Seminar as of September 17, 2014 – Amit R. Stavinsky, Tamar Securities, LLC

Good evening ladies and gentleman. Thank you for coming to our event presentation tonight. Let me start our presentation by first telling you all a joke that in my opinion summarizes the “Double Edge Sword” that most of us face nowadays when investing.

The Joke: an upcoming IRS audit forces Mosses to decide between which two suits to wear. A torn up suit to make him appear poor; thereby, avoiding a prolong audit as opposed to an expensive; Georgiou Armani suit to make him appear strong and powerful; thereby again, avoiding a prolong audit. When asking his Rabbi for help, the answer he gets is the exact same one his wife got on their wedding night. She in turn on that night was also asking just about the same question; that is, which night gown to wear: “The sexy red night gown showing her beautiful cleavage or the sexy black night gown with a very low cut showing her long legs”? The answer she got was the same answer Mosses gets; that is, “Either way you look at it you are going to get _______________”.

This is the “Double Edge Sword” of a challenging investment environment that investors face today.

1Multi-Decade Low Interest Rate Environment

  • The target Fed Funds rate is between zero to 0.25%
  • The 10 and 30 Years Treasury rates are respectively at 2.61% and 3.34%
  • Historically record low rates on high yield bonds of just above 5%
  • Historically record low rates on high grade double tax free, municipal bonds maturing in 10 and 30 years of 3.36% and 4.19% respectively.

Multi-Decade High Taxable Environment


2Federal Tax Rate

In general, the marginal tax rate of single filers and/or married couples filing jointly and earnings over $400,000 is 39.6%.

3California State Tax Rate

In general, the marginal tax rate of single filers and/or married couples filing jointly and earnings respectively over $300,000 and/or $600,000 is 11.3%.



4Affordable Care Act taxes (Obama Care Taxes)

In general, the tax rate of individuals with earnings above $200,000 and married couples making more than $250,000 is 3.8%.

The New Cumulative Tax Bracket for Top earners

The new cumulative tax rate is 54.7% (Federal Tax Rate of 39.6% plus the California State Tax Rate of 11.3% plus the Affordable Care Tax Rate of 3.8%). At this tax bracket, a municipal bond paying for example a double tax free, current yield of 4% per year is equivalent to 8.83% annual taxable return.

One Solution to the Problem is to Increase Asset Allocation to California, State and Federal Tax Exempt Municipal Bonds.


Classifying Municipal Bonds

General Obligation Bonds (5Approximately 44% of the 6$3.7 Trillion Municipal Market)

There are two main types of municipal bonds: General Obligation bonds and Revenue Municipal bonds. General Obligation bonds (GOs) are backed by the “full faith and credit” of a taxing authority which if necessary pledges to raise taxes with its unlimited taxation power in order to pay its outstanding GO debt when due.

Revenue Bonds

Revenue Municipal bonds; on the other hand, are used to finance either a municipal facility or a project such as a department of water and power or a toll road; and hence, have a dedicated stream of revenues from these facilities for the payment of interest and principal to the bond holders. In this case, if the revenue stream is not sufficient to pay the bonds, it is likely that the issuer will default on its payment. The issuer is not obligated to use other revenue sources to pay the bondholders.

Types of Revenue Bonds (7Approximately 56% of the $3.7 Trillion Municipal Market)

  • Sewer and water systems
  • Public power systems
  • Single- and multi-family housing
  • Airports
  • Rapid transit
  • Hospitals
  • Resource recovery
  • Seaports
  • Colleges and universities
  • Industrial development and pollution control facilities
  • Sports facilities and convention centers
  • Student loans
  • Toll roads and bridges
5Barclays Capital Municipal Bond Index components as proxy for the mix of the investment-grade muni market as of April 26, 2011
7Barclays Capital Municipal Bond Index components as proxy for the mix of the investment-grade muni market as of April 26, 2011


Double-Barreled Municipal Bonds

These bonds pay interest and principal first from a specific flow of a revenue stream and second from the general obligation and unlimited taxation power of a municipality. On the other hand, limited tax municipal bonds are secured by limited revenue sources and taxes that are restricted to certain maximum rates.

