MainLine West Monthly Review – September 2014

September 2014 Monthly Summary:

The month of September has presented some interesting industry news, and not a great deal of market news. The municipal market remains the star of the fixed income world. Bank of America/Merrill Lynch indices show the following total returns year-to-date:

Index Total Return 12/31/13 to 9/25/14
Municipal Bond Master Index 8.22%
Government Bond Master Index 3.595%
BAB –Taxable Municipal Bond Index 12.96%
Corporate Bond Master Index 6.24%
Mortgage Bond Master Index 4.21%

In this month’s review, we may finally see some dark clouds forming over the muni world, but they may take a while to take effect. During the month, demand remained strong, even in the face of an uptick in issuance and taxable interest rates.

Leading the way for September industry news, Loop Capital Markets released their annual public pension funding review. This provides a great opportunity to explore the darkest cloud on the municipal credit quality horizon. As we have reviewed these results over the years, it is becoming more clear the issues and concerns facing municipalities as they try to keep their pension promises. These concerns heightened as the Detroit bankruptcy appears to be placing pension liabilities as the top priority (1st lien before debt), and other state courts stopping or slowing down planned reforms.

September 2014 Municipal Market Review:

The municipal market held firm in the face of rising taxable interest rates and increased issuance. More specifically:

  • Municipal yields increased slightly by 2 to 10 bps with taxable Libor rates increasing 13 to 18 bps.
  • Issuance increased and is now below 2013’s level by only 9% (versus 14%).
  • Credit Default Spreads(CDS) spreads were mixed.  General market names increased 5 bps, but the state index average decreased 7 bps, due mainly to Puerto Rico spreads tightening.

Muni industry news:

  • Puerto Rico has received additional financing from various hedge funds, relieving the market’s solvency concerns until at least spring 2015. CDS spreads dropped by over 1000 bps.
  • The municipal market is shrinking as issuers continue to practice fiscal discipline. The market has shrunk $9.8 billion since last year. This is due to supply being down and maturities/ bond calls not being fully refinanced. This has temporarily helped fuel the strong year-to-date municipal market returns.
  • The price of cash? Last month, we informed you of the State of Texas setting an all-time low yield on its tax and revenue anticipation notes at a .134% for notes due 8/31/15. Well this month the great state of California beat that mark. $2.8 billion revenue anticipation notes due 6/22/15 were priced at a .107% yield. Little reward to stay in cash.
  • The 100 year opportunity? If one year notes are worth 11 bps, what is a 100 year bond worth? The Cleveland Clinic Foundation issue $400 million bonds due 1/1/2114 (yes that’s the year 2114). These were taxable municipal bonds rated AA- (S&P) and Aa2 (Moody’s) priced at a 4.858% yield.

Investment Strategy Review:

The municipal market continues its strong performance versus the rest of the fixed income world, but there are some signs that weakness may be coming. We highlight the following:

  • Tax-exempt fund flows have stopped, and have actually turned negative for taxable fixed income funds. The fear of higher rates is having an impact on investors, and munis may finally be feeling this breeze.
  • There have been a few industry reports released showing a higher need for infrastructure projects in the coming years.  This may not trigger higher issuance in the near-term, but does highlight the need for more municipal bonds going forward.
  • Relative value of municipal bonds decreased over 5% versus taxable bonds last month. Crossover buyers and relative value accounts will not find municipal bonds the value they once did.

October is usually a technically weak time period for munis, and it will be interesting to see what other cracks may form over the next 30 days. We recommend maintaining a defensive cushion investment strategy. It could still be sometime before value returns and, therefore, we advise earning some income versus staying in cash.

September 2014 Credit Review – Update on the “Pending Municipal Pension Crisis”

Background:

Chris Mier and our friends in the Loop Capital Markets Analytical Services Division released their

Twelfth Annual Public Pension Funding Review during the month of September. This is a very thorough report that allows for good trend analysis and insight into the “pending pension crisis”. We felt this provided a great opportunity to update our investors on the darkest cloud concerning municipal credit quality that we see on the horizon.

