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.

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2012 Mid-Year Municipal Market & Credit Update

It’s important to frame the developments in the broader financial markets over the last six to twelve months before discussing the municipal market’s continued ability to absorb issuer-specific credit events. Roughly a year ago, the United States’ triple-A credit rating was downgraded by Standard & Poor’s. This triggered one of the most pronounced and initially counterintuitive flights to quality in years. The Treasury rally continued to gain steam as the European debt crisis dominated market concerns.

To put these events into perspective, 10-year Treasuries were yielding between 260 and 270 basis points (bps) in early August 2011. During the first week of August 2012, yields had fallen roughly 100 bps. Municipal bond yields have followed suit, despite supply being up 65% year-over-year, albeit two-thirds of which were issued for refunding purposes.

Positive municipal market indicators 

Today, municipal bond yields are also at near historic lows. The Thomson MMD scale shows 10-year triple-A bonds yielding 166 bps, down 97 bps from a year ago. Even more telling is the muni-treasury ratio. A year ago the 10 year muni-treasury ratio was approximately 96%. Last week that figure jumped to the 113% range – suggesting municipal bonds are an attractive allocation compared to Treasuries. Furthermore, broader market indicators show how well the municipal market is able to compartmentalize headline risk related to municipalities experiencing financial distress.

Low historic municipal defaults

Municipal Market Advisors (MMA) is an independent municipal research firm that produces market commentary. Recently the firm began reporting a weekly default trends article. In their July release, they reported that “par affected by first time defaults this year is just 0.02% (est. $750 million) of the outstanding municipal market; for the cumulative amount of par affected by first time defaults since 2010, just 0.28% (est. $10.36 billion) of the outstanding market.” As of July 31st, the report showed a total of 42 issuers experiencing first time payment defaults versus 68 and 83, over the same period in 2011 and 2010, respectively. The most fascinating statistic the report presents is that nearly 40% of the Chapter 9 bankruptcy filings since 2007 have occurred in California (8) and Nebraska (11).

Political will metric now critical

In last year’s mid-year credit review, we highlighted the cost of credit default swaps on 10-year bonds of three states: California, Illinois, and New York. We pointed out that when a state or municipality shows a willingness to raise taxes or curb spending, the market responds and insurance against a possible default becomes less expensive. The same can be said when a state or municipality shows an unwillingness to make responsible decisions. The cost of insurance on a 10-year State of California bond was roughly 180 bps in August 2011. On August 6th, 2012, the cost was 240 bps. Similarly, insurance on a 10-year State of Illinois bond cost just less than 200 bps in August 2011, but 282 bps in August 2012.

Willingness to honor financial obligations is perhaps the latest development in municipal credit. Historically, most distressed municipalities suffered from projects gone awry. Certainly there are examples of those types of issuers today, but more and more the municipal market is faced with issuers damaged from the compounding effects of poor financial management. Long before certain administrations contemplated their willingness to pay bondholders, they demonstrated an unwillingness to restore structural balance to operations and sensibly approach labor negotiations. The ex post nature of the evidence is what makes incorporating “willingness to pay” into municipal market analysis such a considerable challenge. The concept itself is intangible, can change as quickly as administrations change, and frequently requires investors to predict whether elected officials will opt for fiduciary responsibility or short term self-preservation. The solution for bondholders, even in light of attractive buying opportunities, is to remain highly selective and continue thorough due diligence practices.

Renewed debt ceiling debate looms 

In the near term, or until economic conditions for municipal governments improve, expect pockets of distressed municipalities to take their chances in bankruptcy court or with some form of state fiscal oversight committee, where applicable. Moreover, there are two events to watch closely as it pertains to municipal credit quality – the mandatory spending cuts at the federal level and revisiting of the US debt ceiling. Interestingly, the dialogue and fiscal conditions surrounding both events exemplifies the struggles occurring at the state and local government level. Governments have bills to pay and services to provide, but have limited resources to do so. The outcome of those events will undoubtedly impact the bottom line for taxpayers and municipal governments alike.

