Smith Affiliated Capital

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1 RESEARCH S C A Smith Affiliated Capital 800 Third Avenue, New York, NY TEL: FAX: info@smithcapital.com October 2005 HIGH YIELD VS. HIGH GRADE MUNICIPALS Edition II: No Alpha Contribution for the Risk Assumed Conclusion: For the investor who is looking for 1) preservation of capital; 2) income; 3) call protection; and 4) liquidity. The additional risk to the investor s capital from a loss of diversification that is assumed by investing in bonds below investment grade is nowhere justified by additional price return or any additional after-tax income. As the bond markets have maintained historically low yield levels in recent years, high-yield taxable bonds have been promoted as an enhancer, or alpha strategy, for municipal bond portfolios, i.e., a way to achieve greater income and after-tax returns. This alternative has the appearance of higher yields on a gross or unadjusted basis, but what is not transparent is the additional risk exposure taken on by investors, chasing the appearance of additional income and return. For the purposes of this review, the information was compiled using the Merrill Lynch (ML) indices for the period beginning in September 1995 through September Quarterly total return data was compared for both the ML Corporate master index and the ML master index. In our last review, dated January 2000, we compared the characteristics of only the two indices of 12/31/00. Now it is very important to contrast the changes on each index (shown below in Table I) over the last five years, and then to currently compare them with each other as of 9/30/05: Table 1: and Index Comparison December 31, 1999 September 30, 2005 Index Characteristics Bond Bond Average Quality B1 AA1 B1 AA1 Average Coupon 8.22% 5.42% 7.99% 5.32% Yield to Maturity 11.12% 6.09% 8.17% 4.31% Tax Status Taxable Tax-Exempt Taxable Tax-Exempt After-Tax Yield 6.71% 6.09% 4.93% 4.31% Average Price Index Changes over the Period The big change in the ML index since January 2000 has been that Fitch was added to the composite rating algorithm, and the new algorithm has been based on the average of Moody s, S&P, and Fitch. In the beginning of the five-year period, there were 501 issuers, and, as of 9/30/05, only 97 issuers were still in the index. 27 issuers were upgraded to investment grade but 377 dropped off because of bankruptcy, mergers, or other corporate restructuring. Hence, we have a huge survivorship bias to address for comparability, which severely overstates the performance of the index.

2 The rating criteria for the ML Index also became an amalgam, or average, of Fitch, Moody s, and S&P. Additionally, minimum size requirements were reduced from $50 million on a graduated scale based on the security s initial term to final stated maturity at time of issuance. These changes resulted in an increase in the number of constituents in the municipal index to over 12,000, from 1,527, and increased the total capitalization of the index to approximately $660 billion, from $169 billion. The depth and quality of the municipal index is huge, with credit being seven levels above the high yield index. However, the closeness of the spreads between these two indices for each of the time periods has remained about the same, which masks the survivor bias that exists in the high yield index. Alpha and Diversification Presented below in Chart I is our S&P 500 equity correlation chart for a wide spectrum of indices, for the last five years ending 8/31/05. It is important to note that inverse correlation is the measure of diversification, and the more people attempt to enhance returns through the assumption of credit risk, the more positive the correlation to the equity market. The inverse correlation of quality municipals makes them a key provider of portfolio stability. Chart 1: Correlation between S&P 500 and Major Market Indices, Last Five Years Ending 8/31/ Correlation Coefficien Wilshire 5000 Dow Jones Ind us t rial MSCI EAFE Nasdaq Russell 2000 LB EMG ML HY WIL REIT HUI ML Global ex US LB Credit LB Munis LB TIPS LB Agg LBGC LB Long Tsy As investors have come to accept the expectations of modest forward-looking market returns over the intermediateterm horizon, the appeal of enhancing returns or adding alpha risk has become popular again, even after the credit implosions of 2000 to Since the high yield index walks and talks much like the municipal index, i.e. possesses similar coupon, maturity, yield spread, duration, and credit quality values, one is tempted to think of them as carrying the same risk; looking at the chart above, however, it is clear the high yield index correlates much closer to equities. High yield carries significantly higher risk, including price volatility, loss of income and principal due to default, lack of liquidity, political uncertainty, and the lower quality sources of revenue available for debt servicing; all having been masked by the survivorship bias of the index. In the comparison of gross total returns (coupon and price change) between the ML and indices, it is easy to understand the temptation of flavoring a municipal portfolio with an allocation to high yield. In our chart below, unadjusted for tax or risk, the 10-year overall results are as follows: Page 2