Highlights:

Funding ratios are down slightly from 2012 to 2013. Data shows that cities have higher pension burdens than states. More specifically:

  • A review of 247 state pension plans showed the following:
    • A slight decline in ratio from 73.5% funded in 2012 to 73.1% funded in 2013.
    • An average 4% of a state’s budget is used to meet pension related costs.
  • A review of 84 local government (cities) pension plans showed the following
    • A slight decline in ratio from 65.6% funded in 2012 to 65.3% funded in 2013.
    • An average of 12% of city budgets are used to meet pension related costs

It is becoming a story of the strong getting stronger and the weak getting weaker. 19 states showed improvement (these are mainly smaller states that are already well funded at ratios above 80%), 26 states have become worse (these are mainly older states that are funded poorly at ratios below 75%).

The Courts remain pension protection friendly. Since 2012, 49 states have enacted some type of pension reform. In most cases, legal battles have slowed up or disallowed them. In fact, there are seven states that have constitutions that disallow any changes to pension plans. The reality of reforms being implemented is much different than the ability to pass reforms. Of the 17 states trying to make changes to COLA (cost of living adjustments), 12 have gone to court at this point, and the courts have disallowed them.

GASB 67/68 will improve the financial reporting of pension plans going forward. These changes provide a more traditional accounting view (value of liability and market value of assets on the balance sheet) versus the “funding-base” approach used in the past.

The pension liability for some issuers is BIG. Unfunded pension liabilities outweigh the amount of outstanding bonded debt for many municipal entities. On average, the average state pension to debt ratio is 6.2 times. When these balances reach the balance sheet, things will not look so good, especially for some of the poorly funded states.

Going Forward:

It is a bit surprising that strong stock market returns have not helped improve funding ratios. The problem remains the unwillingness of municipalities to make large enough annual contributions. If the proper amount of contributions had been made, combined with the strong stock market returns, funding ratios would have improved. Instead states have used the recent increase in revenues to pay down debt, increase program spending, or cut taxes. There needs to be better discipline to fund the pension plans going forward.

Those with poor funding levels appear to be getting worse. This is not a good trend, and as time goes by investors will want to begin avoiding issuers that are not addressing their biggest credit quality concern. The lowest funded states reported in the review are the following:

  • Illinois 39%
  • Kentucky 48%
  • Connecticut 49%
  • New Jersey 54%
  • Alaska 55%

Be careful! Looking at just funding ratios to judge a municipality’s pension burden is flawed. The ratio could be high, but the entity has used debt to finance the funding gap. For example, the city of Detroit has a funding ratio of 91%. Yet it issued $1.4 billion in 2006 to get it to this respectable level. Now these bondholders are left with virtually worthless bonds. The top funded states from the report are as follows:

  • South Dakota 100%
  • Wisconsin 100%
  • North Carolina 95%
  • Washington 95%
  • Tennessee 92%

The Answer?

For today’s problems: It appears the pension reforms being sought by municipalities are either going to be legally difficult to implement or are not going to create the savings needed. Most of the proposed reforms are focused on cutting benefits. It appears municipalities with funding ratios lower than 80% are going to have to take a different approach. Instead of focusing entirely on trying to cut costs, an increase in monies to make the required payments is also needed. This could include increasing taxes, creating new fees, or requiring pensioners to pay more money into their own plans. Florida has already done this by increasing the amount of employee contributions by 3%.

For tomorrow’s problem: Instead of categorizing plans as defined benefit (DB -requiring the employer to bear the full burden of funding) or defined contribution (DC – requiring the employee to bear the full cost of their retirement), there is a common-ground plan being used in the Netherlands with some success, which is making its way to the USA. It is a plan that involves the sharing of risks by employers and employees called the Defined Ambition (DA) plan. A DA plan limits the liability risk of employers, while providing a stream of income for retirees. Other highlights are as follows:

  • The DA plan would have the employee and employer define a target minimum post retirement income level (for example, 75% of inflation adjusted indexed average salary). If the employee wants a higher standard of living, they may have other retirement savings, but at least they are guaranteed something at retirement.
  • Contribution levels would be set to meet this target level of retirement income for both the employer and employee using long-term assumptions on employee longevity, inflation, and market returns.
  • As these variables change, annual contribution rates and/or retirement age would change gradually to offset them. Both parties are bearing the risks and rewards from changes in the assumptions.
  • As time passes, the market based investments will be turned into fixed annuities, which will be used as income streams to fund the retirement years of the employee.
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