MainLine West Monthly Review – March 2014

The municipal market is off to its best start since 2009, and year-to-date returns look good. Credit quality appears to be improving and the curve is starting its flattening move. Yet there seems to be some confusion at the credit rating agencies and, once again, they appear to be looking in the rear view mirror. In this month’s credit review, we highlight the following:

  • The reasons behind the great 1st quarter returns and why this may be creating an opportunity.
  • Moody’s criteria changes that appear to make general obligation credit quality weaker, while S&P’s changes appear to make it stronger. However, we remind investors how the Detroit bankruptcy proceedings could change these criteria again.

Municipal Market Review:

As the 1st quarter comes to an end, the municipal market has registered its best 1st quarter performance since 2009. The Barclay’s Municipal Bond Index was up 3.32% over the three-month time period, due to low supply (roughly 26% lower),  lower treasury yields (roughly 30 bps), and better appreciation for tax-free income once investors started looking at their new tax rates from 2013. More specifically:  The curve began flattening during the month of March and flattened by roughly 37 bps. More specifically:

  • 5-year yields increased 31 bps
  • 7-year yields increased 23 bps
  • 10-year yields increased 9 bps.
  • 15 to 25-year yields decreased 2 to 6 bps.
Default InfoYTD as of 3/25/14 # of Defaults $ Par Amount (in Blns)
2012 17 .36
2013 20 4.12
2014 5 .16
Source: Municipal Market Advisors March 25, 2014.
  • The municipal market has begun the year on track to set a recent record low in the rate of defaults. We continue to see improved credit quality from issuers, even if the rating agencies cannot decide. We will discuss this confusion in this month’s credit review titled “Who’s Zoomin’ Who?” Default information year-to-date versus recent years is as follows:

Image

Investment Strategy Review:

We feel investors should remain defensive, as we are about to move into a technically weak time period. Whether yields will increase or not looks to be dependent on new issue supply. At this point, the 30-day supply looks low, but the market appears to have priced this in and we feel yields are as low as they can go for now. If supply picks up, we could see the market sell off and yields increasing. Although, the curve flattening has begun, we estimate it is only 1/3 done, and the next move will not be until the 2nd half of the year. An investor should not be afraid to sell the 7-year and shorter part of the curve (including cushion bonds) to fund longer-term purchases if we get some market weakness in the long-end.

Who’s Zoomin’ Who?

What is a poor municipal investor to do? S&P is revamping their criteria for rating general obligation (GO) bonds, which will cause a significant amount of upgrades (1,000 to 1,200 issuers). Moody’s also changing their criteria which will cause credit downgrades (150 to 200 issuers). In addition to this confusion is the recent news that the Detroit bankruptcy process looks like it may be challenging the heart of the “full faith and credit” general obligation pledge. So I ask you (to borrow the 1985 album name from Aretha Franklin) – “Who’s zoomin’ who?” Or, in other words, “Who’s foolin’ who?”

In fairness to both rating agencies, S&P began their process in September 2013 and Moody’s in August 2013. The Detroit bankruptcy plan was just announced in February 2014. Yet, this trifecta of opinions on general obligation credit quality confirms that investors need to do their own homework, and cannot rely solely on the rating agencies. They appear to be going in different directions, and both are looking behind.

S&P’s changes for rating general obligation bonds:

S&P released new criteria to rate state and local government debt on September 12, 2013. They are now in the process of reviewing all general obligation bonds of states and local governments they rate (roughly 4,000) starting with the largest population issuers first. They anticipate this process to take nine months to complete. After one quarter, S&P has upgraded 503 general obligation issuers based on the new criteria. On average over the last four quarters, prior to the new process, there had been 174 general obligation upgrades. More specifically for the last quarter of 2013:

Total S&P USPF Upgrades 774
Total State & Local Issuers Upgraded 727
Total Upgraded Due to New Criteria 503
Average # Upgrades Last 4 quarters 175

S&P’s review process will continue for the first half of 2014 and, therefore, the upgrade trends of general obligation debt will too. In the end, S&P is estimating that roughly 1,000 to 1,200 state & local government GO ratings will be upgraded.

Why the new criteria? It is designed to do the following:

  • Be forward looking in scope.
  • Be more transparent in nature.
  • Enable better comparisons between US locality debt and local government ratings in other countries.

The new criteria set up a framework for the factors to be reviewed and set certain weight to each. They are as follows:

  1. Economic Factors (30%)
  2. Management Factors (20%)
  3. Financial Measures (total of 30%, 10% each)
    • Liquidity
    • Budgetary Performance
    • Budgetary Flexibility
  4. Debt & Contingent Liabilities (10%)
  5. Institutional Framework (10%)

It appears the high weighting on the economic factors (which places a focus on the demographics of the issuer) has had the greatest impact, causing the rating scale to adjust upward on roughly 1/3 of the state and local issuers rated by S&P.

Moody’s changes for rating general obligation bonds:

Moody’s proposed weighing pension liabilities more heavily in its credit rating process for state and local government general obligation bonds in an announcement on August 14, 2013. It carried through with this threat when it downgraded the city of Chicago and its municipal entities in March of 2014. In the end Moody’s is estimating that another 150 to 200 issuers GO credit ratings will be downgraded.

Why the new criteria? It is designed to do the following:

  • Be forward looking in scope: Moody’s feels the increased weighting to the debt burden statistics reflects the population’s capacity to absorb additional obligations and therefore they can foretell future financial distress more quickly.
  • Be more transparent in scope: Moody’s feels this is accomplished by focusing on the size of the pension liability.

The changes proposed by Moody’s credit rating criteria are as follows:

  • Increase long-term debt to a 20% weighting from 10% (this now includes pension liabilities).
  • Decrease the economic factors weighting from 40% to 30%.
  • Management (20%) and financial strength (30%) weightings will stay the same.

Conclusion:

It appears the adjustments being made will put the rating agencies credit criteria more in line with one another. They now compare as follows:

Rating Factor S&P Moody’s Difference
Economic Performance 30% 30% 0%
Management Performance 20% 20% 0%
Financial Related: Budget performance & flexibility, liquidity 30% 30% 0%
Debt & Other Liabilities (Pensions) 10% 20% 10%
Institutional Framework 10% 0% 10%

The only difference in their process is a higher weighting for Moody’s regarding the debt/pension factor, and S&P having a weighting on the institutional framework of an issuer. This institutional framework refers to the legal and practical structure the municipality operates in. States with laws/policies that limit revenue growth, or restrict their ability to cut expenditures will have lower ratings using S&P’s criteria.

If you want to take the “gift wrapped” lesson from the rating agencies changes, you will feel comforted that they are now more similar in how they approach rating GO bonds. Or you can open the package and try it on for size. It shows that the rating agencies continue to adapt slowly to the ever changing municipal bond market. I would expect S&P and Moody’s making more changes in the near future once the Detroit bankruptcy process plays out. Then who knows what we may see, but please do not expect me to show them any RESPECT!

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Posted in Investment Strategy, Munis in the news, Uncategorized

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