“You could see 50 sizable defaults, 50 to 100 sizable defaults, more. This will amount to hundreds of billions of dollars worth of defaults.”
– “60 Minutes”, Meredith Whitney commentary, December 2010
“The notion that many bond investors have that all municipal bonds are equally secure is at best, a silly one and at worst, a dangerous one. In most instances, municipal bond investors will be paid promptly. The importance of hands on credit analysis and reliance on traditional municipal issuer credits remain an important component of sound portfolio management.”
– Bernardi Securities, Inc., “Bond Market Commentary”, October 2007
2011 began with a tumultuous municipal bond market – the result of Ms. Whitney’s December prediction. Investors withdrew approximately $14 billion from municipal bond funds between December 22, 2010 and February 2, 2011 as bond yields increased and prices declined sharply. Many worried investors sold quality bonds during this period.
Eleven months later, 2011 closed with a bullish municipal bond market, the best in many years for investors. Bonds did not default en masse as predicted. Capital flowed back into the market in the final half of the year and bond yields declined to near historic lows. Investors who committed capital to quality municipal bonds in 2011, particularly in the first half of the year, locked in some very attractive bond yields as the municipal bond market was one of the best places to invest your money in 2011.
We spent much time and effort educating and calming frayed investor nerves during the tumult, often referring to one of the themes of our October 2007 market commentary. Throughout the year, our municipal bond research analysts spent hundreds of hours reviewing many of the bond credits on our approved list – reassessing and updating our view on various issuers as well as expanding and improving our credit research process. It was (and remains) a tedious, tiresome and, at times, a seemingly unfulfilling endeavor. As it turns out, our clients’ portfolios exited the year very well, in part, because of this diligence.
Our clients’ 2011 successes aside, we remain alert. Complacency is inappropriate as many potential credit problems exist and will persist in the marketplace for several years into the future. Defaults may well rise in 2012 as structural financial imbalances exist in places across the nation. Today, places like Harrisburg, Pennsylvania and Jefferson County, Alabama are most often cited as the poster children for fiscal mismanagement, but they are not alone. Problem situations must be addressed and rectified in a sensible and expeditious manner.
An important goal of our municipal bond credit research process is to uncover these situations early. Our process is far from perfect as we continually strive to improve it, but it has served our clients remarkably well for the past 27 years. Proudly, we can say our portfolio-managed clients do not own, and have not owned, either Harrisburg, Pennsylvania or Jefferson County, Alabama issues for many, many years. WE CONTINUE TO BELIEVE A TRADITIONALLY STRUCTURED MUNICIPAL BOND PORTFOLIO COMPRISED OF SAFE SECTOR PUBLIC PURPOSE ISSUES IS BETTER ABLE TO WEATHER PRESENT DAY FINANCIAL STRESS.
2011 reminded us of the importance of analyzing and understanding the three pillars of municipal bond credit research. They are, in fact, at the core of our bond research process:
1. Underlying credit quality matters
2. Deal purpose matters
3. Deal structure matters
The three pillars should work in tandem, in our view. For example, when the underlying credit quality is solid, but not stellar, we often look for an elevated deal purpose. The rhetorical question often asked during one of our credit committee meetings focuses on issue purpose, “is it for a pool or a school”. In a stressed situation, deal purpose may make a difference between payment and non-payment.
When the underlying credit quality is acceptable, but at the lower range of our comfort zone, not only will we often seek an elevated deal purpose – we will often want an elevated security structure. If this elevated structural element is missing, we may not allow the credit onto our approved list. An issuer’s ability to pay and willingness to pay are two distinct issues. We believe an elevated deal structure serves to enhance the prospects of the latter and is a required element for certain credits. We wonder if certain decision makers in Harrisburg, Pennsylvania and Jefferson County, Alabama would be acting more responsibly if elements of elevated deal structure had been incorporated into the structure of the bond issues they now disavow.
Lastly, when the underlying credit is stellar, deal purpose and deal structure elements concern us less.
This all may sound confusing, even a bit technically idiosyncratic, but when we examine most of the notable and recent municipal bond defaults, bankruptcies and threatened bankruptcies, they all tend to be lacking, in our view, in the areas of deal purpose and deal structure. When you overlay a weak underlying credit dynamic, it does not surprise us that debt holder interests are compromised or threatened.
We have stated many times over the years that the diversity of the municipal bond market is one of its greatest strengths. The presence of this characteristic rewards both knowledgeable investors and responsible borrowers. The market’s diversity IS a major factor contributing to the historically high percentage of debt repayment of public purpose, essential service municipal bond issues, in our view.
