Munis

Over the past few months, munis have a hit hard, very hard. Even after the mild recovery since the end of June, index funds such as MUB (duration 7.17 yrs, distribution yield 2.97%) are down in excess of 7% YTD. High-yield munis, HYMB (duration 12.02 yrs, distribution yield 5.89%), are taking it even worse with a YTD drawdown of almost 12%. In a perfect storm of rising yields, illiquidity, high redemptions, and a default from Detroit to boot, munis are facing considerable challenges. HYMB, especially, is exhibiting considerable discount to NAV at the 3-5% level. Unfortunately, as others have noted, for highly illiquid assets such as muni bonds, the market price might actually be more accurate than the NAV. That said, even with the Detroit bankruptcy, which has been thrown back into court, the credit impact on HYMB should be muted as Detroit only comprises 1.33% of NAV and even all of Michigan only 3.53%. There is, however, the risk of other municipalities defaulting, but that risk has been there for a while. Note that muni bonds typically have high recovery rates (as high as 68%). The remaining headwinds of rising rates and redemptions will likely be challenging enough for the muni market. As the economy recovers and state coffers get replenished, the credit spread ought to tighten, but whether enough to counter the effect of rising rates is another question.

Election Day Yields

What does the fixed income market look like after a horrible superstorm and on the an election day which may or may not be decided quickly? Since the announcement of QE Unlimited, mortgage-backed securities prices have come down quite a bit as has their commercial MBS cousin. In fact, MBSes have been pulling back pretty much all day. Emerging market debt has pulled pulled back. The following table shows the 1 week max drawdown, max drawdown as a % of principal, and standard deviation of prices for several fixed income ETFs. I bond (savings bond) rates have been reset to a mere 1.76% due to persistently low CPI numbers.

Sym	MDD	(%MDD)	STD	Yield
AGG	0.39	0.35%	0.15	3.54
SHY	0.03	0.04%	0.01	1.13
LQD	0.78	0.63%	0.31	4.81
CSJ	0.17	0.16%	0.06	2.79
CIU	0.34	0.30%	0.12	4.20
JNK	0.13	0.32%	0.05	10.16
HYG	0.33	0.36%	0.13	8.68
MUB	0.28	0.25%	0.11	3.53
MBB	0.18	0.17%	0.07	3.58
CMBS	0.09	0.17%	0.07
TIP	0.5	0.41%	0.19	2.48
EMB	0.75	0.62%	0.27	4.93
ELD	0.16	0.30%	0.06

QE3 Fixed Income Aftermath

So what happens to fixed income after QE3? I thought it would be interesting to look at the max drawdowns versus the current 30-day SEC yields for a select cross-section of the fixed income ETF space for the past 52-weeks. All yields are quite compressed as is expected. Yields are so compressed that only MBB (US agency-based mortgage bonds) has a 30-day SEC yield exceeding the max drawdown. TIPs have negative yield as was true for quite a while now. It seems the contagion of return-free risk has spread to most of the fixed income ETF universe at this point.

Seeking Yield

Prolonged ZIRP has risk-averse conservative investors to a lot unlikely places. Mike Ashton, the Inflation Trader, who seldom recommends specific investments, has given a low-down on series I savings bond as a last bastion of "risk-free" inflation matching yield. Since TIPs are negative and nominal Treasuries have horrendously negative real yields, there aren't a lot of safe havens that make sense anymore. Investors have piled on corporates, emerging market debt, preferred shares, and even dividend-growers to bump up the scant yields they are seeing everywhere. Today, dividend-payers and growers (Schwab's dividend ETF (based on DJ US Dividend 100 Index) has a 30-day SEC yield of 2.99%) are looking like a relatively good deal when compared to Treasuries. But is all this risk worth it and what about the opportunity cost of sitting on short-term instruments? I bonds are interesting in that they have relatively high current yield (2.2%, the same as CPI-U) and are exempt for state income taxes (2.48% taxable equivalent yield for high income tax states). In fact, when the proceeds are used for educational purposes, it is also exempt for federal income taxes (meaning 3.8% taxable equivalent at maximum income tax rates). The term structure of these instruments are standardized: 30-years but redeemable penalty-free from 5-years. These instruments are not transferrable so there is no secondary market. The downside is that the excess fixed rate of return (set by Treasury) is guaranteed to be zero (which is better than TIPs right now) and each person can buy at most $10k worth of these.

