In recent months, we have often heard the refrain from investors, “I’m just going to wait until interest rates rise.” and, in fact, many investors are waiting for Federal Reserve policy makers to raise interest rates before committing money to the bond market. This attitude is understandable given the Federal Funds rate has been held in the 0% to 0.25% range for many months. Rates MUST go up, right? The answer, of course, is yes (but when and what interest rate are we talking about?). A portion of the hike in interest rates that investors are waiting for may have already happened. In just the past 15 months, the yield on the Benchmark, 10 year Treasury note has climbed from 2.65% to 3.55%, where it stands as of this writing. That’s a 90 basis point increase in yield at the same time the Fed Funds rate has remained unchanged.

Shown below is an analysis of four past Fed credit tightening cycles along with the resultant yield on the 3 year and 10 year Treasury notes during the same period. You will notice that the Fed Funds rate actually ended up higher than the yield on the 10 year T-Note in three of the four cycles!

July 1st, 2004 through September 2007:

  • Fed Funds increased from 1.00% to 5.25%, plus 425 basis points
  • 10 year Treasury note yield increased from 4.27% to 4.63%, plus 36 basis points
  • 3 year Treasury note yield increased from 3.03% to 4.02%, plus 99 basis points

February 30, 1999 through May 16th, 2000:

  • Fed Funds rate increased from 4.75% to 6.50%, plus 175 basis points: 
  • 10 year Treasury note yield increased from 5.79 to 6.44%, plus 65 basis points
  • 3 year Treasury note yield increased from 5.24% to 6.84%, plus 160 basis points

February 4, 1993 through February 1, 1995:

  • Fed Funds rate increased from 3% to 6%, plus 300 basis points: 
  • 10 year Treasury note yield increased from 6.26 to 7.65%, plus 139 basis points
  • 3 year Treasury note yield increased from 4.57% to 7.47%, plus 290 basis points 

January 1988 through February 1989*:

  • Fed Funds rate increased from 6.50% to 9.75%, plus 325 basis points: 
  • 10 year Treasury note yield increased from 8.67% to 9.36%, plus 69 basis points 
  • 3 year Treasury note yield increased from 7.97% to 9.41%, plus 144 basis points

*Fed Funds rate figures for this period are approximated as Federal Reserve decisions were not officially announced at the time.

It’s important to remember that, historically, the Federal Reserve has not been an active trader of longer maturity bonds. Traders, investors and other market participants dictate the yields on long bonds based, in large part, on future inflation expectations. As the economy expands, these “participants” typically drive the yields of long bonds upward to compensate for the expected erosion of net return resulting from inflation.

Many expect the Federal Reserve to start raising rates later this year or in early 2011. We, too, have this expectation, but our view is tempered somewhat by the continued weakness in the housing market. The root cause of the 2008-2009 financial crisis was the collapse of the significantly over-inflated housing market. A modern day economy from which we can draw a parallel is Japan’s in the late 1980’s. Japan experienced a similar real estate meltdown and its economy is still dealing with deflationary pressures 25 years later. So we wonder, what is different for us today? Additionally, we believe the persistent, near double-digit, national unemployment rate and weak bank balance sheets will make it politically difficult for the Federal Reserve to raise short term interest rates too high or too quickly. Clearly, the Federal Reserve will have to walk a fine line as it attempts to spur the economy without stoking inflation.

We believe the reason many bond investors are maintaining high balances in low yielding money markets right now is because they’ve been scared into thinking the value of their investment will decline sharply if interest rates rise. They may well be right. They may be wrong. We do not know with certainty. However, we do know with certainty that approach has been dead wrong over the last 12 – 18 months and it may continue to be the wrong strategy for another 12 – 18 months.

In our view, it is the dreaded “total return” argument that is a questionable strategy for many bond investors. Annual total return measures the net coupon rate plus or minus the change in a bond’s value over a 12-month period. For those who hold the bond to maturity, the fluctuating value of their bond is meaningless; their net coupon rate IS their annual return. Investors looking for INCOME from their portfolio should not leave investment funds in near zero paying money markets waiting, hoping for rates to rise. Get the funds invested out along the interest rate curve and get your funds earning a higher return. Let’s be clear: this is not a blanket recommendation advocating 20 year bond investments today for everyone. We are advocating committing your funds beyond a money market time frame.

Here’s an illustration to bring this all home: Assume one has $100,000 available to invest in the municipal bond market. Let’s say you can invest the funds either in a 7 year, non-taxable municipal bond with a 3.00 % coupon, priced at par, or park the money in a money market fund yielding 0.30 %. An investment in the money market for 12 months gives you $300 while the bond returns $3000 annually. The money market investor retains liquidity, but at a steep cost.

Over the next three years, the bond investor will earn a total of $9000.00. Let’s assume money market rates increase 100 basis points over a 3 year period (we assume in equal installments on January 1st of each year), which mirrors the yield increase experienced by the taxable 3 year Treasury note from July 1, 2004 through September 2007.

Under these circumstances, the money market investment will earn approximately $1890.00 over the three-year period or $7110.00 less income than what is produced by the seven-year bond investment.

Of course, because interest rates have risen over this three-year period, the bond investment will have a market value that is less than its original cost, while the money market will presumably have retained its $100,000.00 value. If we assume nontaxable, municipal bond rates increase by the same magnitude (100 basis points) as the yield increase experienced by the taxable, 3 year Treasury note, the now 4 year, $100,000.00 par value, municipal bond will have an approximate market value of $96, 337.00. If the investor sells the bond after 3 years, he will realize an approximate principal loss of $3663.00. Subtract this principal loss from the $7110.00 gain in income cited above and the bond investment option nets $3447.00 more than the money market investment strategy. That is approximately 3.44 % more total return over the 3 year period produced by the bond investment versus leaving the funds in a low paying money market. That difference, in our view, is significant.

If you’re a buy and hold investor, the preceding analysis is moot. If you generally don’t sell prior to maturity, you know the score of the game at the outset, which is the yield you’ll earn and the amount you get back at maturity. What happens to the market price in the interim should ultimately be of little concern.

We are not advocating abandoning your current investment parameters by investing in long-term bonds and disregarding the potential of higher interest rates in the future. Rather, we suggest you adhere to your existing ladder strategy without focusing too greatly on trying to time the market. There’s a hefty price to pay for thinking you can predict the unpredictable.

Thank you for your continued confidence. Please call us with any questions or comments.

Bernardi Securities, Inc.

May 2010

 

In this two-part video briefing, Ronald Bernardi summarizes the key points of the President’s Letter below. 

The 2009 municipal bond market was much kinder and gentler than the 2008 version and, as a result, some investors are falling back into the pre-2008 malaise: making uninformed or spur-of-the-moment investment decisions often based upon inadequate information. 

Recently a client asked, “what did you learn about the bond market during the financial crisis?” I prefaced my response by saying, “before the crisis ever happened we already believed in our investment philosophy; the crisis indelibly reinforced those beliefs. Now, we know our approach is correct.”

The first section of this letter addresses, in part, our client’s question. The balance of my letter focuses on the Build America Bonds Story.

A few of my 2008/2009 financial crisis “takeaways”:

1. Understand your bond investment because underlying credit quality, purpose and structure matter. Always start the bond investment process with credit analysis. Hands on credit analysis is best. An outside rating agency credit assessment is helpful in determining credit quality, but is only one credit metric to consider. What is the purpose of the debt issued? What party are you lending to and how does the obligor intend to pay you back? Are your funds close to the obligor or are they 2, 3 contra parties (auction rate securities) removed? If you are unable to figure any of this out, the investment probably should be avoided.

2. I am convinced more than ever that the “perfect” bond market hedge does not exist. Many, many investors lost money over the last 18 months on “hedged” bond investments and swaps. Some would have seen their “hedged” investments wiped out entirely had not the government rescued certain financial institutions. When making an investment in the bond market, understand there is risk and be prepared to lose money occasionally. If you cannot reconcile with that possibility, you should not invest in the bond market.

3. Complex derivatives equal volatility. There is nothing wrong with this dynamic. In fact, the volatility dynamic often works wonderfully in your favor when the market is going your way. Returns can be significant. However, when the market goes against you, this volatility often creates significant loss. 

4. Outsourcing bond portfolio management, bond credit analysis and regulatory oversight and control responsibilities often proves problematical for companies. At Bernardi Securities Inc., we have in house vertical integration of these services, which provides our clients significant advantage in terms of flexibility, market efficiency and operational integrity. These services are at the core of our business model and our near complete control over them is the primary factor responsible for our clients’ success over the years.

