MainLine West Monthly Market Review – November 2012

Municipal Market Review:

The performance of the Municipal bond market in 2012 has proven that munis can now be considered an investment “safe haven” for concerned investors.  In the face of the European financial debt crisis, subpar economic growth, and the new fiscal cliff crisis concerns, municipal bonds have performed brilliantly. Historical issues with market liquidity and credit quality disclosures have not been enough to keep investors away from the “white swan” of investments in 2012.  Other highlights include: 

  • Yield ratios have tightened from last year versus the Libor swap market all along the curve. This reflects municipal bonds have outperformed their like-rated taxable equivalents.
    • 10 year yield ratio went from 100% to 88%.
    • 25 year yield ratio went from 130% to 87.5%.
  • Municipal yields have decreased from last year versus the taxable Libor curve as  follows: 
    • 10 year municipal yield is down 75 bps, 10 year Libor yield is down 55 bps.
    • 20 year municipal yield is down 141 bps, 10 year Libor yield is down 30 bps.

Investment Strategy Review:

We are no longer advising investors to execute the cushion bond strategy at these new lower yield levels. The recent move in rates (30-40 bps in the last 30 days), along with the current unresolved issues in Washington, D.C., have MainLine West concerned with the risk/return profile of implementing the cushion trade at this time. We are not recommending selling cushion bonds for investors who have already executed this strategy. Over the short-term, we are now recommending holding cash until further information or resolutions occur on several muni-specific items. We will continue to monitor the market, as things can change on a moment’s notice. If we feel value has returned, we will let you know as soon as possible.   As of this moment, we feel the following items demand attention as they have not been priced into the current municipal market:

  1. Fiscal cliff negotiations have created uncertainty with munis on several fronts:
    • Limiting exemption of tax free income to 28% as a way to help plug the budget gap. A recent research paper from Citigroup estimates this will increase borrowing costs on states and local borrowers by 60 to 70 bps.
    • Bush tax cuts expiring: The municipal market has assumed this will happen and that top tax rates are going up. The recent market rally has priced this in, and anything different will cause a revaluation to cheaper munis.
    • Budget cuts will impact the economy, lower aid to states and localities, and decrease subsidies to the taxable Build America Bonds. These are all “credit negative” items, currently not “priced in”.
  2. The Volcker Rule, which prohibits banks from making markets on municipal revenue bonds, is scheduled to be implemented in 2013. This rule, if left unchanged, would hurt the liquidity and, therefore, market value on revenue bonds. The rule, however, does allow banks to make markets on General Obligation bonds, which would then create a bifurcated trading market. There is a movement in Washington, D.C. to delay the implementation of this rule until 2014, so that its impact can be further reviewed.

The Decline of Detroit:

On November 29, 2012, Moody’s downgraded the city of Detroit for the 3rd time this year (now rated Caa1) and warned of its looming bankruptcy. Some analysts are predicting the city will run out of cash by mid-December 2012. This is not a surprise to municipal investors and is the culmination of a long, slow deteriorating demographic trend. It provides us the right time to understand and evaluate the impact that demographics and city management have on a municipal bond’s credit quality.

Introduction:

For full disclosure this analysis does not begin to detail all that went wrong with the city of Detroit. We know it can be said that at one time, Detroit was the example of a modern booming city. Sixty years later, it is now a test case for the management of an urban decaying city, reflected by the mass exodus of people and industries. In the 1950’s, due to the boom in the automobile industry, Detroit had over 2 million residents and was the 5th largest city in the United States. Yet, as early as 1961, Time Magazine ran a special report speculating about the “Demise of Detroit”. Little did they know, the scale of decline we were about to see, nor how long it would take.  Since the 1950’s, the city’s population has declined 60% (now barely at 700,000) and is now smaller than towns like Austin and Charlotte. Detroit can no longer afford to provide the most essential of services to its residents and is strapped with the debt and bills once used to support a city 2 ½ times its current size. This creates a perilous position for residents and investors. How did this demise occur? Can it be fixed? What are the future ramifications for investors and residents?

How did this happen? 

There are numerous social and economic studies detailing the downfall of Detroit. Other cities went through their struggles (Pittsburgh and Cleveland are two examples), yet they have been able to rebuild themselves. Why, then, has Detroit continued to decline? After reading numerous studies, it seems to boils down to poor city leadership, city planning, the influence of and dependency on the auto industry. More specifically: 

  • The city was originally developed around and catered to the auto industry. Its layout, “usability” for residents and other industries were compromised to make the auto industry happy.
  • Poor attempts were made to manage the changing industries and societal environment along the way.
  • In the last 60 years, there has been time to make changes, reinvent, and refocus. However, politicians have failed to do this and, in some cases, the corruption made it worse.
  • The poor development and planning of housing and living communities has left the city divided, inconvenient for residents, and has inefficiently utilized its resources.

Can it be Fixed?

 Will Detroit ever return as a financially sound city and living environment? Yes, it’s possible, but only if the city focuses on providing services to one-third of its service region. It is now a test case study for the management of a decaying urban city. This will not be the last city/municipality to face turmoil, and how Detroit approaches its “downsizing” will be worth watching. The city is going to try and “resize” into areas with the potential for economic growth, solid working infrastructure, and good prospects for residential living. It is no longer going to try and support decaying, under populated, and economically deprived districts. More sensibly, it will provide infrastructure maintenance (ex: roads, sidewalks), and city services (ex: street lights) to the areas it wants to be part of the “New Detroit”. The City ultimately hopes that the residents in the decaying “Old Detroit” will relocate to the “New Detroit” and make it a functioning, economically, and operationally self-dependent city.

Impact on Residents & Investors:

The ramifications of this downsize jepoardizes the city’s direct debt and some of its essential service provider’s ability to make debt service payments. It has financially managed a system to support at least 2 ½ times its current revenue base. How can it expect to downsize and continue to carry this debt burden? Let’s take a look at the city’s recent credit rating history, in combination with its demographic data and debt.

Does S&P’s credit rating trend match the demographic or the debt level trend of the city? Looking at thedemographic trends (lower population, lower employment, lower GDP), and watching the credit ratings make you wonder what S&P was thinking from 1997 to 2005. The eyeball test should have kept an investor out of this issuer, although the credit rating agency may not have.

My hunch is the state will find a way to save the city, and investors will be made whole. Michigan has a system in place to support fiscally struggling municipalities and has a strong track record of taking care of them. It will have to in this case, so Detroit can finally move forward and continue to turn out the lights across the old city. It will never be the economic and social power it once was, but it could make for a nice large mid-size city along the Detroit River on the Canadian border.

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