January 2013
Pam Flournoy, CFP® Flournoy Wealth Management Financial Advisor
1165 Lincoln Avenue, Suite 330 San Jose, CA 95125 408-271-8800 Fax: 408-271-8833 [email protected] www.flournoywealthmanage ment.com
CA Insurance Lic# 0E58750
In This Issue
Outlook 2013 | The Path of Least Resistance
In 2013, many different forces will combine to influence the direction of the markets to follow the path of least resistance leading to modest single-digit returns in the U.S. stock and bond markets.
Bond Market Perspectives | Week of December 17, 2012
On a longer term basis, we find municipal bonds one of the more attractive high-quality bond options, and in what is likely to be a low-return environment going in 2013, such pullbacks may provide opportunity.Outlook 2013 | The Path of Least Resistance
Dear Valued Investor,
In 2013, many different forces will combine to influence the direction of the markets to follow the path of least resistance leading to modest single-digit returns in the U.S. stock and bond markets.* The path for the year may be set at the end of 2012, or in early 2013, as policymakers implement critical decisions.
We foresee three potential paths in the year ahead. Our base case path is supported by our view that key decision makers will find it is better to determine a way to overcome an avoidable and unnecessary economic recession, buy time to actually propose and vote on competing long-term fiscal visions, and do something to help restore confidence in Washington's ability to govern.
However, there are paths that differ from this base case outcome: a bear path where the consequences of fiscal contraction damage confidence as well as the economy, and a bull path where an historic opportunity to address the U.S.'s long-term fiscal challenges is embraced and leads to sustainable solutions. Which of these three is the path of least resistance is likely to be determined by the end of the first quarter of 2013.
Please enjoy the enclosed Outlook 2013 that provides a comprehensive perspective on the markets and the economy -- with a focus on the path of least resistance -- and the many factors that will influence them in the year ahead.
IMPORTANT DISCLOSURES
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
*Equity market forecast is for the S&P 500 Index and is based upon a low-single-digit earnings growth rate supported by modest share buybacks combined with 2% dividend yields and little change in valuations. Bond market forecast is for the Barclays Aggregate Index and is based upon a less than one percentage point rise in rates, with price declines offset by interest income.
This research material has been prepared by LPL Financial. Tracking # 1-120355 Exp. 12/13
Bond Market Perspectives | Week of December 17, 2012
Highlights
Several factors combined to spark a notable municipal bond market sell-off last week.
Pressures may persist over coming days, including many seeking to sell after recent gains and poor year-end liquidity.
On a longer term basis, we find municipal bonds one of the more attractive high-quality bond options, and in what is likely to be a low-return environment going in 2013, such pullbacks may provide opportunity.
Early Lump of Coal for Municipal Bonds
After presenting investors with good returns for much of 2012, the municipal bond market handed investors an early lump of coal last week. The Barclays Municipal Bond Index declined 0.8%, the worst weekly decline in just over a year. There was no "naughty" behavior to single out. Defaults among municipal issuers remain isolated and continue to decline, and valuations remain attractive relative to Treasuries on a longer term basis. Nonetheless, several factors combined to spark a sell-off and a difficult week for municipal bond investors.
Heavy new issuance. One of the largest weeks of new bond supply in 2012 was the primary catalyst for municipal bond weakness. More than $11 billion in new issuance was scheduled to come to market but met weak demand. Bond dealers, who typically get conservative as year-end approaches, cut prices sharply to avoid holding excess inventory.
Strong recent performance. The tepid response to new issuance was likely exacerbated by recent strong performance, and investors held back. Since the November 6, 2012 election, the municipal bond market outperformed Treasuries by nearly 1.0%, according to Barclays Index data. To illustrate, from November 6, 2012 through December 7, 2012, the average AAA-rated 10-year municipal bond yield declined by 0.24% compared to the 0.13% decline of the 10-year Treasury yield.
Record-low yields. Along with strong performance came higher prices and record-low yields. Record-low yields hindered investor demand just when the market needed to help absorb hefty supply. Record-low yields gave investors reason to hesitate-or simply wait on the sidelines.
Increased talk of a 28% cap. News reports suggested that a 28% cap on all allowable exemptions (mortgage interest, state and local taxes paid, and of course municipal bond interest income), was gaining traction in Washington as fiscal cliff negotiations continued. Capping the tax exemption of municipal interest income would make municipal bonds less attractive relative to other fixed income investment choices and gave investors contemplating a sell one more reason to do so.
