Michelle Bernardi Landis summarizes the key points of the President’s Letter below.
There have been many news stories recently regarding the municipal bond market and its impending debt crisis. Most of them have been unnerving and intimidating. Many of these sensational news stories are warranted while many are overblown and will be played out in the years ahead.
The purpose of this piece is to discuss the relevant issues featured in today’s municipal bond credit market. In addition, our intent is to give readers a flavor for how we, here at Bernardi Securities, Inc., approach municipal bond credit analysis. We will explain our view of the various types of municipal issuers and how we apply our research framework in the decision making process even as these issuers are faced with mounting financial stress and uncertainty.
This piece is long as the subject matter requires a thoughtful and thorough response.
I urge you to read it in its entirety.
“PAST PERFORMANCE IS NO GUARANTEE…..”
– Bond fund prospectus, December 2010
We often remind our clients that investing entails risk. Our experience and common sense tell us that the municipal bond market is not and cannot be immune from the financial crisis we have all endured the last few years. Frankly, these are difficult economic times and we will likely be mired in them for several years to come. We take comfort in that, historically, traditional municipal bond investments have a long, proven and stellar track record of paying principal and interest promptly. Moreover, default rates for municipal bonds are well below similar metrics for corporate bonds. Finally, and most importantly, despite the headline grabbing news stories, municipal bankruptcies have been a very rare occurrence. All that said, it is the disclaimer at the bottom of every prospectus, “past performance is no guarantee of future results…” that serves to alert us all that losses may occur when making an investment, including a municipal bond investment. As an investor, if you are uncomfortable with this possibility, you should not be in this marketplace.
We do believe a traditionally structured municipal bond portfolio will be better able to weather the present day financial crisis than many other bond investments. Our belief is based, in part, on the experience of our clients in 2008, which for many investors was disastrous. Calendar 2008 is also a recent scenario we can reference. The operative phrase in our belief is “traditionally structured” and later we will explain how we define that phrase. In order to do so, we will first need to describe our core beliefs on municipal credit analysis.
“MUNICIPAL FINANCE IS MOSTLY A LOCAL PHENOMENON”
– Unnamed municipal finance administrator, circa 1988
I first heard that phrase many years ago from an administrator of a municipality. Admittedly, at first, I did not understand what he meant by it. It took me some time, but after reflecting on it for a while, I figured out its significance and relevance. Years later, his assertion helped us to develop and today serves as a centerpiece of our municipal bond credit analysis process.
In our view, there are three constants to the municipal bond credit analysis process:
Deal purpose matters
We ask: Pool or school, municipal court or tennis court?
Deal structure matters
We ask: is there a specific tax or revenue source backing the issue or is it simply a “promise to pay” pledge?
Underlying credit quality matters
We ask: what does the issuer’s P/L and balance sheet look like?
At Bernardi, these are the 3 pillars upon which we build a traditionally structured municipal bond portfolio.
In our opinion, a bond’s rating is an important metric, but not necessarily the only credit metric to consider. The above questions serve as a few examples of what needs to be asked to better assess credit quality beyond a rating. Normally, one or two pieces of information alone will not determine if a credit is solid; information in the aggregate allows us to make that determination. Often, if the answers to questions in one area indicate a weaker credit (underlying credit quality, as an example), then we will look for a greater strength in other areas (deal purpose and structure, as an example). This is most often a labor intensive process.
We have found in our experience of over a quarter century, that almost always, when a municipal bond portfolio is comprised of bond issues with clear deal structure, traditional purpose intent and sound underlying credit quality, timely principal and interest payments have been made. It is our expectation that issuers at least meeting those three standards are better equipped to withstand the inevitable fiscal stresses. We will have to wait and see if past events serve as accurate predictors of our financial futures.
Conversely, when principal and interest payment problems have occurred with issuers, it is almost always, in our opinion, because the issuer falls short with one or more of the Bernardi pillars. Current examples include:
Harrisburg, Pennsylvania – solid waste issue deal purpose, city wide debt service guarantee deal structure and weak underlying credit quality.
Jefferson County, Alabama – esoteric auction rate deal structure coupled with excessive underlying debt load.
Vallejo, California – excessive operating and pension expenses resulting in very weak underlying credit quality; weak deal structure.
