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Dear Shareholder:
Flight to the Stock Market: There are times when I am proud of our shareholders, and now is one of those times. The municipal bond fund industry has experienced a loss of funds over the last year as investors have moved to stocks, but we have actually experienced a net cash inflow. You have been buying when prices are down, and that is smart!
For fear of "missing out on the big one" investors have been leaving cash flow securities (bonds) at historically low prices to invest in capital gains securities (stocks) at historically high earnings multiples. Risk has been redefined to mean, "not making as much on stocks as the other guy". The May edition of market commentary by Gabriele, Hueglin & Cashman, a New York bond dealer, addresses this problem in an interesting way. I am paraphrasing it here.
Bonds compose much less of the household balance sheet today than they have in the past. Money has been exiting bonds to chase stocks with their more attractive capital gains.
Today's markets are composed of essentially two kinds of securities. Those that produce a return from cash flow (most bonds) and those that are expected to produce a return from capital gains (most stocks).
In a cash flow security there are two parties involved: the issuer of the security and the owner. The owner of a cash flow security expects to have nearly all of his income paid directly by the issuer.
On the other hand, the owner of a capital gain security must get his income from the sale of his stock investment. This presumes that there is a third party in the market who will pay him that hoped for price. Regardless of how well the underlying company does, there still must be this third party who will pay the higher price, and stock investors should know they are depending upon this.
There is something terribly ironic about the movement of large sums of money from a sector that provides a reliable cash flow to one that eats cash flow (tech companies). The ditching of cash flow assets for capital gains assets, making bonds that much more of a bargain, is especially ironic when one realizes how important cash in hand will be should that third party investor disappear, or at best, begin to demand much lower earnings multiples before investing in stocks.
Since that commentary was written, third party investors have begun to demand somewhat higher earnings multiples. Tech stocks, in particular, have finally begun to be evaluated on a more realistic basis.
About Bonds and Boys: When I got out of the Navy about 45 years ago and joined my father in Harlan, Kentucky, he was acting as fiscal agent for several school districts. When a school district wants to borrow money to build a school, they sell bonds. The fiscal agent leads them through that process. One of Dad's clients was Leslie County; Ky. home of quarterback Tim Couch, now of the Cleveland Browns. I was only three years out of college, so you can imagine there was a certain amount of "new" that hadn't completely worn off. And furthermore, I had graduated from Yale, so I suppose I felt Eastern Kentucky was fortunate to have me back. My father could see this clearly.
About two weeks after I had started work, and after the briefest introduction to the legal steps necessary to create a bond issue, Dad, with an appraising eye, suggested I take the bond ordinance and resolution to the Leslie County School Board meeting that night for reading and passage. I had on my gray flannel suit and vest. He said I would probably find the Board meeting at the School Superintendent's office in Hyden. So I set out, full of self-confidence. When I arrived in Hyden I found the Board was meeting that night at Chairman Howard's house. I was told I would see cars parked at a certain spot and would find the house about 100 yards up a path that followed beside a dry creek bed.
But when I found the cars, as promised, there was a new problem; it was dark! Not to be deterred, since I had been told I was expected, I stuck out toward the house on what looked like a path. In fact I was walking up the "dry" creek bed, and as I learned that night, dry creek beds contain a few wet holes. My gray flannel was soaked to the knees by the time I spied the house lights. I had lost the path completely, so I set out straight for the lights thru a blackberry patch. Halfway there I ran into a fence, so I tucked my papers under my arm and climbed the fence, barbed wire and all. As one foot touched the ground I felt hot breath on my ankle and a tremendous roar of howling and barking began! The hounds had set upon me and I was frozen in place, halfway over the fence!
Just in time, Mr. Howard called the dogs off, invited me in, cleaned me up a little, and we passed the papers. And that is how you create a bond issue, ruin a gray flannel suit and get over Yale all in one night.
Federal Reserve Board Action: On June 28th the Federal Reserve Board elected not to raise rates again at this time, but expressed a bias toward higher rates, explaining that inflation was still a threat. The immediate reaction was a slight downturn in the bond market, where all the pessimists reside, and exuberance in the stock market where CNBC and other optimists encourage each other. My guess is that when cooler heads examine what this seems to tell us, they will conclude this is good news for bonds, and possibly bad short-term news for stocks.
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