Last week was a very important one. The U.S. Treasury placed a record level of debt, the Federal Reserve announced it would not expand its monetary easing, and we got many top players opining about the economy. In addition, we are facing the uncertainties about ‘Cap and Trade’ legislation and the healthcare reform. And to cap it all, we are about to close the first half of 2009, with all the consequences in terms of portfolio adjustments that need to take place.
The Treasury debt placement was well received by the markets. We saw these issues amply oversubscribed and trading well after their placement. This was very encouraging. End of the half adjustments also saw a bid coming back into the U.S. dollar. And, with the Federal Reserve issuing a statement in which they are not expanding quantitative easing further, the ghost of hyperinflation is delayed for the time being.
With all the slack in the U.S. economy there is no room for manufacturers to pass cost increases on to consumers. As the fiscal and monetary stimuli become ingrained, this will change. But for the moment, the great fears of a runaway monetary base have been moderated.
This view is also supported by the commentaries of both Warren Buffet and General Electric Co. (NYSE: GE) Chief Executive Officer Jeffery Immelt. The oracle of Omaha saw no recovery yet in his numbers. And Buffett’s group holdings are diversified enough, and he and his management team are as well connected enough, to be ahead of any recovery.
Similarly, Immelt commented that the underpinnings for a recovery were in place. And he also observed that China, and some government-driven emerging markets are strong and could be driving U.S. exports. He did mention that the thrust of aircraft engine orders come from abroad rather than the United States.
In this column, we took early and aggressive advantage, starting last October and December, of low market valuations. The market did not price then the strong monetary and fiscal stimuli that were devised to bolster the economy.
Without the Fed’s strong measures and quick actions, we would have fallen into a deflationary spiral and much deeper downturn. But the Fed’s actions normalized markets one by one; starting at the epicenter, the interbank and money markets, and moving outward in concentric circles through mortgages, and student and car loans. These actions helped bring the corporate bond markets and the equity markets back to life.
Stocks appreciated the Fed’s effort, as the market shifted its valuation from an “end-of-the world” scenario to a deep recession scenario or better. But that trade is over.
As Warren Buffet says and Jeff Immelt implicitly recognize, the recovery will take a long time to materialize. There are still huge numbers of homes facing foreclosures, and the slack in the U.S. economy is very pronounced. We need to see some more good news in order to justify higher valuations.
Ahead of this realization by the market, we have been in profit-taking mode for the most volatile stocks and moved to hold for longer-term recommendations.
The Standard & Poor’s 500 Index has recognized this and had started moving sideways with a very slight downward bias as of late. Do not construe this to be bad news. In fact, the cup-and-handle formation in the S&P 500 usually precedes a sharp move up.
That is a very distinct possibility that we will eventually be playing with many of our existing ‘Buy’ recommendations, as well as with new ones, should the scenario materialize. But we need to get over the cap-and-trade and healthcare reform humps.
If the cap and trade legislation passes, the overall cost of energy will go up, taxing the whole economy, and there will be a shift to renewables, creating many jobs in this industry and ample profits. We need to see these issues defined before pulling the trigger in most hugely actionable trades.
So, I started screening different income-generating strategies and I discovered a great way to have both upside with high-yielding, yet low-default bonds, and at the same time enjoy dividends from mammoth companies that are likely to keep paying them: The TS&W/Claymore Tax-Advantaged Balanced Fund (NYSE: TYW).
I normally shun from recommending funds. Why pay management fees when I can come up with a similar strategy on my own and recommend it to you?
But there are two circumstances that make this case different:
- When there is such a level of expertise behind the strategy that it would be almost impossible for a non-expert to replicate with a decent chance to obtain similar results.
- And when the value of diversification is huge, and such diversification is unavailable or almost impossible for the individual investor to obtain.
Both of these reasons are huge factors here. Let me explain.
Let’s start by explaining what this fund has in its belly. It can invest from 50% to 60% of the fund in tax-free municipal securities and between 40% and 50% in equities and other income securities. So we are not only playing the rally in bonds that stand to benefit from the markets’ realization that we are in for a longer recession than expected, that inflation is very subdued, and that the debt placements by the U.S. Treasury were well received.
It helps the bond market a lot to have seen that the Fed did not continue expanding its quantitative easing. So why not benefit from this by buying high-yielding, tax–free bonds?
We are going to get both capital appreciation and a high yield.
The fund is positioned right now some 54% in munis and 10% in other income. And it is well diversified in 59 strong large caps with an average market capitalization of about $55 billion that pay an average dividend yield of 4.85%!
The key to the strategy is executing precisely in the muni world, given the fund’s higher weight in it. Also, this very specialized asset class requires detailed credit analysis of municipal and project finances. The beauty of most munis is that these jurisdictions have taxing power and they are careful to keep their credit ratings.
In fact, fund’s holdings are 42% in AAA-rated bonds, making it 88% of the bond holdings rated single A or better. In addition, it has a duration of 15 years, which will be beneficial to returns with a bond rally.
But as many in the market learned painfully last year, “not all AAA bonds are made equal,” and many went straight to default. I have known this for a long time and have always done my own research on credit quality, never relying on rating agencies. Because of this discipline, I was able to get out of Enron, Worldcomm, the toxic-waste-laden structured investment vehicles, and innumerable securities well before they were downgraded to junk.
So why am I sending you to a muni-heavy fund, at a time that the US municipal and state finances are under such pressure? Because I know the manager of the fund very, very well. He is not just your typical fund manager. He is someone that has been at the top of his class for decades. He is extremely well known by his clients, issuers, and Wall Street, which grants him top-level access.
I used to work a few offices down the corridor from Vincent Giordano at Merrill Lynch Asset Management and cannot even begin to tell you how much I have learned from him over the years. He was responsible for bringing the municipal bond management of the firm up to above $60 Billion from $2 Billion by the time he left to start this fund. He did that on the basis of exemplary and disciplined performance, leveraging the superb distribution network that Merrill Lynch has. “Vinnie,” as all his friends call him, is the poster-child of discipline, never becoming complacent and always questioning his own assumptions. This requires inordinate amounts of reading, research and consulting the best sources in the market. He is a master of risk-reward analysis, which is the key in any investment.
But get this: The fund is trading at a 12.46% discount to Net Asset Value. That is, as a closed-end fund you are buying exposure to the securities it holds at such discount to what you would have to pay just to buy them yourself.
In addition, the fund yield is an amazing 9.50%, most of which is tax free, since it is coming from munis.
Hence, on the back of a very supportive fixed-income environment and to keep a toe in high-dividend, strong large caps, we go for an expertly-managed and well diversified balanced muni-equities fund.
Recommendation: Buy the TS&W/Claymore Tax-Advantaged Balanced Fund (NYSE: TYW) at market (**)
(**) - Special Note of Disclosure: Horacio Marquez holds no interest in the TS&W/Claymore Tax-Advantaged Balanced Fund.
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