A Tale of Two Sectors: BABs and Everyone Else, (4/1/11)

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 peter.demirali@cumber.com.

The taxable bond market appeared to have a rather uneventful quarter, looking at where the quarter started and where it ended. Yields were a touch higher at quarter- end, but not significantly. However, there were plenty of crosscurrents, speed bumps, and turbulence along the way. Economic data in general showed growth domestically as well as globally. The industrial sector continued to chug along at a brisk pace, although the durable goods report for February showed some surprising weakness. Business surveys report growth, and optimism recovering. The employment situation has improved somewhat, with the private sector adding to payrolls while state and local governments continued to shed workers. A very mixed picture.

Build America Bonds took home the Oscar for Best Sector in the U.S. investment- grade bond universe for the quarter. As of March 31, 2011, this sector returned 2.41%, according to the Merrill Lynch Build America Bond Index. There were a number of reasons for this outperformance. The primary reason was the scarcity premium. The Build America Bond program (BABs) was introduced in the first quarter of 2009 and expired on 12/31/10. The program was a resounding success, allowing state and local governments to lower their borrowing costs for infrastructure projects, as well as expanding the investor base in municipal bonds to include pension funds, taxable bond funds, and foreign investors. Lack of supply and continued demand caused prices to rise and spreads to narrow. Another reason for the outperformance is the substantially higher yields BABs offer when compared to similarly rated corporate bonds. Triple-A-rated BABs can offer spreads 25-50 basis points higher than triple-A-rated corporate debt. Single-A- rated BABs often offer 75-150 basis points higher yield than A-rated industrial or utility bonds. Those higher-coupon BABs bonds generate significantly more coupon returns in a market that is more or less unchanged. Another justification for why these bonds have performed so well is that BABs provide diversification and high credit quality (low default risk relative to corporate debt) that money managers and pension funds cannot get elsewhere. Many of these managers have been underweight this sector relative to the benchmark and needed to add these bonds to the portfolios they manage.

Cumberland Advisors was one of the earliest to capitalize on the generous yields and high credit quality of BABs. Our decades of managing tax-free portfolios gave us a jump on other money managers and pension funds in allocating to this sector, as we were quite familiar with many of these credits. Most of our taxable-bond portfolios have a significant overweight to this sector. Since most of these bonds have a longer duration, the added yield and steepness of the yield curve (difference between short-term and long-term rates) have allowed our portfolios to generate returns in excess of the benchmark. We anticipate this trend of narrowing spreads and higher prices will continue for at least another quarter or two.

Published with permission from our friends, Cumberland Advisors