Advanced Fixed Income: Municipal Bonds, Interest Rate Swaps, and Preferred Stock

Market Context and Current Economic Climate

  • Semester Performance Observations

    • The semester began approximately one month ago. Since then, the Fed funds rate has remained unchanged, and the Secured Overnight Financing Rate (SOFR) has experienced minimal movement.

    • Yield Curve Flattening: There has been a distinct flattening of the yield curve this semester.

      • Short End: The short end of the yield curve is up. This is attributed to the Federal Reserve signaling a tightening bias.

      • Long End: The longer end of the yield curve is down. This is driven by expectations of lower inflation.

    • Inflation Expectations: Inflation expectations (e.g., the five-year expectation) are down significantly, dropping by approximately 4040 basis points. Much of this shift occurred following recent market developments and bond market activity.

  • Commodity and Economic Indicators

    • Oil Prices: One month ago, oil was priced at approximately $103\$103. It recently dropped to approximately $74.75\$74.75. This significant decline has directly contributed to the reduction in inflation expectations.

    • Bond Market Resilience: If interest rates are down, especially at the long end, bond prices are up. The market has seen a 1.1%1.1\% increase in certain debt instruments.

    • Yield Spreads and Volatility:

      • Fixed-rate mortgages are at approximately 7%7\%.

      • The ten-year Treasury note is down 1010 basis points.

      • The ICE Index (a measure of volatility or the "fear index" for bonds) has decreased, suggesting less market uncertainty.

    • Gold Markets: Gold has faced downward pressure, which is typical when the dollar is strong and short-term interest rates are rising. Gold does not provide a coupon or interest rate, making it less attractive in a rising-rate environment. While short-term trends are down from late January peaks, the long-term outlook remains bullish due to government spending levels.

The Federal Reserve and Kevin Walsh

  • Press Conference Highlights

    • Kevin Walsh's first-ever press conference signaled a return to basics: maximum employment and price stability.

    • Focus on Price Stability: Walsh emphasized that price stability is currently the most critical objective, suggesting the Fed had "lost its way" over the last decade by becoming involved in political issues.

    • Tightening Bias: The Fed indicated a definitive tightening bias. Because markets generally prefer loose monetary policy, the stock market dropped significantly following the announcement.

  • The Two-Year Treasury Note Sensitivity

    • The two-year Treasury note is the most sensitive to Federal Reserve policy.

    • On "Fed Day," the two-year Treasury experienced a 1313 basis point rise in yield (which corresponds to a drop in price).

    • This was the largest move on a Fed Day since 20082008.

  • Policy Shifts and Skepticism of Data

    • Forecasting: Walsh expressed a desire to reduce the amount of forward forecasting. The speaker notes that the Fed is often wrong in its forecasts because data changes rapidly.

    • Data Quality: There is growing skepticism regarding traditional data metrics, such as jobs numbers, which are frequently revised. Response rates for surveys have declined, making for a less reliable sample than in previous decades.

    • News Interpretation: Walsh argued that the market should interpret news for what it is, rather than obsessing over how the Federal Reserve will interpret that news. This aims to reduce the disproportionate power held by the organization.

  • Fed Funds Hike Probability

    • In the next 4040 days, the market sentiment has shifted.

    • Approximately 85%85\% of the market now expects a rate hike by the end of the year, while only 15%15\% believe rates will remain the same.

    • Some extreme market participants anticipate a jump of as much as 100100 basis points.

Discussion of "The Big Short" and Financial Crises

  • Investment Strategy and Market Dynamics

    • The film follows three hedge funds that identified the impending collapse of the mortgage market and sought to profit through Credit Default Swaps (CDS).

    • Liquidity and Regulation: Pre-20082008, the CDS market was illiquid, non-regulated, and lacked transparency. Prices were often set by the sellers themselves. Eventually, market pressure and high demand forced prices up to reflect reality.

    • The AIG Bailout: Firms holding CDS were at risk of getting zero if their counterparty (like AIG) went insolvent. The bailout of AIG by the government ensured these hedge funds could collect their profits.

  • Credit Rating Agencies

    • Moody’s and Fitch were criticized for "rubber-stamping" triple-A (AAA) ratings on top tranches of subprime debt because they were backed by monoline insurance and other mechanisms.

    • Modern equivalents, such as Collateralized Loan Obligations (CLOs), are considered safer than the old CDOs because they are backed by more reliable mortgages.

  • Market Bubbles

    • The Japan Bubble (Late 80s): A simultaneous stock market and real estate bubble. When both popped, Japan entered a three-decade economic stagnation.

    • US Dot-Com Bubble (Late 90s): Market valuations were justified by the revolutionary nature of the internet despite a lack of cash flow or profits.

    • The "Cab Driver/Janitor Effect": A theory suggesting that a market bubble is peaked when non-experts (like cab drivers or janitors) begin providing investment advice because "everybody is an expert" during a massive upswing.

Municipal Bonds (Munis)

  • Definition and Types

    • Municipal Bond: A bond issued by a government entity other than the federal government (cities, states, counties, airports, waterways, or universities).

    • General Obligation (GO) Bonds: Approximately one-third of the market. These are backed by the "full faith and credit" of the issuer, specifically their ability to levy taxes on the local population.

