The first month of 2013 began quietly for the municipal bond market. It ended, here in Illinois, with a thud.
This month brings us the thirteenth year of the third millennium as measured by the Gregorian calendar. The Chinese calendar recognizes 2013 as the year of the black snake. The Mayan Long Count Calendar doesn’t recognize 2013 at all since it called for an apocalypse in 2012.
Here in Illinois, 2013 may be remembered as the year of the bond-market vigilantes.
Illinois downgraded, $500M bond issue postponed
Last week, the State of Illinois postponed a $500 million general obligation competitive bond sale following a credit rating downgrade. Standard and Poor’s rating agency downgraded the State’s rating to A- from A, the worst among all states. Officials pulled the bond deal after conversations with potential bidders led them to conclude demand for the State’s bonds was tenuous. They wisely postponed the financing recognizing the state’s borrowing cost would have been far greater than most current market rates.
The market’s reaction was not surprising to us, though it was painful to witness. Many would argue it was overdue. Lack of action in Springfield on reforming the state’s vastly underfunded pension system and reducing its backlog of $8 billion in unpaid bills has frustrated the rating agencies and many investors for years.
Bond vigilantes turn to Illinois
In the 1980’s and early 1990’s bond vigilantes (BV’s) dominated the market and greatly influenced monetary and fiscal policy. This amorphous group was widely feared leading James Carville, a Clinton administration strategist to quip, “I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone.”
The actions of bond market vigilantes, in recent years, have been less intimidating. The group of 7 who office at 20th Street and Constitution Avenue and their numerous QE iterations have co-opted the group’s influence. BV bond sales to protest fiscal policy are no match for the Fed’s printing press and its related treasury debt buying binge and balance sheet expansion.
The story line in Illinois is different. Feeling unappreciated by many in Washington, bond vigilantes turned their attention on our home state last week clearly reversing a trend of low cost capital for the Prairie State.
Illinois headline risk & your municipal bond portfolio
Some clients have asked for our assessment of what last week’s events mean for Illinois, its local government municipal credits and, in particular, their portfolios. So here are several thoughts.
In general, the headlines may be somewhat disconnected as it relates to a particular bond portfolio.
Specifically, here are some thoughts and questions to consider pertaining to a portfolio:
- Are there any State of Illinois or any state agency issues present in the portfolio? If so, what is the percentage exposure? Furthermore, are there any issues in the portfolio related to the State’s university system as it is heavily reliant on state funding? Depending on what the review uncovers, it may be prudent to reduce the portfolio exposure, if any exists, in these credits. Keep in mind, future headline risk may also threaten market values of these issuers. Nearly four years ago, we ceased adding these issues to our discretionary, portfolio managed accounts. Additionally, over this period we actively sold many existing positions of these issuers taking gains as interest rates have tumbled. We do not intend to begin adding these issuers until the State presents a practical solution and we see evidence of improvements in its financial picture.
- What is the portfolio’s state composition? Which states comprise the largest percentage? You may want to reduce state allocation in certain cases where the allocation exceeds your comfort level especially if there is no state income tax exemption benefit.
- Are all of the credits in the portfolio on an approved credit list and how financially dependent is each credit on the State of Illinois for revenue? At this time, we see no need to sell Illinois municipal credits that are on our approved list solely because of last week’s events. There are many solid quality local municipal bond credits located in Illinois. Additionally, due to the “halo effect” (see Senator Mark Kirk’s 2011 report , “Report on Illinois Debt”) most Illinois municipal issues offer higher yields than similar quality and maturity issues outside of Illinois. They are forced to pay a yield premium because of the State’s weak financial position. We view this as an opportunity for investors.
To reiterate, you have heard us say and we have written many times over the years about these recurring themes:
- Underlying credit quality matters. We have preached this theme for years (see “To Be or Not To be AAA rated”, Fall of 2000).
- Our portfolio management process starts with credit research. And our credit research process focuses on three pillars: deal purpose, deal structure and underlying credit quality (see “Credit Research Matters More than Ever”, November 2010).
These two disciplines are the foundation upon which we base our bond portfolio management process.
Clearly, poor state finances effects jurisdictions located within the state’s boundaries, but not uniformly. This is one credit metric we examine as part of our credit research process.
Generally, the State of Illinois continues to remit funds it collects (sales tax, school district general state aid, etc…) on behalf of local jurisdictions in a timely manner. The State is delaying school district categorical aid payments and, in many instances, this is problematical for the affected school district. These payment delays have affected certain districts’ programming (lunch, bus and after school activities, as examples), but do not directly threaten principal and interest payments on unlimited tax general obligation bond payments.
The 5th most populous state deserves better
Last week’s sobering news aside, Illinois remains this nation’s 5th most populous state with an abundance of natural resources, an educated work force, and a diverse and highly developed economic base. The City of Chicago is one of the world’s most vibrant cities and a leading financial center. Some of the nation’s finest universities are located in the state. Illinois is at the crossroads of America and, in many respects, serves as a microcosm of our country. Its residents deserve far better than what has been delivered to them in the last 10 years. Let’s hope the events of last week motivate state legislators to enact a sensible plan that begins to rehabilitate the state’s financial standing.
We hope this commentary is helpful to you. Please call us if you have any questions or would like us to help you review your portfolio.
Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
February 5, 2013