“Welcome to congress Mr. Senator, be careful when you open the door to your new office – the fiscal cliff waits”.
The 114th Congress could be greeted with a nice welcoming gift from those they just replaced. Failure by the current administration and Congress to reach a compromise on spending tax cuts by year-end could cause upheaval in the financial markets.
What is the fiscal cliff and why do we care? In summary it is the following:
- Bush tax cuts will be rolled back, costing the economy $400 billion in income. This includes the following highlights:
- Income tax rates will go from 35% to 39.6%
- Loss of the 2% cut in payroll tax
- Long-term capital gains tax rate goes from 15% to 20%
- Dividend income tax rate goes from 15% to 39.6%.
- Across the board spending cuts of $207 billion.
Overall the impact is a net result of taking $607 billion of spending out of the US economy. The initial impact will be severe and could impact the economy as follows:
- Lower 2013 GDP by 4%, and possibly taking it negative for the year.
- Increase the unemployment rate to over 9%.
- Tax revenues decrease by 3-5%.
THE FISCAL CLIFF AND MUNICIPAL BONDS
There are numerous opinions from the talking heads on how the fiscal cliff could impact the municipal bond market. For example:
- The weaker economy will financially hurt municipal localities and they will experience an increase in defaults. This will hurt the value of the municipal bond market.
- Higher tax rates will make municipal bonds the star asset class as their tax equivalent yields will increase. This will help the value of the municipal bond market.
- The economic recession will once again create a flight to quality, and money will flow out of “risk based assets”. This means everything but treasuries and gold will be adversely impacted.
There does remain a hidden concern, buried in the details of the fiscal cliff and the automatic sequestration cuts. The taxable version of municipal bonds, the Build American Bond program, where the US Government provides a 35% subsidy to issuers, is in the “cutting headlights”. It appears $255 million in subsidies (roughly 7.6%) will be cut to issuers participating in the program. This means issuers will need to pick up the bill on this 7.6%, and will increase their expenditures accordingly. Most analysts feel the credit impact is negligible, since a majority of the issuers are large, with this increased cost being a “blip” on their income statement. In fact, most of the issuers do not even plan the subsidy payment into the debt service coverage. Yet there does remain a few concerns:
- The small financial issuer, who does not have a lot of flexibility, and the BAB program, provided a means to help finance a project could be hard-pressed to make up that subsidy loss.
- Extraordinary Redemption Clause (ERP) – most BAB’s were issued with the ability to make an in whole market call if there is any material change in the program. This 7.6% cut, does not seem to clear the ERP hurdle, but some may debate this. There are also numerous bonds that were issued with par calls, which could be at risk.
- Lastly, the ability of the US Government to change the provisions of the program in midstream is very concerning. How can you trust this program going forward? It could damage the ability to bring back BAB’s in the future. Basically, the subsidy goes from 35% to 32.3%. What’s next? 28%?
From our view in Denver, we see any sell off in tax-exempt municipal bonds due to the fiscal cliff as a buying opportunity. We feel essential service provider’s credit quality will not be adversely impacted. Their revenue base will remain stable as they collect dedicated fees for their services. The increase in tax rates will fundamentally make these municipal bonds more attractive in the long-run.
Unfortunately, the ability to bring back the taxable equivalent BAB program will be very hard. It has become more obvious in this era of politics that depending on the US Government as a source of revenue is not a good credit bet. It would be hard to trust them again; in fact, this could become an ongoing burden to the BAB market.
MUNICIPAL MARKET REVIEW
Month-end yields and relationships look like they did at month end for August -s. The Fed remains on hold, if you believe the forward Libor curve, until late 2015 or early 2016. The Euro world continues to “get by”, and only stocks showed life during the month of September by rising 2.42% (S&P index). The municipal bond market continues to see a high volume of refunding deals (over 50% of new issuance), and they have accounted for 86% of the municipal issuance growth to date. The street continues to talk of impending supply in the fourth quarter of this year, which we are anxiously awaiting.
- Municipal Market Advisor Default Trends Analysis (data from MMA)shows the pace of defaults in 2012 continues to lag 2011. More specifically:
- 56 issuers for a par amount of $1.05 billion have defaulted as of September 25, 2012. This is .38% of issuance to date.
- 79 issuers for a par amount of $1.58 billion this same time last year. This represented .87% of issuance in to date in 2011.
- The National Association of Bond Lawyers released a “white paper” discussing the importance of tax-exempt bonds to the National Economy. It is an excellent analysis on the benefits of municipalities being able to issue tax-exempt bonds.
Municipal bonds still represent value on a historical basis as compared to their taxable equivalents. Click here to see this and other chart details. Yet, with the fiscal and political uncertainties surrounding the markets and municipal bonds, the “locking-in” of current yields does not feel like a long-term winning investment strategy.
INVESTMENT STRATEGY REVIEW
We continue to advise investors on executing a cushion bond strategy, buying 4-7 year callable premium coupon bonds. In the short-term, short call, premium coupon bonds can provide a 2.0%-2.5% tax exempt yield, and have low price duration if rates do go up. This strategy has been a strong performer over recent months.