Market Commentary (MUNICIPAL BOND MARKET UPDATE)

Municipal bond prices continued their move upward during the month translating into lower yields on new issues and current market offerrings. The bond price rally has been powerful over the last three months resulting in month end municipal bond yield levels that we have not seen in some time. Yields spreads are compressed across the different quality and maturity spectrums, as well. This flattening of the yield curve is the result of several factors including: the reduced supply of non taxable municipal bonds resulting from the Build America bond program, the continued strong demand for non taxable municipal bonds and investors’ general willingness to ignore credit scares by not demanding greater yield premiums.

Legislation to extend the Build America bond program beyond its scheduled expiration at year end has not been approved and is stalled in the Senate, most likely until after the fall elections.

Harrisburg, Pennsylvania announced that it would not meet a mid September debt service payment on an outstanding unlimited tax general obligation bond issue. This issue is not directly related to its failing incinerator project issue whose debt service, in part, is backed by the city’s pledge.

For more information contact your Bernardi Investment Specialist.

Market Commentary

In response to the slowing recovery, the Federal Reserve announced yesterday that it would use yet another weapon in its arsenal to keep the economy from slipping back into recession. In addition to repeating its outlook of the last 17 months, that weakness in the economy will keep the fed funds rate at “exceptionally low levels” for an “extended period,” they will also begin buying longer dated Treasury paper.

From August 2008 to the present, the Federal Reserve’s balance sheet increased to nearly $2.4 trillion–about $1.3 trillion of which is mortgage backed securities. As this mortgage backed paper pays down, they will use the proceeds to buy longer dated Treasury Notes and bonds. After the announcement, the effect on the Treasury market was immediate: the 10-year Treasury Note yield has fallen from 2.83% on Monday to 2.72% today. Less than two months ago the 10-year Note yield was 3.30%.

Municipal yields have also been affected. The average “AA” rated, 10-year GO bond yield is 2.70% today; In mid-June it was 3.22%. Presumably, investors are discounting recent media stories about the imminent wave of municipal defaults and are growing more comfortable with the lower yield levels. While nobody can predict the future, a “tsunami of municipal bond defaults,” as Bloomberg news cited, is unlikely in our view and if it does occur, would most likely be contained within the usual sectors that buckle under pressure–but that’s a topic for our next market update–Stay Tuned.

Regards,

Jeffrey D. Irish
Bernardi Securities, Inc.
Vice President
August 11, 2010

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Moody’s Recalibrates

Moody’s recently announced it is changing its municipal rating scale to a uniform global scale. This change should occur by the end of April and will mean its municipal bond ratings will be directly comparable to the ratings it assigns to other bond issuers.

We thought it would be helpful if we shared with you a few of our thoughts on the subject:

  1. This change is a recalibration of Moody’s current rating system. Moody’s emphasizes that any changes to current municipal bond ratings are not upgrades or downgrades, but “re ratings” using a new global rating scale. Admittedly, Moody’s position is confusing to this writer and underscores our long held belief that a bond rating is only one metric to consider in the analysis of a municipal bond credit. We expect that many municipal bond issues currently rated by Moody’s will benefit from this new policy by receiving either higher ratings or improved outlooks. We expect positive actions to occur especially in the general obligation bond sector.
  2. If we are correct in our belief that many municipal issuers’ current ratings will benefit from this policy change, bond prices of these issuers should be positively affected and their borrowing costs should decline. Issuers that are currently lower rated should see the greatest benefit. Additionally, higher ratings will broaden investor interest in the market place as high quality investors will have a larger universe to consider.
  3. This policy change will most likely create some short-term problems with the month end pricing of affected issues. Month end municipal bond pricing is a matrix evaluation process and, one that we suspect, will experience some implementation issues with this change.
  4. The few remaining healthy bond insurers will suffer as a result of this change. Higher underlying ratings translates into fewer insurance opportunities and lower premiums received from the upgraded issuers.
  5. Municipal bond issuers will be able to increase their borrowings as a result of this policy change because their borrowing costs will lessen; many issuers will see their debt loads increase, perhaps exacerbating long term credit quality for many issuers. For us at Bernardi Securities, Inc., this means ongoing issuer credit and sector surveillance remains a sensible strategy.

We hope this brief market commentary is helpful. Please call us should you have any questions, comments or concerns.

Thank you for your continued confidence in our bond portfolio research and management process.

 

Sincerely,

Ronald P. Bernardi
President/CEO
April 2010

 

 

Widest Municipal Yield Spread in Two Years, Bankruptcy Update

Municipal bond prices held up surprisingly well during the month, despite an increased supply of new municipal bond issues following months of low issuance.