Justin Formas, CAIA
Director of Credit Research
Bernardi Securities, Inc.
August 13, 2012

Some perspective on the recent California bankruptcies

There have been three municipalities that have either filed or have voted to approve filing bankruptcy in California in the past year: Stockton, Mammoth Lakes and most recently, San Bernardino. Stockton and San Bernardino went bankrupt due to the “usual” circumstances, they overspent or over-promised services and benefits to their citizens and employees (current & retired) and when the economy slowed, they could not adjust in time. Mammoth Lakes’ filing was due to a $43 million judgement ruling against the city awarded to a developer.

We suspect these filings will not be the last and we remain very wary of California credits. But let’s put things into perspective by viewing the three bankruptcy filings within context of the entire California municipal bond market. There are 58 counties in California, there are 478 cities and towns, 72 college districts, 977 school districts = 1,585 municipalities; Add to that the numerous park districts, community redevelopment districts, fire protection districts, library districts, water utilities, sewer utilities, electric utilities, etc. and you see that 3 bankruptcy filings out of 2000+ municipal entities is about 1/10th of 1-percent, which is not far off from the historical norm.

Could the three become many as municipalities seek an “easy” solution to their problems? According to a recent article from CNN-Money, Chris Hoene, research director at the National League of Cities was quoted as saying, “Most cities are either passing through or over the worst of the economic downturn and should start recovering in the near future. Sales taxes, for instance, are recovering in most locales”. The bankruptcies are “a sign of short-term strife,” he said. “But it’s also a sign they’ve hit bottom.”

While most of the previous comments are specific to California, here are some figures about the improving health of State revenues in general: According to Rockefeller Institute research and Census Bureau data, State tax revenues grew by 3.6 percent in the fourth quarter of 2011, marking the eighth consecutive quarter that states reported growth in collections. The Rockefeller report goes on to state, “Overall state tax revenues are now above peak levels that came several months into the Great Recession. In the fourth quarter of 2011, total state revenues were 3.0 and 7.4 percent higher than during the same quarters of 2007 and 2008, respectively.”

We hope that you find this information to be helpful and as always, if you have any questions, please contact your Bernardi Securities Investment Specialist.

Sincerely,

Jeffrey D. Irish
Vice President

Justin Formas, CAIA
Director of Municipal Bond Credit Research

Municipal Bondholders 1, Jefferson County Newspeak 0

Score one for bondholders. 

A federal judge ruled in June that Jefferson County, Alabama could not reduce debt payments while in bankruptcy in order to spend more of the system’s net operating revenues on its aging sewage system. 

County’s Orwellian claim at odds with municipal market

In its losing argument, the county claimed future capital expenditures were, in fact, “necessary operating expenses” and it was entitled to hold back significant portions of its net operating income for these operating expenses rather than apply them to current debt service payments as called for in the bond indenture. The county’s claim is at odds with most municipal bond lawyers’, investors’ and market participants’ understanding of the law and contrary to decades of historical precedence.

The federal judge ruled: “operating expenses as determined under the indenture do not include (1) a reserve for depreciation, amortization, or future expenditures, or (2) an estimate for professional fees and expenses.” In other words, the Judge ruled any available income after covering the system’s current operating expenses (i.e. salaries, electric bill, etc.) must be applied to debt service payments. That is how the indenture (bond contract) reads – this is not a complex issue.

From the outset, the county’s claim seemed to be Orwellian in nature with an Alabama twist. It was nonsensical – an attempt to redefine basic words, terms and concepts municipal bond market participants have relied on for decades. Fortunately, it was thwarted by the decision of U.S. Bankruptcy Court Judge Thomas B. Bennett and, temporarily, returns a modicum of sanity to the ongoing financial and political fiasco that has engulfed Alabama municipal finance for the last several years. We are hopeful officials in Jefferson County, Alabama will take note of the Court’s decision and begin to deal with their problem in a responsible manner.

We applaud Judge Bennett for his decision relying on Orwellian newspeak to write, “the judge’s decision prevented an ungood (bad) situation from becoming double plus bad (worse)” . 

