Finally, bond yields moved higher in December reversing the predominant 2012 trend line and reminding many that losses are possible even in Mr. Bernanke’s contrived bond market utopia. Centuries ago the bard from Avon opined (as did our own January 2004 commentary) “Sell when you can, you are not for all markets”.

For a man that never traded bonds, William Shakespeare understood a basic bond market tenet: at certain times, selective selling often is a sensible strategy. When it made sense in 2012 and especially during the final months of the year our portfolio management process employed this strategy for many mature and fully invested client portfolios. In December, as attractive investment opportunities became more plentiful, portfolio selling was overshadowed by investment activity.

Certain headlines and events forced bond prices lower in December and U.S. treasury, ten year taxable bond yields moved above 1.80%.

Municipal bond yields followed the treasury lead as the 10 year “AAA” rated national MMD index closed 2012 yielding slightly more than 1.70% up from 1.47% at the end of November. Budgetary uncertainty, year-end tax trading and a temporary year end supply glut served as additional forces pushing municipal bond prices lower and yields higher. The Bloomberg News chart below shows the monthly supply gyrations of the municipal bond market in 2012:

Historical 30 day visible supply for last 12 months (competitive and negotiated issues)

Generally, municipal bond prices declined in December by the steepest amount in two years and, on a percentage basis, by a greater degree than treasury bond price declines. The sharp price decline, in part, was set up by the dismally low yields reached in late November (a near four decades low). We view December’s price decline as a needed market adjustment; municipal bond yield ratios relative to taxable bond yields had become too expensive during November.

December’s bad news for bond portfolio valuations aside, 2012 proved to be a solid year for most bond investors, a continuation of the multi-year bond market rally. Annualized 3%-4% total returns for non-taxable, intermediate and long term municipal bond portfolios occurred. Those are attractive returns compared to the present day near 0%- 2% short/intermediate term U.S. Treasury bond universe. 

“CALIFORNIA DREAMING”

The California trio of Chapter 9 bankruptcy filings (Stockton, Mammoth Lakes and San Bernardino) all within 6 weeks of each other this past summer was big news in 2012, but did nothing to slow the mid- summer bond market rally.

In December, the California Public Employee’s Retirement System (Calpers) and various unions representing city of San Bernardino employees repeated their objections to the Chapter 9 filing and argued in court it was illegal for the city to defer pension payments for policemen, firefighters and other city employees. Calpers argued San Bernardino cannot defer its pension payments to the fund while in bankruptcy and that the deferral is unfair since Calpers is still required to pay city retirees defined benefits of almost $ 4 million each month. Notably, Calpers views the city’s pension obligations as senior to other unsecured debts (including municipal notes, certificates of participation and certain unsecured bonds).

The City of San Bernardino and debt holders have a different opinion on this issue.

We have stated before we are not attorneys and therefore we will leave it to the courts to decide these important matters. However, recent comments related to this topic made by our friend and well-respected bankruptcy attorney, James Spiotto in a December 5th, edition of the “ Bloomberg Brief” were not lost on us: “A defined benefit that isn’t capable of being funded is not a defined benefit- it’s an illusion.”

Well and pointedly stated.

Late in December, U.S. Bankruptcy Judge Meredith M. Jury ruled in favor of the City of San Bernardino and against Calpers and city unions allowing it to continue deferring pension payments while in Chapter 9. Judge Jury stated forcing pension payments “would be the death knell” for the city at this time.

We are certain this is not the end of this matter, but take some heart in the Judges’ sensible and logical ruling on this specific issue.

1966 brought us the iconic rock band “The Mamas and the Papas”, their hit song, “California Dreaming ” and its musings about brown tree leaves, grey skies and a winter day.

We are uncertain as to the meaning of the song’s lyrics and wonder if, perhaps, they serve as bond market metaphors for the general state of California’s present day municipal finance.