Municipal yield spread against Treasuries widest in two years

The 10 year, “A” rated MMD Index bonds yielded 3.21% on November 30th versus the 2.07% taxable yield offered on the 10 year U.S. Treasury bond.

Although nominal bond yields are low across most bond sectors, on a relative basis, non-taxable municipal bond yields exceed long-term Treasury bond yields by the widest margin in more than two years. Supply will remain elevated over the first couple of weeks of December and we expect the significant sums of available cash will easily absorb it.

“Something is rotten in the state of Denmark”

Today, Marcellus’ commentary to Horatio could be amended slightly to call out Jefferson County, Alabama and Harrisburg, Pennsylvania given their recent Chapter 9 municipal bankruptcy filings. The immediate impact of these filings on the national bond market was minimal, although the filings will raise the financing costs for other, well-run issuers located in these states absent any state intervention.

The State of Pennsylvania has acted swiftly and responsibly by immediately challenging the Harrisburg filing. As of this writing, a Pennsylvania court has dismissed the Harrisburg filing, agreeing with the state’s position that Harrisburg lacks the legal authority to file for bankruptcy. We hope this court decision stands for the sake of every well-run, local government unit in Pennsylvania and its residents.

Jefferson County, Alabama is a different story to this point. We have long expected Jefferson County to file for bankruptcy for several reasons:

  • Debt load – Its debt load is significant, poorly structured and ill-conceived
  • Fraud – Fraudulent activity occurred over the years related to some of this debt issuance
  • Lack of local responsibility – A number of local decision makers hold the view there is little, if any, local culpability and responsibility for its current plight

For years, Jefferson County, Alabama has been a poster child for municipal corruption and fiscal mismanagement. Recently, it exacerbated its plight by attempting to take control of system assets away from the trustee and receiver. In effect, Jefferson County is asking the court to deny sewer bondholders preferential treatment to system net revenues, a security lien that is clearly stated in bond documents.

The county is making several claims contradicting widely held, longtime views among investors and bond counsel regarding the security of bonded debt and issuer obligations to its investors. This includes the County’s claim that bondholders lost the right to be paid before others once the county filed for bankruptcy – forcing them to wait for payment, like all other creditors, until the case is resolved. 

Although our portfolio-managed clients have not had any exposure to Jefferson County, Alabama debt for many years, we are watching the proceedings very closely. It is critically important that the court honors the treatment of special revenues, even in bankruptcy. The financial interests of senior creditors such as bondholders cannot be pushed aside for misguided parochial interests. We assume the chances of this occurring are low, but we are disappointed local and state officials allowed the issue to devolve to this point. We remain very wary of Alabama debt until the court resolves several issues revolving around Jefferson County.

Our suggestion for now – avoid any Alabama debt until the bankruptcy judge clarifies this issue.

Gang of Twelve: No decision good for municipals (for now)

The continuing political stalemate in Washington has benefited the municipal market, albeit temporarily. The various Presidential and Congressional threats to tax exemption have fallen to the wayside for now and most likely will remain on the backburner until after the 2012 elections. This is a short-term municipal credit positive development for state and local governments.

State and local governments currently have plenty of challenges already without having to deal with the issues of higher borrowing costs and diminished local control over infrastructure projects – two situations that will occur if the federal government enacts legislation eliminating or severely restructuring today’s well-developed, broad-based municipal bond market.

We will have more to say on this topic in the coming weeks.

Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
December 3, 2011

Municipal Market Progresses Unevenly

The municipal bond market showed more signs of progress in October, albeit unevenly – a persistent market narrative that creates opportunities for the disciplined and informed.

State revenues growing despite property tax declines

The macro economic picture for state governments generally continued to move in a positive direction as tax revenues saw double-digit growth (10.8%) year over year in the second quarter, according to the Rockefeller Institute. This was slightly revised from the preliminary number we mentioned in our August commentary. The growth resulted primarily from an increase in income and sales taxes, although total states’ revenues lag behind 2008 totals for this same period.

Local governments continue to see property tax revenue decline from prior periods. In the second quarter, property tax revenues fell 1% year over year, per the Rockefeller report. Local property tax receipts have fallen for the last few quarters forcing local governmental units to pare their budgets. This trend will continue in the months ahead.

Municipal market still attractive for some, challenging for others 

Municipal bond yields moved slightly higher in the latter part of October. An increasing new issue supply added to dealer inventories as investor demand flattened a bit from prior weeks. Market liquidity is a challenge at times, especially for average and weaker credits. This dynamic will not change soon, in our view, and generally is a negative for total return investors and a positive for the income oriented investor. 