Follow the leader – Stockton files 

Stockton, California filed for Chapter 9 bankruptcy protection in June becoming the largest U.S. city to seek court protection from its creditors. The current year budget (July 1st) defaults on approximately $10 million in bond payments and $11 million in employee pay and benefits. Salaries and benefits for employees coupled with retiree benefit costs account for approximately 70% of its general fund. Additionally, two bond issues for non-essential, non-traditional public purposes (ice hockey arena and waterfront development projects) increased its outstanding debt approximately $200 million. The city stated its largest unsecured creditor is the California Public Employees’ Retirement System. Debt holders represent the second largest creditor group and mostly, but not universally, enjoy a secured creditor status. 

Let the newspeak, California style, begin.

Three pillars of municipal credit research stand

How do we react to and interpret the evolving events in Jefferson County, Alabama and Stockton, California? How do these events affect our clients’ managed bond portfolios even though none own any Stockton, California or Jefferson County, Alabama bonds?

The first thought that comes to mind is that there will be more situations similar to Stockton and Jefferson County so diligence remains primary.

Secondly, we remind our readers of a municipal bond market truism we believe and have recited many times over many years – municipal finance is mostly a local phenomenon. 

Stockton and Jefferson County face serious financial problems – greatly of their own making – resulting from a series of very bad decisions over many years. That was apparent to anyone paying attention to details years ago. Now, each one of these communities will spend years struggling to right itself financially so that it can progress and prosper in the years ahead. The future success or failure each will experience will depend greatly on decisions made locally and at the state level in the months ahead as these communities move through the Chapter 9 process.

As an example, the Rhode Island state legislature enacted legislation clearly stating the long recognized, priority interest of SECURED BONDHOLDERS in any Chapter 9 filings occurring in its state. This action positively impacts and lowers borrowing costs for local governments across Rhode Island and serves to encourage investors to invest capital in Rhode Island.

California and Alabama, to date, have not taken similar actions. Will they? Until we see some clarity, we remain wary of credits in these states. These will be interesting case studies to follow.

Thirdly, not all communities have behaved like Stockton and Jefferson County – and most, we would argue, have behaved more rationally and responsibly. There are hundreds of well-run municipal governments. There are hundreds of desirable, solid credit public purpose municipal bonds available to investors.

We know this because when we review a municipal issue to determine if it is credit worthy we seek the three pillars of municipal credit research:

1. Essential and public service deal purpose

2. Strong deal structure

3. Solid underlying credit quality metrics

Understand the presence of all three elements does not necessarily guarantee deal solvency, but it is a very good start in our experience. The three elements work in tandem. Weaker underlying credit quality demands heightened deal purpose and deal structure, in our view. 

The municipal bond market is highly diverse. This is one of its greatest strengths. As tragic as the Stockton and Jefferson County stories are, they do not represent the prevailing market narrative. The market’s diversity creates challenges and complications at times. And this creates opportunities for knowledgeable investors.

Please call us if you have any questions or would like a portfolio review.

I wish you and your family a happy and safe Fourth of July holiday.

Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
July 2, 2012 

 

Treasuries Continue to Rally, Municipal Bonds Less Affected

Renewed questions as to the health of the European Economic Union coupled with news of slowing growth in China, India and here at home sparked a strong rally in the Treasury market this past month. 

Treasuries rally more pronounced 

While this may read like the same “Treasuries rally” market commentary from March or April, the May market move was more pronounced. Treasuries of all maturities were either sold at auction or were traded at record low yields during May. The 10-year Treasury note, for instance, hit a record low 1.45% during the closing days of the month—down from 1.94% on May 1st. That’s an impressive 49 basis point move from an already low level.

Municipal bond yields moved only slightly 

Municipal bond yields moved lower as well during the month, but were less affected. AAA rated, 10-year municipal bonds started May at 1.88% and ended at 1.80%. That relatively small drop-off in yield came despite continued strong demand and rather weak issuance.