5. The municipal bond market has been amazingly resilient despite many setbacks over the past 18 months. The marketplace has served investors and state and local governments for over 100 years helping to raise capital for public projects. It has not always been easy or the most efficient process, but, all in all, the system has worked remarkably well at allocating capital for local projects at reasonable borrowing costs. 

The 2009 municipal bond market storyline featured three major themes:

1. Sharply higher bond prices

2. Continued stress on issuer credit quality in many sectors

3. Build America Bonds

We have discussed the first two themes in detail in recent publications so today I will focus on the Build America Bonds (BABS) story.

The BABS program was part of the American Recovery and Reinvestment Act of 2009 and its purpose was to temporarily (calendar year 2009 and 2010) assist municipalities access the credit markets and spur local capital projects in order to create jobs. Certain issuers had difficulty accessing the credit market in the latter half of 2008 and early part of 2009. Additionally, many issuers that did access the marketplace paid higher interest rates than they had become accustomed to paying during the first part of the decade. Job creation is a noble goal, of course. All of these factors led to the creation of the two-year BABS program.

The BABS experiment has transformed the municipal bond marketplace. If success is measured by usage, then the program’s success has been remarkable. Approximately $64 billion in new bonds have been issued since the program’s inception in March of 2009 as States and municipalities across the nation have borrowed under the program. The program pays them a 35% (45% for super BABs) federal subsidy on the interest cost of taxable capital projects bonds they issue in 2009 and 2010. Faced with the option of issuing traditional, non-taxable bonds for the same capital projects or the federally subsidized taxable bonds, responsible state and municipal officials across the country are opting for the BABS program when it is economically advantageous for them to do so. The program gives municipal bond issuers a powerful new tool to raise money because it expands issuance option and the investor base.

If success is measured by usage, then the program’s success has been remarkable. Approximately $60 billion in new bonds have been issued since the program’s inception in March of 2009.

Recently, many elected officials have indicated support to extend and expand the program. President Obama has included provisions in the administration’s fiscal 2011 budget proposal making the BABS program permanent, expanding the program’s permitted uses and reducing the federal subsidy from 35% to 28%. I expect the proposed expansion will prevail in some form. 

I am worried, however, of the potential negative, long-term implications of the BAB program for both municipal governments and all taxpayers. Here’s why:

1. Significant program cost to taxpayers – The Congressional Budget Office (CBO) January 2010 report estimates the BABS program will cost the Treasury $26 billion in ADDITIONAL outlays over the 2010-2019 time period. This significant cost overrun has occurred in just ten months and does not include any additional costs that will result from extending and expanding the program as currently proposed. In an earlier 2009 report, the CBO estimated the BABS program tax credits would cost taxpayers approximately $1 billion a year from fiscal 2012 through 2019. The current CBO estimate for the program is over $3 billion a year through 2019. In short, the current BABS program is over initial budget estimates by a factor of three in 10 months. Keep in mind these estimates do not include program administrative and compliance costs either at the local or federal level.

How much additional cost can we expect from an expanded program? Who knows? But, the cost to taxpayers will be significantly greater than the basis on which the program was introduced in early 2009.

2. Why pay less, when you can pay more? – At the macro economic level, the need for the program today makes much less economic sense than it did one year ago. Let’s remember the program was initiated to assist municipal governments access the market and help lower borrowing costs for those who paid too high a price during the height of the financial crisis in 2008 and 2009. This market dynamic has changed dramatically (in part, because of the BABS program) and, today, most municipal governments enjoy wide access to the municipal market and historically low borrowing costs. Only the credit challenged municipalities that perennially run deficits appear to be experiencing elevated borrowing costs. In short, a relatively efficient and accessible municipal bond marketplace for most issuers has returned now that the investing world has calmed and the panic that ensued from the 2008 financial crisis has passed.

Therefore, why extend and expand the BABS program? Why offer the program to all municipalities regardless of financial strength? The program, as it is currently structured, allows local issuers to borrow at lower interest rates than its economic fundamentals would otherwise allow and is paid for by taxpayers across the nation. Is this behavior we want to encourage? Perhaps, the program should be extended only to the weakest municipal credits with some fiscal strings attached. Should taxpayers across the nation subsidize 35% of, let’s say a 6% taxable bond issue to finance the construction of a park district facility half way across the country for a solvent, well run district that could finance the project on its own at a 4.50% non taxable rate relying on local tax receipts or revenues to pay off the loan? Should taxpayers across the country subsidize a poorly run issuers finances and help it defer the tough economic decisions it should resolve? Why pay 6% at the national level rather than 4.50% at the local level? 

Financial independence and the ability of state and local governments to raise capital independent of the federal government is critical to maintaining this balance.

3. The BABS program serves to reduce a tax break benefiting the wealthy? – The federal income tax exemption enjoyed by municipal bond investors has been in the gun sights of many in Congress for years. The BABS program will help reduce this subsidy to the rich, say certain proponents of the program, by reducing the supply of non-taxable bonds available for investment forcing some investors into buying taxable BAB municipal bonds instead. These taxable investments would generate tax receipts for the Treasury. In fact, the Treasury recently stated it would spend $2.9 billion in 2010 on the program while recouping $1.3 billion in taxes paid on interest earned by BABS investors during the same period for a net program cost of $1.6 billion. The figures, I assume, are correct. But to refer to a “net” cost figure is somewhat misleading because the “net program cost” analysis has a serious flaw, I believe. 

At Bernardi Securities, Inc., we have not seen the investor crossover assumed in the analysis. Investors in high tax brackets are not shifting their investment dollars from non-taxable municipal issues into the taxable municipal BABS issues. High income tax bracket investors continue to invest their capital in the remaining $2.5 trillion pool of outstanding non-taxable municipal bonds. In the years ahead, we expect high tax bracket investors will continue to invest their capital in the remaining substantial supply of outstanding non taxable issues as well as new non taxable issues that will come to market. There is no doubt the program is generating tax receipts for the Treasury, but the receipts, I suspect, are coming mostly from investors who in the past invested in other types of taxable bonds. The fact is, the significant investors in the BABS issues to date have been foreigners, pensions, other types of retirement accounts and low income tax bracket taxpayers. For the most part, these are investors who pay either no federal income tax or pay taxes at the lower end of the spectrum. One thing is for certain: the jury is still out on this one and it will be years before we have accurate data on the issue. My guess is that what we are seeing on a small scale at Bernardi Securities, Inc., will prove to be consistent with the wider view.

4. Maintaining an historic balance between federal power and states’ powers is critical in my view. Financial independence and the ability of state and local governments to raise capital independent of the federal government is critical to maintaining this balance. The BAB program may well threaten all of this.

The U.S. Supreme Court ruled in 1895 that the federal government had no power under the U.S. Constitution to tax interest on municipal bonds (Pollock vs. Farmer’s Loan & Trust Company, 157 U.S. 429) because such a tax violated the doctrine of intergovernmental tax immunity (“the power to tax involves the power to destroy”, Justice John Marshall, 1819). This Court decision laid the foundation for the development of the tax-exempt municipal bond market. Following the enactment a federal income tax in 1913, the federal government has indirectly aided municipal governments finance capital projects by exempting interest income on state and local government debt from federal income tax. Over the decades, the tax-exempt municipal bond market has developed into a sophisticated marketplace; a market that has provided capital for thousands of municipal projects. In short, the tax-exempt municipal bond market has helped state and local governments raise capital for local projects independent of the federal government and its often fickle agenda. This ability to raise capital has played a significant role in maintaining the balance between federalism and states’ powers, a central tenet on which this nation is founded.

In 1988, the Supreme Court ruled (South Carolina vs. Baker) Congress could tax interest income on municipal bonds if it so desired on the basis that tax exemption is not protected under the Constitution. There have been occasional attempts to remove the tax-exempt status of municipal bonds over the years, but none has been successful to date. The BABS program does not threaten the exemption directly, but certainly challenges it an indirect manner. 

After all, if Congress were to increase the federal subsidy on BABS issues from the current 35% to, say 80%, would it not, in effect spell the end of the tax exempt bond market over time as virtually all municipal issuers would opt for issuing the taxable debt in order to receive the generous federal handout? Today this seems farfetched, but with every diminution of the tax-exempt bond market, the financial independence of state and local governments is also diminished. 

Let me be clear that I do not believe BAB proponents have hidden motives. I agree with and applaud the program’s initial intent and its resounding success to date.

But things change as do the powers in Washington and I believe it is very important all of us at the local level understand the broader implications of the current program and the proposed expanded version. Specifically, the current proposal to expand the BAB program includes allowing the federally subsidized bonds to be issued to pay for municipal issuers refinancings and operating expenses.