Additional Municipal Bonds

In addition, there are various other municipals such as pre-refunded and certificate of participation bonds. Pre-refunded municipal bonds mean that bonds are normally escrowed with 100% U.S. Treasury bonds guaranteeing interest and principal on the bonds at maturity. Certificate of participation bonds provide the bondholders of the certificates a participation right in the revenue stream generated from a facility or a project.


Fixed Income Portfolio (FIP) Investment Discipline

Our firm emphasizes discounted high-grade debt securities over equity and alternative investments in order to achieve both constant annual income returns and Fixed Income price appreciation. This program discipline does not attempt to time the direction of Interest Rates in the market place. The guiding principal is to allocate funds into mostly Tax Free Income instruments based on three main criteria for best risk/reward return on investment:

  1. Duration: our firm constantly searches for the ideal sweet spot along the yield curve in order to position new assets. At times, short duration bonds of 1 to 5 years to maturity are purchased, and at other times intermediate as well as very long duration bonds are purchased (less than 10 years and up to 30 years or longer to maturity respectively). For example, in today’s interest rate environment that sweet spot in my professional opinion is 8 to 16 years to maturity.
  2. Credit Quality: our firm constantly performs in this highly large and fragmented municipal bond market in depth analysis of credit quality irrespectively of the underlying credit quality assigned to bonds by Moody’s, S&P and/or Fitch. Here again, our firm searches for the ideal best risk reward return of a fixed income instrument given its assigned credit rating. For example, in today’s interest rate environment in my professional opinion that credit quality ranges between BB to A- rated bonds in order to achieve the maximum return on investment without having to extend maturity too far. Once again, independently of the assigned credit rating to bonds some of the research done by our firm when analyzing the credit quality of General Obligation and Revenue Bonds include but is not limited to: current updates of financial statements, outstanding debt levels, net surpluses, balanced budgets, assessed valuation of property values, unemployment , the viability and competitive landscape of a project, hierarchy of flow-of-funds and/or seniority, debt service coverage, additional bond test, and reserve fund.
  3. Coupon Payment: our firm constantly evaluates the ideal coupon payment of a bond in order to execute best in class purchase price for an optimal total maximum return on investment. In general, during times of low interest rates; premium bonds with 4.5% to 6% coupon payments are purchased. And at other times, during periods of rising interest rates; discount bonds with coupon payments of 3% to 4.5% are purchased. For example, in today’s extremely low interest rate environment, in my professional opinion marginal premium bonds with a coupon payment of 3.75% to 4.5% should be purchased in order to try to achieve optimal risk reward return on investment.

What We Currently Buy

  • BB/BBB/A-/A3 Rated bonds or better.
  • 8-16 years-to-maturity bonds.
  • 3.75% to 4½% current yield.
  • Mostly discounted and/or marginal premium bonds to Face Value.
  • GO Bonds: States, Districts, and Counties.
  • Revenue bonds of Essential Services: Water, Power, and Sewer.
  • Senior Debt.
  • Property Tax Bonds: Loan to Value coverage of 10 times or better rolled back to 2002.
  • Redevelopment Agency Bonds: Debt-to-service coverage at 115% or better rolled back to 2002.

What We Normally Don’t Buy

  • Public Works Bonds of Jail System.
  • Lease abatement Revenue Bonds.
  • Toll Road Bonds.
  • Hospital Bonds.
  • Certificate of Participation Bonds.
  • Subordinated Debt.