Don’t fight the Fed

The Federal Reserve has been actively purchasing longer dated Treasury notes and bonds as part of Operation Twist. This program is set to wind down in June. There is speculation that absent Fed purchases, there are few buyers willing to step in to buy Treasuries at such low yields. Further analysis seems to reveal that these fears may be misplaced. 

At the May 17th auction for instance, Treasury sold $13 billion in 10-year inflation protected securities, or TIPS – and the Fed accounted for only 14% of the orders. Demand for Treasury securities has been very strong with orders covering more than three times total debt sold at several auctions held during the month.

Granted, the “fear trade” could weaken, but it looks improbable yields will spike anytime soon. If rates do spike, the Fed could step back in to drive yields back down. The current mantra of many – “Don’t fight the Fed” – continues to prevail.

Please contact your Investment Specialist if you have any questions on these latest market moves.

Jeffrey D. Irish
Vice President
Bernardi Securities, Inc.
June 6, 2012 

 

“Intercalary” February: An Extra Day of Bond News

Leap Year means 29 days in February 2012, so there is an extra day of bond news this month.

New issue supply remained modest, demand strong

The new issue supply of municipal bonds remained fairly modest in February and investor demand remained strong during the month. Prices in the U.S. Treasury bond market held up during the month and, as a result, January’s low bond yields continued into February. 

Minimal Greek debacle yield impact amid continued refinancing

Greece’s “non-default” default had minimal impact on domestic bond yields – as did certain threatened and real municipal bond issuer bankruptcies. Many municipalities continue to reduce their costs by refinancing debt at a pace not seen in several years to take advantage of borrowing rates at 40-year lows. Issuers have refinanced more than $16 billion of debt through the first two months of the year. Generally, most U.S. states operating budget constraints continue to ease with several notable exceptions. 

Slightly higher bond yields not expected to climb much in near team

The January jobs report, released in the early part of the month, was stronger than many expected signaling some needed good news for the economy. The positive employment numbers put a little pressure on bond prices forcing bond yields a little higher by the end of the month. This positive development aside for income investors, we do not expect to see significantly higher bond yields in the near term.

Stockton would be largest U.S. city to file for bankruptcy

The City Council of Stockton, California voted last Tuesday to enter mediation with its creditors. It hopes to renegotiate with its creditors in order to avoid filing for bankruptcy. If it files, it will be the largest U.S. city to file for bankruptcy. The City Manager, Mr. Bob Deis, recently noted the city faces a $20 million deficit in the upcoming fiscal year and an unfunded $450 million retiree health care liability. These benefits were greatly expanded in the 1990s around the same time bonded debt levels increased tied to economic expansion projects.

Jefferson County charting new territory for investors and issuers

Jefferson County filed a cross appeal notice that it may challenge the bankruptcy judge’s January ruling that allows sewer revenues to be used for debt service. A total of eight parties are now challenging portions of Judge Bennett’s rulings. Nothing is certain as it relates to Jefferson County, Alabama other than it will be in the news for many months to come and that it is charting new territory for investors and issuers. Bond investors need to watch this one closely to see if debt-holder interests are respected by the courts.

Credit positive developments across the country in February

There were several notable credit positive developments during the month:

  • Detroit – Detroit, Michigan and unions representing firefighters struck an agreement helping the city close its deficit. Municipal employee unions agreed to a number of concessions including a 10% pay cut and health care and pension benefit reductions.
  • California – The State of California’s ratings outlook was revised to “positive” from “stable” by Standard & Poor’s ratings service; the state benefitted immediately from this upgrade when it priced an issue and took orders at a 2.70% yield for 10 years.
  • Dekalb County – DeKalb County, Georgia returned to the credit market and borrowed for 10 months at 0.22%. This is very positive development for the county given last year’s “super downgrade” of its unlimited tax general obligation bonds. Since the downgrade, the county has improved its finances, clarified its financial picture and improved transparency of its financial reporting. The lesson for issuers here – keep finances in order, report clearly and promptly and investors will eagerly lend funds.
  • San Diego/New York – San Diego, California mayor and New York Governor Cuomo each launched pension reform initiatives.
  • Michigan – Michigan passed a new law featuring an enhanced intercept structure creating an extra layer of security for bondholders. This enhanced structural feature will increase investor confidence and should lower borrowing costs for many Michigan school districts.

