Widest Municipal Yield Spread in Two Years, Bankruptcy Update

Municipal bond prices held up surprisingly well during the month, despite an increased supply of new municipal bond issues following months of low issuance.

Municipal yield spread against Treasuries widest in two years

The 10 year, “A” rated MMD Index bonds yielded 3.21% on November 30th versus the 2.07% taxable yield offered on the 10 year U.S. Treasury bond.

Although nominal bond yields are low across most bond sectors, on a relative basis, non-taxable municipal bond yields exceed long-term Treasury bond yields by the widest margin in more than two years. Supply will remain elevated over the first couple of weeks of December and we expect the significant sums of available cash will easily absorb it.

“Something is rotten in the state of Denmark”

Today, Marcellus’ commentary to Horatio could be amended slightly to call out Jefferson County, Alabama and Harrisburg, Pennsylvania given their recent Chapter 9 municipal bankruptcy filings. The immediate impact of these filings on the national bond market was minimal, although the filings will raise the financing costs for other, well-run issuers located in these states absent any state intervention.

The State of Pennsylvania has acted swiftly and responsibly by immediately challenging the Harrisburg filing. As of this writing, a Pennsylvania court has dismissed the Harrisburg filing, agreeing with the state’s position that Harrisburg lacks the legal authority to file for bankruptcy. We hope this court decision stands for the sake of every well-run, local government unit in Pennsylvania and its residents.

Jefferson County, Alabama is a different story to this point. We have long expected Jefferson County to file for bankruptcy for several reasons:

  • Debt load – Its debt load is significant, poorly structured and ill-conceived
  • Fraud – Fraudulent activity occurred over the years related to some of this debt issuance
  • Lack of local responsibility – A number of local decision makers hold the view there is little, if any, local culpability and responsibility for its current plight

For years, Jefferson County, Alabama has been a poster child for municipal corruption and fiscal mismanagement. Recently, it exacerbated its plight by attempting to take control of system assets away from the trustee and receiver. In effect, Jefferson County is asking the court to deny sewer bondholders preferential treatment to system net revenues, a security lien that is clearly stated in bond documents.

The county is making several claims contradicting widely held, longtime views among investors and bond counsel regarding the security of bonded debt and issuer obligations to its investors. This includes the County’s claim that bondholders lost the right to be paid before others once the county filed for bankruptcy – forcing them to wait for payment, like all other creditors, until the case is resolved. 

Although our portfolio-managed clients have not had any exposure to Jefferson County, Alabama debt for many years, we are watching the proceedings very closely. It is critically important that the court honors the treatment of special revenues, even in bankruptcy. The financial interests of senior creditors such as bondholders cannot be pushed aside for misguided parochial interests. We assume the chances of this occurring are low, but we are disappointed local and state officials allowed the issue to devolve to this point. We remain very wary of Alabama debt until the court resolves several issues revolving around Jefferson County.

Our suggestion for now – avoid any Alabama debt until the bankruptcy judge clarifies this issue.

Gang of Twelve: No decision good for municipals (for now)

The continuing political stalemate in Washington has benefited the municipal market, albeit temporarily. The various Presidential and Congressional threats to tax exemption have fallen to the wayside for now and most likely will remain on the backburner until after the 2012 elections. This is a short-term municipal credit positive development for state and local governments.

State and local governments currently have plenty of challenges already without having to deal with the issues of higher borrowing costs and diminished local control over infrastructure projects – two situations that will occur if the federal government enacts legislation eliminating or severely restructuring today’s well-developed, broad-based municipal bond market.

We will have more to say on this topic in the coming weeks.

Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
December 3, 2011