The Municipal Bond World, According to John Derrick
July 19, 2014
by Frank Holmes
of U.S. Global Investors
As we move into the second half of 2014, the Federal Reserve has continued to reduce its stimulus measures intended to boost the U.S. economy. Just this week we heard rumors from Fed officials that if the job market improves faster than expected, key interest rates may be increased sooner than expected.
While the Fed is gradually reducing stimulus measures in the U.S., other areas of the world are embarking on new monetary stimulus measures. More than ever before, we are feeling the impact of the global economy, with monetary stimulus programs in Europe and Japan taking pressure off of the Fed, and ultimately contributing to the bond market rally we have seen so far this year. The European Central Bank (ECB) recently cut its rates to negative on worries of deflation and on the possibility of slower or no growth in the eurozone.
I sat down with Director of Research John Derrick, who also manages our Near-Term Tax Free Fund (NEARX), to get his thoughts on interest rates, the bond market and what investors should pay attention to as we move into the second quarter of 2014.
After hearing what the Fed officials said on interest rates this week, what is your outlook?
There are a lot of Fed officials with their own opinions, but I think it’s important to focus on what the Fed Chairman is saying. Janet Yellen said that rates are not going up, and although we’ve seen steady labor market improvements, it hasn’t been anything dramatic. For these reasons, I think an interest rate increase is still at least a year away.
How will this affect the municipal bond market?
Each time the Fed has announced tapering measures, investors have been fearful. If you look back at each of these instances, though, whenever the Fed took stimulus away, the market rallied due to fear of economic slowing. We did see a solid rally in the bond market during the first half of this year. I think interest rate increases are far enough away to still have a constructive position within the bond market, so to me the outlook is positive moving towards 2015.
How can investors take advantage of municipal-bond benefits?
On a tax-adjusted basis, municipal bonds have a very compelling risk-reward profile, which means the risk-adjusted returns are high. To take advantage of this, I would encourage investors to add exposure to their portfolio by investing in a product that holds high-quality, traditional municipal bonds. These are the type of bonds we look for and hold within the Near-Term Tax Free Fund. Our fund is in the “sweet spot” you could say; not too long, not too short, with some interest rate risk, but manageable for most investors. NEARX has generated consistent, positive annual returns and has been run by the same portfolio manager for 15 years.
For investors that like to sleep well at night, I think the fund is an attractive way to gain exposure to muni bonds. This is not the type of fund where you are going to be surprised with an unusual credit event that causes a significant impact. When choosing investments for the fund, I have a buy and hold mentality, letting the investments benefit the fund over time. The turnover of NEARX is very low and it has performed very well against its peers; take a look at the recent performance. Additionally, the fund seeks preservation of capital, and has a floating $2 NAV that has demonstrated minimal fluctuation in its share price.
How has the situation in Puerto Rico spooked the bond market?
Puerto Rican municipals are an area of the market that nobody really thought could declare bankruptcy, so what happened there didn’t help investors’ views of the muni market. We still have a small exposure to Puerto Rico within our fund. Our Puerto Rican positions are insured, however, which is important to help mitigate the risk aspect in this type of investing.
Our Near-Term Tax Free Fund has an overall Morningstar rating of 4 stars.* The fund is diversified and invests in municipal bonds with relatively short maturities, seeking to provide tax-free monthly income. If you’re looking to add tax-free bonds to your portfolio, with the option of modest allocation to this area of the market, I encourage you to request an information packet and take a closer look.
*Morningstar Overall Rating™ among 163 Municipal National Short funds as of 06/30/2014 based on risk-adjusted return.
- Major market indices finished higher this week. The Dow Jones Industrial Average rose 0.92 percent. The S&P 500 Stock Index advanced 0.54 percent, while the Nasdaq Composite gained 0.38 percent. The Russell 2000 Small Capitalization Index fell 0.72 percent this week.
- The Hang Seng Composite rose 0.79 percent. Taiwan fell 1.00 percent and the KOSPI advanced 1.54 percent.
- The 10-year Treasury bond yield fell four basis points to 2.48 percent.
Domestic Equity Market
The S&P 500 Index bounced back after last week’s selloff, rising about 50 basis points. Technology stocks led the way with strong results from oldies such as Intel and Microsoft. Financials and telecom services also had a good week, while health care brought up the rear.
- The technology sector rose more than 1.5 percent. Intel rose 8 percent as the company reported strong results across product lines including PCs, laptops and mobile. Large cap tech was well represented this week with strong performances from Microsoft, Google and Facebook.
- The financial sector was strong as the brokerage stocks performed well, mostly on the back of earnings. Citigroup led the way, rising 5.45 percent, but JP Morgan, Goldman Sachs and Morgan Stanley were also outperformers and not far behind this week.
- Time Warner was the best performer in the S&P 500 Index this week, rising more than 20 percent. Time Warner, whose stock closed the week at $87.23, confirmed that it had rejected a takeover proposal from Twenty-First Century Fox that valued Time Warner at $85 billion.
- The health care sector was the worst performer this week. In Federal Reserve Chair Janet Yellen’s written report to Congress this week, the Fed highlighted concerns regarding valuations in several markets and specifically mentioned small cap biotech companies as an area of concern. These comments weighed on the entire biotech sector, with Biogen Idec, Celgene and Regeneron Pharmaceuticals among the worst performers for the week.
- The consumer staples sector also underperformed this week. The key negative driver for the sector was the conclusion of the long-running takeover saga in the tobacco area with Reynolds American entering an agreement to acquire Lorillard. This effectively ended the speculation around what