Obama’s 2013 budget seeks to limit municipal bond tax exemption

Lastly in the February news department, President Obama’s 2013 budget released mid-month calls to cap the tax-exempt interest deduction at 28%. The proposed budget also seeks to revive the mothballed Build America bond program. The Administration estimates the tax-exempt interest cap will reduce the deficit by $584 billion over the next 10 years.

In our view – presented in our recently published white paper, Tax-Exempt Municipal Bonds: The Case for an Efficient, Low-Cost, Job-Creating Tax Expenditure, based on thorough analysis – the magnitude of budget savings is grossly overstated by the Administration’s proposed budget.

The deduction cap idea has little support in Congress at this point. That said, the threat of retroactive taxation to is very troubling to us. We will continue to follow the developing municipal bond tax exemption story very closely and publish our views on a regular basis.

If you do not already receive them, please consider subscribing to our email updates to stay in the loop. And as always, contact your Investment Specialist if you have any questions or concerns.

Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
March 7, 2012

 

Bond Rally Continues

The bond market’s powerful December rally continued unabated into the first month of the year. Bond yields declined to near historic lows in both the U.S. Treasury and municipal bond sectors. The 10-year Treasury yield fell to 1.80% on January 31st versus 3.37% on the same day last year. The 20-year “AAA” rated municipal bond index dropped to 2.72% on the last day of the month versus 4.56% on January 31st last year. 

Greece risk, Fed announcement drove rally

The January rally was fueled primarily by the impending and inevitable principal write down for many Greek bondholders and the Federal Reserve’s announcement that it would hold interest rates at exceptionally low levels for at least two years. A generally lackluster economic picture coming out of the holiday season also was a contributing factor to lowering bond yields.

Slight supply increase no match for demand

The supply of new issue municipal bonds increased slightly in January compared to last January’s levels, but was low compared to issuance levels of several years ago – and certainly no match for the increased level of capital flowing into the municipal bond market during the month. Consequently, municipal bond yields declined in January with no significant near term reversal in sight.

Jefferson County debt holders win judgement 

The Jefferson County, Alabama situation remains complicated and far from resolved. Alabama federal Judge Thomas Bennett issued a ruling in January agreeing with the county that it should retain control of certain management decisions and limiting the power of the receiver of its sewer system. The Judge did rule favorably for debt holders by ruling the county’s special revenue pledge remains in force and debt service payments will be paid from the system’s net revenues while the bankruptcy case proceeds. He did note he will determine the amount available for debt service payments in a future ruling. The county persists in challenging traditional notions of “net revenues” and is seeking to expand its definition to the detriment of debt holders.

We discussed the potential impact of these two recent rulings in our January 2012 President’s Letter, Back to Municipal Bond Basics.

Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
February 7, 2012 

Credit Research Matters More Than Ever

As Bernardi Securities, Inc. begins its 27th year, we are acutely aware of the importance of understanding the credit quality of the municipal bond issues we recommend to our clients. We have long believed the bond portfolio research and management process starts with credit analysis. Our long-time clients have heard us preach these three constants many times over the years in regards to their municipal bond investments:

  • Underlying credit quality matters
  • Deal purpose matters
  • Deal structure matters

These are the primary reasons we have dedicated significant firm resources for over two decades to our in-house municipal bond credit research department. In our experiences over the years, we have found that without in-depth, careful analysis, it is often very difficult to make suitable determinations regarding the three factors above. This commitment to credit research has served our clients well for the past 26 years, and in many respects we were at the vanguard of our industry in our approach to researching municipal bond credit quality.

The municipal finance landscape has changed dramatically over the last several years and we expect there is more change in front of us. So we continue to invest in this area – implementing new platforms and expanding our intellectual capital. These ongoing investments will allow us to continue to serve our clients in a manner consistent with our past performance.