Municipal Bonds—Unique Asset Class

  1. 8Low Default Rate Municipal bonds have for a long time offered investors a safe Investment Vehicle. The 10 year cumulative default rate on municipal bonds was 0.04% between 1970 and 2000. By comparison, the 10-year default rate for corporate bonds over the same period of time was 9.83%.
  2. 9High Recovery Rate Defaulted municipal bonds have a fairly high recovery rate of 68.33%. [Source: 2003, Fitch Findings.]
  3. 10Large Market Size $3.7 Trillion as of August/2014.
  4. Generally, liquid secondary market for sizeable offerings.
  5. 11Largest owners of municipals bonds. High-net worth individuals, mutual funds, money market funds, property and casualty insurance companies and commercial banks. The 100 largest institutional holders represent approximately 35% of the entire municipal bond market.
  6. Generally, High Grade Ratings (A-/A3 or better by S&P and Moody’s.)
  7. Surety credit enhancement of interest and principal over an underlying rating.
  8. Attractive yield curve for tax-free and taxable municipal bonds.
  9. 12Attractive spreads over U.S. Treasury bonds (AAA Rated tax-free municipals.) 1 year-149.7% 5 year-109.2%; 10 year-128.8%
  10. 13Attractive spreads over U.S. Treasury bonds (AA Rated taxable municipals.) 1 year-215%; 5 year-108%; 10 year-135%
  11. 14Attractive spreads over U.S. Corporate bonds (AAA Rated tax-free municipals.) 1 year-315%; 5 year-166.4%; 10 year-113%
8Source: November 2002, Moody’s Investor’s Services.
9Source: 2003, Fitch Findings.
11Source: 2009, Thomson Reuters eMAXX
12September 12, 2014 Charles Schwab & Co., Inc. (“Schwab”).
13Source: US Muni Taxable AA Curve; Bloomberg.
14September 12, 2014 Charles Schwab & Co., Inc. (“Schwab”).


So, the next question to answer is; what is in store for the Municipal Bond and Stock Market?

Buying Opportunity

Policy Change in Monetary Quantitative Easing Causes Volatility Risk

After three rounds of quantitative purchases of Treasury and Mortgage bonds that swelled the Fed’s balance sheet to about $4 trillion, the current quantitative easing which has peaked at $85 billion per month is about to end in October and potentially cause uncertainty and heightened volatility risk. Although the central bank reiterated it will probably keep the target of its benchmark interest rate in a range of zero to 0.25 percent for a “considerable time” the bond market is now embracing for potentially some significant changes to that language such as dropping the “considerable period” phrase from the Fed’s announcement statement. This alone can cause elevated market volatility by pushing the 10 year Treasury rates from the current 2.61% (Was just recently at 2.33%) to 3% or above. However, all that it really means in my opinion is that the U.S economy is no longer on a “life support”; and hence, it might present another buying opportunity similar to the one that took place last August when high grade, 3% coupon bonds that only few month earlier were issued at par value, were trading at about 80 cents on the dollar, paying yields to maturity of about 5% exempt from State and Federal taxes.

Short Term Versus Longer Term Yield Curve Risk

The first actual rate hike almost certainly won’t happen before March of 2015 (15There is a 62 percent chance the central bank will increase its benchmark rate by July 2015, federal fund futures show), but it’s the impending announcement that is likely to cause the sharper market reaction. A template for what could happen when the Fed starts raising rates might be the last sell off last summer of the entire bond market (Long duration investments like municipal bonds, high grade corporate bonds, and 30-year treasuries were among the hardest hit) as well as the most recent sell off in the high yield bond market in late July. Worries about inflated valuations, geopolitics, and eventual rate hike combined to cause an acute but brief drop in junk bond prices. If anything, this acute, pending volatility has the potential to bring about some interesting buying opportunities. For example, because the Fed might be tinkering with short term rates, two-to five year Treasury bonds are most vulnerable. However, later on in the cycle, if the market assumes too much tightening in a sub- par growth economy, the longer end of the yield curve might start reversing an immediate sell off; thereby, rewarding investors allocating funds to longer duration bonds.

Sub-Par U.S GDP Growth Rate and Euro Zone Bond Market Support of US Debt

In general, sub-par growth at home and near stall growth rates in Europe combined with exceptionally low global rates have the potential to put a floor on any bond market selloff in the US. For example, the byproduct of an aggressive quantitative easing announcement by the European Central Bank (ECB) (of a rate reduction to 0.25% plus two asset purchase programs similar to the U.S easing policies) likely resulted in some of the 16following depressed government debt in continent Europe on 09/15/2014: 1) 1.06% on German Bund 10-year to maturity(At the end of August, 2014 17the 10-year German Bund yield hit an all time low of 0.87%), 2) 2.52% on similar maturity U.K bonds, 3) 1.42% on French 10-year bonds to maturity, 4) 2.33% on Spanish 10-year bonds to maturity, and 5) 2.33% on Italian 10-year bonds to maturity. What this means to global bond investors is that their investable funds can find better home in higher yielding U.S financial assets. For example, Stronger rated U.S government debt as well as the U.S debt environment in general yield substantially more than BBB rated, investment grade Spanish and Italian debt. With the possibility of an eventual increase in U.S rates, stronger dollar, foreign currency influx into U.S financial markets in search for higher return on investments, 18cash deposits for households in the U.S approaching $10 trillion and 19$1.7 trillion in cash excess for the top 1500 equities in the U.S, financial assets at home could recover any market correction in Fixed Income and Equities alike.

