Brillion, Wisconsin

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City of Brillion successfully issued $2.645 Million of Series 2015B General Obligation Corporate Purpose Bonds

The Bonds are Non-Rated

The Bonds are being issued for the public purposes of financing street improvement projects; water system projects; storm water improvement projects; and to refund certain obligations of the City. The Bonds are valid and binding general obligations of the City, and all the taxable property in the City is subject to the levy of a tax to pay the principal of and interest on the Bonds as they become due which tax may, under current law, be levied without limitation as to rate or amount.

The City of Brillion, with a current estimated population of 3,191, comprises an area of 1,135 acres and is located approximately 25 miles south of the City of Green Bay.  The City’s 2014 estimated equalized value totaled $191.98 million.  The top ten taxpayers in the City accounted for 21.48% of estimated equalized value, the largest of which was Ariens Company (commercial lawn mower manufacturer, corporate headquarters) representing 5.18%.  Following this issuance the City will have approximately $8.1 million in general obligation debt outstanding.  This translates to a debt to equalized value ratio of 4.22% and a debt per capita ratio of $2,539.

Bernardi Credit Overview

Purpose:  The Bonds are being issued for essential service improvements, specifically street, water, and sewer.  Additionally, a portion of the issue, approximately $750,000 will advance refund the City’s Series 2006 General Obligation Corporate Purpose Bonds.  The refunding will provide the City with interest cost savings.

Security: The Bonds have been duly authorized and executed by the City and are valid and binding general obligations.  All the taxable property in the City is subject to the levy of ad valorem taxes to pay principal of, and interest on, the Bonds, without limitation as to rate or amount. The Issuer is required by law to include in its annual tax levy the principal and interest coming due on the Bonds.  See Article XI, Section 3 of the Wisconsin Constitution.

Structure: The Bonds are structured to mature serially, May 1st, 2016 to May 1st, 2035.  Property tax statements are distributed to taxpayers by the town, village, and city clerks in December of the levy year.   Personal property taxes, special assessments, special charges and special taxes must be paid to the town, city or village treasurer in full by January 31, unless the municipality, by ordinance, permits special assessments to be paid in installments.  Current state law requires counties to pay 100% of the real property taxes levied to cities, villages, towns, school districts and other taxing entities on or about August 20 of the collection year.

Market Review – Spring 2015

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Market Update:  Municipal bond yields ended the 1st quarter of 2015 relatively unchanged from prior year end.  Municipal yields rose in February, partially offsetting the declines across the yield curve that occurred during the month of January.  During March, yields on the long end of the curve fell, while short-term yields (5 years and in) continued their rise from February.  

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Market Review – Spring 2015

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Market Update:  Municipal bond yields ended the 1st quarter of 2015 relatively unchanged from prior year end.  Municipal yields rose in February, partially offsetting the declines across the yield curve that occurred during the month of January.  During March, yields on the long end of the curve fell, while short-term yields (5 years and in) continued their rise from February.

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Turning 30 — A Milestone Year

By Ronald P. Bernardi

We thank our clients and others who count on us and wish everyone a healthy and prosperous 2015. This past November marked the beginning of our thirtieth year in business. Today, I want to share a few thoughts with you, some of which I’ve been reflecting on for a long time.

The municipal bond market was much different when we began in 1984. Today, our business model does not resemble our model in 1984, but our core values remain unchanged:

  • Municipal bond specialization – Remain experts in our area of the bond market through in-depth research, continuing education and plain hard work
  • Excelling at core market competencies – Excel at the core functions of municipal bond specialization: municipal bond credit research, portfolio management, public finance, trading and underwriting
  • Honest client service – Serve our clients honestly and forthrightly
  • Clear communication – Maintain timely and clear communication with our clients
  • Above average performance – Constantly endeavor to achieve above average performance for our clients
  • Principal oversight – Firm principals engaged in daily business operations
  • Consistent employee commitment – Ensure each and every employee of Bernardi Securities understands and conducts business in a manner consistent with these values

Common sense tells us if we focus our energies on these values, work hard, treat people fairly, push ourselves to evolve and improve, then our clients will prosper by interacting with us. We believe our success will follow.

This is what has occurred over nearly three decades. We started as a small organization of four people. Over three decades our team, talents and responsibilities have grown. Our role has developed into something significant: across the country, thousands of people, their families, dozens of communities and financial institutions rely on us to help improve their lives and organizations.

I thank our clients for your confidence and support over the years. From the outset, we were fortunate to have loyal people who believed in us. Everyone at Bernardi greatly appreciates and values this honor.

In Italian, there is a phrase “grazie mille.” Familiarly it means, “thank you, very much.” Literally, the phrase means “ thank you, one thousand times.”

Grazie mille, to all of you who count on us and all those who have helped us over the years.

The idea of forming Bernardi Securities, Inc. belongs to our Chairman Edward Bernardi. Ed is my father and has been involved in the municipal bond business for over 50 years. He led and taught us for years. He urged us to remember our principles, believe in ourselves, work hard and treat people fairly. He taught us what we needed to know about running a business, teaching both the formal and informal lessons: lessons we needed to learn in order to help our clients and our firm prosper. He was masterful, a great communicator. There were many, mostly small, moments in time when he taught us. And over many years, the sum of these moments has brought our organization to the place where we find ourselves today. Thank you, Ed.

COOL HAND LUKE SYNDROME

We have noticed over the years that market participants, including ourselves, sometimes suffer from the Cool Hand Luke syndrome — “a failure to communicate.”

Poor or inadequate communication inevitably leads to mistaken and inaccurate impressions. It allows the actions of a few to taint the market’s perception of the many. The municipal bond industry suffers a bit from this.

The press has focused its attention on the municipal bond market in recent months.

Some of the reporting is accurate and some of it is oversimplified storytelling.

Our family has been active in the municipal bond market for over 50 years. We can attest that it is a complicated place. Sometimes municipal bonds are hard to understand. These are two reasons we decided to specialize in this market. Often, people who sell them do not understand what they are buying or selling.

This market update discusses several problematic issues facing the industry. It addresses how the market generally operates and how Bernardi operates and navigates through it. It offers our perspective on these issues and describes some of our policies and best practice procedures. We have put these in place to better ensure we interact with our clients effectively, efficiently and fairly.

MUNICIPAL BONDS BUILD AMERICA – A CHANGING MARKET NEEDS TO ADAPT

The municipal bond market has been one of our nation’s greatest growth engines for over 100 years. It is a $3.7 trillion market with new issuance surpassing $330 billion in 2014. Our public finance market is envied around the world for its ability to raise capital efficiently and independently of the federal government. In a typical year, approximately 70% of our country’s public infrastructure is financed by municipal bonds.

All of that said, it needs to improve in many ways and here’s why — the state of a nation’s infrastructure greatly determines its future, so a healthy and effective municipal market is critical to our country’s future prosperity.