To help us reach our goals, we are pleased to announce the addition of Justin Formas to our team. Justin joined Bernardi Securities, Inc. this past April and serves as Director of Municipal Credit Research. Justin’s primary role is to oversee our Credit Research Department and its processes as well as analyze municipal bond credit quality. Justin brings with him a wealth of knowledge and experience in the area of municipal bond credit analysis, having spent six years at Standard & Poor’s prior to joining us. Justin received his BS degree in Public Financial Management from Indiana University and earned his MBA degree in Financial Analysis from DePaul University. In addition, he holds the Chartered Alternative Investment Analyst designation. Justin is a member of the National Federation of Municipal Analysts and the International Association of Financial Engineers.

We believe Justin’s November 2010 market update on municipal disclosure and transparency will serve as a good introduction to him. 

As always we appreciate your continued support and confidence.

Sincerely,
Ronald P. Bernardi
President and CEO
November 2010

Municipal Market Update

In this video briefing, Ronald Bernardi summarizes the key points of the market update below.

The three prevailing bond market themes during the first half of 2010 were alternately annoying and unnervingly consistent:

1.   Annoyingly low, nominal yields.

2.   Unnerving, sporadic credit scares.

3.   Unnerving liquidity concerns.                                               

We do not expect these three dynamics to change much in the months ahead. It has been and will continue to be a tiresome marketplace, in our view. That said, the continued existence of the above factors will also create opportunities for the patient and knowledgeable bond investor.

HIGH PRICES = LOW YIELDS

This is the classic good news/ bad news conundrum. The value of good quality bond portfolios have, for the most part, appreciated during the first six months of the year while new money is invested today at lower yields when compared to earlier in the year. In the non- taxable municipal market, yields are especially acute as supply is tight, a direct result of the great success of the Build America Bond (BABs) program and the expectation that top marginal taxpayers will be paying even higher income taxes next year.

BABs have been hugely popular amongst issuers and most politicians so expectations of a program sunset are misplaced in our view. However, the program has experienced a few hiccups including: IRS rebate holdbacks, intensifying IRS and Treasury surveillance, increased reluctance within Congress to expand the program, all of which has modestly dampened both issuer and market participants’ enthusiasm for the program.

Over the past year approximately $7 billion of municipal bonds have defaulted. Most of this amount has occurred in what we refer to as “non traditional” sectors of the municipal bond market.

Still, absent any future legislation expanding the program’s reach, its zenith has most likely passed. This could lead to an easing of some of the current upward price pressure in the month’s ahead in the non-taxable, municipal bond market.

In addition, we expect the Federal Reserve to maintain low, nominal, short-term interest rates for the balance of 2010 and into 2011 and we expect demand for U.S. Treasury paper to remain strong around the globe in the months ahead. Inflation is tame for now and macro-economic activity is subdued. These prevailing factors will generally translate into low bond yields for the foreseeable future — especially in the 1 to 5 year range which are most affected by Fed rate decisions. 

Barring heavy selling by institutional investors or funds, we do not foresee a sharp rise in non-taxable bond yields in the near term in the general market. We expect future price volatility in certain sectors of the market and with specific issuers directly resulting from adverse credit events. These events should create some good investment opportunities.

“I’M GOIN’ THROUGH THE BIG-D AND DON’T MEAN DALLAS”

These song lyrics seem quite apropos these days as we attempt to navigate client portfolios through a difficult financial landscape. We have taken artistic license, of course, with “Big-D” as we are fairly certain singer/songwriter Mark Chestnut is not crooning about bond defaults. 

There have been a handful of notable municipal defaults and outright Chapter 9 bankruptcy filings over the past year (Las Vegas monorail and Vallejo, California) and we expect the list to grow in the coming year. State and local municipal governments across the country are experiencing significant financial challenges. We take some comfort in reading that most are dealing with revenue shortfalls by cutting budgets and staff with a smaller universe beginning to address some of the significant structural financial problems (overly generous, under funded pensions, outdated compensation and benefit packages, under funded federally mandated programs, over ambitious capital projects) besetting state and local governments. 