All three of these issuers have been tenuous credits for years, long before their present day problems were plastered on the front page of newspapers. It was readily apparent to anyone who took the time and effort to thoroughly analyze these credits. For this reason, many years ago, all three of these credits failed to qualify and make our approved list of credits for our portfolio managed portfolios.
Today, the list of stressed municipal bond credits is as large as I have ever seen in my 30 year career. Therefore, adherence to a thorough and disciplined credit analysis process is of critical importance.
“SMALL IS BEAUTIFUL”
– E. F. Schumacher, British economist, 1973
Generally, from a credit quality perspective, we tend to favor small to medium sized municipal issuers over the large, big name issues. That said, there are many large issuers of municipal bonds that are currently on our approved list.
Our bias for small to medium sized issuers is based on several factors. Keep in mind the factors listed below are generalizations and should not be automatically applied universally:
Clarity of audits and other financial documents – For those issuers in this group, specifically diligent issuers that file financials regularly and on time, the information is typically discernable and easily understood. We can usually see the good, the bad and the ugly in the financials. This is not always the case with the larger issuers.
Simple and traditional financing methods – Most often this group of issuers keeps it simple when they issue debt. Financing techniques like auction rate securities, credit default swaps and interest rate swaptions are rarely used by this group. Rather, old fashioned, plain vanilla, fixed rate, fixed maturity, self – amortizing debt structures prevail. An issuer develops a financing plan and pays it off over the useful life of the project, all the while locking in an affordable fixed rate. They remember they are in the business of providing needed municipal services and are not in the finance business, thereby avoiding the mistake made by several large, supposedly sophisticated issuers. Many of the larger issuers currently experiencing stressed finances today would be much healthier had they followed this approach.
Lower current and future operating costs as a percentage of the overall budget – Generally, the expense side of the ledger for this group is less onerous. Labor contracts and benefits tend to be more reasonable and there is usually less bureaucratic waste as a percentage of the budget.
The business of the municipality tends to be run more like a business because very often the elected official decision makers are local business people. Generally, smaller communities will give us swifter responses to financial questions we might ask. Often, we can discuss important issues with high ranking municipal officials more easily and we often find that our input is given important consideration. We understand politics play a role in the running of every municipal government, but generally (and most certainly not universally) the presence of the above factor tends to better insure that financial decisions will be made without being overshadowed by political considerations.
“TAKE NOTHING ON ITS LOOKS; TAKE EVERYTHING ON ITS EVIDENCE. THERE’S NO BETTER RULE.”
– Great Expectations, Charles Dickens circa 1860
We believe when assessing municipal bond credit quality one needs to look at details of the specific credit (“municipal finance is mostly a local phenomenon”). Clearly, the State of Illinois is a weakened credit today, but this does not lead us to conclude all credits in Illinois are weak. Many are, but many more are not. We make this determination only after going through our credit analysis process.
Frequently, the process is made all the more cumbersome as municipal financial disclosure rules are much less stringent than rules governing U.S. corporations. Financial disclosure by municipalities has improved greatly over the last 20 years, but it still needs improvement. We expect this issue to be fast tracked by regulators, particularly given the spotlight that has been thrust upon this segment of the market. For our needs, we have found a sufficient number of municipal governments that provide adequate and timely financial information. For those that fall short in this area, well, that serves a red flag in our research process.
We often say at Bernardi that municipal credit research is much more an art than a science, there is no silver bullet answer or one statistical measure. It is a very diverse market place and, as we have preached before, not all municipal bonds are created equal (visit www.bernardsecurities.com website, “President’s Letter Fall 2000”).
These days we are often asked, “How do you determine if a bond’s quality is satisfactory?”
The following is an abbreviated glimpse of our municipal bond credit analysis process which should help explain how we try and answer the above question:
The issuer is a small community (approximate population of 11,000) in northwest Indiana approximately 45 minutes from downtown Chicago, Illinois. This issue is non –rated. The municipality is issuing $5.0 million of Sewage Works Refunding Revenue Bonds. First question we ask ourselves is what are these bonds being issued for? It is an essential service project for a school, road, or other infrastructure or is it more of an economic development project involving private developers or special taxing districts?