Surge in secondary market sells. All of the above factors led to a surge in bonds for sale [Figure 1]. The five-day moving average of the par value of bonds seeking sale (known as "bid-wanteds" in the marketplace) surged to levels not seen since Meredith Whitney's negative comments on municipal bonds in late 2010. Whitney predicted a wave of defaults possibly totaling $100 billion leading to a sharp sell-off, but the default wave never came remotely close to materializing.
The recent sell-off is on pace to be the worst of 2012, exceeding pullbacks in March and June of this year. Treasury market weakness, also a factor in the current sell-off, combined with seasonal tax-related selling and then record-low yields drove the March 2012 pullback. June witnessed a more modest sell-off related to a seasonal surge in issuance at the start of the month.
In the coming days, we believe additional modest weakness may persist due to the large amount of bonds in the secondary market looking to be sold. In addition, with year-end approaching, most bond dealers get conservative, and their support of the market is likely to be limited. Furthermore, the municipal bond market,
as measured by the Barclays Municipal Bond Index, is still up over 7% year-to-date through last Friday, December 14, 2012, and may spark additional profit taking on what is still a good year relative to the broad taxable bond market, up 4.2%, and Treasuries, up 2.1%, both according to Barclays Index data.
On a positive note, new supply drops off sharply over the remainder of the year and the first week of January. This week, less than $3 billion is scheduled to come to market versus $11 billion last week, and the Christmas and New Year's holiday weeks should see extremely limited issuance. We believe the bulk of weakness may be behind us due to the sharp drop in new issuance, but stabilization may be the best investors can anticipate in the coming days. A bounce back is unlikely, given illiquid trading conditions that are likely over the coming two weeks as a result of the Christmas and New Year's holidays. Importantly, unlike the late 2010/early 2011 sell-off, widespread default fears that ultimately proved to be widely misguided are not behind the current sell-off.
Supply-related sell-offs do occur in the municipal bond market but can give way to opportunity. Over the past five years, a period that includes the 2007-2009 financial crisis and Great Recession, the municipal market has experienced a pullback of 0.7% or more over five trading sessions (one week) many times. Our analysis of daily return data for the Barclays Municipal Bond Index over that time frame indicates that the median return over the subsequent 20 days (four weeks) is 0.74%. We take these results with a grain of salt, since it does not rule out negative returns over the subsequent four-week period. However, we find it supports prospects for the market to bounce back once short-term supply imbalances recede.
Over the longer term, we continue to find municipal bonds attractive. The favorable supply-demand backdrop underpinning the market for much of the past few years remains intact. The municipal bond market is likely to exhibit very limited net new growth in 2013 with total supply to be similar, or only slightly greater, than that of 2012. Additionally, we believe market reaction to a potential 28% cap on municipal interest income is
premature. Tax treatment of municipal bonds could take several forms (e.g., older issues could be grandfathered leading to a potential rally), and we would not make trading decisions based solely upon anticipating changes to tax treatment. Furthermore, higher tax rates without a cap would likely bolster municipal bonds.
Municipal bonds remain one of our favorite high-quality bond sectors to eke out the best of what is likely to be a low-return environment in 2013 (please see our Outlook 2013 and the December 4, 2012 Bond Market
). The lackluster return environment that is likely in store for bond Perspectives:Fixed Income 2013 Outlook
investors in 2013 is cause for a contrarian view, in our opinion. Such bouts of weakness should be used by investors to bargain hunt and lock in more attractive yields or total return opportunities in the municipal bond market.
IMPORTANT DISCLOSURES
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.
Corporate bonds are considered higher risk than government bonds, but normally offer a higher yield and are subject to market, interest rate
Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free, but other state and local taxes may apply.
Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.
High-yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
An obligation rated 'AAA' has the highest rating assigned by Standard & Poor's. The obligor's capacity to meet its financial commitment on the obligation is extremely strong.
Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.
Default rate is the rate in which debt holders default on the amount of money that they owe. It is often used by credit card companies when setting interest rates, but also refers to the rate at which corporations default on their loans. Default rates tend to rise during economic downturns, since investors and businesses see a
decline in income and sales while still required to pay off the same amount of debt.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
INDEX DESCRIPTIONS
Barclays Aggregate Bond Index: is comprised of the Barclays Government/Corporate Bond Index, Mortgage- Backed Securities Index, and Asset-Backed Securities Index, including securities that are of investment-grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $100 million.
The Barclays Municipal Bond Index is a market capitalization-weighted index of investment-grade municipal bonds with maturities of at least one year. All indices are unmanaged and include reinvested dividends. One cannot invest directly in an index. Past performance is no guarantee of future results. This research material has been prepared by LPL Financial.
To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.
guarantee of future results. All indices are unmanaged and cannot be invested into directly.
LPL Financial, Member FINRA/SIPC
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