These proposed expanded uses of the BABS program strike me as inconsistent with the program’s original intent. Why the change? Will the federal government require these subsidized funds be spent in a specific manner to promote its agenda once municipalities are hooked on the federal subsidy? Oregon’s Senator Ron Wyden, who is a key sponsor of the BABS legislation, has stated, “I would like to see different flavors of BAB’s created…that would allow us to adjust the subsidy and give, for example, transportation infrastructure investment a larger subsidy than other types of projects because transportation projects typically create more jobs and other public benefits. 

Should we create a system where taxpayers across the nation are subsidizing a municipal issuers operating capital?

Years ago (1978), I wrote a paper on the “Municipal Finance System in Italy”. I was junior in college, studying in Florence, Italy and had the opportunity to interview city officials, local politicians and University of Florence finance professors all of whom helped me in my research. At that time, the saying, “all roads lead to Rome” applied to the way in which Italian municipal governments received funding for local projects. There was a tedious, red tape laden, seemingly never ending bureaucratic process that local governments had to endure in order to receive funding from the central government in Rome for the most basic municipal projects: school construction, street improvements, water and sewer system improvements.  

To a person, all of the people I interviewed were frustrated by the inefficiency of the financing process and the lack of independence that existed at the local level. Local governments enjoyed very little independence from Rome because Rome controlled the purse strings of the local governments. It was an illuminating lesson to learn first hand.

It is a lesson I have never forgotten.

Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
February 2010

 

 

Michelle Bernardi Landis summarizes the key points of the President’s Letter below. 

There have been many news stories recently regarding the municipal bond market and its impending debt crisis. Most of them have been unnerving and intimidating. Many of these sensational news stories are warranted while many are overblown and will be played out in the years ahead.

The purpose of this piece is to discuss the relevant issues featured in today’s municipal bond credit market. In addition, our intent is to give readers a flavor for how we, here at Bernardi Securities, Inc., approach municipal bond credit analysis. We will explain our view of the various types of municipal issuers and how we apply our research framework in the decision making process even as these issuers are faced with mounting financial stress and uncertainty.

This piece is long as the subject matter requires a thoughtful and thorough response.

I urge you to read it in its entirety.

“PAST PERFORMANCE IS NO GUARANTEE…..”

– Bond fund prospectus, December 2010

We often remind our clients that investing entails risk. Our experience and common sense tell us that the municipal bond market is not and cannot be immune from the financial crisis we have all endured the last few years. Frankly, these are difficult economic times and we will likely be mired in them for several years to come. We take comfort in that, historically, traditional municipal bond investments have a long, proven and stellar track record of paying principal and interest promptly. Moreover, default rates for municipal bonds are well below similar metrics for corporate bonds. Finally, and most importantly, despite the headline grabbing news stories, municipal bankruptcies have been a very rare occurrence. All that said, it is the disclaimer at the bottom of every prospectus, “past performance is no guarantee of future results…” that serves to alert us all that losses may occur when making an investment, including a municipal bond investment. As an investor, if you are uncomfortable with this possibility, you should not be in this marketplace.

We do believe a traditionally structured municipal bond portfolio will be better able to weather the present day financial crisis than many other bond investments. Our belief is based, in part, on the experience of our clients in 2008, which for many investors was disastrous. Calendar 2008 is also a recent scenario we can reference. The operative phrase in our belief is “traditionally structured” and later we will explain how we define that phrase. In order to do so, we will first need to describe our core beliefs on municipal credit analysis.

“MUNICIPAL FINANCE IS MOSTLY A LOCAL PHENOMENON”

– Unnamed municipal finance administrator, circa 1988

I first heard that phrase many years ago from an administrator of a municipality. Admittedly, at first, I did not understand what he meant by it. It took me some time, but after reflecting on it for a while, I figured out its significance and relevance. Years later, his assertion helped us to develop and today serves as a centerpiece of our municipal bond credit analysis process.

In our view, there are three constants to the municipal bond credit analysis process:

Deal purpose matters
We ask: Pool or school, municipal court or tennis court?

Deal structure matters
We ask: is there a specific tax or revenue source backing the issue or is it simply a “promise to pay” pledge?

Underlying credit quality matters
We ask: what does the issuer’s P/L and balance sheet look like?

At Bernardi, these are the 3 pillars upon which we build a traditionally structured municipal bond portfolio.

In our opinion, a bond’s rating is an important metric, but not necessarily the only credit metric to consider. The above questions serve as a few examples of what needs to be asked to better assess credit quality beyond a rating. Normally, one or two pieces of information alone will not determine if a credit is solid; information in the aggregate allows us to make that determination. Often, if the answers to questions in one area indicate a weaker credit (underlying credit quality, as an example), then we will look for a greater strength in other areas (deal purpose and structure, as an example). This is most often a labor intensive process.

We have found in our experience of over a quarter century, that almost always, when a municipal bond portfolio is comprised of bond issues with clear deal structure, traditional purpose intent and sound underlying credit quality, timely principal and interest payments have been made. It is our expectation that issuers at least meeting those three standards are better equipped to withstand the inevitable fiscal stresses. We will have to wait and see if past events serve as accurate predictors of our financial futures.

Conversely, when principal and interest payment problems have occurred with issuers, it is almost always, in our opinion, because the issuer falls short with one or more of the Bernardi pillars. Current examples include:

Harrisburg, Pennsylvania – solid waste issue deal purpose, city wide debt service guarantee deal structure and weak underlying credit quality.

Jefferson County, Alabama – esoteric auction rate deal structure coupled with excessive underlying debt load.

Vallejo, California – excessive operating and pension expenses resulting in very weak underlying credit quality; weak deal structure.

All three of these issuers have been tenuous credits for years, long before their present day problems were plastered on the front page of newspapers. It was readily apparent to anyone who took the time and effort to thoroughly analyze these credits. For this reason, many years ago, all three of these credits failed to qualify and make our approved list of credits for our portfolio managed portfolios.

Today, the list of stressed municipal bond credits is as large as I have ever seen in my 30 year career. Therefore, adherence to a thorough and disciplined credit analysis process is of critical importance.

“SMALL IS BEAUTIFUL”

– E. F. Schumacher, British economist, 1973

Generally, from a credit quality perspective, we tend to favor small to medium sized municipal issuers over the large, big name issues. That said, there are many large issuers of municipal bonds that are currently on our approved list.

Our bias for small to medium sized issuers is based on several factors. Keep in mind the factors listed below are generalizations and should not be automatically applied universally:

Clarity of audits and other financial documents – For those issuers in this group, specifically diligent issuers that file financials regularly and on time, the information is typically discernable and easily understood. We can usually see the good, the bad and the ugly in the financials. This is not always the case with the larger issuers.

Simple and traditional financing methods – Most often this group of issuers keeps it simple when they issue debt. Financing techniques like auction rate securities, credit default swaps and interest rate swaptions are rarely used by this group. Rather, old fashioned, plain vanilla, fixed rate, fixed maturity, self – amortizing debt structures prevail. An issuer develops a financing plan and pays it off over the useful life of the project, all the while locking in an affordable fixed rate. They remember they are in the business of providing needed municipal services and are not in the finance business, thereby avoiding the mistake made by several large, supposedly sophisticated issuers. Many of the larger issuers currently experiencing stressed finances today would be much healthier had they followed this approach.

Lower current and future operating costs as a percentage of the overall budget – Generally, the expense side of the ledger for this group is less onerous. Labor contracts and benefits tend to be more reasonable and there is usually less bureaucratic waste as a percentage of the budget.

The business of the municipality tends to be run more like a business because very often the elected official decision makers are local business people. Generally, smaller communities will give us swifter responses to financial questions we might ask. Often, we can discuss important issues with high ranking municipal officials more easily and we often find that our input is given important consideration. We understand politics play a role in the running of every municipal government, but generally (and most certainly not universally) the presence of the above factor tends to better insure that financial decisions will be made without being overshadowed by political considerations. 

“TAKE NOTHING ON ITS LOOKS; TAKE EVERYTHING ON ITS EVIDENCE. THERE’S NO BETTER RULE.”

– Great Expectations, Charles Dickens circa 1860

We believe when assessing municipal bond credit quality one needs to look at details of the specific credit (“municipal finance is mostly a local phenomenon”). Clearly, the State of Illinois is a weakened credit today, but this does not lead us to conclude all credits in Illinois are weak. Many are, but many more are not. We make this determination only after going through our credit analysis process.