The PURPOSE (“pool or school?”) for this community’s debt issuance is to refund three series of outstanding bonds. The refunding aggregates the individual payments into one payment and restructures the principal payments to provide level debt service over the life of bonds. This is important as it gives the community a predictable fixed payment schedule and conceivably limits the possibility of sewer users experiencing a large rate increase to compensate for higher debt service costs. The city saves an estimated 7% of par value over the life of the bonds, equating to between $350,000 and $400,000 during the next 15 years.
Next we look at STRUCTURE (specific, pledged revenue stream or promise to pay?) and legal provisions. This section is particularly important for bondholders as it addresses a lot of the “what if” scenarios that could occur before maturity. Structure questions run from the basic: “is this a 5, 10, 20, 30, or 40 year maturity schedule? Why?” To the more nuanced: “is there an intercept, either a tax-intercept set up to make sure tax revenues earmarked for debt service are set aside before the funds even reach the municipality or a special state-aid intercept program, which in the event a municipality cannot make its debt service payment, the state will use that municipality’s state aid to make the payment in full to bondholders?” We view legal provisions as specific to revenue type deals. “Is there a debt service reserve, is it fully funded today, does it use cash on hand or bond proceeds?” “Is there a rate covenant?” “What’s the Additional Bonds Test?” “What is the flow of funds? Is it open or closed?”
In our case study, the bonds are sewer revenue bonds. Between the offering document and the bond ordinance we were able to answer our structure questions. The deal has a 15 year amortization schedule, there is a debt service reserve fund, and it will be fully funded at the deal’s maximum annual debt service (MADS) with cash on hand at closing. There is an additional bonds test that states net revenues must be 125% of existing and proposed parity MADS. The municipality also maintains a rate covenant stipulating that sewer rates will be set annually to meet all expenses and obligations.
Finally, we look at the UNDERLYING SECURITY or the revenue stream pledged for repayment on bonds. In our example, the bonds are backed by the net revenues of the city’s sewer system. Net revenues were defined as gross revenues of the sewage works system after deduction only for the payment of the reasonable expenses of operation, repair and maintenance. We calculated both the historical and proforma coverage.
Prepared by Bernardi Securities, Inc. Credit research
This table shows the sewer utility business is currently profitable; in fiscal year 2009; the utility, after paying operating expenses, had $1.69 available to pay off every $1.00 of its bonded debt due that year. In 2010, the coverage ratio is projected to increase to a very healthy 2.76 times. Our data base confirms a solid coverage ratio has been in place for many years. Additionally, after studying the current audit, we know pension liabilities and other post-retirement benefits are adequately funded at this time, debt is self -amortizing and there is no variable rate debt or credit default swaps (derivatives) on its books. In summary, after completing this analysis our in house Credit Committee concludes this issuer may be placed on our approved list of credits.
Understand that this current analysis is no guarantee of future financial stability. It is impossible to assess today what the future holds as any number of factors may come into play that could lessen credit quality. For this reason, the credit review process needs to occur periodically.
What we DO understand from this analysis is that currently, this is an attractive, viable credit. It is more attractive, from a credit perspective, than many higher rated issues in our opinion.
This is our credit research process. Many times during the course of a month, credits that come before us do not meet our qualifications; they do not make the approved list. Our process is dynamic and far from perfect, but it has served our clients very well for almost thirty years.
“IT’S A BAD PLAN THAT ADMITS NO MODIFICATION.”
– Publilius Syrus, 1st century, B.C.
“What should I do now?” is a question we are often asked these days by many of our investor clients; our pat answer is, “modify your portfolio so that it has traditional structure.”
Early in the text, we stated our belief that a traditionally structured municipal bond portfolio will be better able to weather future financial stresses. Here is how we define such a portfolio:
- Separate account, non–leveraged comprised primarily of fixed rate, fixed maturity laddered individual bonds
- Well researched, quality issues for traditional purpose intent
- Minimal derivative investment exposure
We believe a municipal bond portfolio with the above attributes will provide a reliable income flow while offering reduced portfolio volatility and greater portfolio liquidity than many other available options.
The municipal bond market going forward will have diminished market liquidity, this will result in continued price volatility causing pain for some investors while creating nice opportunities for the disciplined and informed.
The municipal bond marketplace is a resilient one and has played an important role in the economic life of this nation for decades. We look forward to the years ahead.
We hope this writing is helpful. Thank you for your continued confidence.
Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
January 6, 2011