A year ago, our look ahead discussion for 2010 predicted some draconian headlines and predications that focused on default concerns as the year progressed. November and December exceeded this expectation, rattling the confidence of many investors with predictions of near-apocalyptic events in municipal finance. So-called “experts” who have limited municipal finance experience are often the source of these dire predictions, reminding MainLine West and other seasoned municipal bond specialists that their opinions are, to say, “questionable”, at best.
That said, some claim it sure feels like a crisis, looks like a crisis, and maybe even behaves like a crisis. Is it a credit crisis? Confidence crisis? MainLine West looks forward to 2011 with optimism by taking a page from former Obama administration chief of staff, Rham Emmanuel, “You never want a serious crisis to go to waste.” Let’s take a look at ways investors, and the market, can take advantage of this advice in 2011.
A YEAR OF ENLIGHTENMENT AND COURSE CORRECTION
Municipal finance is not dynamic, but an evolving process. What appears to be a credit crisis today, has actually been brewing for years – and it will take years to unwind. What we will then realize is that it was more of a policy crisis, and less of a credit crisis. In the future, our retrospect on 2011 will show it was the year that the fiscal situation for municipalities improved because difficult policy decisions were made.
“TOMORROW” HAS ARRIVED
2010 started with an uncertain economic environment, and a political environment that was ignoring fiscal reality. The politicians’ answer to everything in 2010 was to write a check. “Why deal with an issue today (and not get reelected), when you can write a check and deal with it tomorrow?” It is probably safe to conclude that in 2011, both environments have changed for the better. We are already seeing tax revenues stabilize and, in some cases, improve. There is some talk and effort being made by politicians to practice fiscal restraint. The elections of 2010 have proven that the voting public is preparing to feel the fiscal pains. But, don’t be fooled, higher income tax rates are still on the horizon.
CREDIT RESEARCH REVEALS OPPORTUNITY
Not all municipal bonds are created equal, even those backed by the full faith and credit of its issuers. (Suggested reading: MainLine West Advisory Note – “Not All General Obligation Bonds Are Created Equal”; contact us for a copy). Generally speaking, MainLine West prefers issuers with the ability to adjust their own revenue streams on a timely basis, and those directed by a management team with a track record of conservative, and prompt, fiscal management.
A specific bond type we like are essential service revenue bonds with the authority to charge rates for their services, have a cost competitive advantage or provide a monopoly service to their customer. We also like general obligation bonds (GO’s) that have unlimited taxing power, which has been approved by voters, and have no restrictions on executing this pledge. Most importantly, the issuer must be run by a management team that has a proven track record, and understands fiscally responsibility. A good management team will know when changes need to be made to meet their obligations, and have the power and foresight to do so.
Unfortunately, politics plays a big role in municipal finance, and management teams do not always do the right thing. Don’t be surprised if some spineless government entity uses the threat of “default” as a means to make budgetary reforms. If a large municipality goes through with the threat (highly unlikely due to the direct and indirect costs), it would cause a disruption to the market. The impact of such an event can be muted by sticking to the issuers we discussed. The investor can be comfortable that the means by which a municipality declares bankruptcy, Chapter 9, is much more investor friendly (better chance of full repayment over time) then the corporate equal Chapter 11. This is a fundamental and proven historical strength of municipal finance. It is also a reminder of the importance of proper portfolio diversification and underlying credit quality research.
We recommend taking advantage of any market weakness brought on by the municipal fiscal and credit concerns. There will be headline news, supply and demand discomforts that will manifest throughout the year, with many deals getting priced that will represent outstanding value. This happened in December of 2010. If an investor is nimble, and patient, it will repeat throughout 2011, making for a trader’s market. Below is a sample of opportunities available in December 2010 that MainLine West purchased for clients, representing a variety of maturities:
These bonds meet MainLine West’s credit quality criteria and are backed by one of the following: 1) general obligation pledged; 2) essential service revenues; or 3) backed by an agency of the federal government.
Let’s get more specific about what defines an “opportunity”. A rough analysis of daily interest rate levels on AAA credit rated 25 year maturing municipal bonds since 1995 looks as in the chart (other maturities could be analyzed, too). For example, this table shows an investor who obtains a 5.50% yield on a strong municipal credit with at least 25 years of maturity would have purchased a bond historically in the top quartile of the highest yields. This top quartile has an average rate of 5.75%. Depending on an investor’s purchasing power and bond-specific criteria (i.e., specialty state, diversification, and maturity preference), the different yield levels will determine the overall value of the “opportunity”.
HEADLINES AND THEMES FOR 2011
In the late spring (June-July), municipalities will approach their fiscal year-end. New budgets will be debated and financial results reported. This will highlight the continued need for fiscal reform. Credit quality outlook will appear negative, and fiscal policy concerns will increase.
Look for a state or a large local municipality to get downgraded, becoming a topic of concern as to whether it remains investment grade. The thought of the State of California or Illinois being a high yield issuer will be disconcerting to the market.
Market imbalance will provide the possible return of Build America Bonds (subsidized taxable municipal bonds). As the municipal market experiences credit struggles, liquidity will tighten, and issuer costs to sell bonds will remain high. A quick revenue-neutral fix is the reintroduction of BAB’s at a subsidy level lower than the previous 35% interest rate. This may provide additional stability and help improve long term, tax-exempt municipal bond prices.
Debt issuance will slow from historical levels. Lack of refunding (due to higher interest rates) and better fiscal discipline will provide the friction. Voters and politicians will be less likely to approve new debt issuance and projects because of cuts in services and increases in fees to pay for what they already have. More fiscal discipline will translate to less debt being issued.
Investors are exposed to many opinions and advice from media talking heads and financial commentary whose focus is often based on the headline of the day. Prudent investors determine the ultimate composition of their investment portfolios by digging beyond the headlines, and by seeking competent guidance from investment professionals who understand the market from a genuine depth of experience. Credit headlines and the “doom and gloom” forecasts, like those proclaimed at year-end, depress prices for high quality bonds and provide an exceptional investment opportunity for prudent, well advised, investors with a long-term, forward looking strategy. We expect numerous compelling opportunities throughout 2011. As municipalities continue to struggle to get their fiscal house in order, there will be a little “color”, as some non-essential service bonds provide the default news, but the fiscal health curve will trend positive.
The municipal market is in a policy crisis – not a credit crisis environment. The economic and political winds have changed, and municipal finance is beginning to react. Don’t let a serious crisis “go to waste” – now is the time to take advantage of the opportunity! Purchases made in 2011 will, in retrospect, become the income highlight(s) of your portfolio as municipal bonds outperform.