(MUB) Archives

The Run in Bonds is Over

This is a bet that the ten-year Treasury bonds, now trading at a 2.50% yield, don?t fall below 2.40% over the next 14 trading days. It has to make this move on top of an unbelievable decline in yields from 3.0% to 2.50% since September. And it has to do it quickly.

The Federal Reserve on Wednesday to consider whether they should raise rates, lower them, or leave them unchanged. Some traders are looking for hints of a taper that may arrive earlier than expected. I think there is zero chance of this. The futures markets for overnight money are trading at prices suggesting that this won?t occur until April or May of 2015! (No typo here). We could be setting up for a classic ?buy the rumor, sell the news? move here.

We are also blessed with a short calendar for the November 15 expiration, as November 1 falls on a Friday. This also takes us into the usual volatility sapping Thanksgiving holidays.

My standing view on bonds is that we will trade in a 2.40%-3.0% range for some time. Given that the ?Great Reallocation? trade may begin in earnest in 2014. We should take a run at the higher end of that range as we go into yearend.

Loss of 1.5% in fiscal drag from Washington next year could take US GDP growth up from a sluggish 2.0% to a more sporty 3.5%. This is not an environment where you want to own any kind of fixed income security.

You might also consider buying November call spreads on the double short Treasury bond ETF, the ProShares Ultra Short 20+ Treasury Fund (TBT), or just buying the (TBT) outright. Another run at the highs for the year from here is worth ten points.

While examining your own fixed income exposure, you might want to use the current strength in bonds to lighten up in other areas. Municipal bond prices (MUB) are now so high that the capital risk no longer justifies the tax savings. Get rid of them! The only successful muni bond strategy here is to die, and let your heirs sort out the wreckage. That way, your widow gets the step up in the cost basis.

Ditto for junk bonds (JNK), (HYG), which after the latest humongous rally, also see low yields no longer justifying the principal risk. The only bonds I like here are master limited partnerships (LINE), where double digit yields adequately pay you for your risk. I also like sovereign bonds (ELD), which will be supported by emerging market currencies appreciating against the US dollar.

The Run in Bonds is Over

October 29, 2013/by Mad Hedge Fund Trader

Welcome to the Sack of Rome

Newsletter

Let?s face it, the carnage in the bond markets in May outdid the sack of Rome.

Not only did the Treasury bonds (TLT) get hit. The entire high yield space was slaughtered, including corporates (LQD), junk bonds (JNK), REITS (VNQ), master limited partnerships (KMP), municipal bonds (MUB), and high dividend equities. Anything that looked and smelled like a bond got dumped.

As American bonds get their clocks cleaned, so did virtually the entire fixed income space worldwide. Yields on ten-year Japanese government bonds nearly tripled from 0.37% to 0.95%. German bond yields skyrocketed, from 1.20% to 1.55%. Suddenly, a global capital shortage broke out all over like a bad rash.

So has the Great Reallocation out of bonds into stocks begun? Has the Great Bond Crash of 2013 only started? Or is there something more complex going on here?

Don?t worry, the bond market is not about to crash. All we are seeing is a move to a new trading range for the ten year, from 1.50%-2-10% to 1.90%-2.50%. This has been my forecast for the Treasury bond markets all year. High yielding instruments, like those in junk bonds and REITS, will see more dramatic price declines. There are several reasons why this is the case.

For a start, the economy is just too weak to support any further back up in rates. Much of corporate American has grown so used to free money that even a modest rise in rates would be cataclysmic. It was also drop the residential real estate recovery dead in its tracks. Watch the US government?s budget deficit soar, once again, if interest rates continue their assent.

A 2% GDP growth will never be a springboard for 4%, 5%, or 6% yields. In fact, the risk is that we slow down from here, forcing the Fed to come to the rescue with more accommodative swaths of quantitative easing.