16Bloomberg; World Bond Markets
17Trade web data
18Source Citi Research, Equity Strategy, July 2014
19Source Morgan Stanley, U.S Equity Strategy, July 2014


The State of the U.S Economy

Sub-par annualized GDP growth rate of 1.75% to 2.25%; about half the growth rate the U.S economy experienced since World War II, over time could potentially limit erratic spikes in interest rates; and therefore, present buying opportunities at times of acute volatility risk. The followings are some of the data that might support anemic U.S GDP growth rates:

Labor Participation Chart

The Lowest Labor Participation Rate Since 1978 20Participation rate in the labor force is at its lowest level since 1978, at 62.8% and 62.9% in June and July respectively. The participation rate of prime- age males, ages 25 to 54, has gone down from the late 1940s from about 97% to 88%. On the other hand, the participation rate of prime-age women rose to a peak of 76.8% in 1999, from 35% in 1948. However, since 1999, it has fallen back down to 73.2%. One reason for that phenomenon might be a generous Social Security Disability Income (SSDI) payment to recipients of $1,146 per month plus full 21Medicare coverage equivalent to purchasing a life time annuity for $275,000 that incentivizes against labor force participation. The Affordable Care Act also might have had some unintended negative effects on the labor market. For example, by 2016 a firm with fewer than 50 full-time employees will not be required to provide medical benefits. But a firm with 49 full-time employees will face a $40,000 penalty if it fails to provide medical insurance after adding a 50th employee. The huge marginal cost of that 50th worker most likely will deter expansion.

Disability Recipients

Population Growth 22The U.S. working age population (Americans from 18 to 64 years of age) is projected to grow only 0.36% during the current decade, and then limp along at even lower rates from 2020-2030. That’s well below the 1.81% rate that prevailed during the 1970s.

Income Inequality 2352% of the U.S. income growth currently goes to the top 1% of earners. On the other hand, citizens in the bottom 99% of income continue to experience stagnant wages. Also, mean incomes of minorities in the U.S. have remained at about 60% of white incomes in recent decades.

Aging Population 24The U.S. population that is over 65 years of age is projected to rise from 13% to 20% over the next 20 years. But the entire world is aging. Most famously, Japan’s retirement-age population has risen steadily. It is expected to hit 26% of the total population by 2015, and top 29% by 2025 (according to the United Nation’s Population Division). In China, the 65-plus group is on track to grow from 10% in 2015 to nearly 14% in 2025 (According to the U.N. figures). The same trend is well under way in Europe. For example, in Germany and France the retirement age is already above 20% and forecast to rise to 25% by 2025.

20Barron’s; Cover Story, September 1, 2014;Work’s for Squares
21Barron’s; Cover Story, September 1, 2014;Work’s for Squares; Author’s calculations
22Barron’s: Cover Story, October 28, 2013; Slowing to a Crawl
23Barron’s: Cover Story, October 28, 2013; Slowing to a Crawl
24Barron’s: Cover Story, October 28, 2013; Slowing to a Crawl


Productivity 25Over the past three years, nonfarm labor productivity increased at only 0.7% annual pace (JP Morgan economists: Michael Feroli, and Robert Mellman recently pointed that out in a report entitled “U.S. Future Isn’t What It Used To Be: Potential Growth Falls Below 2%.”). This compares with the post World War II average annual boost to GDP of 2.3%, and the 2.9% average yearly rise for the decade ending in 2005. This might be a result of slower growth in spending on private research and development that has fallen from an average of 4.7% a year between 1980 and 2000 to 2.8% per year in the last 10 years.

