We Need BABs!
June 21, 2011
Yields on Treasury notes and bonds are at lows for the year, following weak economic data and declining equity and commodity markets. Higher food and energy prices drained the budget of a consumer sector that is saddled with a high debt burden and poor job and income prospects. Given that backdrop, spreads on investment-grade corporate bonds are at the tightest levels since the financial crisis first appeared. Corporate bond issuance has been very robust, reaching $384 billion in 2010 and $514 billion through June!
The corporate bond market was the first sector to heal from the financial crisis, as institutional investors correctly predicted lower chances of default in all subsectors except financials. Spreads have tightened dramatically across the credit curve from AAA to BBB. AAA-rated 30-year industrial bonds trade around 60-70 basis points higher in yield than the comparable Treasury bond. In the ten- year maturity range, AAA-rated industrials trade at roughly 50 basis points over the ten-year Treasury note. Single-A-rated telecoms like Verizon or AT&T trade at roughly 115 basis points over the ten-year Treasury. We believe spreads are narrow because of the dearth of supply from other sectors. The securitization markets have shut down for all intents and purposes. The commercial mortgage- backed securities market and private-label residential mortgage-backed securities market barely exist. Even the short-term commercial paper market has seen issuance decline over 60%, despite the fact short-term rates are close to zero.
The employment situation in the U.S. is not healthy. Construction employment and housing-related employment have fallen dramatically. The housing bust and financial markets collapse wiped out a tremendous amount of household wealth. Consumers have seen the value of their assets shrink while their liabilities remained the same or even increased. This situation, where liabilities are greater than assets, is called a balance-sheet recession, a term coined by Richard C. Koo of the Nomura Research Institute and author of the book The Holy Grail of Macroeconomics. His book discusses Japan’s experience of the last twenty years, as well as the Great Depression. His analysis suggests that monetary policy is ineffective in combating a recession caused by a financial shock. He argues that fiscal policy is the only remedy.
The municipal bond market is ideally suited to stimulate growth and also replace the lack of supply in the debt markets through some reincarnation of the Build America Bond (BABs) program. This program was a huge success in 2009 and 2010 by way of expanding the investor base of municipal debt. Pension funds, foundations and endowments, sovereign wealth funds, and others recognized the value, diversification, and low default risk these bonds offer. Last week the bipartisan congressional Joint Tax Committee published a report stating that permanently reinstating the Build America Bonds program would only result in a cost (loss of revenue) of approximately $5.7 billion dollars over a ten-year period. The cost savings to issuers would be significant, and the increased supply would be welcomed by investors in every category. Most importantly, it would help put people back to work.
States have made tremendous headway in reducing costs and increasing revenues. This year, state and local debt has contracted at the fastest rate since 1996. As a percentage of GDP, debt at the state and local level is at 16% and declining. Difficult decisions regarding budgets and expenditures are being made in state capitals and town halls across the country. States also know what projects are important and can manage them better than federal agencies. To relieve the pressure on household balance sheets, a long-term infrastructure initiative is necessary. It would have the benefit of improving our roads, water systems, ports, and transportation systems. An initiative like the BABs program would likely achieve what monetary policy is unable to accomplish: the creation of stronger, long-lasting economic activity.
Peter Demirali, Managing Director and Portfolio Manager
Peter Demirali is a portfolio manager and heads Cumberland’s taxable fixed income area and is a long time veteran of taxable fixed income markets. He is a member of Cumberland Advisor’s Management Committee. His bio may be found at www.cumber.com. Comments on this article may be directed to firstname.lastname@example.org.
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