3 Chart 2: Gross Total Returns: vs. s On a gross total return basis, the Index under-performed the Index in 25 of the 40 quarters from 9/30/95-9/30/05. The average under-performance was -0.07% per quarter and cumulatively -6.76% over the horizon. It also should be noted that the volatility is so much more with high yield, and this despite the constant refreshing of the index with new names. For the additional risk of investing in a B1 index, well below investment grade, the investor received 0.28% per year more in gross return over the AA1 municipal index. For an investment of $1,000,000, that was only an additional $2,800 in pre-tax total return each year, not adjusting for the survivorship bias. The risks assumed became perfectly clear in the second quarter of 2002 when the high yield spiked down 7.0%. Now tax- (but not risk-) adjusting the coupon returns for the maximum federal tax rate (incorporating the 2001 tax law changes) over the 10-year period, the contrast between the high yield and municipal indices is very close, as shown below, and the overall results are as follows: Chart 3: Tax-Adjusted Total Returns: vs Chart uses Federal tax rate of 39.1% in 2001, 38.6% in 2002 and 35% thereafter) On a tax-adjusted basis, the Index out-performed the Index in 19 of the 40 quarters from 9/30/95-9/30/05. The average outperformance was 0.75% per quarter and cumulatively 29.83% over the horizon. Page 3

4 Additionally, the volatility of after-tax coupon returns is a function of the price volatility and credit risk of the asset class. A higher coupon return does not always provide higher income taxes after taxes are taken out. In fact, the numbers show quite the opposite. If coupon income is an objective, it is also evident that high yield does not pay the investor enough actual coupon income to justify the significant additional investment risk. Taking the adjusted coupon returns and combining them with the price component of each index, unadjusted for tax, since both are taxed at the same rate, one can now begin to fully appreciate the competitive lack of attraction between the two asset classes and the inability of any alpha contribution to be provided by high yield. The chart below provides the quarterly comparison for the last 10 years, with the summary results as follows: Chart 4: Coupon Returns: vs On a tax-adjusted basis, the Index out-performed the Index in 22 of 40 quarters from 9/30/95-9/30/05. The average out-performance was 0.01% per quarter and cumulatively 0.30% over the horizon. In reality, when one compares the total returns on an after-tax-adjusted coupon basis, municipals provided $3,141 more in performance each year for 10 years on a $1-million investment. Finally, in comparing changes to the high yield index, the advent of fallen angels that is, investment-grade credits, such as automakers GM and Ford, crossing over into junk or high-yield status is a very recent phenomenon, as is the falling out of the auto part makers and airlines from junk to bankruptcy. Defaulting airlines Delta and Northwest triggered the removal of nearly half the debt in the airline sector of the index. Delphi, the largest auto parts supplier, followed Collins and Aikman into bankruptcy. Since this has occurred starting in the second quarter of 2005, it does not impact or alter the results presented, and certainly underscores the elements of risk and survivorship bias in comparing these asset classes. Paul J. Matus, Portfolio Manager, Tax-Exempt Investments Matthew J. Smith, Vice President for Business Development Smith Affiliated Capital is a privately held investment advisory firm, founded in 1982 and registered under the Investment Advisors Act of We specialize in the active total return, separate account management of quality taxable and tax-exempt fixed income portfolios for institutions, endowments and foundations, and wealthy individuals and their families. We welcome your comments on this or any research piece or commentary published by our firm. For further information, please contact us by telephone at or at info@smithcapital.com. We also invite you to visit us online at Page 4

5 Disclaimer: This publication contains the current opinions of the manager and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Such opinions are subject to change without notice. This publication is distributed for education purposes only. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Forecasts are based on propriety research and should not be interpreted as an offer or solicitation, nor the purchase or sale of any financial instrument. No part of this publication may be reproduced in any form, or referred to in any publication, without the express written permission of Smith Affiliated Capital Corp.