Frequently, the process is made all the more cumbersome as municipal financial disclosure rules are much less stringent than rules governing U.S. corporations. Financial disclosure by municipalities has improved greatly over the last 20 years, but it still needs improvement. We expect this issue to be fast tracked by regulators, particularly given the spotlight that has been thrust upon this segment of the market. For our needs, we have found a sufficient number of municipal governments that provide adequate and timely financial information. For those that fall short in this area, well, that serves a red flag in our research process.

We often say at Bernardi that municipal credit research is much more an art than a science, there is no silver bullet answer or one statistical measure. It is a very diverse market place and, as we have preached before, not all municipal bonds are created equal (visit www.bernardsecurities.com website, “President’s Letter Fall 2000”).

These days we are often asked, “How do you determine if a bond’s quality is satisfactory?”

The following is an abbreviated glimpse of our municipal bond credit analysis process which should help explain how we try and answer the above question:

The issuer is a small community (approximate population of 11,000) in northwest Indiana approximately 45 minutes from downtown Chicago, Illinois. This issue is non –rated. The municipality is issuing $5.0 million of Sewage Works Refunding Revenue Bonds. First question we ask ourselves is what are these bonds being issued for? It is an essential service project for a school, road, or other infrastructure or is it more of an economic development project involving private developers or special taxing districts?

The PURPOSE (“pool or school?”) for this community’s debt issuance is to refund three series of outstanding bonds. The refunding aggregates the individual payments into one payment and restructures the principal payments to provide level debt service over the life of bonds. This is important as it gives the community a predictable fixed payment schedule and conceivably limits the possibility of sewer users experiencing a large rate increase to compensate for higher debt service costs. The city saves an estimated 7% of par value over the life of the bonds, equating to between $350,000 and $400,000 during the next 15 years.

Next we look at STRUCTURE (specific, pledged revenue stream or promise to pay?) and legal provisions. This section is particularly important for bondholders as it addresses a lot of the “what if” scenarios that could occur before maturity. Structure questions run from the basic: “is this a 5, 10, 20, 30, or 40 year maturity schedule? Why?” To the more nuanced: “is there an intercept, either a tax-intercept set up to make sure tax revenues earmarked for debt service are set aside before the funds even reach the municipality or a special state-aid intercept program, which in the event a municipality cannot make its debt service payment, the state will use that municipality’s state aid to make the payment in full to bondholders?” We view legal provisions as specific to revenue type deals. “Is there a debt service reserve, is it fully funded today, does it use cash on hand or bond proceeds?” “Is there a rate covenant?” “What’s the Additional Bonds Test?” “What is the flow of funds? Is it open or closed?”

In our case study, the bonds are sewer revenue bonds. Between the offering document and the bond ordinance we were able to answer our structure questions. The deal has a 15 year amortization schedule, there is a debt service reserve fund, and it will be fully funded at the deal’s maximum annual debt service (MADS) with cash on hand at closing. There is an additional bonds test that states net revenues must be 125% of existing and proposed parity MADS. The municipality also maintains a rate covenant stipulating that sewer rates will be set annually to meet all expenses and obligations.

Finally, we look at the UNDERLYING SECURITY or the revenue stream pledged for repayment on bonds. In our example, the bonds are backed by the net revenues of the city’s sewer system. Net revenues were defined as gross revenues of the sewage works system after deduction only for the payment of the reasonable expenses of operation, repair and maintenance. We calculated both the historical and proforma coverage.

              Prepared by Bernardi Securities, Inc. Credit research 

This table shows the sewer utility business is currently profitable; in fiscal year 2009; the utility, after paying operating expenses, had $1.69 available to pay off every $1.00 of its bonded debt due that year. In 2010, the coverage ratio is projected to increase to a very healthy 2.76 times. Our data base confirms a solid coverage ratio has been in place for many years. Additionally, after studying the current audit, we know pension liabilities and other post-retirement benefits are adequately funded at this time, debt is self -amortizing and there is no variable rate debt or credit default swaps (derivatives) on its books. In summary, after completing this analysis our in house Credit Committee concludes this issuer may be placed on our approved list of credits.

Understand that this current analysis is no guarantee of future financial stability. It is impossible to assess today what the future holds as any number of factors may come into play that could lessen credit quality. For this reason, the credit review process needs to occur periodically.

What we DO understand from this analysis is that currently, this is an attractive, viable credit. It is more attractive, from a credit perspective, than many higher rated issues in our opinion.

This is our credit research process. Many times during the course of a month, credits that come before us do not meet our qualifications; they do not make the approved list. Our process is dynamic and far from perfect, but it has served our clients very well for almost thirty years.

“IT’S A BAD PLAN THAT ADMITS NO MODIFICATION.”

– Publilius Syrus, 1st century, B.C.

“What should I do now?” is a question we are often asked these days by many of our investor clients; our pat answer is, “modify your portfolio so that it has traditional structure.”

Early in the text, we stated our belief that a traditionally structured municipal bond portfolio will be better able to weather future financial stresses. Here is how we define such a portfolio:

  • Separate account, non–leveraged comprised primarily of fixed rate, fixed maturity laddered individual bonds
  • Well researched, quality issues for traditional purpose intent
  • Minimal derivative investment exposure

We believe a municipal bond portfolio with the above attributes will provide a reliable income flow while offering reduced portfolio volatility and greater portfolio liquidity than many other available options.

The municipal bond market going forward will have diminished market liquidity, this will result in continued price volatility causing pain for some investors while creating nice opportunities for the disciplined and informed.

The municipal bond marketplace is a resilient one and has played an important role in the economic life of this nation for decades. We look forward to the years ahead.

We hope this writing is helpful. Thank you for your continued confidence.

Sincerely,

Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
January 6, 2011
www.bernardsecurities.com 

 

Last month I was invited to participate in an hour-long discussion hosted and aired live by InvestmentNews, Muni Markets: Maneuvering Through the Minefield. The content was wide-ranging and lively. Over the past few years, we have written about a number of the topics discussed, while other issues covered by the group offered new material to our ongoing discussion and musings on today’s municipal bond market. I want to share some of the highlights of the conversation along with a few follow up thoughts.

All municipal bonds are not created equal

“….we are continuously surprised to find the general attitude among certain municipal bond investors that all bonds are really the same and that certainly all “AAA” rated issues are equal. The belief that an insurance policy on a bond issue somehow creates a municipal bond commodity that should be valued uniformly is wrong”, as we highlighted twelve years ago in our Fall 2000 market update.

For those of you that have a long history with us, you have heard variations on the above theme, ad nauseam. The two co-panelists took time during the early part of the discussion sharing their insights on insured bonds and agreeing with what we wrote in 2000. We believe the diverse and fragmented nature of the municipal bond market is an immutable fact and one of its real credit strengths. Municipal bonds are not and never were homogenous assets. Attempts to create uniformity are misguided, in our view.

Historically, in a normally functioning market, issuer diversity allows sound credits access to capital at an affordable rate, while providing lesser credits access to the market at an appropriately higher borrowing rate. Certain below average credits may temporarily lose access to the market until finances are stabilized. We believe the presence of this dynamic is a primary reason for the historically low default rate of public purpose, essential service municipal bond issues. We believe any force — including municipal bond insurance and a federal guarantee of municipal bonds — that significantly blurs or masks the diversity of underlying credit quality of issuers is a big, fat red herring.

The illusion of credit homogeneity is bad for the investing public and should be viewed warily. In many ways, the present day insured bond market functions as it originally did in the early 1970s. It provides average and below average issuers with wider market access to investors at a reasonable cost — and provides investors with a heightened level of security for these credits. Stellar stand-alone credits eschew the insurance option almost universally.

Today, since the market no longer views all insured bonds as part of one credit continuum, yield disparities exist across the insured market and investors typically earn different returns from insured bonds. This was generally not the case prior to the collapse of the insured market in 2008-2009.

The portfolio management process starts with credit research

This has been a Bernardi mantra for many years. The specifics of each credit are largely what matters and serve as a centerpiece of our portfolio management process. The panel discussed at great length the importance of bottom up credit analysis as well as some of the nuances of a proper municipal credit research process.

At Bernardi Securities, credits do not qualify for our approved list and issues are not underwritten until the underlying credit quality meets the standards of our credit committee. Analysis of the issuer’s underlying credit quality is required. Oftentimes, a look at an issuer’s P&L and balance sheet is needed in order to gain an insightful understanding of the strengths and weaknesses of a particular issue. Ratings and insurance policies are helpful credit metrics, but the analysis does not stop there. We find this deeper understanding of a credit also helps us in properly bidding or pricing the security.