Chicago shows leadership on municipal financial challenges

Timely and complete municipal disclosure is slowly improving, but much work is yet to be done in this area. 

Two weeks ago, I attended the City of Chicago’s first Chicago Investor Conference – which was also a first for me in over 30 years in the municipal bond industry. To my knowledge, I do not recall a municipal issuer hosting such a forum designed to inform investors and other industry stakeholders on the state of operations and finances. Mayor Emanuel spoke openly about how the city is trying to deal with the critical issues of improving operational efficiencies, union pensions, lengthening the school day and the effect of state finances on the city’s budget.

Clearly, the city has financial challenges in front of it, but this event is a positive signal to the marketplace and a message to other issuers of what is needed and expected by investors today. I applaud Chicago for showing leadership on this critical issue.

Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
November 1, 2011 

Yield Search Favors Municipal Market

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 

 

U.S. Downgrade Domino Threat

The prevailing August municipal bond market story was the threat posed by the U.S. rating downgrade. The improving state tax situation and the search for better yields also led municipal bond market news in the past month.

Wholesale municipal rating downgrades unlikely

As we wrote in our market update The Effect of a U.S. Rating Downgrade, the downgrade did not surprise us. Internally, we have discussed a possible downgrade of the U.S. and its impact on other rated municipal issuers for some time. The downgrade of the U.S. was unprecedented and as such it is impossible to predict any outcome. However, in the near term, we do not believe there will be wholesale rating downgrades of municipal issuers excepting those issues either directly secured by U.S. Treasury issues (pre-refunded and escrowed to maturity issues) or indirectly secured by government agencies (such as certain housing and student loan issues).

This latest development leads to a glaring question. How do market participants interpret credit ratings? Therein lies the bottom line we have believed for a long time – at the outer edges, municipal bond credit analysis is as much an art as it is a science. Independent municipal bond credit research matters now more than ever.

State revenues improve for sixth quarter, fastest growth in six years

State revenue collection continued to improve in the second quarter of 2011 and boosted balance sheets. The Rockefeller Institute’s report on preliminary data from 46 early reporting states shows collections from major sources up 11.4 percent in the second quarter vs. the same quarter last year – the strongest year-over-year growth since the second quarter of 2005. Tax collections have now been growing for six consecutive quarters, reversing the trend set by five quarters of declines. Revenues were still 7.8 percent lower than in the same period three years ago.

The strong, continued tax collection growth in 2011 for every state except New Hampshire indicates that the revenue situation is slowly recovering for most state governments. Alaska, North Dakota, Illinois, Nebraska and New York showed the greatest total tax growth – with Illinois up 37.7 percent overall. Most states have closed their books for fiscal year 2011 and preliminary data show 8.4 percent tax revenue growth for the nation as a whole. 

Municipal bond fund outflows signal search for better yields

A new round of outflows from municipal bond funds continued through every week of August. Unlike the municipal bond fund selloff of late 2010 driven largely by credit concerns, this new trend appears to be motivated by investors in search of better yields. As we mentioned in our Mid-Year Municipal Credit Update and other publications, municipal market yields are transitioning toward specific idiosyncratic issuer credit risk and away from the very homogenous “AAA-insured” interest rate sensitive environment.

While this may unnerve 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. Additionally, investors in longer maturities will be rewarded for accepting the interest rate risk. 

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

For more information, please contact your Investment Specialist.

Calmer, Bullish Municipal Market: Opportunities Amongst Problems

Municipal bond prices continued their upward move during May resulting in lower yields across the maturity spectrum at month end. A calmer tone to our marketplace has set in over the past two months as much of the selling hysteria earlier in the year has subsided.

Bullish market emerges in calm after the storm

This moderating dynamic, coupled with a significantly reduced supply of new issue transactions and lower U.S. Treasury bond yields in recent weeks has resulted in a bullish municipal bond market. June reinvestment demands total a fairly significant sum, so absent a sizable sell off in Treasury bond prices, we expect non-taxable municipal bond indices to maintain much of their year-to-date gains.

State revenues improved for fifth consecutive quarter

Generally, state revenue collection year to date continues to exceed budgeted projections and fiscal situations are improved from last year. The Rockefeller Institute of Government reported that tax revenues rose by over 9% in the first quarter. This is the fifth consecutive quarter of state revenue growth. California, Michigan, Pennsylvania, New Jersey and Texas all recently reported greater than budgeted revenue collection numbers. New York approved its annual budget on March 31st before the beginning of its fiscal year starting April 1st and reduced expenditures by approximately 2.5%. This is the first time since 2006 the state has approved its budget before the start of the fiscal year and the first time since 1995 it has reduced expenditures. 