The demand side of the municipal bond market has shifted in recent years. Today, municipal issuers are more dependent than in the past on individual investors and community banks. Many hedge funds and insurance companies have reduced the size of their municipal bond portfolios in recent years. Some are no longer active buyers. The Federal Reserve’s September ruling that excludes municipal bonds that can be held by large banking institutions from the list of high-quality liquid assets may reduce future demand for municipals from some of these institutions. Additionally, the number of dealers supporting the market has shrunk. Some broker-dealers and dealer banks are committing less capital to their municipal business than they allocated pre-2008 because their business model is under considerable stress. Dealers act as buffers absorbing bonds investors want to sell and holding them in inventory until an appropriate buyer is found. These changes have affected market liquidity.

It is important that creative solutions emerge to address the marketplace’s issues. Public officials representing municipal bond issuers, investors and their advisors need to have confidence in the market’s integrity of information and its fairness. There are changes that can be put in place to improve the marketplace.

Lastly, leaders need to position themselves at the vanguard of change. We intend to continue to be part of this change.

So what are the issues of the day?

COST, TRANSPARENCY & DISCLOSURE — THE MUNI MARKET’S TRIPLE HORROR SHOW?

  “Muni Bond Costs Hit Investors in Wallet” – The Wall Street Journal, 3/10/2014

  “SEC’s Piwowar Wants Simpler Muni Bond Transactions”  – The Bond Buyer, 8/1/2014

  “SEC cracks down on disclosure in municipal bond sales” – The Washington Post, 6/28/2013

  “Munis Beating All Debt Shows Faith in Local Government” – Bloomberg News, 11/4/2014

  “Munis Are Talk of the Town-high returns this year outpace those of blue chip stocks, corporate debt” – The Wall Street Journal, 11/3/2014

  “Investors Flock to Municipal-Bond Market” – The Wall Street Journal, 12/29/2014

If Edgar Allen Poe had ever written a tale about the municipal bond market and based it solely on the top three headline stories, the work would have been a bone chilling horror story.

The last three headlines underscore the market’s paradoxical nature. Today, there is a lot of confusion and misunderstanding about the municipal bond market. In the coming pages we share our perspective.

The municipal bond market is vast. There are over 50,000 distinct issuers, more than one million municipal bond issues outstanding. The market is well developed and generally efficient given the number of issuers. It is diverse, fragmented and nuanced because there are so many issuers.

Generalizing about municipal bonds makes for a risky business. Each municipal bond, each sector has unique characteristics, criteria and risks. It is not a homogeneous marketplace. Which is a major reason the market did not implode during the 2008-2009 financial crisis — unlike the commoditized mortgage market. This characteristic is a bedrock of its strength and a primary reason conservative investors find it an attractive place to invest.

The diversity and lack of homogeneity in the municipal bond market create some of its most vexing issues. Herein lies the cause of the market’s paradoxical nature. Different borrowers have differing needs and views as to how best repay their loans. Different investors have different needs. Loans are customized to suit these differing needs.

Therefore, creating market scalability is difficult and, arguably, undesirable to some market participants. It is an intrinsically, fragmented market. Fragmentation affects cost and liquidity.

The market’s lack of homogeneity is both a strength and a weakness. A conundrum perhaps — but not a bad or troublesome issue in our view. The market is much improved from 5-10 years ago. Additional improvements are needed, are occurring and will continue.

REGULATORY OVERSIGHT OF THE MARKET IS SIGNIFICANT

The municipal bond market is highly regulated. Generally, it is orderly and fair. Investors and issuers enjoy great protections provided by regulatory authorities and many responsible firms serving the marketplace.

Bernardi Securities takes great pride in its exemplary regulatory record. We have experienced first-hand, for over 30 years, regulators from the SEC, FINRA and state agencies routinely examine, audit and visit our offices. These exams ensure our policies and procedures adhere to the many rules we are required to follow. These exams are thorough.

Investors clearly want more regulatory protection and, per a recent FINRA study, appear willing to pay for some of it. In November, FINRA released a study with findings showing 92% of investors say it’s important to have a “cop on the beat” to protect them, 74% support “additional regulatory protections” and more than half (56%) favor enhanced regulation even if it results in “a minimal increase” in costs. It is likely regulatory oversight and investors’ costs will increase in the coming years.

Some market critics feel regulatory agencies have not focused sufficient attention on the municipal bond market; some even claim it has been ignored. We disagree.

The market is not broken and it is not static. Improvements to market structure are never finished. The SEC has ramped up its enforcement capabilities in recent years and has become much more effective in protecting investors and issuers. Likewise, FINRA, our industry self-regulator, has clearly raised the bar for broker-dealer conduct. It has strengthened the suitability rule and has provided clear guidance on mitigating or avoiding conflicts of interest. There are numerous recent examples of how modern technological resources enhance the data regulators, issuers and investors receive and analyze about the municipal bond market.

Here is a sample of established rules governing independent municipal advisors and broker-dealers, as well as a few recent regulatory and industry led initiatives. The scope of these rules demonstrates that regulators and market participants are leading the market to a heightened level of transparency and disclosure. This results in improved information flow and lowers investor and issuer costs.

We follow each rule with a brief explanation of our internal policy related to it. Our policies are designed to produce results exceeding what is required by the rule.

1.  Municipal Securities Rulemaking Board (MSRB) Rule G-19 – the rule requires a broker-dealer to have a reasonable basis to believe a recommended transaction or investment strategy involving a municipal security is suitable for a customer. Suitability is determined through information obtained through reasonable diligence of an investor’s investment profile.

Here are two Bernardi policies designed to ensure our behavior surpasses what Rule G-19 requires. Since our inception, we have been bearish on passive bond investing and bullish on credit analysis. We manage our clients’ mattress money so our municipal bond portfolio research and management process starts with credit research.

Firstly, all municipal bonds bought by our firm are approved by the Bernardi Credit Committee. The only exceptions to this rule occur when a client instructs us to purchase a particular issue for them. If the credit is not on our approved list, we inform them of that fact and execute the trade on an unsolicited basis.

The committee adheres to a time tested process. This process has been honed over many years and numerous market cycles. It is time consuming and granular to its core. It has served our clients very well especially during and in the aftermath of the 2008-2009 financial crisis.

We meet many times during the course of a typical week discussing and reviewing the current state of credits brought to our attention by our credit research department. The outcome of these meetings varies — credits are added to the list, some are removed and others are placed on a heightened watch status. The result of this work is important to our clients — only credits approved by the committee are offered to them for investment.

Secondly, our policies and procedures require that all of our portfolio-managed clients complete a Letter of Understanding and Investor Profile document before any investment program commences. Periodically, the documents are reviewed and amended, if the situation warrants. The client is assisted in this process by our investment specialists and portfolio managers.

Similarly, our policies and procedures require non-managed accounts to complete a Bond Offering Profile (BOP).

Adhering to these disciplines better ensures our recommendations are consistent with client needs and objectives, ensuring our compliance with the rule.

