfunded pensions led to the need for greater transparency and comparability.  More specifically, a statement released by Moody’s calls for four principal adjustments to reporting pension information. These adjustments include:

• Multiple-employer cost-sharing plan liabilities will now be allocated to specific government employers based on proportionate shares of total plan contributions.
• Accrued actuarial liabilities will now be adjusted based on a corporate bond index discount rate of 5.5%. Previous discount rates were approximately 8%.
• Where possible, asset smoothing will be eliminated in favor of market or fair value estimates as of the actuarial reporting date.
• Annual pension contributions will be adjusted in order to reflect fair market estimates as well as equalizing amortization schedules.

States See Growth in Tax Collections

According to a report released by the National Conference of State Legislatures (NCSL), nearly three-quarters of U.S. states are reporting projected increases in tax collections of between 1% and 4.9% for the first three months of fiscal year 2013. The NCSL’s report was based on surveys of legislative fiscal directors in all 50 states and the District of Columbia during the summer of 2012. Georgia and Oklahoma have forecasted more than 5% growth in personal income, general sales and use, and corporate taxes in fiscal 2013. Tax collections have increased for 10 consecutive quarters, beginning in the first quarter of 2010. This turnaround followed five quarters of decline resulting from the economic downturn. The report analyzed personal, income, general sales, and corporate taxes. Personal income taxes are often the largest share of state collections, accounting for roughly 34% of total tax collections. NCSL reported that fourteen states projected personal income taxes to increase at least 5% in fiscal 2013. California projected a 14% increase, pending Governor Brown’s tax initiative on the November ballot. Three states (Maine, Kansas, and D.C.) expect negative personal income tax collections compared to 2012. Of the forty-five states that levy a general sales tax, only six are forecasting that their sales tax collections will surpass last year’s levels by more than 5%.   

Treasury Market Yields

With continued Euro Zone headlines, increasing investor demand for safety and the Fed’s “QE3” announced last month, Treasury Yields held steady or increased slightly entering the 4^th quarter. According to U.S. Treasury Department data examined by APA, Treasury yields traded approximately the same from September with 2-year Treasuries at 0.25% on October 9from 0.25% on September 18 and from 0.24% on August 8^th. The benchmark 10-year note yield increased to 1.74% on October 9 from 1.67% September 18^th. This was a marked increase however from the July 25th intraday trade at a historic low of 1.43%. Triple-A rated municipal bond spreads to comparable Treasuries were above average at 97.7% on September 10^th from 104% on September 17^th, 2012. The historic spread average is near 85%.

The yield on the 10 year AAA muni also showed increases through final month of the 3^rd quarter. The September 17^th yield of 1.84% was 5 bps above the June 1^st yield of 1.79%.

 

AAA Municipal Yield Curve

Source: MMD

APA’s 2012 Strategic Direction

APA’s Investment Committee believes the best strategy in today’s market environment is a modified barbell strategy. A sample portfolio consists of high quality bonds, half with a 1 to 5 year maturity and half with an 8 to 12 year maturity. APA’s overall duration target is 4 to 4.5 years. To help enhance clients’ portfolio yield, APA invests up to 20% of the total portfolio within the A-rated category.  More specifically:

1. For investors with a lower risk tolerance, APA recommends a Short-Term Strategy. We feel that lower duration and high credit quality bonds offer clients a defensive position against rising interest rates. We recommend this strategy to investors seeking principal protection in a rising rate environment while looking for higher returns compared to traditional money market funds. APA tailors this portfolio for each client based on their individual liquidity and future cash flow needs. 

 

1. For investors seeking slightly higher yields at lower risk than longer duration bonds, APA recommends an Intermediate Strategy. With a slightly longer duration than APA’s Short-Term Strategy, bonds are selected utilizing a modified barbell investment approach targeting bonds with 1 to 12 year maturities. We also increase our A rated bond holdings from 10% to 20%.

As we do not see any significant near-term threat from inflation, the Investment Committee believes that subtle improvements in the current economy could benefit investors buying along this curve. As stated, our overall duration target is now in the 4 to 4.5 year range. The top five municipal bond sectors in our Intermediate Strategy include local general obligation bonds (GOs), higher education, “other revenue”, state GOs, and utility bonds.

1. For investors with a higher risk tolerance seeking stronger yields and attractive after tax returns, APA recommends our High Income Strategy which we feel attempts to provide a higher return with exemption from federal income taxes. The bonds purchased in these portfolios have a longer duration, lower credit ratings and longer maturities.  The top sectors in this strategy typically include the following: hospitals and health care, higher education, local GOs, and continuing care retirement communities.
2. For all of the strategies detailed above, APA recommends investors allocate a portion of their portfolios to out-of-state bonds, even in high-tax states, in order to increase geographical diversification and help mitigate concentration risk. Currently, investors may take advantage of a municipal yield curve that has flattened slightly but remains steep overall, to lessen the tax effect on out-of-state bonds by extending maturities a year or two out.
3. Additionally, we believe that APA is well positioned to capture higher yields by investing in market sectors where credit spreads remain wider than historical averages. For example, we emphasize purchases of single A-rated issues, water & sewer bonds, highly rated hospital bonds, public power authorities and public school district debt in states offering an “intercept” program which can strategically bolster diversification and price stability.

Disclosures:

Past performance is not indicative of future results.  This material is not financial advice or an offer to sell any product.  The actual characteristics with respect to any particular client account will vary based on a number of factors including but not limited to: (i) the size of the account; (ii) investment restrictions applicable to the account, if any; and (iii) market exigencies at the time of investment. Asset Preservation Advisors, Inc. reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time you receive this report or that securities sold have not been repurchased. The securities discussed may not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings.  It should not be assumed that any of the securities transactions, holdings or sectors discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein.

APA is a registered investment advisor. More information about the advisor including its investment strategies and objectives can be obtained by visiting www.assetpreservationadvisors.com.   A copy of APA’s disclosure statement (Part 2 of Form ADV) is available without charge upon request. Our Form ADV contains information regarding our Firm’s business practices and the backgrounds of our key personnel.  Please contact APA at 404-261-1333 if you would like to receive this information.  APA-12-231