The panel also touched upon the differing role a host county or state government may play in determining the strength or weakness of an issuer. I pointed out the hands-off policy the state of California adopted towards the recent California municipal bankruptcy filings as a “credit negative.” To us, it is a notable, Bill Engvall “there’s your sign” moment when the state of California stands by and allows three of its municipalities to file for bankruptcy as they disavow legal and financial commitments to secured bondholders.

We contrast this laissez-faire approach with the more proactive approaches of state governments in Michigan, Pennsylvania and Rhode Island when confronted with similar situations. The actions taken in 2010 by Rhode Island’s state legislature (Fiscal Stability Act) assisted Central Falls in its Chapter 9 filing and protected secured bondholders, as did last year’s law — giving bondholders priority lien on property taxes and general fund revenues in any Chapter 9 filing. These actions are notable and significant “credit positives” for bond investors. We are not attorneys so we won’t waste our time or energy arguing whether Golden State statutes allow or prevent the state of California from acting similarly. We will simply look for other places to invest our client’s money until we see some clarity on secured bondholders senior lien status — an issue that is crystal clear in our minds.

There is much talk in Washington these days amongst legislators and regulators about improving liquidity in the municipal bond market. Market liquidity has improved greatly over the 32 years I have been in this business. Improved liquidity is good for investors and issuers. It lowers borrowing costs for most issuers of municipal bonds.

The recent improvements in liquidity, however, will be compromised if sovereign state governments sit idly by and allow local units of government to disavow their financial obligations to secured bondholders. Any uncertainty or loss of trust in how the system will behave can cause an adverse reaction amongst investors. This potential development hurts everyone and needs to be met head on. Legislators and regulators could help in spreading the message to state and local governments to avoid this scenario and intervene when prudent.

The chart below summarizes the differing approaches state law takes in regard to Chapter 9 filings. These state variances oftentimes help shape our view — positive and negative — regarding a specific issuer’s credit quality.

An audience question we didn’t have time to get to, but worth taking the time to answer here was “Thoughts on Illinois?” Well, we have many, many thoughts on Illinois given we reside here and are incorporated in this great state. Illinois clearly has its share of problems as underscored by the recent Standard and Poor’s rating downgrade to “A” (negative outlook) from “A+”. We believe the state’s low pension funding level of approximately 45%, coupled with a lack of political will among the legislature to solve the underfunding problem were the primary factors responsible for the downgrade. The special, one-day legislative session convened by the governor last month did not solve the pension issue and appears to have accomplished very little, if anything at all. No measures to address the pension problem were approved by lawmakers during this session.

There are a number of proposed solutions that have been aired, including increasing employee contributions and requiring local school districts to cover pension costs. None have gained sufficient traction amongst legislators at this point in time. Additionally, continued structural deficits persist despite last year’s income tax increases, which are set to expire on January 1, 2015.

Putting these significant problems aside for a moment, there has been some positive news regarding the State of Illinois economy. A report recently released by the Illinois Municipal League cited the following positive developments:

  • Per capita LGDF distribution up 4.5% — In fiscal 2012 (May 2011- April 30, 2012), per capita distribution of Local Government Distributive Fund (LGDF) was $81.44 which was a 4.5% increase over the prior year’s distribution. LGDF is distributed to municipalities and counties on a per capita basis and represents income tax receipts collected statewide.
  • Expected to grow another 2-2.5% this year — Current year LGDF distributions are expected to exceed last year’s payments by approximately 2%-2.5%.
  • Out-of-state use tax distributions up more than 7% — Distributions to local governments of the Illinois use tax on out-of-state purchases increased by over 7% last fiscal year compared to a year earlier.

Willingness versus ability to pay

I found this part of our discussion both fascinating and frustrating. Fascinating in that, as panelist Stephen Winterstein correctly stated, today there are handful of issuers that have chosen not to pay secured debtholders in spite of the fact dedicated revenue streams are sufficient to honor certain debt commitments. We discussed the possibility that certain issuers seem to be using bankruptcy and default as a financial tool.

In the past, defaults have occurred mostly because projects failed financially. For example, revenues from a project were insufficient to cover debt service or taxes collected were insufficient to cover debt service. Today, in a limited number of instances, a sufficient, secured source of revenue exists, and is pledged to a specific debt issue payments — yet elected officials choose to use these funds for other purposes to satisfy another need and constituency. This unwillingness to pay is not a new phenomenon, but it certainly appears to be more widely accepted today than in the past. The issue of political will is a frustrating and worrisome development.

We wrote on the topic in our June market commentary and more recently in our 2012 Mid-Year Municipal Market & Credit Update. Admittedly, determining issuer willingness to pay is difficult as it is mostly an intangible concept. But there is some art to this science and decades of experience and municipal market specialization has taught us a few things, which we often incorporate into our credit research process.

There are some positive signs and trends on this issue. San Bernardino, California recently reversed itself when it filed its budget plan to pay for city services during its bankruptcy proceedings. The current plan includes debt service payments for its outstanding general obligation pension bonds. Previously, when the city adopted an emergency budget before filing for bankruptcy, its plan excluded such payments.

Warren Buffett’s municipal bond sale was just a trade

The panel was asked about Berkshire Hathaway’s recent termination of $8.25 billion in credit default swaps representing approximately one half of its exposure. The group briefly discussed the topic and agreed it did not view the Berkshire bond sale as a signal it expects massive municipal bond defaults or bankruptcies. InvestmentNews summarized this discussion in the article Buffett’s muni sale no cause for concern, experts say. We at Bernardi view it as a trade. Mr. Buffett is a very smart man and was astute enough to underwrite insurance against municipal defaults back in 2008 and he’s paid out very little. We suspect he’s made a lot of money on that trade. We don’t necessarily conclude he sold because he’s concerned about massive defaults in the muni market. As William Shakespeare said — and we often quote — “Sell when you can; you are not for all markets.”

We have no illusions that more municipal bankruptcies and defaults lie ahead, because there are significant credit problems remaining in many places across the country. Certain issuers will successfully navigate through these difficult times, others will not. Keep in mind bankruptcy does not necessarily equal bond default, and similarly, bond default does not necessarily lead to bankruptcy.

Municipal transparency imperative lost in the Whitney hype

In her oft-referenced 60 Minutes interview on December 19, 2010, Meredith Whitney claimed, “You could see 50 sizable defaults. 50 to 100 sizeable defaults. More. This will amount to hundreds of billions of dollars worth of defaults.” When asked about this statement, our group discussed it briefly citing the obvious. Clearly, these events did not occur in 2011 as predicted by Ms. Whitney.

To me, however, her missed clarion call was helpful for two reasons:

  • Strained state and local government finances received needed attention – Additional attention was brought to the generally strained financial condition of many state and local governments, forcing elected officials to begin to deal with structural budget imbalances. Certain issuers have responded in a positive fashion and many others have not.
  • Better municipal disclosure is truly needed – Lost in the hullabaloo surrounding her commentary was the observation regarding the lack of transparency in the municipal marketplace and the need for better financial disclosure practices.

The need for improved and timelier municipal disclosure has been a theme of ours for years and good progress has been made recently. Between July 2009 and June 2012, the Municipal Securities Rulemaking Board (MSRB) received 396,091 continuing disclosure documents with 139,043 submissions in the most recent 12-month period. During this three-year period, approximately 53% of the submissions were for event disclosures and 47% were financial and operating disclosures. Lastly, on a month-to-month basis, the number of continuing disclosures received by the MSRB has generally increased since it began collecting documents. This is remarkable progress in a short period of time.

Another audience question revolved around the quality of this information, it’s timeliness and completeness. Generally, we find the quality of information available in audited financial statements is very good and complete. We also find that when we take the time to telephone an issuer or its auditor to inquire about an item in their audit, parties are generally responsive and helpful in answering our questions. Timeliness of filings remains a problem in too many cases.

Continuing improvements in this disclosure area are needed, and when they are implemented will greatly increase market efficiency for issuers and investors. The SEC released an extensive report on July 31, 2012 entitled “Report on the Municipal Securities Market.” A section of the report focuses on improving issuer disclosure practices. It offers several legislative considerations in order to provide the Commission the authority to improve disclosure practices:

  • Authorize the Commission to require municipal issuers prepare and disseminate official statements and disclosure during the outstanding term of the securities, including timeframes, frequency for such dissemination and minimum disclosure requirements,
  • Authorize the Commission to establish the form and content of financial statements for municipal issuers who issue municipal securities, including the authority to recognize the standards of a designated private-sector body as generally accepted for purposes of the federal securities law, and provide the Commission with attendant authority over such private-sector body.
  • To provide a mechanism to enforce compliance with continuing disclosure agreements and other obligations of municipal issuers to protect securities bondholders, authorize the Commission to require trustees or other entities to enforce the terms of continuing disclosure agreements.