2.  MSRB Rule G-30/FINRA rule 2111 – these rules require dealers to purchase and sell municipal securities for its own account to customers at a price that is fair and reasonable given the prevailing market conditions.

This is a governing rule that helps determine how we price bonds we offer to our investor clients.

Trading of municipal bonds is highly decentralized and the process for selling bonds is very different from selling stocks. There is no central exchange to look at in order to determine the price of a particular security and rarely are there numerous buyers and sellers of a given municipal bond (same cusip) over a short time span. The MSRB 2013 Fact Book points out that on average, an individual municipal security trades less than 3 times per day. Since new issue securities often trade multiple times a day, the ordinary trade frequency of secondary market securities is even lower. There are over 1.5 million unique municipal bonds outstanding versus approximately 5400 corporate issuers.

This reality makes bidding and pricing municipal bonds an inherently more subjective exercise. This is a reality of the municipal bond market. It behaves differently than the commoditized U. S. Treasury bond market. Perhaps one day, multiple standardized electronic trading protocols will change this dynamic, but that day will not arrive until municipal bond offerings are simplified and standardized. Simplification will require excluding features like sinking fund call dates and special redemption features. Standardization will require, perhaps, a “one size fit all” call feature or complete lack of a call option altogether.

Generally, these changes will improve market liquidity, but will come at a cost for issuers: reduced choices and flexibility. If standardization occurs, it will require the market to move away from its current issuer centric focus to a more investor centric focus. This change will prove problematical for some issuers, especially small, less frequent issuers.

Clearly, investors need help with pricing disclosure in spite of great improvements in this area in recent years. Today, there is significant trade and transaction data available to retail investors. Price information flow to investors has improved greatly and advancements will continue in this area.

Firstly, in 2000, the MSRB began making public all trade data available on a one day delay. In 2009 the MSRB created an investor website called EMMA (Electronic Municipal Market Access). EMMA provides access to official statements, market statistics and a price discovery system. Information is provided at no cost to the public and is helpful to investor’s and market participants. Its introduction and subsequent improvements have greatly improved pricing discovery and disclosure in the municipal bond market.

Secondly, technological innovation continues to yield additional information and efficiencies to investors. Some standardization will be incorporated into the disparate new issue market in the future. This will help improve both market liquidity and reduce costs.

At Bernardi we have a thorough, multi-step process to ensure fair and transparent pricing. We have built checks and balances into our pricing and bidding procedures in order to minimize pricing subjectivity affecting our investor clients. We compare a bond’s price to benchmarks and comparable issues recently traded. We check to see if the particular cusip has traded in recent days. Market volatility at the time of pricing may also affect a pricing decision. Our procedures coupled with Rule G-30 guide how we price bonds. They have evolved over the years and our stringent adherence to them help ensure our compliance with the rule.

Investor costs, of course, are related to fair pricing and are a critical determinant to performance. Years ago, we developed two pricing models in order to help clients assess the reasonableness of our compensation. Both models provide portfolio-managed clients pricing transparency and a reasonable cost structure. We offer two options because investors have different needs.

Too often, we see people with a tendency to look at the cost issue as a black versus white issue — commissions are good, fees are bad or commissions are evil, fees are good. In reality, one option is often more economical for one person and less economical for another. A fee-only option is suitable for a particular portfolio and in other cases a non-fee option is appropriate. That is why we offer two pricing options:

  • Fee-only option through Bernardi Asset Management (BAM). BAM was formed in February of 2000 at the request of clients who wanted this type of management. BAM is a wholly owned subsidiary of Bernardi Securities, Inc. (BSI). BSI is a licensed broker-dealer regulated by the SEC, FINRA, various state agencies and subject to rules written by the MSRB. BAM is a SEC registered investment advisor serving as a fiduciary and managing bond portfolios on a fee only basis. There are no mark-ups/mark-downs under BAM management; bonds are placed in portfolios at the same price as BSI buys from the selling party. There is a nominal trade ticket charge.
  • Non-fee option through BSI. Clients are charged on each transaction through a mark-up or mark down rather than paying an annual management fee. If there are no transactions, the portfolio incurs no costs. The BSI portfolio management process captures the mark-up/mark down of each transaction. Portfolio managed clients are welcome and entitled to know the exact mark-up or mark-down of a particular transaction. Some clients request we include this information as part of their year-end portfolio management report. Some request the information more frequently and many do not request it at all. We instituted this open book policy for managed portfolio clients more than ten years ago in order to promote transparency.

The net effect of MSRB rule G-30 coupled with our policies and procedures provides our clients with cost effective and transparent order execution and is another example of how our best practice policies go beyond what the rule requires. These policies work well for our clients and our organization.

3.  Municipal Advisor Rule, effective date July 2014 – the rule regulates previously unregulated independent municipal advisors (IMA) interacting with issuers and exists to protect issuers. The rule clearly defines differing roles of IMA and underwriters. It also limits an underwriter’s interaction with issuers absent an exemption.

Bernardi serves only as an underwriter and does not serve as a municipal advisor. We’ve made significant revisions to our operating procedures to comply with the rule after dozens of hours of internal meetings and in consultation with regulatory agencies and our counsel. As a result of the rule, our bankers clearly communicate to issuer officials, verbally and in writing, at the earliest moment of a potential transaction, our role, responsibilities and all other required disclosures. We provide only general information and hypothetical borrowing cost and potential refinancing savings absent an exemption.

Naturally, many issuer clients seek our advice and recommendations once we are engaged.

The net effect of the rule improves transparency and disclosure in the market and better protects issuers, taxpayers and system users from poor performing municipal advisors and underwriters.

4.  MSRB Rule G -18 – the SEC recently approved the MSRB’s proposal to require municipal bond dealers to seek the most favorable price possible when executing transactions for investors. The “best–execution” rule is effective December 2015.

The rule does not require the dealer to always achieve the absolute best price in spite of the rule’s label.

The rule establishes an explicit obligation for dealers to use reasonable diligence when handling and executing municipal security trades for retail investors. The rule’s goal is to achieve as favorable a price as possible under prevailing market conditions and requires dealers to have a process to evaluate all reasonable venues to trade a customer’s bond and execute at the best price the process reveals. This proposed rule would replace the current “fair pricing” standard which requires a dealer to know the market value of a security and use diligence in the attempt to ascertain it.

At Bernardi we have long had in place an execution diligence process and feel strongly our process operates fairly and efficiently on behalf of our clients. Our process consistently delivers an execution level far above what current rules require.

Strengthening the execution standard will provide investors with additional protections by requiring all dealers to diligently search for the best price for a customer.

5.  The MSRB has requested comment on whether it should require dealers to disclose its price or a mark-up as a way to improve market transparency. The proposal is an attempt to address concerns about hidden mark-ups in so called “riskless principal transactions.” The proposed rule would require a dealer to disclose to its customer what the dealer paid for the security on the same day for all transactions of $100,000.00 or less.

Arriving at consensus definition of “riskless principal transaction” is major point of disagreement. The proposal is currently in its comment phase. We recently submitted a comment letter to the MSRB.