On the other hand, credit homogeneity reduces the attractiveness of bond market yields for income oriented investors and certain issuers. Investors are lulled into a false sense that all credits are “the same”, accepting low yields while certain poorly run issuers are able to borrow funds at an artificially low rate. This additional, prolonged borrowing cycle only exacerbates the issuer’s existing, underlying credit problems. In the long run, a market dynamic espousing credit homogeneity coupled with a private, or worse, public guarantee of its debt is very costly to all of us, as we have recently experienced with the collapse of most “AAA” rated municipal bond insurers and the collapse and subsequent taxpayer bailout of FNMA and FREDDIE MAC.
“MUNICIPAL FINANCE IS MOSTLY A LOCAL PHENOMENON”
– An unnamed municipal finance administrator, circa 1988
Last year at this time, I wrote about the circumstances of when I first heard this statement, what it meant and how it helped shape our municipal bond credit research process (i.e. the “three pillars’) over the past 23 years.
With 2011 now in the rearview mirror, I am wondering if the above statement should be expanded along these lines, “municipal finance is mostly a local phenomenon, AS IS THE TREATMENT OF IMPERILED DEBT SERVICE PAYMENTS”.
What do I mean by this?
In 2011, credit problems that had been brewing for years came to a head for three different municipalities: Central Falls, Rhode Island, Harrisburg, Pennsylvania and Jefferson County, Alabama.
Central Falls filed for Chapter 9 bankruptcy in August, Harrisburg filed in October and Jefferson County filed in November. In our view, the filings were not unexpected. More notable and important to us is the manner in which state and local officials have approached the three different filings as it relates to debt payments.
This month, Bankruptcy Court Judge Frank Bailey approved pension agreements between Central Falls and its retirees and public sector unions. Last July, weeks before the City’s receiver filed for bankruptcy, the Rhode Island state legislature passed a new law protecting public bondholders by requiring municipalities to guarantee lenders first rights to collected property taxes and general revenue. This new law confirmed the long held belief of municipal bond market participants and investors that secured bondholders have a priority interest. Its passage, most likely, also compelled retirees, current employees and the State to make the needed financial concessions in order to craft the agreement.
The Central Falls agreement shows how a city, its employees and retirees, working with a responsible state legislature and governor, can reorganize and work through financial difficulties and avoid making a bad situation worse. When a city does this successfully, bond investors will want to invest in the city. I expect that to be one of the positive outcomes for Central Falls.
After months of internal wrangling, the Harrisburg City Council voted in October, 4-3, to file for Chapter 9 bankruptcy. The Mayor and Governor had opposed the filing and immediately challenged its legality on the basis the filing violated the state’s fiscal code. The code was amended last year to prevent cities from filing Chapter 9. In November, the City’s filing was thrown out of U.S. Bankruptcy Court by Judge Mary D. France who ruled that the City was not authorized to file.
The Court’s rapid and unqualified response coupled with the steadfast opposition to the filing shown by the Mayor and Governor bodes well for secured bondholders and Harrisburg itself. There is much work ahead and a final resolution is far from certain, but recent events create an environment conducive for a more positive outcome.
The situation here has devolved with potential solutions far from certain and most likely negative for secured debt holders. A recent ruling by the bankruptcy judge sided with legal precedent affirming net system revenues are to be used to make debt payments. The County claimed these net revenues should be placed in an escrow account pending bankruptcy settlement negotiations rather than paid out to cover debt service obligations. Additionally, the Judge agreed with the County by staying the receiver’s control of the utility system, allowing the County to manage and control the daily operation of the utility. Control includes such responsibilities as authorizing expenditures and increasing or reducing sewer rates.
Lower sewer rates would obviously impact the net revenues available to make debt service payments to debt holders. Several elected County officials have decried for years that sewer rates are too high, so we will not be surprised if maintaining current sewer rate charges becomes a negotiating chip with debt holders. As long as the County retains control over these types of decisions, this scenario is very plausible. Given the poor decision making history of those in charge at the utility and the County, we expect trouble ahead for debt holders. Lastly, unlike the state legislatures of Rhode Island and Pennsylvania, the Alabama legislature has done very little to protect secured debt holders rights.
Perhaps the prevailing cavalier attitude towards Jefferson County debt holders is attributable to the fact the debt is held primarily by the investment banks that have some culpability in creating the current chaos. We are not certain of much, frankly, when it involves Jefferson County, Alabama other than this – for our portfolio-managed clients, we continue to avoid, as we have done for many years, any credit associated with the county. And we remain wary of Alabama credits, in general.
Headline risk remains for stressed credits
We expect the Jefferson County and Harrisburg story lines will be major topics of interest for our market in 2012. Additionally, we expect other, similar credit stressed situations to develop in the coming year in other places across the country. The details will be different in each case as will the manner in which affected local and state officials choose to deal with the problem. As we stated above, the municipal bond market is greatly diverse. The presence of this dynamic means there are potentially many different story endings for those municipalities that go the way of Harrisburg, Pennsylvania and Jefferson County, Alabama – some good, some bad and some very, very ugly.