Look at the inflation, that great destroyer of bonds. The last reported unadjusted YOY CPI by the Bureau of Labor Statistics came in at a gob smackingly low 1.1% in April (click here for the website).? Real deflation is anything but a major threat, and will not provide the rocket fuel for further bond selling. When you here of friends getting surprise 20% pay hikes, then you can expect a return in inflation. That has been happening in China for several years now. But so far, I have not heard the good news at home.

Check out who has been buying bonds for the last five years? More than half of the Treasury auctions have gone to foreign governments. First it was China, and more recently to European central banks. These people don?t sell. They just redirect new cash flows. You can count on them keeping the bonds they already have until maturity, even if it is 30 years out. They will never be the source of large scale selling.

Examine who has the highest fixed income weightings in the US. It is the fabled ?1%.? When I serviced some of the wealthiest old money families on behalf of Morgan Stanley during the 1980?s, I was struck by one thing. These were the most conservative people in the world. Protection of principal was their primary consideration. Interest income was almost an afterthought.

This is because the majority of wealthy investors inherited their money, and lived in constant fear they would lose what they have. This is because, as trust fund kids, they had no idea how to earn their own money and create new wealth. Once capital disappeared, it was gone for good. Get a job? Heaven forbid! This investor class also has no desire to get hit with the long-term capital gains such sales would generate. So don?t expect selling from them either.

So, at worst case, you might see another 20-25 basis point rise in Treasury yields to the top end of the new range. At that point, they will be a buy for a rally that might correspond to a stock market selloff and flight to safety bid for bonds which I expect this summer. This takes the ten-year back to a 1.90% yield.

This will be particularly crucial for those who have been trading leveraged short fixed income instruments like the (TBT). They saw a dramatic 12-point, 20% rally in May from bottom to top. Any further gains from here will be of the high risk, low return variety. Maybe, it?s time to sit down and smell the roses? Or take a long summer vacation, as I plan to.

Bonds Certainly Got Roughed Up in May

June 5, 2013/by Mad Hedge Fund Trader

When Sterilization is Not a Form of Birth Control

Diary, Newsletter

I received a flurry of inquires the other day when Ben Bernanke mentioned the word ?sterilization? in his recent congressional testimony. And he wasn?t giving advice to the country?s wayward teenaged girls, either.

Sterilization refers to a specific style of monetary policy. Sterilized policies seek to manipulate the money markets without changing the overall money supply. The Fed implemented just such a strategy in 2011 when they initiated their ?twist? policy. This involved buying 10, 20, and 30 Treasury bonds and selling short an equal amount of short-term Treasury bills.

The goal here was to force investors out of the safety of Treasury bonds and into riskier assets like stocks, commodities, and real estate. Given the market action since then, I?d say they succeeded wildly beyond their dreams.

Dollar for dollar there is no change in the Fed?s balance sheet when sterilized actions are undertaken, although there is a huge increase in the risk profile of their portfolio. A private institution would be insane to do this at this stage of the economic cycle, as the risk of capital loss is great. But governments are exempt from mark to market rules and can carry this paper at cost or par, whatever they want. That?s why we have a central bank.

The Fed is now running up against a unique problem. The twist program is so large that it is literally running out of short-term securities to sell. When this happens, they may well resort to 28-day repurchase agreements instead, which are essentially sales of short term paper out the back door. This is what Uncle Ben was attempting to explain to our congressional leaders, which I?m sure went straight over their heads.

The really interesting thing here is why Bernanke is suddenly interested in sterilization? These are the types of policies you pursue to head off inflation. With wages continuing to fall, it is difficult to see why this should be an issue.

Maybe he?s looking at the price of homes and the stock market instead, which have recently been going through the roof. Perhaps he?s looking several years down the road. The great challenge for the Federal Reserve from here will be unwinding their massive $3.5 trillion balance sheet it built up during the Great Recession, without triggering runaway price increases.

For an excellent explanation of the history of monetary sterilization, please click here at http://en.wikipedia.org/wiki/Sterilization_(economics).

