MainLine West Monthly Review – November 2014

November 2014 Monthly Summary – Is that a Monoline Fossil?

The outperformance of the muni market came to a halt during the month of November. Increased supply and a slowdown in the retail sector caused munis to significantly underperform their taxable equivalent. We do not feel this is the beginning of a muni correction. Bullish technicals are awaiting us in January.

Does anyone remember MBIA? AMBAC? How about monoline insurance? Yes, it is back and slowly making its way back into municipal finance. The players have changed (sort of) and their business models evolved. The muni market is a fertile breeding ground for these bottom-feeders and some experts think they can grow from their meager 5% of issuance up to 30%. We review this re-evolving market in this month’s credit review.

MainLine West still feels an investor needs to understand the underlying finances and issuer demographics of a bond. We leave the dependence on monoline insurance to the lazy and untrained muni investor. One rule we at MainLine West always follow: Never pay up for insurance, or pay down for sushi!

November 2014 Municipal Market Review:

The market finally recorded its first increase in yields month over month in a quite a while. Municipals also underperformed taxables significantly (from 15 to 26 bps) as supply picked up, and there appears to be a slowdown in retail demand. This does not appear to be credit driven and is more a function of muni technicals. More specifically:

  • Municipal yields increased, while taxable yields decreased along the curve as follows:
    • 5 year maturities, +4 bps munis, -10 bps Libor, net underperformance of 14 bps.
    • 10 year maturities +6 bps munis, -14 bps Libor, net underperformance of 20 bps.
    • 15 year maturities +10bps munis, -16 bps Libor, net underperformance of 26 bps
    • 25 year maturities +5 bps munis, -15 bps Libor, net underperformance of 20 bps.
  • Issuance continues to increase and is now trailing 2013 by only 4%. The first two weeks of December appear to be big supply weeks. After that the calendar should be light through year-end.
  • Default rates for 2014 look to be a little ahead of 2013 totals, but this is deceptive and does not show the improvement of credit quality in 2014. MMA data shows that through November 19th the following default trends:
    • 48 issuers vs. 54 year-to-date 2014.
    • $8.86 billion in par vs. $8.26 billion year-to-date 2014.
    • Two-thirds of the 2014 par amount is from Detroit Water & Sewer revenue bonds. Bondholders tendered certificates agreeing to receive less than 100% of par for fear that if the process was handled in the courts, they would have received less.
    • Numbers without the inclusion of the voluntary Detroit W&S tender would be closer to $3 billion and not $8.8 billion.

Muni industry news:

  • Muni Curve Flattening – We discussed, in our 2014 outlook, the importance of where your portfolio was exposed on the yield curve, ”What stroke does your Sleep Well at Night portfolio use?”. We recommend stretching out your stroke; from the short-end to the longer end/intermediate part of the curve.   Let see how this has played out year-to-date:
    • The municipal curve has flattened as follows:
      • From 2 to 25 years 117 bps
      • From 5 to 25 years 98 bps
    • What does this means for a portfolio’s total return? Returns from the Bank of America Muni Master Index (through mid-November) are as follows:
      • 1 to 3 year index = .78%
      • 3 to 7 year index = 3.429%
      • 12 to 22 year index = 11.23%
      • Greater than 22 years = 14.25%
  • Disappointment with Illinois Pension reform court ruling. The state court has ruled that any changes in its retiree’s health care benefits and premiums are protected under the state’s constitution. A 1970 provision added to the constitution states that retirement benefits cannot be diminished or impaired. This ruling appears to suggest that this provision is far reaching regarding any changes to pension plans. It implies that the state’s other intended reforms will also not be approved and, therefore, the state has a bigger challenge ahead in controlling pension costs.

 

Investment Strategy Review:

Year-end could bring a little price volatility and slightly higher yields. Yet, we expect 2015 to start out strong with demand outpacing supply and correcting any back-off over the last 30 days. There is little reason at this point to change from a defensive strategy. We are currently working several active floating rate strategies for customers and expect to continue this into early 2015 or longer, as market technicals dictate.

November 2014 Credit Review – From Extinction to Re-Evolution: The Story of the Monolines:

When we last looked at the monoline municipal bond insurance industry, it was on life support. At its peak, 57% of new bond issuance and had credit ratings of AAA. Then, the collapse of the housing market took this industry with it. By the end of 2010, the monolines were unable to underwrite new policies and their business models were on the verge of insolvency. The major players and their credit ratings in late 2010 were as follows:

11-2014At one time, all of these insurers were rated AAA by S&P. It appeared, by the end of 2010, that the industry was on its way to extinction. Now there are three firms looking to reinvent and grow the industry. They come from different backgrounds and are approaching the business differently.