Central Bankers at Jackson Hole

Well, the much anticipated Jackson Hole Bernanke speech has come and gone. Everyone from bloggers to the big fund managers have taken drastically different interpretations of the speech. Some argue that the speech was even more bullish than announcing a definite QE3 right then and there. Others interpret this as definitely indicating that there will be no QE3 soon and definitely not before the election. On Twitter, PIMCO's Bill Gross claims

"#Bernanke to go out with his guns blazing. #QE3 a near certainty. It will be open-ended but increasingly impotent."

Most of the I-bank analysts interpret the speech as calling for more easing and on fairly quick order.

Fixed Income Update

While equities have certainly entered summer doldrums, bonds have recently mounted an impressive rally. It's no surprise at this point that high-grade corporates are very popular for fixed income allocations since they are one of the few remaining bastions where one can obtain an inflation-beating yield. Since the May 22 near term trough, high-grade corporates (as represented by LQD), high-yield corporates (JNK), and intermediate term Treasuries (IEF) have rallied 3.49%, 3.76%, and 2.03% respectively. I am choosing to compare LQD to IEF because they have similar durations, 7.69 and 7.55 respectively. Though Treasuries have yet to reclaim their highs for the year (achieved on Jun. 1), high-grade corporates are looking at a multi-year high (the highest at least as far back as 2002). The correlation coefficient between LQD and IEF during the span between May 22 to July 9 stands at 0.737. Historically, for the nearly 10-year period from July 31, 2002 to July 6, 2012, the correlation coefficient between LQD and IEF stood at 0.952. The whole Treasury complex is quite richly valued at this point. Have we reached the point where high-grade complex are even more richly valued?

Asset Classes

Given the past few eventful weeks, I thought it would be interesting to review the state of the various asset classes. Below is a table with the 3-months returns for some ETF proxies for various asset classes.

Security	3 mos return
GLD	0%
OIL	7.4
JJC	7.7
GSC	9.1
LQD	4.4
JNK	3.7
EMB	4.4
LAG	-0.2
DIA	6.1
SPY	9.1
VWO	12
MDY	10.7
PFF	10.4

Notably, gold and bonds (LAG) are underperforming the other classes after tremendous outperformance last year (2011). With the good job numbers coming out in the past couple of months, the prospective for real growth is looking a little better, thus denting the appeal of gold despite the massive central bank easing through the world. Bonds, which have been looking a negative real yields for a while now, are still holding up pretty well all things considered. Of course, Operation Twist is probably still helping quite the bit.

Permanent Portfolio

Amidst the past few years of turmoil, Harry Browne's Permanent Portfolio is an interesting case. Browne is an investment manager, author, and two-time Libertarian Presidential candidates (for some reason a whole lot of investment managers are Libertarian). The Permanent Portfolio is composed of four equally weighted components: stocks, bonds (long-dated Treasuries), cash (short-term Treasuries), and gold (bullion). The Permanent Portfolio is currently available to the public in two forms: Michael J. Cuggino's Permanent Portfolio mutual fund (PRPFX) and Global X's Permanent ETF (PERM). Of course, one can certainly build one's own permanent portfolio using individual securities and ETFs. As least from PRPFX's perspective, the lost decade was hardly a lost decade. It returned a respectable 164% for the period 2002-2011. That isn't to say that there wasn't some volatility along the way. During the depths of the crisis from June 2008 to February 2009, the portfolio experienced the maximum drawdown of 19.6% (though max quarterly loss was only 6.86%). Cuggino's execution emphasized Swiss sovereigns (in Swiss francs so there is some currency exposure) alongside US Treasuries. For the growth component, he overweights energy, miners, and REITs.

Finance Research Papers

Here are some papers of interest I ran into recently:

Earnings versus Dividend Yields

Given the good Bank of America earnings announcement today, I thought it is fitting to look at the earnings yield versus dividend yield of the S&P over a 50 year stretch of time. The ratio has been growing for a long, long while. Back in the 1960s, companies paid out a lot more of their earnings in dividends. Even given the rising trend, the ratio seems over-extended at this point. We have pretty high earnings yield at 7.7% but only a 2.1% dividend yield. The ratio seems to fall whenever we have some recession or slowdown, indicating that dividend cuts may lag earning declines. Assuming that earnings yield at least hold the line (a big IF), the long term trend suggests an overall dividend yield of 2.57%.

