SMC Fixed Income Management

A much colder than normal winter throughout the United States has impacted daily activities. Folks are remaining indoors and waiting for the March thaw. Not only are there fewer pedestrians, but runners are a rare sight. The logical inference is that many dedicated exercisers have retreated to the warmth of their basements or local health clubs for exercise, and are instead logging miles on stationary treadmills.

Pick your poison: weaker oil and copper prices; increasing gold demand; Swiss Franc and Canadian Dollar devaluations; another possible Greek tragedy; launch of European Central Bank (“ECB”) bond buying program; waning emerging markets; weakening U.S. stock prices; global deflation worries. It appears to us that the broadening global weakness could be beginning to negatively impact the U.S. expansion. Given the current state of global events, we see no reason for the Fed to prematurely move ahead with its rate normalization plan as many anticipate occurring by mid-year 2015.

"Constructive but cautious is our 2015 mantra. Price appreciation has been a major contributor to portfolio performance as evidenced by the yield curve shift from the beginning of the year. 2015 market performance should largely be determined by income, with less support from declining yields.

The most surprising and impressive asset class performance has been generated by long-term municipal bonds. Most pundits were calling for negative market performance again this year following the sharp 2013 sell-off; no one we know of (ourselves included) foresaw the stellar returns achieved through the years first ten months.

While tax-exempt yields did follow Treasuries higher during September, the snap-back has been fast and significant; yields have recently established new twelve-month lows. Meanwhile, investors appear to be repositioning from equity and other asset classes into fixed income. The move to bonds includes municipal securities, as evidenced by strong flows into tax-exempt funds, which is forcing cash-laden portfolio managers to buy at the highest prices of the year.

Heightened international unrest and the likelihood of accelerating economic weakness in Europe will provide further support for fixed income securities. It is unlikely central banks will move from their current accommodative monetary positions anytime soon. Since we do not anticipate a meaningful upward move in Treasury rates, municipal bond prices should also benefit. Yields are likely to remain close to current levels and even possibly move lower. Strong market technical factors will also provide support.

Financial market conditions were as good as could be expected during the first half of the year, as evidenced by positive investment performance across all asset classes.

In order to gauge the potential impact of an interest rate hike on a fixed income portfolios performance, not only does the amount of the rate move have to be ascertained, but the timing and duration must also be quantified. In summary, investors should not necessarily jump to the conclusion that rising interest rates automatically result in negative total returns.

Rarely do the financial markets provide the double treat of simultaneously rising equity valuations and falling bond yields. Almost midway through the second quarter of 2014, key stock indices reached new all-time highs while global bond yields have retreated to levels not seen in over six months. Something has to give: either stock prices retreat or yields rise. Right? At least this is the popular assumption supported by classic economic rationale for a normal investment environment.