Background:

Let’s take a few moments to review what a monoline insurer is, and what happened.

  • Municipal bond insurance guarantees the principal and interest of the debt obligation it is supporting. The insurers collect premiums from the issuer, in exchange for guaranteeing its debt.
  • The insurers began insuring pools of home loans as a way to grow their profits. When the housing market began to unravel, the insurers took the first hit, losing capital to meet the defaults that they were insuring. This impacted their capital and claims paying ability, which in turn impaired their ability to insure municipal bonds.

Rising up from the Ashes:

The nature of the municipal market is still fertile ground for bond insurers.   It is an industry with over 80,000 issuers, low default rates, over 45% owned by individuals, and full of small issuers that do not frequently issue bonds. This requires some form of “commoditization” that makes the investing process easier for individual investors and smaller issuers.

There are three insurers leading the charge out of extinction. They are trying to make insurance a factor in the municipal market again. It looks like they may be having some marginal success as they are now insuring roughly 5% to 6% of new issuance, which is up from 3% to 4% in 2013/12. These three monolines all have a different story: One survived the meltdown, one that is a sibling of a non-survivor, and one is brand new. They are listed below with their current credit S&P ratings.11-2014bLet’s review each of these:

Assured Guaranty (AGM) & Municipal Assurance Corporation (MAC):

  • AA S&P rating with stable outlook.
  • Investor owned company which has to report revenue growth and earnings to shareholders.
  • Highest claims paying ability of all the insurers; appears to be leading the way in new underwriting.
  • Does have a legacy residential mortgage backed portfolio from 2008, which AGM is managing its roll off. According to S&P, its impact on the company no longer hurts is ability to insure municipal bonds.
  • MAC is a subsidiary of AGM launched in 2013. It is designed to insure only the two lowest risk sectors of municipal finance. My guess is that AGM is hoping this entity can become AAA rated in a short period of time and then it can be spun off.
  • AGM does have the highest exposure to Puerto Rico of any of the insurers. This has investors worried about future claims paying ability. S&P just finished a review and feels AGM has adequate claims paying ability at this time.

Build America Mutual Assurance Co. (BAM):

  • AA S&P rating with stable outlook.
  • Set-up as a mutual company, where each policy issued is funded with capital by the issuer. This makes the company owned by the issuers of the bonds backed by BAM, and not investor owned.
  • Appears to insure only the low risk sectors and issuers of the municipal market.
  • Growth is managed due to the mutual structure, but should provide a strong long-term capital base.
  • No legacy portfolio from the housing crisis meltdown.
  • Seems to be the best long-term option for actually providing credit enhancement, going forward.

National Public Finance Guarantee Corporation (NATL):

  • AA- S&P rating with stable outlook
  • NATL is a spin-off of MBIA. MBIA is an investor owned company which has to report revenue growth and earnings to shareholders
  • Largest municipal bond insurer with over $250 billion in policies. It is just now beginning to underwrite new policies, as it has had to finish reorganizing away from the rest of MBIA.
  • MBIA, although still profitable, has a large legacy portfolio of residential mortgage backed loans from 2008. MBIA barely survived and now needs to start up NATL to get back into the municipal bond business.
  • NATL is well positioned to grow as it gets its business going. Let’s just hope they do not “step in stuff” along the way.

 

Conclusions:

  • The ability to support investors in the Detroit bankruptcy, the Stockton bankruptcy, and add value to Puerto Rico issuers is a positive for the industry. These events let investors know that the product does work.
  • S&P feels there is a capacity for the insurers to grow back up to 20-30% of the market.
  • Ability to contribute to the market will remain limited as they can only add credit quality to issuers with ratings lower than AA/AA-. This means economically they can only enhance debt with credit ratings of A or lower. (58% of the industry has issuers rated “A” or lower.)
  • It appears the insurers are now being more selective on the issuers and sectors they are enhancing. We also hope they remain muni only in their underwriting practices.
  • MainLine does not see the market allowing the same blind obedience to insurers as we saw pre 2008. Investors always need to look at the underlying project and make investment decisions based on it. The insurance should only be viewed as a low cost safety net. Never pay up for principal protection policies!
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