Liquidity challenges still good for some, bad for others

Market liquidity remains a challenge depending greatly on the idiosyncrasy of the specific credit up for sale. We have discussed this topic at length in earlier publications and do not expect this to change anytime soon. Its presence will continue to create problems for certain investors and opportunities for others. As always, we believe that diligent, independent credit research is the key to knowing and capitalizing on the difference.

Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
June 2, 2011 

For more information, contact your Investment Specialist.

Municipal Bond Supply & Demand Imbalance

The municipal bond market through the first three months of 2011 was particularly choppy, culminating in March with one of the most muddled trading environments we’ve experienced in quite some time. To discuss March’s performance, it’s important to examine the events that led us to this point.

As a result of a favorable price-to-yield relationship, municipal mutual funds experienced a net cash inflow of $32.2 billion during the first 10 months of 2010. This increase can be primarily attributed to lackluster returns in other asset classes where investors have historically parked cash during uncertain equity markets.

More interesting is what occurred during the next four months that drove supply and demand to such an imbalance. Net cash outflows from municipal mutual funds totaled $37.7 billion from November 2010 to February 2011. This was caused by three main events:

  • Build American Bonds program expiration. With the expiration of Build America Bonds, issuers accelerated debt issuance plans in order to receive the federal subsidy. Subsequently, this saturated the market, outpaced demand, and eroded prices.
    • New long-term issuance spiked in October to December 2010 to $122.5 billion, then plummeted to $48.2 billion between January and March 2011.
  • Media frenzy. Exacerbating supply problems was the near constant media attention.
  • Tax cut extension. Extension of tax cuts, which simultaneously reduced the need to shelter income and drove less muni-focused asset managers to seek more absolute return strategies in the equity markets given the perceived negative sentiment and risk/return imbalance in municipals.

From the demand side, investors remained bearish, given the negative media coverage, especially as budgetary deficits, pensions, and healthcare costs continued to dictate market opinions. However, the real underlying factor was that historically investors had a perceived level of protection buying a non-rated issuer as long as it was also wrapped with bond insurance, thereby negating the need for in-depth credit research. Considering the near extinction of highly rated bond insurers, many investors are reluctant to buy lesser known, smaller name issuers over more prominent ones. This dynamic exposes the true imbalance exhibited in March – investment decisions were not being made based on quality.

This paradigm was also observed through significant pricing variability in which price discovery for short end, highly-rated issuers was relatively accurate, while longer maturities of lesser known names (regardless of rating), generated fewer and wider spread bids.

This convergence of factors can be seen in the average monthly price, which fell from $100.77 in June 2010 all the way to $92.08 in January 2011, with corresponding yield-to-maturity of 5.14% to 5.75%, respectively.

Justin Formas, CAIA
Director, Credit Research
April 11, 2011

For more information, contact your Investment Specialist.

Municipal Market Attractive for Some, Challenging for Others

Municipal bond yields ended the month at higher levels than where they began the month, resulting in a negative monthly total return number for most portfolios. This decline in portfolio value was more pronounced on higher duration portfolios and bond funds as you would expect.

The higher municipal bond yields resulted from:

  • The continuing sell-off in the U.S. Treasury bond market 
  • Massive redemptions of municipal bond funds 
  • General apprehension of municipal credits

The continuing unease that currently pervades the municipal marketplace was fueled in part by Congressional discussions on the merits of introducing legislation that allows states to file for bankruptcy. New issue volume declined significantly and this factor prevented prices from falling further and, in fact, contributed to a rebound in bond prices over the final 7 to 10 days of the month. The run up in bond prices at the end of the month, however, was not enough to offset the earlier losses.

The market remains volatile in the New Year. Liquidity is generally thin and sporadic – depending greatly on the specific issue out for bid, the almost daily rumors out of Washington D.C. and apocalyptic predictions about municipal bonds. Expect more of the same until we have some clarity on possible legislation affecting the marketplace. These factors make the municipal bond market attractive for income oriented portfolios, but challenging for total return investors. 

Bankrupt Vallejo, California continued its march towards solvency and filed a restructuring plan with the court overseeing its Chapter 9 proceedings. It is a complicated plan without question, and certain creditors will have to absorb different percentages of haircuts on their claims. Municipal debt holders, however, are treated favorably per the plan and that is a significant development in our view.

Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
February 2,2011

For more information, contact your Investment Specialist.