Some of the trends we see developing in these areas are a positive sign to us that municipal governments and their employees are capable of working together to stabilize finances over time. That said, it will be a long and arduous process and there will be fierce battles fought both behind closed doors and in the press as each side will be very reluctant to back off of its respective position.

Over the past year approximately $7 billion of municipal bonds have defaulted. Most of this amount has occurred in what we refer to as “non traditional” sectors of the municipal bond market. To date, bond defaults in the unlimited tax general obligation and water /sewer revenue bond sectors of established, diverse municipal governments remains at very low levels. Recently, states’ revenue collections have stabilized, although they remain far below pre-crisis levels. We expect to see some additional defaults, but we believe most future defaults will occur in the non-traditional sectors of the market.

As we have stated many times before: UNDERLYING CREDIT QUALITY, DEAL PURPOSE AND ISSUE STRUCTURE MATTER. We believe this is especially true today and for the foreseeable future. We strive to recommend issues with solid, underlying credit fundamentals, a needed purpose and sound structure affording investors a high level of payment priority. Assuming courts honor the value of contracts, bond obligations with sound structure generally offer better security. If you are not certain what this means or whether or not it applies to your portfolio, call us and we will help you understand the significance of these issues.

“THERE ARE NO INTRINSIC REASONS FOR THE SCARCITY OF CAPITAL”

You can add the above quote to much of what we disagree with about Keynesian economic theory. I wonder if Lord Keynes would amend the above quote had he tried selling his municipal bond portfolio during the last quarter of 2008. Clearly, there was a scarcity of capital in the marketplace at that time for several, inherently good reasons. We believe the liquidity issue, although improved, will continue to exist because several factors that contributed to the illiquidity experienced in 2008 still prevail.

1.   General uncertainty regarding reliability of rating agencys’ credit assessments.

2.   A significantly diminished insured bond presence in the municipal marketplace.

3.   A significantly diminished hedge fund demand in the municipal marketplace.

For income portfolio oriented investors, there are a number of strategies we recommend to better protect portfolio liquidity.

1.   Issue diversity is a key component to building a more liquid portfolio. 

2.   Not owning the same issues (or issue types) that too many other investors own is another key component to building a more liquid portfolio in our view. 

3.   Carefully monitor issue block size as a one size fits all strategy may prove problematic. Why? Large issue block size is a selling attribute in bullish markets (higher prices/ lower yields) like the current market we are experiencing. In our experience, our investor clients (and probably most income oriented investors) tend not to need to sell in this type of market. Smaller block size is a selling attribute in bearish markets (lower prices/higher yields) as we experienced time and time again in the latter part of 2008 and into the first few months of 2009.

In our experience, it is the bear market when investors typically need to raise capital and often do so by liquidating bond portfolios. In our experience, selling large block issues similar to or the same as what other competing investors need to sell (see #2) in a bearish market usually results in lower bid prices which makes sense in that everyone is selling the same issue type. Couple that fact with a general reluctance of a bidder to commit its capital to a large position in a falling market and naturally, the bid price received is lowered. 

We have found over many years experience across many different interest rate cycles that a portfolio comprised of a diverse number of quality issues with varying block sizes is the best method of assuring good portfolio liquidity for income oriented (versus total return) bond investors.

Lastly, we believe the decommoditization of the municipal bond marketplace that has occurred with the unraveling of the insured bond sector is a favorable event for knowledgeable, income oriented, bond investors. Although, market liquidity has been damaged by this development, nominal yield levels are clearly greater today than they otherwise would be with a robust, insured bond sector. This will translate into better incomes for investors in the years ahead and, importantly, will serve as a healthy governor of issuer fiscal prudence as issuers’ borrowing costs will be determined primarily by their underlying credit quality rather than an increasingly difficult to assess, third party guarantee. 

We hope this commentary is helpful. Please call us if you have any questions or would like us to conduct a review of your portfolio.

We thank you for your continued confidence.

Sincerely,
Ronald P. Bernardi
President and CEO
July 2010