6.  SEC Rule 15c2-12 – the SEC is currently soliciting comments on improving disclosures and regulatory burdens of Rule 15c2-12. It is seeking ways to enhance the quality and clarity of information disseminated pursuant to the rule. Written comments are due by January 20, 2015.

Rule 15c2-12 requires underwriters of municipal securities perform numerous activities and is intended to enhance disclosure in the municipal securities market, thereby reducing issuer fraud. Here is a summary of a few of the rule’s requirements of underwriters:

  • Review an official statement deemed near final by the issuer of securities before making a bid to purchase, offer or sell a municipal security
  • In non-competitively bid offerings, to send, upon request, a copy of the most recent preliminary official statement (if one exists) to potential customers
  • To contract with the issuer to receive, within a specified time, sufficient copies of the final official statement to comply with the rule’s delivery requirement
  • Before purchasing or selling municipal securities in connection with an offering, to reasonably determine if the issuer or the obligated person has undertaken, in a written agreement or contract, for the benefit of holders of such securities, to provide certain information on a continuing basis to the MSRB in an electronic format as prescribed by the MSRB. The information to be provided includes, but is not limited to: annual financial statements, operating information, notices of the occurrence of any of 14 specific events, notices of the failure of an issuer or obligated person to make a submission required by a continuing disclosure agreement.

The SEC released a report recently estimating that approximately 20,000 issuers, 250 broker-dealers and the MSRB will spend 115,248 hours per year complying with Rule 15c2-12. The report estimates issuers will submit approximately 62,596 annual filings to the MSRB in 2014 requiring an estimated 46,947 hours to prepare and submit these filings. Annualizing data received through September, issuer event notice filings will exceed 73,000 in 2014.

The requirements of Rule 15c2-12 are substantial on both issuers and underwriters.

This past year, underwriters, issuers and their advisors spent thousands of hours responding to and attempting to comply with the SEC’s Municipalities Continuing Disclosure Cooperation Initiative (MCDC). MCDC was announced on March 10, 2014. This program provided issuers, their advisors and underwriters the opportunity to self-report non-compliance with continuing disclosure undertakings on prior issuances. The broker-dealer deadline to self- report was September 10th while issuers had until early December to report. It remains unclear at this time as to the scope of any SEC enforcement actions resulting from the initiative.

We’ve spent dozens of hours reviewing underwriting transactions going back 10 years analyzing files on hundreds of transactions. Our review was exhaustive. We uncovered a number of instances where, in our opinion, issuers failed to comply with their continuing disclosure undertakings. We informed those issuers, their counsels and, if applicable, their advisors of our findings. It was then up to each issuer to decide whether it agreed with our opinion and, if so, to report itself to the SEC as we had done.

Disclosure in the municipal bond market has improved significantly in recent years. The gaping holes in disclosure that were prevalent a decade ago have mostly disappeared, but current disclosure efforts need continual improvement.

This is one of the most important issues facing the municipal bond market, in our view. The MCDC initiative has clearly gotten the attention of most market participants. Many issuers, their advisors and counsels who prior to the program did not focus on the rule, are now focused on adhering to its requirements. Responsible underwriters will undoubtedly remind them of their requirements, if that is needed.

At Bernardi, our credit research and underwriting process’ were amended and improved in 2012 shortly after the SEC’s 2012 regulatory alert. They now include a more thorough review of an issuer’s disclosure practices. Rules protecting investors, in effect, necessitate us policing the issuer’s official statement, a document prepared by an issuer, its counsel and advisor. This takes a lot of time and careful analysis. We complete this process several dozen times in a busy trading week.

The Bernardi credit committee views a non-disclosing issuer or an issuer that files late differently from one that files timely, complete and accurate disclosures. Our tolerance level for late or improper disclosures is different than it was in the past. This is not to say we universally avoid trading the bonds of late filers. It depends greatly on the issuer’s circumstances and history. We discuss specific circumstances at length in credit committee meetings.

Additionally in many instances, we remind issuers of their continuing disclosure requirements in order to help ensure timely and accurate filings. This internal procedure of ours helps improve market disclosure practices, we believe.

There are a lot of rules related to operating in the municipal bond market. Adhering to the requirements of 15c2-12 serves as a very good example of how trading municipal bonds is much more complicated than trading U.S. Treasury bonds or equities.

HONEST CLIENT SERVICE & CLEAR COMMUNICATION

Clearly, rules and regulations are needed and participants in the municipal bond market are subject to many. Perhaps layers of regulation are a necessity in today’s complex marketplace, but in the end we believe a fundamental relationship dictum tells us our dealings with clients rely greatly on trust. We expressed this in our third and fourth core values at the beginning of this letter:

  • Honest client service – Serve our clients honestly and forthrightly
  • Clear communication – Maintain timely and clear communication with our clients

Our core values define our organization and the principles of an ethical business culture. They are at the core of our company’s daily actions. For nearly 30 years, these statements have served as the central tenet of our operating philosophy. We strive to reinforce this belief with policies and processes that reward ethical behavior. This approach has worked well for our clients and us for decades.

Successful, vibrant organizations are replete with potential conflicts. Everyone in a successful business encounters a potential conflict or two. This is not bad in and of itself.

It is how one deals with those conflicts that matters.

We have expended great effort over the past 30 years searching for, finding and eventually doing things a better way. It was often difficult, often less profitable and sometimes uncomfortable. But once we start doing something a better way, it really does not matter what the old way was; we know we have moved onto something our clients want and that makes it and us even more relevant.

Rest assured we are not going backwards. We are looking forward to the next 30 years. We hope you are with us along the way.

Thank you for your continued confidence and support.

Sincerely,
Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
January 2015

Wicomico County, Maryland

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Wicomico County, Maryland successfully issued $1.605 Million of Series 2014B Taxable General Obligation Public Improvement Bonds.

The bonds are rated Aa2 by Moody’s and AA+ by Standard & Poor’s.

The Bonds are being issued for the purpose of financing the A.W. Perdue Stadium restoration/modernization project, funding a contingency, and paying the costs of issuance.  The Series 2014B Bonds are valid and legally binding general obligations of the County to the payment of which the faith and credit and taxing power of the County are pledged.  The County is empowered to levy ad valorem taxes, subject to the limitations on the County’s taxing power set forth in its Charter.  Article VII, Section 706.B of the County’s Charter provides that revenues derived from taxes on properties existing on the County real property tax rolls at the commencement of the fiscal year shall not increase, compared with the previous year, by more than two percent, or by the Consumer Price Index for all urban consumers (CPI-U), whichever is the lesser.

Wicomico County, with a population of approximately 100,000, is centrally located on the Delmarva Peninsula at the intersection of U.S. Route 13 and U.S. Route 50, the two major trans-peninsular highways.  The County is 115 miles from Washington, D.C., 115 miles from Baltimore, Maryland, 100 miles from Wilmington, Delaware, and 110 miles from Norfolk, Virginia.