We are certain of two things:

1. Bond investors are watching closely how Chapter 9 proceedings play out in places like Stockton, California and San Bernardino, California. They need assurance from issuers and courts their interests will be treated fairly, not watered down in order to satisfy Calper’s demands.
2. If bondholders interests are unfairly treated or held hostage to long, drawn out and uncertain courtroom battles, many bond investors will choose to invest their capital outside of California (many already are doing so). Borrowing costs for California municipalities will increase and certain borrowers may be shut out of the public market entirely.

The outcome of the California Chapter 9 filings will greatly determine, in our view, if California skies, indeed, are grey. 

We will have to wait and see if reason and common sense will prevail. 

THE YEAR AHEAD

Planning for the future based on the results of the past year may seem logical, but hardly assures we will be masters of the coming year. That said, here is how we see 2013 shaping up and offer some thoughts in anticipation of the year ahead:

1. Interest rates won’t substantively increase until the Federal Reserve printing press ceases operating. Simply put, its bond buying power is the dominant force keeping bond yields low.
2. Demand for non -taxable municipal bonds should remain strong in 2013 absent any significant law changes tied to the current congressional budget and debt limit negotiations.
3. Repealing or significantly curtailing tax-exemption remains in the crosshairs of certain legislators, administrative officials and the president. If changes occur, grandfathering of outstanding issues is a likely scenario, in our view. Repeal or severe curtailment will increase financing costs for local building projects and local control will be compromised. This affects all taxpayers in a substantive way.
4. Great uncertainty continues to prevail in the bond market and we expect this will be the case for many months into 2013. Uncertainty is unsettling to markets, no doubt. Unsettled market lead to nervous investors oftentimes creating nice opportunities for other investors.

We continue to look for these opportunities for our clients in the new year.

Thank you for your continued confidence.

Sincerely,

Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
January 8, 2013

 

This past October, at the Illinois Municipal League’s annual conference held in Chicago, I participated in a panel discussion,“Repealing Tax Exemption- A Clear and Present Danger”. The other panelists included Matt Posner of Municipal Market Advisors and Michael Belsky, former two- term Mayor of Highland Park, Illinois. The audience was comprised of elected and administrative municipal officials as well as other market participants.

The discussion focused on the threat of repealing federal income tax exemption of municipal bond income.

U.S. Congressman Mike Quigley representing the Congressional 5th District of Illinois was a guest speaker and voiced his advocacy for preserving the tax-exempt treatment of municipal bonds. Congressman Quigley recognizes the important role of tax-exempt bonds in creating jobs and lowering local government’s financing costs. He stated it is very important for state officials, local officials and residents from across the country to vocalize their support for retaining the tax-exempt status of public purpose municipal bonds.

Congressman Quigley is spot on: we must remind our elected representatives of the critical role the tax-exempt bond market plays financing low cost infrastructure projects we all use and rely on: schools, roads, courthouses, water and sewer plants, recreation facilities to name a few. Young and old, middle class and lower income families all derive huge benefits from public purpose projects financed with tax-exempt municipal bonds.

One of the rubs on the tax-exempt bond market is that it primarily benefits wealthy investors depriving the treasury of needed revenue. The truth is almost all citizens benefit from tax-exempt municipal bonds- and we need to remind our elected officials of this fact.

In 2011 our firm spent several months and invested hundreds of hours analyzing proposals to eliminate or reduce federal tax-exemption. We interviewed experts and pored over their research. In December of 2011, we published a report “Tax-Exempt Municipal Bonds-The Case for an Efficient, Low-Cost, Job Creating Tax Expenditure” The report underscores the value of the tax exempt bond market and the important role it plays in building our nation’s infrastructure.

Here is a synopsis of the report.

Our nation’s founders purposefully created a government with checks and balances. The origins of the municipal bond market are not rooted in tax policy, but epitomize the doctrine of reciprocal immunity. 

The evolution of financial markets has transformed the municipal bond market into a sophisticated and highly competitive one. Proponents of repealing or significantly reducing tax exemption raise some of the following points:

1. It is a subsidy that largely benefits wealthy citizens. 
2. Tax expenditures need to be reduced given the government’s sizable deficit.
3. A belief by federal policy makers that federal control over local projects will increase efficiency.