There exists a wide gap between the recommendations cited in the report and the reality of what changes can be actually put into place. Suffice it to say, additional regulatory changes are coming to the municipal bond marketplace.

The bedrock for local government funding

The market today is far different from what it looked like a few short years ago. Compared to the marketplace of 1980, when my career began, it has evolved and become a more complex, vastly improved marketplace for both investors and issuers. Additional improvements are needed and certainly will occur. A major overhaul of the marketplace would be a serious misstep and create havoc for issuers, adding to the already high degree of investor uncertainty that pervades today’s financial markets. As SEC Chairman Mary Schapiro has pointed out, “The municipal securities market is the bedrock for funding of local government projects throughout our country.”

The municipal bond market has held up surprisingly well since the 2008-2009 financial crisis. Bond issuance and investor demand levels rebounded nicely following the dramatic declines in the fall of 2008 and spring of 2009. Generally, municipal bond yields today — although low by recent historical standards — offer attractive value relative to U.S. Treasury, certificate of deposit and highly rated corporate bond yields. In recent years, annual total return performance numbers for municipal bond portfolios have compared favorably to other asset classes. The market has evolved nicely since the fall of 2008.

What bonds do we like?

During the panel discussion we were asked, “What areas of the municipal market do you like today?” Our response, as always, was that we prefer investing in safe sector, public purpose municipal bond issues — issues that demonstrate sound underlying credit quality, essential public purpose nature and solid deal structure characteristics.

We have found over several decades, these types of issues have performed very well for our clients’ bond portfolios. Our preference for these municipal bond sectors has been emboldened as issues with these features generally weathered the 2008-2009 financial crisis.

Sincerely,

Ronald P. Bernardi
President/CEO
Bernardi Securities, Inc.
September 14, 2012

“You could see 50 sizable defaults, 50 to 100 sizable defaults, more. This will amount to hundreds of billions of dollars worth of defaults.”

– “60 Minutes”, Meredith Whitney commentary, December 2010

 

“The notion that many bond investors have that all municipal bonds are equally secure is at best, a silly one and at worst, a dangerous one. In most instances, municipal bond investors will be paid promptly. The importance of hands on credit analysis and reliance on traditional municipal issuer credits remain an important component of sound portfolio management.” 

– Bernardi Securities, Inc., “Bond Market Commentary”, October 2007 

 

2011 began with a tumultuous municipal bond market – the result of Ms. Whitney’s December prediction. Investors withdrew approximately $14 billion from municipal bond funds between December 22, 2010 and February 2, 2011 as bond yields increased and prices declined sharply. Many worried investors sold quality bonds during this period.

Eleven months later, 2011 closed with a bullish municipal bond market, the best in many years for investors. Bonds did not default en masse as predicted. Capital flowed back into the market in the final half of the year and bond yields declined to near historic lows. Investors who committed capital to quality municipal bonds in 2011, particularly in the first half of the year, locked in some very attractive bond yields as the municipal bond market was one of the best places to invest your money in 2011.

We spent much time and effort educating and calming frayed investor nerves during the tumult, often referring to one of the themes of our October 2007 market commentary. Throughout the year, our municipal bond research analysts spent hundreds of hours reviewing many of the bond credits on our approved list – reassessing and updating our view on various issuers as well as expanding and improving our credit research process. It was (and remains) a tedious, tiresome and, at times, a seemingly unfulfilling endeavor. As it turns out, our clients’ portfolios exited the year very well, in part, because of this diligence.

Our clients’ 2011 successes aside, we remain alert. Complacency is inappropriate as many potential credit problems exist and will persist in the marketplace for several years into the future. Defaults may well rise in 2012 as structural financial imbalances exist in places across the nation. Today, places like Harrisburg, Pennsylvania and Jefferson County, Alabama are most often cited as the poster children for fiscal mismanagement, but they are not alone. Problem situations must be addressed and rectified in a sensible and expeditious manner.

An important goal of our municipal bond credit research process is to uncover these situations early. Our process is far from perfect as we continually strive to improve it, but it has served our clients remarkably well for the past 27 years. Proudly, we can say our portfolio-managed clients do not own, and have not owned, either Harrisburg, Pennsylvania or Jefferson County, Alabama issues for many, many years. WE CONTINUE TO BELIEVE A TRADITIONALLY STRUCTURED MUNICIPAL BOND PORTFOLIO COMPRISED OF SAFE SECTOR PUBLIC PURPOSE ISSUES IS BETTER ABLE TO WEATHER PRESENT DAY FINANCIAL STRESS.

2011 reminded us of the importance of analyzing and understanding the three pillars of municipal bond credit research. They are, in fact, at the core of our bond research process:

1. Underlying credit quality matters
2. Deal purpose matters
3. Deal structure matters

The three pillars should work in tandem, in our view. For example, when the underlying credit quality is solid, but not stellar, we often look for an elevated deal purpose. The rhetorical question often asked during one of our credit committee meetings focuses on issue purpose, “is it for a pool or a school”. In a stressed situation, deal purpose may make a difference between payment and non-payment.

When the underlying credit quality is acceptable, but at the lower range of our comfort zone, not only will we often seek an elevated deal purpose – we will often want an elevated security structure. If this elevated structural element is missing, we may not allow the credit onto our approved list. An issuer’s ability to pay and willingness to pay are two distinct issues. We believe an elevated deal structure serves to enhance the prospects of the latter and is a required element for certain credits. We wonder if certain decision makers in Harrisburg, Pennsylvania and Jefferson County, Alabama would be acting more responsibly if elements of elevated deal structure had been incorporated into the structure of the bond issues they now disavow.

Lastly, when the underlying credit is stellar, deal purpose and deal structure elements concern us less.

This all may sound confusing, even a bit technically idiosyncratic, but when we examine most of the notable and recent municipal bond defaults, bankruptcies and threatened bankruptcies, they all tend to be lacking, in our view, in the areas of deal purpose and deal structure. When you overlay a weak underlying credit dynamic, it does not surprise us that debt holder interests are compromised or threatened.

We have stated many times over the years that the diversity of the municipal bond market is one of its greatest strengths. The presence of this characteristic rewards both knowledgeable investors and responsible borrowers. The market’s diversity IS a major factor contributing to the historically high percentage of debt repayment of public purpose, essential service municipal bond issues, in our view. 

On the other hand, credit homogeneity reduces the attractiveness of bond market yields for income oriented investors and certain issuers. Investors are lulled into a false sense that all credits are “the same”, accepting low yields while certain poorly run issuers are able to borrow funds at an artificially low rate. This additional, prolonged borrowing cycle only exacerbates the issuer’s existing, underlying credit problems. In the long run, a market dynamic espousing credit homogeneity coupled with a private, or worse, public guarantee of its debt is very costly to all of us, as we have recently experienced with the collapse of most “AAA” rated municipal bond insurers and the collapse and subsequent taxpayer bailout of FNMA and FREDDIE MAC.

“MUNICIPAL FINANCE IS MOSTLY A LOCAL PHENOMENON”

 – An unnamed municipal finance administrator, circa 1988

Last year at this time, I wrote about the circumstances of when I first heard this statement, what it meant and how it helped shape our municipal bond credit research process (i.e. the “three pillars’) over the past 23 years.

With 2011 now in the rearview mirror, I am wondering if the above statement should be expanded along these lines, “municipal finance is mostly a local phenomenon, AS IS THE TREATMENT OF IMPERILED DEBT SERVICE PAYMENTS”.

What do I mean by this?

In 2011, credit problems that had been brewing for years came to a head for three different municipalities: Central Falls, Rhode Island, Harrisburg, Pennsylvania and Jefferson County, Alabama.

Central Falls filed for Chapter 9 bankruptcy in August, Harrisburg filed in October and Jefferson County filed in November. In our view, the filings were not unexpected. More notable and important to us is the manner in which state and local officials have approached the three different filings as it relates to debt payments.

Central Falls

This month, Bankruptcy Court Judge Frank Bailey approved pension agreements between Central Falls and its retirees and public sector unions. Last July, weeks before the City’s receiver filed for bankruptcy, the Rhode Island state legislature passed a new law protecting public bondholders by requiring municipalities to guarantee lenders first rights to collected property taxes and general revenue. This new law confirmed the long held belief of municipal bond market participants and investors that secured bondholders have a priority interest. Its passage, most likely, also compelled retirees, current employees and the State to make the needed financial concessions in order to craft the agreement.