 

Municipal Securities as High Quality Liquid Assets (HQLA)

By Ronald P. Bernardi

For many months, we at Bernardi Securities have closely followed the issue of municipal securities and their status as a high-quality liquid asset (HQLA) for commercial banks and nonbank systemically important financial institutions, or SIFIs (those with total assets exceeding $250 billion). We have been adjusting our portfolio management strategy somewhat in trying to anticipate a market change and reaction to an implemented, final rule. As you may know, the rule has not yet been finalized and the situation remains fluid (an August 28th letter from Bond Dealers of America, or BDA, on the situation follows).

Proposed HQLA excludes municipal bonds

Earlier this year the Federal Reserve Bank, OCC and FDIC proposed new liquidity requirements consistent with the Basel III liquidity coverage standard. The proposed rule excluded municipal bonds from qualifying as a HQLA, which would be a negative demand factor for the market.

Regulators proposed three classes of HQLA:

  • Level 1. Sovereign securities, including U.S. government securities and U.S. guaranteed securities. These assets are not subject to a haircut.
  • Level 2A. Securities issued by U.S, government sponsored enterprises and specific other sovereign entities (Fannie Mae, Freddie Mac, as examples). Assets subject to 15% haircut.
  • Level 2B. Investment grade corporate debt having certain characteristics and equities in the Standard and Poor’s 500 Index. Assets subject to a 50% haircut.

Level 2 assets are limited to 40% of coverage requirement and Level 2B assets cannot exceed 15% of the total.

The proposed rule seeks to include qualifying assets that can be liquidated quickly in large amounts with little impact on prices.

Bond Dealers of America has been an active participant in the ongoing discussion with regulators and elected officials since the rule was proposed. I sit on the municipal bond technical committee of BDA and have contributed a bit to this effort.

Here are some additional facts and my thoughts on the issue as it has developed over the past 7-8 months.

Rash of selling by affected banks unlikely

U.S. commercial banks hold approximately $425 billion worth of municipal securities. Bank demand has been very strong over the last 4-5 years, increasing municipal holdings 60-70%. This has helped to keep prices up and yields low. $425 billion represents approximately 10%-12% of the total municipal market. Strong bank profitability and weak loan demand were important contributing factors to this increase in bank holdings.

A good portion of this $425 billion is held by commercial banks not subject to the proposed rule. As long as these institutions remain profitable, they will continue to hold most of their current positions. We believe that profitable banks subject to Basel III should also continue to hold significant positions in municipal securities, especially if loan demand remains tepid. The after-tax yield advantage produced by current municipal bond returns versus comparable high-quality taxable securities (given a near zero cost of deposits) for these banks will be difficult to let go.

While bank participation in the market is significant and important, we do not foresee a rash of selling by affected banks in the near term. Longer term, we do expect certain, affected banks to pare holdings as time passes. Everything else being equal, less demand will cause prices to fall, and yields to increase. In a normal functioning market, any such paring activity should be absorbed by other investors given the current out of balance dynamic between supply and demand without driving prices down significantly.

Lower volume should offset possible price declines

Keeping in mind new issuance volume of municipal bonds declined 10%-15% in 2013, and that 2014 volume is shaping up similarly, this dynamic will partially offset declining prices from a rash of bank selling, if such activity were to occur. We do not foresee significant increases in new issuance volume in the next year or two.

We disagree on municipal bond illiquidity

We disagree that certain municipal bonds are not readily marketable. It is generally true that an individual municipal bond CUSIP has a low daily trading volume, but this does not mean necessarily a security is illiquid. General market, recognizable bonds of the same issuer, but with different maturities generally trade in tandem with multiple market participants willing to make a market in these securities. It is these issuers that should be recognized as HQLA, in our view. As an example, a State of Virginia General Obligation bond due in one to five years is a highly liquid investment — certainly comparable to many, if not most, Level 2B assets allowed under the proposed rule.

Undoubtedly, certain municipal bonds are less liquid than the proposed allowable Level 1 and 2 assets. We understand what these are and manage a portfolio accordingly. Municipal bond investment products that hold dominant positions in these issues/sectors are, in particular, potentially vulnerable to a market sell-off resulting from HQLA induced selling by banks. This type of forced selling, if it occurs, will present an attractive investment opportunity for us and our clients for a period of time.

Liquidity case in point — 2009-2009 financial crisis

Our most recent — and best — experience with municipal bond market liquidity occurred in Q4 2008 and throughout much of 2009. During this tumultuous trading period, historical trading charts show that spreads of high-grade municipal securities remained fairly steady unlike the spreads of many “AA” rated corporate issues.

Additionally, some of our clients called us during this period requesting partial portfolio liquidations to raise capital to meet margin calls, hedge fund capital calls, etc. I do not recall one instance where raising the required capital by selling municipal holdings was problematical or unduly costly to the client. Make no mistake, the process was not always an easy one during this period. But it was efficient, timely and fair to our investor clients because the portfolios were constructed with sufficient, liquid options. Our separate account strategy of investing in quality, fixed maturity, fixed coupon issues was greatly responsible for this. I do not see HQLA rule passage alone altering this dynamic.

I hope this is helpful. Keep in mind that there may be last minute amendments to the proposed rule. Please share with your colleagues and clients, and call me with any questions.

Ronald P. Bernardi
President and CEO
September 2, 2014

_________________________________

BDA Contacts Regulators:

Urges Inclusion of Municipal Securities as High Quality Liquid Assets

U.S. Regulators are expected to vote September 3, on a proposal which would require banks to hold enough liquid assets in order to fund their operations for 30 days if other funding is not available. Under the proposal, municipal securities would not count as a High Quality Liquid Asset (HQLA).

We are learning of new reports which indicate the Federal Reserve may be changing its mind about this decision. Specifically, according to an article in today’s Wall Street Journal here, “The Federal Reserve, under pressure from lawmakers and state officials, is considering allowing banks to use certain types of municipal debt to satisfy a new postcrisis financing rule, according to a person familiar with the process.” However, according to the article, “It is unclear if the Fed could act unilaterally to alter the rules, which are being written jointly with the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency.”

Just today, the BDA contacted individuals at the Federal Reserve and FDIC’s Board of Directors to express our continued desire to have municipal securities included as high quality liquid assets. Our outreach included a request to consider the the merit of including municipal securities as HQLA, as well as the impact on state and local governments should municipal bonds fail to be classified as HQLA or to otherwise oppose the proposal in its current form.

Earlier this year, the BDA comments on this issue, which you can find here. Specifically, our comment letter focused on:

  • The strong performance of highly-rated municipal bonds in times of market stress.
  • That the proposed rulemaking gives a cursory dismissal of the marketability of securities that are the building block of U.S. infrastructure and for which there is strong demand from investors seeking a stable and well-understood form of domestic investment.
  • A request that municipal bonds merit examination for potential HQLA qualification, just as foreign sovereign state obligations can be determined to meet the HQLA criteria.