Let’s address these points briefly:

1. Subsidy for the wealthy: Federal tax-exemption entices wealthy investors to invest in public purpose municipal infrastructure projects. Approximately 75% of the country’s public spending on roads, water and sewer systems, schools and other infrastructure is paid for by state and local governments. Repeal tax-exemption or limit it to 28% as some propose, replace it with a taxable or tax credit alternative and a portion of this capital will go elsewhere. Borrowing costs will rise and citizens will see taxes increase, higher user fees and scaled down projects. We see nothing positive for communities across the country under those scenarios. Federal tax policy should encourage, not deter, investors to allocate their investment capital to fund public infrastructure projects. Tax-exemption encourages such investment.
2. Cost: Treasury loses revenue because of the tax-exemption as with all tax expenditures. The Joint Committee on Taxation ranks tax-exemption as the 17th costliest expenditure (2010-2014) and the Congressional Budget Office places it 11th. It is far down the list.

   Additionally, the non-partisan 2007 Urban Institute report calculated the cost of tax-exemption was 50% less than JCT and OMB calculations for the same period. The disparity in calculations should make any objective observer question the government’s cost estimates. In short, federal estimates of the cost of tax-exemption to treasury are inaccurate and the methodology used is deeply flawed. We discuss this topic in detail in our paper.

   Here is a sensible way to reduce a portion of lost treasury revenue:

   Clearly define and narrow the definition of public purpose projects and limit tax- exemption only for projects that meet the definition. Reduce the supply of tax-exempt bonds. As an example, tax-exempt financings for sports stadiums would not qualify as public purpose. An aggressive narrowing of the definition would reduce the annual cost to the treasury by approximately 20%.

3. Inefficiency: all tax expenditures are inefficient and all markets exhibit inefficiencies. These are not phenomenon unique to the municipal bond market. We discuss this issue in great detail in our paper. There are several changes that can be made to improve market efficiency without upending it.

What is important is this: tax-exemption allows local officials, driven by local needs to make the decisions regarding infrastructure projects. This is a healthy dynamic that should be fostered, not curtailed.

Today, states and local governments can raise low cost capital independently of the federal government. Tax-exemption helps ensure this independence. Build America Bonds (BABs), for a brief period, were viewed as an attractive alternative, but the recent threat of sequestration exposes vulnerabilities state and local governments have to the BAB program. Additionally, a recently released white paper published by the Swiss Finance Institute exposes significant inefficiencies of BABs. The report’s findings contradict BAB proponent and treasury claims that BABs improve market efficiency. As we state in our report, a reduced and optional version of the BAB program can serve to improve the current market, but is is not a panacea. Replacing tax-exemption entirely with a BAB only alternative will raise overall financing costs and create a great deal of uncertainty for state and local governments.

Not all tax expenditures are bad policy. Sometimes efficiency needs to be sacrificed in order to preserve greater liberty. Tax –exemption for essential purpose, municipal bond projects is one such instance. It is essential for efficiently building and repairing the infrastructure our nation desperately needs.

I am a municipal bond specialist and have dedicated 30 years of my career to this business. I have a seasoned and informed perspective on the topic that has been shaped by thousands of conversations and hundreds of experiences with state and local officials, their constituents and investors.

It is important all citizens help shape this debate. It should not be controlled by a handful of federal policy makers and Congressional staffers removed from the reality of running local government. The discussion should be shaped by state and local government officials from across the country that understand what it takes to run local governments. It should be shaped by citizens from across the country who pay taxes that finance municipal projects and by citizens who use and benefit from these facilities. Lawmakers should not punish state and local governments and their constituents by increasing their borrowing costs in order to help clean up the federal government’s fiscal problems.

If we believe in the principle of federalism embodied in our Constitution, if we believe state and local government should have wide latitude to independently build public purpose facilities their citizens need, want and are willing to pay for, then radical changes to the present day municipal bond market should not occur. If tax-exemption is repealed or substantively reduced, financing costs for local building projects will increase and local control will be compromised. This affects all of us in a significant way.

Sincerely,

Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
January 2013