December 2014 Monthly Market & Credit Review – The Pure Muni?
As 2014 comes to an end, things seem pretty good in muni-land. Returns and overall credit quality was impressive for the year. In this month’s review, we recap the highs and lows of 2014 and set things up for our 2015 Outlook due in early February. We also review a new, higher level of “for the good of the public and planet earth”, municipal bond. Green Bonds are municipal bonds that promote projects and activities that support climate or other environmentally sustainable purposes. Although green bonds have been 1/2% of current muni issuance, they will be more prevalent in 2015. Whether they are successful in lowering issuer borrowing costs, or just a way to play the environmentally-friendly game, remains to be seen. We thought, as we finish off a good year in muni-land, it would be a virtuous time to review a higher level of muni “purity”.
December 2014 Municipal Market Review:
What a year for municipal bonds. We are beginning to expect this from our SWAN investment class: exceptional after-tax returns and solid protection of principal. More specifically:
- Municipal bonds were the top performing investment grade fixed income sector in the US in 2014. Through December 24th, returns were as follows (source is Bank of America/Merrill Lynch):
- Municipals gained 9.4%.
- Investment grade corporate bonds gained 6.8%.
- US Treasuries gained 5.8%.
- Credit quality, on the whole, looks to have improved in 2014. Default rates for 2014 were about the same measured by dollars, but only 75% of the number of issuers defaulted versus 2013.
- 67 issuers in 2013 defaulted vs. 50 issuers as of December 3, 2014.
- $8.56 billion in par defaulted vs. $8.89 billion year-to-date 2014.
- Two-thirds of the defaulted 2014 par amount is from the 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.)
2014 Muni industry Highlights & Lowlights:
- The devaluing of the General Obligation pledge: Bankruptcy proceedings for both the cities of Detroit and Stockton have shown that bonds backed by the full faith and credit of an issuer can take a backseat in repayment priority to pension liabilities. Going forward, municipal investors can no longer assume that the GO pledge is the gold standard. When buying a GO bond, there needs to be a refocus on demographics, a requirement of a statuary lien on revenues, and a review of the issuer’s budget and fiscal health.
- Pension funding has become an immediate concern for some issuers. There were numerous downgrades in 2014 to issuers due to underfunded pension plans and the imbalance they are creating in their budgets. This, coupled with the implementation of GASB 68 (first reporting date is 6/30/15) which will further increase pension liabilities, has some issuers in immediate need of reforms. Investors can no longer assume the pension crisis to be a long-term problem for issuers like Puerto Rico, the State of Illinois and the City of Chicago. Reforms must begin immediately and investors need to factor this into their decisions.
- Municipal issuance finished strong and was close to unchanged from 2013’s level. At one point in May, issuance was down 26% from 2013 levels and, as recent as August, was 13% lower.
- What tax reform? What infrastructure needs? Both were ignored by the municipal market for most of 2014. The fall elections have showed this will most likely not be the case in 2015.
- Muni Curve Flattening – The big returns came at the long-end of the municipal market, as relative value favored long bonds and concerns with fed tightening caused short-rates to increase. More specifically:
- The municipal curve has flattened (please see graph in Appendix I) as follows:
- From 2 to 25 years 144 basis points
- From 5 to 25 years 138 basis points
- What does this means for a portfolio’s total return? Returns from Barclays Municipal Bond Indices by maturity for 2014 are as follows:
- 2 to 4 year index = 1.207%
- 6 to 8 year index = 6.021%
- 12 to 17 year index = 12.97%
- Greater than 22 years = 15.33%
- The municipal curve has flattened (please see graph in Appendix I) as follows:
Green Bonds: The Pure Muni?
Can you further improve an industry that already issues bonds for the common good? How about issuing bonds issued for the common good that are also for environmentally friendly purposes? Introducing Green Bonds: tax-free municipal bonds whose proceeds are used for projects and activities that promote climate or other environmentally sustainable purposes.
First issued by the European Investment Bank in 2007, the concept of Green Bonds made its way to the municipal bond market in 2013 with an issuance from the Commonwealth of Massachusetts. To date, it is estimated that roughly $1.6 billion has been sold to US tax-exempt investors, and the idea appears to be gaining traction.
Green Bond Principles (GBP) were developed by a group of banks and then ultimately supported by 13 financial institutions. GBP provides guidance to issuers who wish to voluntarily meet the following principles:
- Provide investors the eligible types of projects that the bond proceeds fund. (This information should clearly state the types of environmental benefits being sought, and have the ability to quantify them.) Some project examples are as follows:
- Renewable energy & energy efficiency.
- Sustainable waste management.
- Biodiversity conservation.
- Clean Transportation.
- Clean water.
- Provide investors with the process that will be used to evaluate and select proposed projects. (The issuers need to let the investor know how the proceeds will be used to meet “green bonds” )
- Segregate and track proceeds separately for public disclosure. (It is encouraged to have an auditor verify this process.)
- Finally, once an issuer feels they have met the above voluntary GBP’s, a third party opinion is recommended for approval (Some form of assurance that information has been fully disclosed, is accurate, and both are sustainable going forward).
On December 15th the Metropolitan Water District of Greater Chicago issued $300 million of Green Bonds. They were AAA-rated bonds offered with maturities from 2016 to 2044. Proceeds were to fund the following “green projects”:
- Tunnel & Reservoir Plan – Project is to protect Lake Michigan from pollutant backflows and provide outlets for floodwaters.
- Storm Water Management Program Projects – Projects designed to assist Cook County’s watersheds, flood and drainage control problems.
- Resource Recovery Projects – Improve wastewater management so it can retrieve bio solids that can be re-used. For example, recover phosphorus from storm water and reuse it to fertilize crops.
- Water Reclamation Plant Expansion and System improvements – Increase capacity of the current process of treating water from sewage and flood to make it available for re-use.
These green bonds are general obligations of the water district that has taxing powers and the ability to charge unlimited user fees to meet debt service requirements. Bonds were priced at roughly +40 bps to the AAA municipal scale. Non-green bonds priced in 2011 by the District were at +41 bps to the AAA municipal scale.
Municipal investors will have the final vote on the success of Green Bonds. They are able to make a judgment if the project is “green” enough and can decide if they are willing to give up income to support it. There will be some mutual funds or ETF’s (Calvert has already created a fund) that will market the idea and provide a green tax-exempt investment vehicle for investors. The ability of these funds to raise money (and the issuers’ ability to save debt service costs) will be the final judge of its success. At first glance, the water district example cited above does not appear to represent a cost savings for the issuer, as the difference between a non-green and green bond was 1 basis point. However, the city of Chicago (service region for the water district) has had its credit quality downgraded since 2011. The lower credit quality for the service region may have justified a higher spread to the AAA if the bond was not green.
At this time, there is not enough evidence to prove the market acceptance of Green Bonds. I think their success will be marginal at best. The municipal market is somewhat “green” to begin with as projects that have good fundamentals, and are considered essential, tend to get better pricing than those that do not. Green Bonds attempt to add one higher level of “purity” to this hierarchy. It would be nice to have the concept accepted and, therefore, encourage more economically friendly projects. Yet, given the history of the municipal market to forgive misguided issuers and projects in search of yield, it is hard to believe investors will consistently give up yield to make mother earth happy.