We will continue to work with other interested trade groups similarly positioned on this topic and will keep you updated with any new developments regarding the Federal Reserve’s potential consideration of including municipal securities as HQLA.

We hope this information is helpful. Feel free to contact the BDA with any questions.

Mike Nicholas at [email protected]
Jessica Giroux at [email protected]

 

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Detroit and Stockton Emerge from Chapter 9 – A Few Facts, Observations and Takeaways

By Ronald P. Bernardi

Stockton, California emerged from Chapter 9 on October 30, 2014 when U. S. Bankruptcy Judge Christopher M. Klein confirmed Stockton’s plan. Detroit, Michigan emerged from bankruptcy on November 7, 2014 when U.S. Bankruptcy Judge Steven Rhodes confirmed Detroit’s plan. Both judges ruled each plan as presented is fair and feasible to all parties involved. There are clear winners and losers as a result of these decisions. And much remains unresolved with many unanswered questions.

The facts of rough justice in Detroit and Stockton

As we wrote in our April 15, market commentary Detroit settles with UTGO creditors, there is a rough justice in bankruptcy. These two settlements confirm that sentiment. Here are a few facts surrounding the settlements.

Detroit settlement facts:

  • Detroit will pay companies insuring voter approved unlimited tax full faith and credit general obligation (UTGO) bonds 74% of the outstanding principal and interest. This settlement is significantly higher than Detroit’s initial offer of approximately 10%-12%. The insurance companies negotiated this settlement and have stated they will pay investors 100% of principal and interest payments.
  • Detroit will pay limited tax general obligation (LTGO) bondholders 34% of the outstanding principal and interest. This settlement is higher than the city’s initial 10%-12% proposal as well. The insurance companies insuring a portion of the LTGO debt have stated insured investors will receive 100% of promised payments. Detroit will exact a 66% haircut on investors of its uninsured LTGO bonds and the insurance companies.
  • Detroit’ s approved plan does not haircut water and sewer revenue bond debt.
  • Detroit will haircut all other NON-BOND debt investments approximately 88% – 90%, as it originally offered.
  • City pensioners’ benefits were impaired with maximum cuts of less than 5%; cost of living increases were eliminated or reduced depending on retiree class. Health benefits paid for by city were reduced significantly. Pre-bankruptcy, pension liabilities represented approximately seven times more than general obligation bond liabilities.
  • Detroit has paid approximately $135 million in bankruptcy fees.

Stockton settlement facts:

  • Stockton will pay investor Franklin Advisors a 12% recovery rate when a $4 million secured claim is included, according to Judge Klein. Franklin states its recovery rate is only 1% on its $33 million investment in Stockton’s bonds. Judge Klein approved the city’s proposed payout over Franklin’s objections. These lease rental revenue bonds were issued to make improvements to city parks and golf course.
  • Insurance companies and Stockton negotiated a settlement months ago on other debt with insurers taking significant haircuts. The insuring companies have stated investors in these issues will receive 100% of promised payments.
  • Judge Klein confirmed Stockton’s treatment of pension payments to CalPERS — pensions are not reduced either retroactively or prospectively. In an earlier ruling, Judge Klein stated Stockton was free to abrogate its contracts with CalPERS while in bankruptcy and that CalPERS is an unsecured creditor. He stated federal bankruptcy law preempts state law and therefore CalPERS’ lien claim as a legal basis to assess Stockton a $1.6 billion termination fee was invalid in bankruptcy. Stockton did not pursue a CalPERS haircut in its plan making these findings moot because Judge Klein did not go beyond Stockton’s request.
  • Stockton did exact some labor concessions including reducing employee salaries and the elimination of most retiree health benefits.
  • According to Stockton, it has spent approximately $13 million on bankruptcy-associated fees.

Let’s review some observations and takeaways.

No guarantees for bond investors

There are no guarantees for bond investors. Lending capital to municipal issuers entails a degree of risk. This is why thorough credit analysis of an issuer’s finances is critically important in assessing the risk of a municipal bond investment. One must examine an issuer’s underlying credit quality, deal purpose and deal structure in order to find the many quality municipal bond credits. However, a central question — “Are voter approved full faith and credit UTGO bonds secured?” — was never put before Judge Rhodes for consideration because companies insuring UTGO bonds settled with Detroit. Investors and market participants need clarity on this issue and it remains unanswered in the aftermath of the Detroit and Stockton Chapter 9 odysseys. This is disappointing to us. The absence of clarity on this question allowed Detroit to extract a cash windfall from this creditor class. This settlement is not a legal precedent since it was negotiated. The facts, however, are not lost on other stressed Michigan municipalities (and their attorneys). Detroit’s plan is now their practical precedent.

Our takeaway: Until this question is answered by a judge or addressed by the state legislature similar to Rhode Island’s legislation, we continue to warily view investing in many UTGO and LTGO Michigan bonds.

Pensions treated much more favorably than debt holders

Pension creditors’ interests are treated much more favorably than those of debt investors. In both cases, local leaders decided to push plans favoring retirees over all other creditors. In both cases, each judge decided not to intervene — they chose not to alter the proposed plans and spread losses more proportionally based on each creditor class’ relative exposure. Judge Rhodes stated Detroit’s “discrimination in favor of the pension claims in the plan is necessary to its mission” and “the discrimination is not unfair” and the plan “is a model”. He also noted that while his ruling found federal bankruptcy law trumps Michigan’s protection for pensions, Michigan’s voters approved a constitutional amendment to protect pensions and the vote is “entitled to substantial difference”. That is his justification for accepting the city’s plan of better treatment of pensioners compared to other creditors, including bond investors. Similarly, in the Stockton case, Judge Klein chose not to challenge Stockton’s plan that left pension payments unaltered even though he had ruled earlier these pension payments were NOT inviolable.

Our takeaway: Creditors should not expect a federal bankruptcy judge to overrule or amend a Chapter 9 plan haggled over for many months. Both plans discriminated between creditor classes and neither judge altered any terms. Settlements or the filed plan determined recoveries in both cases, not a judge’s decision. Most major creditors settled rather than litigating to the end. Creditors that did not settle saw each judge approve the plan presented by the filing city. In future cases, each creditor class should negotiate a settlement they feel is fair to their interests and, if one is not agreed to, they should litigate to the end. This approach will force the presiding federal bankruptcy judge to address important and unanswered questions. San Bernardino, CA is currently in Chapter 9 and has indicated, contrary to Stockton’s plan, that it is willing to explore possibly reducing payments to CalPERS. If it files a plan cutting pension payments, given Judge Klein’s ruling on this issue, it will be difficult for the judge to sidestep the question. The case will be interesting to watch.

Everything is negotiable in Chapter 9

Certain debt structures are more secure than others, so a waterfall recovery is somewhat applicable. This is why insurance companies were able to limit their haircut to 24% on Detroit’s UTGO bonds while Franklin Advisors is stuck with an approximate 90% haircut on Stockton’s lease revenue bonds. The former has a much sounder security structure than the latter so the companies insuring Detroit’s UTGO bonds had more leverage. Detroit understood this and quickly upped its initial 10% payout offer to 74% and happily pocketed the difference.