“The power to tax is the power to destroy.”
– Supreme Court Justice John Marshall, 1819
Repealing the tax exempt status of municipal bonds was a major story line for our market in 2011 and at times we wondered if change was imminent. Certain individuals of both Republican and Democratic persuasion called for either an outright repeal or a significant roll back of the exemption. The cacophony culminated in late fall as some members in the “Gang of 12” considered the repeal of tax exemption as a way to reduce the national debt while President Obama proposed, amongst other things, limiting and potentially eliminating entirely the tax exempt feature of municipal bonds. Fortunately, the President’s proposal was soundly rejected and the Gang of 12 decided not to pursue the issue. For now, state and local governments’ continue to have access to favorable financing terms provided by the present day municipal bond market.
Although, the threat has dissipated, it will return to the forefront after the 2012 presidential election. As a result of the discussion over the past year and in anticipation of a renewed debate in the future, our staff spent hundreds of hours over five months researching what might be in store for taxpayers and citizens if Congress eliminates tax exempt bonds and substitutes taxable alternatives and federal rebates instead. Our report is notable for the risks it reveals more than the revenue opportunity Treasury suggests when it calls for eliminating tax exemption.
Tax exemption elimination risks include:
- Imperiling local autonomy
- Subsidizing and shifting local debt obligations to an already burdened U.S. Treasury
- Increasing local taxes and user fees for most citizens
- Local job loss as new capital projects are scaled back or eliminated entirely due to increased financing costs
Legislators and policy makers need to understand the long history of the well-developed market and have an appreciation for the relative efficiency, equity and effectiveness it has offered state and local governments for more than a century. In doing so, we believe policy makers and legislators will reach the same conclusions we did that:
- Tax-exempt bonds have been a critical source of capital for state and local governments and support one of the nation’s most consistent and reliable sources of job creation
- The important status of the tax-exempt municipal market needs to be reaffirmed rather than threatened so that it can continue doing its job without new and unnecessary burdens on issuers, investors and citizens across all economic classes
“It’s a bad plan that admits no modification.”
Publilius Syrus, 1st Century, B.C.
“What should I do now?” is a question we are often asked these days by many of our investor clients. Our pat answer remains, “modify your portfolio so that is has traditional structure.”
Early in the text, we stated our belief that a traditionally structured municipal bond portfolio will be better able to weather future financial stresses. Here is how we define such a portfolio:
- Separate account, non-leveraged comprised of fixed rated, fixed maturity laddered individual bonds
- Well researched, quality issues for traditional purpose intent
- Minimal derivative investment exposure
We believe a municipal bond portfolio with the above attributes will provide a reliable income flow while offering reduced portfolio volatility and greater portfolio liquidity than many other available options.
The municipal bond market going forward will have diminished market liquidity, this will result in continued price volatility causing pain for some investors while creating nice opportunities for the disciplined and informed.
The municipal bond marketplace is a resilient one and has played an important role in the economic life of this nation for decades. We look forward to the years ahead.
If the above paragraphs sound familiar, it is because we wrote the exact words last January as 2011 was beginning. If you have been a client for more than a few years, you have undoubtedly heard similar words from us. We repeat them again because, in our view, the concepts are tried and true when it comes to investing in the municipal bond market. These concepts served our clients well in 1984 (our first year), in 1987 (stock market crash), in 1990 (real estate market collapse), in 2000 (tech bubble market collapse) and most recently in 2008-2009 (the Great Recession). There is no reason to change our approach now.
Nominal bond yields, money market rates and certificate of deposit yields are near or at historic lows. A recalibration of your expected returns and income earnings are in order. The supply of new issue municipal bonds in 2012 should increase from the depressed 2011 level of approximately $300 billion, but any increase will be muted.
Our suggested strategy for 2012 follows:
- Stay fully invested; although non-taxable nominal municipal bond yields are low, relative to other quality bond sectors, they offer excellent value
- Invest along the portion of the yield curve suitable to your situation offering the best relative value
- Rely on market expertise to find yield anomalies; understand the credits in which you invest your funds
“Above all we must work hard to find true value for our clients. The bottom line will take care of itself. This has been true for a life-time.”
– “An Old timers Look at Today’s Municipal Bond Market”, Winter 2001, Edward Bernardi, Chairman, Bernardi Securities, Inc.
We are now approximately halfway through our 28th year and the above written words still resonate in our daily actions. Our firm and our clients’ municipal bond portfolios have moved through the financial disasters of the past several years relatively unscathed and for that we are thankful and appreciative. We strive daily to continue on this course.
As always we thank you for your continued confidence and support. If in town, please visit us at our new, beautiful offices. I would welcome the opportunity to talk with you.
Finally, everyone at Bernardi Securities, Inc. and Bernardi Asset Management, LLC wishes you and your family a healthy, happy and prosperous 2012.
Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
January 18, 2012