2012 Outlook – The Birth of the White Swan

If the events of the 2008-2011 capital markets can be classified as a Black Swan Event, then can the performance of the municipal bond market during the same time period be referred to as a White Swan? Nassim Nicholas Taleb in his 2007 book (revised and completed in 2010) defines all major scientific discoveries, historical events and artistic accomplishments as “Black Swans”. More specifically:

  • The event is an outlier, is beyond the realm of regular expec­tations, and nothing in the past can convincingly point to the possibility of it occurring.
  • The event carries an extreme impact to those affected.
  • Despite its outlier status, human nature tries to explain the event, making it appear predictable and explain­able, but after the fact.

As rare and unpredictable the event of seeing a black swan is, the white swan has its own preconceived perception. Throughout history, the white swan has been a symbol of monogamy – pure and unaffected by the world around it. A great parable is that a swan’s feather does not get wet, even though it has been in water. In other words, a white swan continues its grace, core attachments and consistency in life, regardless of the events around it.

The events of 2008-2011 brought about, 1) demise of long standing companies, 2) the downgrading and eventual fiscal restructuring of countries, and 3) the implosion of the US housing and banking market. The municipal bond market, although tested, has not gotten its feathers wet. In other words, the forces that have created these events did not produce the same destructive results on the municipal market. In 2011, the S&P Municipal Bond Index shows a return of 10.4%, outperforming the rest of the market for the 5th time in 6 years. Returns calculated as follows:

So what does this mean going forward for the municipal market? Perhaps the municipal market will finally get the respect it deserves in 2012.

DEFAULTS AND CREDIT CONCERNS
If you read our outlook for 2011, you will remember all the “non-muni experts” were calling for a credit crisis in the municipal market.  Their “doomsday” scenarios predicted numerous defaults and credit downgrades to highlight the deteriorating quality of municipal finance.  Let’s review the year:

If you read our outlook for 2011, you will remember all the “non-muni experts” were calling for a credit crisis in the municipal market.  Their “doomsday” scenarios predicted numerous defaults and credit downgrades to highlight the deteriorating quality of municipal finance.  Let’s review the year:

  •  Upgrades for state General Obligation credit ratings outnumbered downgrades 8 to 3.
  •  States have closed over $325 billion in budget deficits over the last four fiscal years.
  • Municipal default rates were down to .06% for 2011 versus .12% in 2010. This remains a “blip” when com­pared to corporate default rates of 3.4% in 2010, and 1.7% in 2011. Below is a historical graph showing default rates from 2000 to 2011 for all corporate and municipal bonds.

Does this look like the profile of a credit quality crisis in municipal finance? Default rates are up a bit in recent years, but remain a blip versus the corporate market.  Remember some municipal issuers act as conduits for corporations. Relatively speaking, the percentage of defaults remains low and immaterial during the worst financial crisis since the Great Depression. 

MUNICIPAL MARKET RELATIVE VALUE
Relative value of municipal bonds given their credit quality and tax equivalent yield, remains today, as it has for years.  If financial markets are efficient, why does this continue to be the case?  Historically municipal bonds have always traded as a percentage of treasuries.  Depending on the current tax policies, credit concerns, and politics, this range can be from 77.9% to 210.7% (comparing long-term municipal bond yields as a percent of treasuries).  Below is a chart showing this relationship over the last 30 years.  What does this tell us about the municipal market today and going forward?

  • Municipal bonds remain relatively cheap versus comparative taxable standards.
  • Credit quality is not worsening, in fact, it is improving. The statistics show an asset class that has avoided the financial “meltdown” seen by many and has a history of minimal credit risk.

Does this sound like an asset class that remains consistent, and graceful in performance? The Financial Advisory com­munity and the financial press should finally be accepting the SWAN (sleep well at night) qualities of the municipal market.

MainLine believes that this may be the year, and should be the year, that investors realize the long-term value of the munic­ipal tax-exempt market. Historically, municipal bonds have been underappreciated and underutilized by asset allocators.   We see the following for the year ahead:

  • Clipping the coupon. The price appreciation the municipal market enjoyed in 2011 is done. It is hard to con­ceive rates going much lower. An investor should be satisfied with a year’s worth of coupon payments and little change in price.
  • Municipal bonds outperform other US fixed income investments, again. This coupon should be enough to out­perform most US taxable fixed income markets on a tax adjusted basis. “The Swan Effect” will help assure that municipal bonds will outperform.
    • Municipal bonds should finally get the attention they deserve from asset allocation models. How can a financial adviser not carve out an allocation to an asset class that outperformed during the 2008-2011 finan­cial crises? This should create additional demand for municipal bonds, helping to stabilize prices.
    • Municipal credit quality should continue to strengthen. There remain issues, but policy changes, tax rev­enue growth, and fiscal discipline will keep the credit trend upwards. In fact, tax revenues have shown growth for seven consecutive quarters, capping off the 2rd quarter with a 6.1% increase from the same quarter in 2010 (Data from Rockefeller Institute).
  • More noise about pension reform and restructuring the current tax system. A recent survey done by Loop Capital Markets called the “2012 State of The State Briefings” showed the following:
    • 32% (versus 4% in 2011) of the states reported that the Governor plans to focus on pension reform. Reforms appear to be within reach, as court rulings and contract restructuring done in 2011 are getting press nation­wide. This can only improve credit quality for municipalities
    • 40% (versus 20% in 2011) of the states reported that the Governor plans to address the current tax structure. Concerns with structural imbalance and reforming the current system appear in vogue. The theme in 2011 was not to increase taxes, now it is for reforms.

WHAT TO WATCH IN 2012
National Tax Reform. This concern for the municipal market never seems to end, which itself brings some comfort.  Expect election rhetoric and attempts to balance the US budget to bring some “uncomfortable news”.  In recent years, the municipal market has done a good job of ignoring these “hypothetical solutions”.  If any of them are ever taken seriously, then we will need to review further.  Reforms could either hurt or help the value of municipal bonds. 

Credit Concerns from the Shrinking. There remain pockets of deteriorating demographic regions throughout the United States.  Many cities and towns are losing population, employers, and tax base.  It remains hard to see how some of these areas can remain an ongoing entity without drastic changes.  Whether the state steps in and supports its locality’s obligations, or lets them default, time will tell.  Understanding the demographics of the issuer has always been important, and this will be confirmed in 2012.

Chapter 9 in the headlights, and then hopefully in the rear view mirror.  The filing by Jefferson County Water & Sewer will be a big test on the interpretation of Chapter 9, and subsequently its impact on municipal bond investors.  This could impact how different issuers and revenue sources are viewed from a credit perspective. 


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Posted in General, Munis in the news, State Budgets

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