Our takeaway: Chapter 9 is very complicated. Solid deal structure is always important, especially in these distressed situations.

Bond insurance’s value is confirmed

At this point, the value of bond insurance is confirmed. The insurance companies have stated they will pay 100% of debt service payments to all insured debt investors. This is good news. These companies negotiated strenuously with Detroit and cut deals in their best interests. In the process, the interests of other parties were affected.

Our takeaway: In Chapter 9, insurers act as a unifying force and are motivated to maximize their recoveries. Many debt investors benefit from their negotiating strength. Insurance company interests are aligned with the interests of insured debt investors, but not necessarily all debt investors.

Key questions went unanswered in Detroit

Questions surrounding security of Detroit’s water and sewer revenue debt went unanswered. Non-tendering investors will not take any haircut. Detroit tried to foist changes on this group even though the city’s utility backs this debt and is not in bankruptcy. Detroit pulled back from its initial position due to lack of leverage (see above) and decided not to force the issue. It has been resolved for the time being.

Our takeaway: Detroit blinked because it realized its legal standing was shaky. Non-tendering debt holders were resolute in believing their investments were secured and chose not to agree to any impairment.

Significant pension liabilities remain

Stockton preserved pensions entirely and Detroit reduced its pension liabilities minimally. Liabilities will continue to represent significant portions of the respective operating budgets post-bankruptcy. For example, Stockton’s 2020 budget estimates pension payments will absorb 20% of the year’s expected revenues. How will they deal with this fiscal reality?

Our takeaway: Will post-bankrupt Detroit and Stockton be able to make these pension fund payments each year?

Pensions viewed superior to other creditors

Both submitted plans demonstrated local politicians view pensions as superior to all other creditors. It was an easier decision for them to subordinate the interests of bond investors to pensioners demonstrating municipal bankruptcy is an inherently political process. We believe state law and state politics greatly influences Chapter 9 dynamics and therefore, these factors are key to determining final outcomes in these situations. For example, it is not possible to file municipal bankruptcy in certain states, difficult to file in many others and relatively easy in yet another group of states. Some states’ law view bonded debt as a statutory lien, while others do not. Some state legislatures have passed laws that place elevated importance on honoring local municipal general obligation debt. These are important distinctions especially in the case of a financially distressed municipality. We believe, therefore, differing state laws and differing state dynamics will lead to varied outcomes of future distressed municipality situations across the country. We factor this view into our credit analysis process.

Our takeaway: Our federalist system promotes competition between states. This is one of the most dynamic and foremost features of our system of government. States are “laboratories of democracy”, wrote Chief Justice Louis D. Brandeis. Good ideas crowd out bad ideas and investment capital moves across state lines easily. It will be interesting to watch if the flow of investment capital is altered or adjusts in any meaningful way by the resolutions of these two bankruptcies. It will be interesting to see if certain “good ideas” become standard fare in future incidents of Chapter 9.

Please contact us if you have any questions. We thank you for your continued confidence.

Sincerely,
Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
November 12, 2014

Sources:

  1. Bloomberg News
  2. Summary of Oral Opinion on the Record in Re City of Detroit Bankruptcy, Judge Steven Rhodes, November 7, 2014
  3. Oral Opinion of The Record in Re City of Detroit Bankruptcy, Judge Steven Rhodes, November 7,2014

 

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Municipal Bond Specialists for 30 Years — Our Founder Gives Thanks for Bernardi’s Mission

By Edward Bernardi

As we begin to celebrate our 30th anniversary, I have been asked to give you a review of our firm’s history, guiding principles and some of the changes I have seen in the municipal bond market. I have been in this business for over 55 years, and I have seen some dramatic changes during that time — from the use of ticker tape as a communication device to using today’s modern technology. I have seen municipal bond volume surge. Our client base has broadened. What hasn’t changed is our firm belief that we can outperform our competition — and earn the trust of our client — by concentrating our efforts, talents and expertise solely on the municipal bond market. Here are a few observations from an 84-year-old municipal bond professional.

Municipal bond specialists first and foremost

From the onset, our single interest was to run a sound investment firm specializing in municipal bonds. We wanted no part of the equity market and its volatility. While there is absolute importance in owning an equity or real estate portfolio, we wanted to specialize in an asset that allowed you to sleep well during the night. Our mission has been consistent for more than 30 years — specialize in the municipal bond market to deliver superior performance for clients. We are municipal bond specialists first and foremost, and will continue to be specialists solely in the municipal market.

Independent credit research

Our original business plan was to focus solely on the municipal bond industry by doing our own research. We wanted to develop in-house credit research, rather than depending on some outside source to tell us how a bond was rated, how good the bond was or was not. We wanted to have our own take. We wanted to make our own decisions as to the viability of a particular credit. The firm’s ongoing investment in our research efforts provides us with added confidence in the credits we place with clients and offers opportunities to find solid credits at good prices for our clients. This approach continues to this day.

50 years ago we received news and offerings via snail mail and ticker tape. Today, the information is delivered in fractions of a second. I guess progress is progress, but I’d rather take my time and do my homework rather than being rushed into the decision making process. Again, a good research department allows us to make those quick decisions without the inherent risks of decisions without thought.

Better regulation & investor protection

In the early days of my career the municipal market was free of “government interference.” As a result, a number of rogue firms took advantage and hurt communities and investors. Today, the market is regulated by a number of federal and industry-funded agencies, which have brought the interests of the municipal bond market more in line with the clients it serves.

Municipal bond tax exemption repeal threats

The question of municipalities retaining their right to issue debt whose interest payments are tax-free from federal income taxes comes up again and again over time. About 30 years ago, certain politicians attempted to do away with the exemption. Governors, mayors and school superintendents throughout the country vigorously objected. The matter was dropped.

Today the question is being raised again and it is a bad idea. Repealing or capping tax-exemption will make it more expensive for communities to borrow. Communities will still need to invest in their infrastructure.  They will issue taxable bonds instead forcing local taxes and fees to increase.

More than a half-century of changes — and gratitude

Yes, it has been quite a run. My life has been devoted to this industry for more than a half-century — the last 30 years to Bernardi Securities. It is impossible for me to adequately describe the sense of profound joy and pride I feel for the Bernardi team on this, our 30th anniversary. Nor is it possible for me to sufficiently thank our clientele — from those who allowed us to serve their investment needs in the early years to the younger generations who have helped to drive our growth.

A special thanks to the municipal bond specialists of Bernardi Securities. Their honesty, care, dedication and service to our clients built the foundation of our success.  Each and every one of our specialists is a credit to the firm.

Lastly, with great pride I salute my son, Ron Bernardi, who met the new challenges of this day and age — and built a firm which is now one of the most respected in the industry.

The success of the firm will forever represent the singular reward of my business life.

I thank you all.