Inflation, Unemployment Rate and some Positive Indicators Although recent, 1) economic trends indicate26 Inflation Rate of only 2% and27 improvements in retail sales for August of 0.6% higher month-over-month. 2) Improvements in the Consumer Sentiment Index to 84.6%-the highest since July 2013. 3) Improvements in 28the ISM Manufacturing Index in August to 59-the highest since march 2011 (with reading above 50 denoting expansion).  And 4) Improvements in construction spending to 1.8% month-over-month; the persistent secular trends are far more disruptive to the U.S economy. Thereby, putting a lid on any rise in interest rates.

For example, in the29 labor market a positive drop to 6.3% unemployment in April as well as improvement in the broader unemployment measure to a drop of 12.1% in June (Called U6; which includes part-time workers who would like to be full time, and people who want jobs but haven’t looked recently) doesn’t depicts the full picture of the lowest participation rate in the labor force of merely 62.9%.

Disconnect Between High- Quality Stocks versus Low-Quality Stocks (Value versus Growth)

Since the September 2011 announcement of Operation Twist by the Fed, 30low quality stocks ranked C&D, at the bottom of the S&P 500, outperformed the group of the highest quality stocks ranked A+ by approximately 10% per year for the past three years ending August, 2014. The current average multiple of the low quality-growth stocks and the high quality- value stocks is about the same at 16 to 17 times earnings. Utilities and REITS can be examples of low quality, no growth sectors that are interest rate sensitive. For example, using Bloomberg data, the S&P Utility group is projected to grow next year’s earnings at 4.19% and trades at a forward 15.25 earnings multiple. On the other hand, the S&P 500 Index is projected to grow earnings at 10.81% and trades at a forward 13.44 earnings multiple. This in my opinion illustrates the attractiveness of high quality growth stock investments versus low quality, no growth, interest rate sensitive stocks.

Relative forward P/E of S&P 500 Information Technology and Utilities
Relative forward PE

Multi Year De-Leveraging Cycle

Overall cash balances are at record levels; and hence can support financial market investments, spending, and economic growth. 31Household’s cash deposits are rapidly approaching ten trillion dollars 32and the top 1500 equities in the U.S by market capitalization hold in excess of $1.7 trillion in cash. 33A third of that cash is held by technology companies, healthcare, consumer discretionary and industrial stocks. In most cases, such cash is now rewarding investors with a record 4.6% cash return consisting of dividends and stock buybacks. Combined with projections of 21% debt reduction by the S&P 500 companies as opposed to debt increase by 3.7% for the Utility group, during prospects of heightened market volatility buying opportunities of growth stocks with below market multiples and bonds should be considered.

Credit Suisse High Yield Index (yield to worse) source Bloomberg
Credit Suisse High Yield IndexCash Balances, Top-1500 stocks (ex-financials, in $trillions through 2014Q1), source Morgan Stanley.
25Barron’s: Cover Story, October 28, 2013; Slowing to a Crawl
26Bloomberg; CPI YOY
27Schwab Market Update;09/12/14
28Schwab Market Update;09/02/14
29The Wall Street Journal; Monday, September 15, 2014; Rate Decisions Will Test Style of Fed’s Yellen
30Merrill Lynch
31Source Citi Research, Equity Strategy, July 2014.
32Source Morgan Stanley, U.S Equity Strategy, July 2014
33J.P Morgan


Supportive Global Economy

Synchronized global monetary policies similar to the ones enacted in the U.S, in my view, can provide a backstop to bond prices and financial markets alike. Europe and Japan steadily continue on the easing path, and China joins with their recently announced own version of targeted stimulus.


Investing in a multi decade low interest rate environment coupled with multi decade high taxable rate environment is challenging. Add to the mix, a potential change in monetary policy then a “Double Edge Sword’ –type of investment environment might transpire. However, in a historically global low interest rate environment, sub-par GDP growth rate tainted in structural employment challenges, and deeply rooted secular trends; in my view, volatility risk should equal a buying opportunity. It is my belief that any upcoming market volatility in bond and stock prices can bring about attractive entry points in order to attempt to overcome historically elevated taxable environment. Investors should pay extra attention to discounted State and Federal Exempt Municipal bonds as well as high quality growth stocks with pristine balance sheet, strong return on equity, and a meaningful cash return to investors of dividends and buybacks.