The Central Falls agreement shows how a city, its employees and retirees, working with a responsible state legislature and governor, can reorganize and work through financial difficulties and avoid making a bad situation worse. When a city does this successfully, bond investors will want to invest in the city. I expect that to be one of the positive outcomes for Central Falls.

Harrisburg

After months of internal wrangling, the Harrisburg City Council voted in October, 4-3, to file for Chapter 9 bankruptcy. The Mayor and Governor had opposed the filing and immediately challenged its legality on the basis the filing violated the state’s fiscal code. The code was amended last year to prevent cities from filing Chapter 9. In November, the City’s filing was thrown out of U.S. Bankruptcy Court by Judge Mary D. France who ruled that the City was not authorized to file.

The Court’s rapid and unqualified response coupled with the steadfast opposition to the filing shown by the Mayor and Governor bodes well for secured bondholders and Harrisburg itself. There is much work ahead and a final resolution is far from certain, but recent events create an environment conducive for a more positive outcome.

Jefferson County

The situation here has devolved with potential solutions far from certain and most likely negative for secured debt holders. A recent ruling by the bankruptcy judge sided with legal precedent affirming net system revenues are to be used to make debt payments. The County claimed these net revenues should be placed in an escrow account pending bankruptcy settlement negotiations rather than paid out to cover debt service obligations. Additionally, the Judge agreed with the County by staying the receiver’s control of the utility system, allowing the County to manage and control the daily operation of the utility. Control includes such responsibilities as authorizing expenditures and increasing or reducing sewer rates.

Lower sewer rates would obviously impact the net revenues available to make debt service payments to debt holders. Several elected County officials have decried for years that sewer rates are too high, so we will not be surprised if maintaining current sewer rate charges becomes a negotiating chip with debt holders. As long as the County retains control over these types of decisions, this scenario is very plausible. Given the poor decision making history of those in charge at the utility and the County, we expect trouble ahead for debt holders. Lastly, unlike the state legislatures of Rhode Island and Pennsylvania, the Alabama legislature has done very little to protect secured debt holders rights.

Perhaps the prevailing cavalier attitude towards Jefferson County debt holders is attributable to the fact the debt is held primarily by the investment banks that have some culpability in creating the current chaos. We are not certain of much, frankly, when it involves Jefferson County, Alabama other than this – for our portfolio-managed clients, we continue to avoid, as we have done for many years, any credit associated with the county. And we remain wary of Alabama credits, in general.

Headline risk remains for stressed credits

We expect the Jefferson County and Harrisburg story lines will be major topics of interest for our market in 2012. Additionally, we expect other, similar credit stressed situations to develop in the coming year in other places across the country. The details will be different in each case as will the manner in which affected local and state officials choose to deal with the problem. As we stated above, the municipal bond market is greatly diverse. The presence of this dynamic means there are potentially many different story endings for those municipalities that go the way of Harrisburg, Pennsylvania and Jefferson County, Alabama – some good, some bad and some very, very ugly.

“The power to tax is the power to destroy.”

– Supreme Court Justice John Marshall, 1819

Repealing the tax exempt status of municipal bonds was a major story line for our market in 2011 and at times we wondered if change was imminent. Certain individuals of both Republican and Democratic persuasion called for either an outright repeal or a significant roll back of the exemption. The cacophony culminated in late fall as some members in the “Gang of 12” considered the repeal of tax exemption as a way to reduce the national debt while President Obama proposed, amongst other things, limiting and potentially eliminating entirely the tax exempt feature of municipal bonds. Fortunately, the President’s proposal was soundly rejected and the Gang of 12 decided not to pursue the issue. For now, state and local governments’ continue to have access to favorable financing terms provided by the present day municipal bond market.

Although, the threat has dissipated, it will return to the forefront after the 2012 presidential election. As a result of the discussion over the past year and in anticipation of a renewed debate in the future, our staff spent hundreds of hours over five months researching what might be in store for taxpayers and citizens if Congress eliminates tax exempt bonds and substitutes taxable alternatives and federal rebates instead. Our report is notable for the risks it reveals more than the revenue opportunity Treasury suggests when it calls for eliminating tax exemption.

Tax exemption elimination risks include:

  • Imperiling local autonomy
  • Subsidizing and shifting local debt obligations to an already burdened U.S. Treasury
  • Increasing local taxes and user fees for most citizens
  • Local job loss as new capital projects are scaled back or eliminated entirely due to increased financing costs

Legislators and policy makers need to understand the long history of the well-developed market and have an appreciation for the relative efficiency, equity and effectiveness it has offered state and local governments for more than a century. In doing so, we believe policy makers and legislators will reach the same conclusions we did that:

  • Tax-exempt bonds have been a critical source of capital for state and local governments and support one of the nation’s most consistent and reliable sources of job creation
  • The important status of the tax-exempt municipal market needs to be reaffirmed rather than threatened so that it can continue doing its job without new and unnecessary burdens on issuers, investors and citizens across all economic classes

“It’s a bad plan that admits no modification.”

Publilius Syrus, 1st Century, B.C.

“What should I do now?” is a question we are often asked these days by many of our investor clients. Our pat answer remains, “modify your portfolio so that is has traditional structure.”

Early in the text, we stated our belief that a traditionally structured municipal bond portfolio will be better able to weather future financial stresses. Here is how we define such a portfolio:

  • Separate account, non-leveraged comprised of fixed rated, fixed maturity laddered individual bonds
  • Well researched, quality issues for traditional purpose intent
  • Minimal derivative investment exposure

We believe a municipal bond portfolio with the above attributes will provide a reliable income flow while offering reduced portfolio volatility and greater portfolio liquidity than many other available options.

The municipal bond market going forward will have diminished market liquidity, this will result in continued price volatility causing pain for some investors while creating nice opportunities for the disciplined and informed.

The municipal bond marketplace is a resilient one and has played an important role in the economic life of this nation for decades. We look forward to the years ahead.

If the above paragraphs sound familiar, it is because we wrote the exact words last January as 2011 was beginning. If you have been a client for more than a few years, you have undoubtedly heard similar words from us. We repeat them again because, in our view, the concepts are tried and true when it comes to investing in the municipal bond market. These concepts served our clients well in 1984 (our first year), in 1987 (stock market crash), in 1990 (real estate market collapse), in 2000 (tech bubble market collapse) and most recently in 2008-2009 (the Great Recession). There is no reason to change our approach now.

Nominal bond yields, money market rates and certificate of deposit yields are near or at historic lows. A recalibration of your expected returns and income earnings are in order. The supply of new issue municipal bonds in 2012 should increase from the depressed 2011 level of approximately $300 billion, but any increase will be muted.

Our suggested strategy for 2012 follows:

  • Stay fully invested; although non-taxable nominal municipal bond yields are low, relative to other quality bond sectors, they offer excellent value
  • Invest along the portion of the yield curve suitable to your situation offering the best relative value
  • Rely on market expertise to find yield anomalies; understand the credits in which you invest your funds

“Above all we must work hard to find true value for our clients. The bottom line will take care of itself. This has been true for a life-time.”

– “An Old timers Look at Today’s Municipal Bond Market”, Winter 2001, Edward Bernardi, Chairman, Bernardi Securities, Inc.

We are now approximately halfway through our 28th year and the above written words still resonate in our daily actions. Our firm and our clients’ municipal bond portfolios have moved through the financial disasters of the past several years relatively unscathed and for that we are thankful and appreciative. We strive daily to continue on this course.

As always we thank you for your continued confidence and support. If in town, please visit us at our new, beautiful offices. I would welcome the opportunity to talk with you.

Finally, everyone at Bernardi Securities, Inc. and Bernardi Asset Management, LLC wishes you and your family a healthy, happy and prosperous 2012.

Sincerely,

Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
January 18, 2012

After August outflows, the municipal bond market turned bullish once again in September with four weeks in a row of bond fund inflows – and the last week more than doubling the inflows of the previous week. The month also saw a couple of true superlatives.

Biggest municipal bond fund inflow in a year

Municipals benefited from a September flight to safety as investors abandoned stocks. Tax-exempt funds gained $1.9 billion in September, the best monthly municipal inflow since September 2010. Investors continued the $29.3 billion stock mutual fund outflow in August by withdrawing roughly $4 billion more in the first three weeks of September.

Best municipal bond performance since April 2009

The municipal fund flow reversal was driven largely by the ongoing search for better yields. 10-year tax exempt municipals beat comparable Treasuries for five consecutive weeks – the best performance since April 2009.