    • Revenue Bonds: Approximately two-thirds of the market. These are backed by the revenue generated by the specific project the bond funded (e.g., tolls from a bridge, concessions from a stadium).

  • Tax Implications

    • Most munis (roughly 85−90%85-90\%) are federally tax-free regarding their coupon interest.

    • If a resident of Alabama buys an Alabama muni, the interest is tax-free at both the federal and state levels.

    • If that same resident buys a Georgia muni, they still pay Alabama state income tax on that interest.

    • Capital gains from selling a muni early are still subject to capital gains tax.

    • Target Audience: Munis are primarily purchased by the wealthiest individuals in the highest tax brackets (37%37\% federal) because the tax-free benefit is most valuable to them.

  • Mathematical Analysis of Munis vs. Corporates

    • Scenario: A two-year Corporate double-A bond (4.34%4.34\% yield) vs. a two-year Muni double-A bond (2.88%2.88\% yield).

    • Combined tax rate (Federal 37%37\% + Alabama State 5%5\%) = 42%42\%.

    • Method 1: After-Tax Corporate Yield         4.34%×(1−0.42)=2.52%4.34\% \times (1 - 0.42) = 2.52\%

      • Conclusion: The Muni (2.88%2.88\%) is better than the after-tax Corporate (2.52%2.52\%).

    • Method 2: Taxable Equivalent Yield         2.88%(1−0.42)=4.97%\frac{2.88\%}{(1 - 0.42)} = 4.97\%

      • Conclusion: The Muni is equivalent to a taxable bond yielding 4.97%4.97\%. Since the Corporate only offers 4.34%4.34\%, the Muni wins.

    • Method 3: Indifferent (Breakeven) Marginal Tax Rate         1−Muni YieldCorporate Yield=1−2.884.34=33.64%1 - \frac{\text{Muni Yield}}{\text{Corporate Yield}} = 1 - \frac{2.88}{4.34} = 33.64\%

      • Decision Rule: If your marginal tax rate is above 33.64%33.64\%, buy the Muni. If it is below, buy the Corporate.

Interest Rate Swaps and the Silicon Valley Bank (SVB) Failure

  • The Mechanics of a Swap

    • An interest rate swap typically involves swapping a fixed-rate payment for a variable-rate payment.

    • The SVB Crisis: SVB had a mismatch between short-term liabilities (deposits) and long-term assets (Treasuries and Mortgage-Backed Securities). When interest rates rose, the value of their long-term bond portfolio plummeted, making the bank insolvent on a mark-to-market basis.

    • Failure to Hedge: The speaker notes that SVB had numerous political and social committees but lacked a department proficient in interest rate swaps to hedge against rising rates.

  • Example of a SOFR Swap

    • Notional Value: $10,000,000\$10,000,000 (used as a multiplier, not an exchange of principal).

    • Fixed Rate (The Bank Pays): 3.555%3.555\%

    • Variable Rate (The Hedge Fund Pays): One-month term SOFR.

    • The Calculation:

      1. Bank's Fixed Payment: \10,000,000 \times 0.03555 = \355,500355,500

      2. Hedge Fund's Variable Payment (Assume SOFR is 3.63312%3.63312\%): \10,000,000 \times 0.0363312 = \363,312363,312

      3. Net Result: The Hedge Fund pays the Bank the difference: $363,312−$355,500=$7,812\$363,312 - \$355,500 = \$7,812

    • Hedging Purpose: This net payment to the bank would offset the losses the bank suffered in its bond portfolio due to those same rising interest rates.

Preferred Stock

  • Hierarchy and Characteristics

    • Preferred stock is a hybrid security: legally it is equity, but it functions like fixed income.

    • Liquidation Priority: Debt holders (bonds) > Preferred Stockholders > Common Stockholders.

    • Issuers: Primarily financial firms (Banks, Insurance), utilities, and some industrials.

  • Dividends (Coupons)

    • Cumulative: If a dividend is missed, it must be paid in arrears before any dividends are paid to common stockholders.

    • Non-Cumulative: If a dividend is missed, it is not owed to the stockholder. Most financial firm preferred stocks are non-cumulative for regulatory reasons.

    • Fixed Payments: Most retail preferred stocks have a par value of $25\$25 and pay quarterly dividends.

  • Math and Yield

    • Annual Dividend = Coupon Rate×Par Value\text{Coupon Rate} \times \text{Par Value}

    • Example: 5.88%5.88\% coupon on $25\$25 par = $1.47\$1.47 per year (or $0.3675\$0.3675 per quarter).

    • Current Yield: Annual DividendMarket Price\frac{\text{Annual Dividend}}{\text{Market Price}}. If price is $23.79\$23.79, yield is 1.4723.79=6.18%\frac{1.47}{23.79} = 6.18\%.

  • Risk Factors

    • Perpetual Nature: Most have no maturity date, making them highly sensitive to interest rate risk.

    • Call Provisions: Most are callable at par ($25\$25) after an initial five-year period.

    • Negative Convexity: Because they are callable at $25\$25, the price rarely rises significantly above $25\$25, capping capital gains while allowing for unlimited downside if interest rates rise.

    • Credit Ratings: Preferred stock is typically rated 11 to 44 notches below the company's bonds. A company with investment-grade bonds could have "junk" rated preferred stock.