No, Not This One

March 21, 2013/by Mad Hedge Fund Trader

The Muni Bond Myth

Newsletter

Have I seen this movie before? Four years ago, analysts were predicting default rates as high as 17% for Junk bonds in the wake of the financial meltdown, taking yields on individual issues up to 25%.

Liquidity in the market vaporized, and huge volumes of unsold paper overhung the market. To me, this was an engraved invitation to come in and buy the junk bond ETF (JNK) at $18. Since then, the despised ETF has risen to $41, and with the hefty interest income, the total return has been over 160%. What was the actual realized default rate? It came in at less than 0.50%.

Fast forward to two years ago (has it been that long?). Bank research analyst Meredith Whitney predicted that the dire straits of state and local finances will trigger a collapse of the municipal bond market that will resemble the ?Sack of Rome.? She believed that total defaults could reach $100 billion. This cataclysmic forecast caused the main muni bond ETF (MUB) to plunge from $102 to $93. Oops! That turned out to be one of the worst calls in the history of the financial markets. But the fees she earned making such a bold prediction landed her on Fortune?s list of the wealthiest women in America.

I didn?t buy it for a second. States are looking at debt to GDP ratios of 4%, compared to 100% for the federal government. They are miles away from the 130% of GDP that triggered distressed refinancing?s by Italy, Greece, Portugal, and Ireland.

The default risk of muni paper is being vastly exaggerated. I have looked into several California issues and found them at the absolute top of the seniority scale in the state's obligations. Teachers will starve, police and firemen will go on strike, and there will be rioting in the streets before a single interest payment to bond holders is missed.

How many municipal defaults have we actually seen in the last 20 years? There have only been a few that I know of. The nearby City of Vallejo, where policemen earn $140,000 a year, is one of the worst run organizations on the planet. Orange County got its knickers in a twist betting their entire treasury on a complex derivatives strategy that they clearly didn't understand, sold by, guess who, Goldman Sachs (GS). The Harrisburg, PA saga continues. To find municipal defaults in any real numbers you have to go back 80 years to the Great Depression. My guess is that we will certainly see a rise in muni bond defaults. But it will be from two to only a dozen, not the hundreds that Whitney is forecasting.

Let me preface my call here by saying that I don?t know much about the muni bond market. It has long been a boring, quiet backwater of the debt markets. At Morgan Stanley, this is where you sent the new recruits with the 'C' average from a second tier school who you had to hire because his dad was a major client. I have spent most of my life working with top hedge funds, offshore institutions, and foreign governments for whom the tax advantages of owning munis have no value.

However, I do know how to use a calculator. Decent quality muni bonds now carry 3% yields. If you buy bonds from your local issuer, you can duck the city, state, and federal tax due on equivalent grade corporate paper. That gives you a pre tax yield of 6%. While the market has gotten a little thin, prices from here are going to get huge support from these coupons.

Since the tax advantages of these arcane instruments are highly local, sometimes depending on what neighborhood you live in, I suggest talking to a financial adviser to obtain some tailor made recommendations. There is no trade for me here. I just get irritated when conflicted analysts give bad advice to my readers and laugh all the way to the bank. Thought you should know.

There are two additional tail winds that munis may benefit from in 2013. No matter what anyone says, your taxes are going up. Balancing the budget without major revenue increases is a mathematical impossibility. That will increase the value of the tax-free aspect of munis. A serious bout of ?RISK OFF? that sends the Treasury market to a new all-time high, as I expect this summer, will cause munis to rise even further.

Perhaps the best way to play this area is through the Invesco High Yield Muni A Fund (ACTHX), which boasts a positively Olympian 5.56% tax-free yield.

This is Not the Muni Bond Market

February 12, 2013/by Mad Hedge Fund Trader

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The Run in Bonds is Over

Bonds Certainly Got Roughed Up in May

No, Not This One

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