Vicious Cycle

The Fed didn't ride in with the cavalry today. Looking from their perspective, why would they? The domestic data from the past few weeks did not indicate catastrophe. Popular support for further easing is tenuous at best. The main risk is from the debt situation in Europe. The evanescent hope that fueled the past few weeks' action dissipated just as quickly. The Dollar and Treasuries skyrocketed from the lows of the day. In Europe, there is a vicious cycle going on. The large private holders of sovereigns (i.e., banks and funds) insist on being made whole, thus pressuring the very sovereigns they don't want to default. The European governments insist on more and more austerity, negating what little chance they had to have secular growth lift them out of the mess.

A Paper on "High Frequency" Treasuries

There is a paper from London Business School dated from a while back (2002) that studies simple pairs strategies applied to the whole universe of US treasuries secondary market. The data used are intraday quotes and transaction information from GovPX (thus "high frequency"), which has since been acquired. The paper has an interesting table comparing equity and treasury markets (Table 1). One particular metric is the "social acceptance" of shorting the securities. The claim is that shorting equities has low acceptance whereas shorting treasuries is "less affected". The proposed strategies reduced the standard deviation of returns considerably though the level of returns were also dragged down somewhat. The best performing strategies generally kept risk controls very tight. When transaction and financing costs are accounted for, the returns start to trail the risk free return, though it outperforms equity and the treasury bond index in terms of Sharpe ratio and Gain-Loss ratio. Curiously, these strategies are slightly positively correlated with equities and slightly negatively correlated with the bond index.

Euphoria

The markets have been alternating quite quickly from euphoria to depression and back to euphoria. Today is one of those euphoric days. S&P e-mini December (ES) is up more than 3.2% as I write this. The 10-year (ZN) took a nose-dive after news from the central banks and ADP numbers (which were very good and came with a hefty upward revision of October numbers), but has recovered to a -0.23% loss. The dollar (DX) has tanked also at 78.450. The next big event is Friday Nonfarm Payrolls (NFP).

Options Expiration Friday

Today is options expiration Friday and Leading Indicators at 10:00am. Futures currently read as follows:

Contract	Price
ES Dec	1223.00
ZN Dec	130'155
DX Dec	77.840

Correlations

Looks like the stock market broke down a bit and is hanging outside the previous trading range. I put together a script to calculate correlation coefficients to see where things stand.

	spy	sdy	tlt	zroz	uup	gld	xle	xlf
spy	1.00	0.93	-0.68	-0.64	-0.34	-0.57	0.95	0.94
sdy	0.93	1.00	-0.41	-0.36	-0.15	-0.43	0.83	0.77
tlt	-0.68	-0.41	1.00	1.00	0.69	0.51	-0.77	-0.87
zroz	-0.64	-0.36	1.00	1.00	0.72	0.45	-0.75	-0.84
uup	-0.34	-0.15	0.69	0.72	1.00	-0.08	-0.53	-0.51
gld	-0.57	-0.43	0.51	0.45	-0.08	1.00	-0.42	-0.61
xle	0.95	0.83	-0.77	-0.75	-0.53	-0.42	1.00	0.95
xlf	0.94	0.77	-0.87	-0.84	-0.51	-0.61	0.95	1.00

The correlation coefficients are computed for the past 100-days of returns calculated from adjusted closing prices for each asset. There is a little something for everyone here. Equities (SPY) and dividend-paying equities (SDY) have strong correlations. Despite appreciating crude prices, energy stocks (XLE) are still strongly tied with equities as a whole. To get negative correlation with equities, one may look to treasuries (TLT and ZROZ [Pimco Long Dated Zeros]), the dollar, and gold. TLT and ZROZ similar but in terms of correlations with other assets, it happens to be TLT that exhibits the slightly more pronounced negative correlations despite ZROZ being more of a pure play. Surprisingly, the least correlated assets in this study are gold (GLD) and dollar (UUP).