Sincerely,
Edward Bernardi
Chairman
Bernardi Securities, Inc.
November 5, 2014

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Premium Municipal Bonds: Benefits in a Rising Rate Environment

By Matthew P. Bernardi

Many investors find it difficult to pay a price greater than par for a bond. We often find this hesitation is purely psychological and causes some investors to miss an advantageous structure in a low interest rate environment. This market commentary is written to explain why premium municipal bonds often offer value in today’s market — helping to justify paying above par for a bond.

Premium bonds carry a coupon rate that is higher than current market yields. This causes the price of the bond to trade above the par value ($100) to bring the overall return in line with current rates. The higher coupon of premium bonds creates a number of benefits for the investor.

Reinvestment at higher rates

If rates rise, the higher coupon payment (i.e. cash flow) of premium bonds can be reinvested at the high rates. Take for example two $1,000,000 par amount portfolios. One is invested in premium bonds carrying 5% coupons, the other in par/discount bonds with 3% coupons. The first portfolio generates cash flow of $50,000 per year compared to the second at $30,000 per year. An additional $20,000 in cash flow from the premium bond portfolio is now available to take advantage of rising rates. $50,000 compounded at a 4% yield for 10 years amounts to $74,012 — whereas $30,000 amounts to only $44,407.

Less volatility

Higher coupon bonds are inherently less volatile than lower coupon bonds. Duration is a measure of the sensitivity of the price of a bond to changes in interest rates. The higher the duration, the more volatile a bond’s price changes as rates fluctuate. There are a number of factors affecting the duration calculation. One is a bond’s coupon rate. Because a relatively higher coupon returns cash flow to the bondholder sooner, it is a favorable input in the calculation and lowers the duration (volatility) of the bond.

Dearth of demand

There is a large contingent of the retail investor base that entirely avoids premium bonds. This reduces demand and makes them less expensive for others to buy at relatively higher yields. If you have read this far, hopefully you are no longer part of that crowd.

A defensive opportunity — with one caveat

The benefits of premium municipal bonds described above provide investors with both an opportunity and a defense mechanism in a rising rate environment. One caveat, however, should be noted about premium bonds — often these types of securities carry a short-term call date. Because of the high coupon, the likelihood of a call is often relatively high. Investors must take into account this possibility in the context of the overall portfolio structure — and should be properly compensated in yield return priced to that date.

Please contact us if you have any questions on portfolio strategies for a rising rate environment or would like a portfolio review.

Sincerely,

Matthew Bernardi
Bernardi Securities, Inc.
October 2, 2014

 

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2014 Mid-Year Municipal Market Update

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Since June of last year the economy has added almost 2.5 million jobs and the unemployment rate has fallen from 7.50% to 6.08%. Nonfarm payrolls have surpassed pre-crisis levels and PCE inflation readings — although subdued — have increased from 1.16% to 1.48%[1].  Many economists maintain a positive employment outlook as well, calling for the unemployment rate to fall to 5.8% in Q1 of 2015 and inflation to touch the Federal Reserve’s target of 2% in that same quarter.

What’s keeping bond yields so low?

With a healthy backdrop and positive outlook it is difficult to accept why the 10-year Treasury bond trades at a lower yield today (2.46%) than it did a year ago (2.60%). The 30-year bond has had an even larger move, going from 3.67% on July 29th, 2013 to 3.22% today. Municipal yields have moved lower too — and to an even greater extent. The effect of higher tax rates setting in, reduced supply and continuing improvement in municipal balance sheets are factors responsible for the relative move of lower municipal bond yields.

There are a number of explanations why market pundits calling for a rate shock have been disappointed. For one, investors have reduced their projections of the Federal Reserve’s “normalized”[2] federal funds rate level. Secondly, global central banks — led by the European Union, China and Japan — continue to ease as they try to keep their currency values relatively weak. A closer look at the yield curve, however, may give us the most appropriate answer for why we have experienced this fall in long-term rates. While the 10- and 30-year bond yields have dropped, shorter term rates have actually been on the rise.

Higher rates means lower rates

The emerging theme of a flattening yield curve, which we overviewed in our March market update, has largely played out as expected. Since the start of the year, the difference in the 5-year and 10-year Treasury bonds has fallen from 1.28% to 0.77%. The 2-year/10-year spread has moved from 2.64% to a 1.94% difference. This move is in response to the market projecting slower growth in the future brought on by higher short-term rates prompted by the Fed’s eventual tightening. Should rate increases arrive sooner or greater than projected (3Q 2015), the yield curve flattening will become more pronounced, if not inverted. (i.e. higher short-term rates compared to longer-term rates.)

Municipals offer compelling opportunities

From a relative rate perspective, municipals offer compelling after-tax risk-adjusted returns, with the 10-year AAA rated tax-exempt benchmark municipal trading at 89% of the 10-year Treasury yield.[3] This ratio averaged 86% in the 7 years prior to the crisis. Even at the 15% Federal tax-bracket, the taxable equivalent yield is above Treasuries. The elevated level of tax-exempt rates compared to taxable Treasuries is largely due to perceived credit weakness in the market as the headlines of Puerto Rico and Detroit linger. Our own backyard — the State of Illinois — also contributes to market stress. For a “bottoms-up” research firm like ourselves, this creates opportunity. We touched on this in our Illinois Effect white paper published last month.

Credit research lessons in Detroit distress

These pockets of distress have created opportunities and lessons alike. Detroit’s bankruptcy filing, to date, has failed to provide any legal clarity regarding the putative secured status of Unlimited Tax General Obligation bonds and Limited Tax General Obligations. Instructively, the City’s public position and certain proposed and agreed upon settlements with bond creditors have provided clarity as to how Detroit’s officials view the security of these debts. We are interested to see if the bankruptcy court finds these agreements and proposals fair and equitable with respect to each class of claims that is impaired. This opinion will provide a degree of legal clarity and it will be very instructive to us as it relates to Michigan bonded debt, generally.

Detroit’s final settlements with bondholders may portend what other investors might expect as settlement in future distress situations occurring elsewhere in Michigan. We do not necessarily infer similar treatment for non-Michigan general obligation bonds during distress scenarios, but clearly a bad precedent seems to be developing in Motor City. The market will always be regional in price, politics and legal structure. Adhering to our Three Pillars of Credit Research has allowed us to successfully navigate away from such municipal credit strains and the politics of a bankruptcy settlement.

Continued economic improvement likely ahead

As the year progresses we expect the economy will continue to improve. The health of the credits we follow should improve simultaneously as property values rise, tax revenues increase and pension funding recovers.

As always, please call us if you have any questions or would like a portfolio review.

Sincerely,
Matthew Bernardi
Bernardi Securities, Inc.
July 29, 2014

[1] Source: Bloomberg. The preferred measure by the Federal Reserve of inflation is the change in the Personal consumption expenditures price index (PCE).
[2] When the fed funds rate is consistent with real GDP equaling its potential level (potential GDP).
[3] Source: Bloomberg. Ticker: MUNSMT10 Index Index