Executive Summary

The Yield Curve Flattens: The market appears to believe low inflation and slow growth in a still leveraged society will keep interest rates down for an extended period of time.

Europe Is Still a Mess: Interest rates continue to fall in Europe causing the euro to drop in value against the dollar.

Taxable and Tax-Free Markets: It was a volatile quarter marked by selloffs in July and September in taxable bonds, and a quiet quarter in the municipal markets.

Two and five year rates have risen as the economy is improving and the front end of the yield curve anticipates a future rate hike. However, 10 and 30 year interest rates continue to decline causing the yield curve to flatten. I don’t believe the market response is what the Fed had anticipated. The Fed is model driven and the bond market is not. The Fed would like to see a steep yield curve. However, the market appears to believe low inflation and slow growth in a still leveraged society will keep interest rates down for an extended period of time.

U.S. Treasury Interest Rates
3/31/14 6/30/14 9/30/14
2 year 0.42% 0.45% 0.57%
5 year 1.71% 1.63% 1.75%
7 year 2.30% 2.13% 2.20%
10 year 2.71% 2.53% 2.49%
30 year 3.55% 3.36% 3.16%
Source: Bloomberg


QE: “Gone with the Wind”

The Fed continued to pair back on QE II, reducing bond purchases again, and it is believed QE will be wound down to zero by October or November. And the market’s response to this is?

Frankly, my dear Janet, I don’t give a damn about higher long term rates.

~The Market

Europe Is Still a Mess

Here is a snapshot of global interest rates at the end of the third quarter 2014:

Global Government Bonds as of 9/30/2014
5 year 10 year
6/30 9/30 6/30 9/30
France 0.64% 0.64% 1.69% 0.64%
Germany 0.34% 0.34% 1.24% 0.34%
Italy 1.35% 1.35% 2.85% 1.35%
Spain 1.27% 1.27% 2.66% 1.27%
Portugal 2.36% 2.36% 3.64% 2.36%
Source: Bloomberg


Mario Draghi’s Day Off

Not shown on this global interest rate chart is that German two year rates are negative. Europe is suffering from deflationary pressures and stagnant growth in the periphery countries of the euro. Mario Draghi is trying to begin a QE program in Europe that can replicate the results the U.S. Federal Reserve has produced. The result of his efforts has been that interest rates continue to fall in Europe causing the euro to drop in value against the dollar.

Central banks response to slowing economic conditions has been to debase their currency, which in theory increases exports. Will it take the euro reaching parity with the dollar to start an economic recovery?

Mario?…..Mario?……Anyone? ……Anyone??

The Taxable Portfolios

The U.S. Dollar Index bottomed on July 1st and began a 12 week move up. The result was increased bond market volatility in high yield bonds. A high yield sell-off in July was followed by a snap-back rally in August. Another round of high yield selling occurred in September, breaking the July lows to end the quarter.

The higher dollar has caused commodity prices to drop across the board. Oil, copper, nickel, iron ore — all are down. Energy and material bond holdings were down sharply. We are monitoring the energy holdings and looking to increase our allocation to healthcare in the upcoming quarter.

The Tax Free Portfolios

It was another quiet quarter in the municipal market, volatility wise. We have been shortening our stated maturities in the portfolio and concentrating on 4% coupons from 5 to 20 years. In our opinion, 5% coupon bonds with short calls in the 2017-2019 range, which we had bought in the past, don’t seem to present any value. Therefore we will continue to look for value in the 4% coupon structure.

On the macro front, news from Puerto Rico has been quiet and bonds have seemed to find equilibrium. If stocks close higher in the fourth quarter and for the year, the next sell off may be tax selling as investors look to harvest losses in 2014.

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