Municipal meltdown prediction failing to materialize

Another contributing factor to recent municipal bond bullishness was more favorable media attention, as the apocalyptic predictions of a municipal meltdown are proving to be wildly inaccurate. Questionable math predicted hundreds of billions in municipal bond defaults this year and that has not occurred. As we mentioned in our Mid-Year Municipal Credit Update, less than $10 billion materialized as of June 30th. Actual defaults continue to be a small fraction of those erroneously foreseen.

Regardless of the direction of fund flows or fickle media attention, we always encourage our clients to “know thy bonds” through independent credit research. Please contact your investment specialist if you have any questions on these latest market developments.

Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
September 7, 2011

In this commentary, we will summarize where municipal credit quality has been, where we believe it is today, and what our clients should expect over the near term investment horizon. The municipal market began the year with a tumultuous first quarter, but managed a trend reversal during April and May before leveling off in June. Bond price gains were driven primarily by investors who placed their trust in credit fundamentals and recognized the values left behind by the abrupt municipal bond fund sell off in late 2010. The exodus of many investors from funds was motivated mainly by concerns that fiscal challenges facing municipalities would lead to “sizeable” bond defaults this year. We disagreed with that extreme view and, as we will highlight in this commentary, current data supports our opinion.

Recently, the robust rally has tapered off despite a continuing decline in new long term municipal bond issuance. As part of our research we tracked the monthly average dollar price of the Bond Buyer Municipal Bond Index which is based on standardized prices for 40 large, long-term municipal bonds with an average maturity of 28 years. The average monthly price rebounded from a low of $92.07 (YTM of 5.749%) in January to $95.18 (5.647%) in April and $98.76 in May (5.42%). For June, the index’s average monthly dollar price reached $100.98 with yield-to-maturity dipping to 5.21%. The index’s smaller gain from May to June indicates a slowing rally as well as suggests some possible near term price stability.

More concisely, in our view there were two major factors supporting the recent rally:

1. Investors that rode the wave out of municipal bonds returned to the market as positive economic news dwindled and skepticism increased over sustained value growth in the equity markets.

2. Much of the speculation regarding significant municipal defaults occurring in 2011 simply has not materialized. Our view on this topic is validated, in part, by municipal bond default data provided through Municipal Market Advisors. The data shows that through June 30th, there were $9.6 billion of outstanding municipal bonds in which bondholders were missing a payment. This equates to 0.26% of the estimated $3.7 trillion municipal market1.

Further evidence supporting municipal credit quality, at least from a macro level, is shown in the graph below. The graph highlights the cost of credit default swaps (CDS) on 10 year bonds of three states: California, Illinois, and New York compared to rates on 10 year U.S. Treasuries. Credit default swaps represent the cost of purchasing insurance against a security’s default. Essentially, the greater the perceived risk of default, the greater the costs to provide insurance, as concerns dissipate — prices fall. The cost of default insurance on the three states has declined considerably since the beginning of the year, particularly relative to the movement in Treasuries. This suggests investors have become less convinced that these municipal credits will default; instead investors have turned their attention to the challenges of reducing the federal deficit and to a greater degree the national debt ceiling, as evident from the rise in treasuries. Furthermore, the chart also suggests that when a state or municipality shows a willingness to raise taxes or curb spending, the market responds quickly and rationally. Notice how the CDS market responded to the state of Illinois after it raised the state income tax 66% in January 2011. On January 6th, 2011 the cost of insuring Illinois’s debt topped out at 359 basis points, only to fall 62 basis points a week later once the legislators had formally signed the tax increase. Since January 6th, the cost of a CDS on a 10 year state of Illinois bond has fallen 40.2% to 214.75 basis points.

Moreover, the 2011 Q:1 report on state and local government tax revenue released by the U.S. Census Bureau indicated tax revenues for state and local governments were up 4.7% over Q:1 2010. This marks the sixth consecutive quarter of positive year over year growth. Individual income taxes, general sales taxes, and corporate income taxes lead the way with year over year increases of 12.0%, 5.8%, and 6.3%, respectively. These tax increases in concert with expenditure reductions are the key factors in balancing budgets. In fact, on the heels of the Bureau of Labor Statistic’s May jobs report, an Associated Press story from June 6th, noted that “more than 467,000 state and local government jobs have vanished since the recession officially ended in June 2009, including 188,000 in schools.”2 To a credit analyst, these figures are bittersweet, they are certainly undesirable from an overall economic perspective; however, they suggest that municipalities are willing to make the difficult choices to balance budgets. How deep the cuts will go and for how long will be predicated on the course of the U.S. economy.

Near Term Credit Outlook

Despite a recent downgrade cycle in the municipal market, we expect the improving market sentiment to carry well into the summer. We anticipate headline risk to continue to weigh on the municipal market and its investors, although we surmise the preponderance of hard evidence to the contrary should provide a sufficient counterweight. We believe there will continue to be strong rhetoric from municipal leaders on tax increases and spending reductions, particularly at the local level. The degree to which either will actually occur appears tied to the U.S. economy.

As we have pointed out previously, yields in the municipal market are transitioning away from the very homogenous “AAA-insured” interest rate sensitive environment toward specific idiosyncratic issuer credit risk. While this movement may be a bit unnerving to some municipal investors, it is a development that ultimately will reward those that have carefully followed our three pillars of municipal credit research. Investors willing to accept incrementally more credit risk will be compensated with a boost in yield. Conversely, investors in longer maturities will be rewarded for accepting the interest rate risk.

I invite you to attend our next webinar; we look forward to circulating those details shortly.

Justin Formas, CAIA
Director of Credit Research
Bernardi Securities, Inc.
July 12th, 2011

______________________

1 Jennifer Galloway, “MSRB Launches Twitter Feed to Disseminate Municipal Market News,” 2011

http://www.msrb.org/News-and-Events/Press-Releases/2011/MSRB-Begins-Disseminating-Municipal-Market-News-over-Live-Twitter-Feed.aspx

2 Paul Wiseman, “Usually a Job Engine, Localities Slow US Economy,” June 6th, 2011, Associated Press Archive.

What Will it Mean to Municipal Bonds in 2011 and Beyond?

As the economy expands, it is becoming clearer that we are nearing the end of the “easy money” policy that the Federal Reserve has pursued over the past few years. So what can we expect once the Fed starts raising interest rates?

It’s important to remember that when we’re talking about the Fed raising interest rates, we’re talking about the very short, Federal Funds rate and discount rate. While linked and influential, these short term borrowing rates do not control the yields on longer-term bonds, which (absent contrived programs like QE1 and QE2) are influenced by traders, investors and other types of market participants.

The Fed may move aggressively.
Depending on what emerges later this year and into 2012 in terms of economic recovery, inflation and job growth, the Federal Reserve may be very aggressive in hiking these rates. Unlike the Alan Greenspan led Fed and its measured, 25 basis point hikes or cuts, the Ben Bernanke led Fed has shown a proclivity to act much more ambitiously.

Under Bernanke, in the roughly 16 months from late September 2007 to early December 2008, the Federal Funds rate was slashed from 5.25% to zero to combat the worst recession in generations. When the Fed does begin hiking rates, why should we expect a timid response if they feel it necessary to hike more assertively?

The past four Fed tightening cycles & municipals.
When the Fed does raise the Federal Funds rate, an interesting and perplexing thing often occurs, the yields on longer-term bonds like the 10-year Treasury Note, will peak and then start to fall. This happens because the Fed Funds rate is tied to the prime rate, which is directly tied to almost all forms of consumer and most business borrowing. When these rates go up the cost of borrowing goes up, which slows the economy. A slowing economy is usually welcome news for bond investors because costs of goods and services tend to stabilize or even fall when the economy slows, which preserves the buying power of fixed income investments.

Shown on the reverse of this letter is an analysis of the past four Fed credit tightening cycles along with the resultant yield for the 10-year Treasury note during the same period. You will notice that the ultra-short, Fed Funds rate actually ended up higher than the yield on the T-note in three of the four cycles!

As of this writing, the yields on longer term, municipal bonds remain greatly disconnected from the movement on longer term, Treasury yields. Municipal bond yields are still high on a relative, historic basis, but we expect the same dynamic illustrated in the above analysis for Treasury yields to play out in the municipal market as well.

What does all this mean?
If your portfolio is short – i.e. a five year, laddered time-frame or shorter – an increase in Fed rates should start boosting short-term bond yields. However, if you have a longer-term ladder, stick to it. If you’ve been waiting for higher rates on the longer end of the yield curve, your wait may already be over. In just the past six months, the yield on 10-year, AA rated municipal bonds has climbed 64 basis points while 20 year, AA rated yields have climbed 94 basis points!

Jeffrey D. Irish
Vice President
May 10, 2011