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Municipal Tax Revenue Grows for 7th Straight Quarter.

Sunday, October 2nd, 2011

Municipal credit revenue continues to improve. This week it was reported that US state and local government tax revenue rose almost 7% in the second quarter, from a year earlier. This marks seven quarters in a row of growth (following five quarters of decline). More importantly, tax revenue now slightly exceeds the peak of revenue set in 2008, before the financial crisis set in.

This is important on two counts. First, it blunts the Meredith Whitney arguments that led to the bond-fund sell-off last winter. But also, it reinforces the argument about the quality of municipal credits. Many state and local municipal entities enjoy captive audiences – for water, sewer, transportation, etc. They performed in this recession like they have in others, by tightening belts, cutting costs, and raising fees where necessary. And this has been a big contributor to the curing of the muni market since last winter.

The White House proposals are keeping muni rates high. The Obama administration’s Jobs Bill has proposed imposing a tax on individuals or couples above certain income thresholds, to essentially eliminate the tax advantage enjoyed between the 28% and 35% tax bracket. This 7% tax would translate into roughly a 35-basis-point tax on muni yields (4-4.5% range). We do not think there is much chance of this proposal being enacted – certainly not to include existing municipal bonds. However, the uncertainty is helping to contribute to tax-exempt bond yields which are much higher than they would be without it. In some cases, taxable BABs (Build America Bonds) yields are only marginally higher than the tax-exempt form of the very same credit. The market has started to see cross-over buyers respond to this anomaly.

As we head into the last quarter of the year we expect to see municipal supply pick up. It downshifted greatly early in the year, due to the high interest rates fostered by the Whitney meltdown. With lower nominal rates, visible supply is starting to pick up. But the December/January reinvestment period should also be vigorous – especially given the volatility of the equity market. That should mean most of the reinvestment goes back into the muni market.

And after much consternation on all sides, we do not expect the Administration proposals with regard to tax-free bonds to pass. This should also mean that the muni market will return to more normalized pricing levels relative to Treasuries.

Thanks to our friends at Cumberland Advisors.

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Posted in municipal bond defaults, obama's job bill, Uncategorized | No Comments »

Obama’s Jobs Bill Will Punish Muni bonds.

Tuesday, September 13th, 2011

Obama’s Jobs Bill Will Punish Muni bonds. Municipal bonds have always been synonymous with tax-free income. That would end if President Obama gets his way. The Obama Administration wants to raise taxes on “high earners” defined as couples earning more than $250k to pay for the jobs bill. Yet in many US cities the $250k earnings level represents the upper middle class not the wealthy. And retail middle class bond investors own 70% of all municipal bonds. Changing the tax free investment status rules retroactively on muni bonds will completely disrupt the investment marketplace.

That said, while reviewing the tax exempt status afforded to muni bonds is a legitimate question for a democracy and all its people to consider, it should be addressed forthrightly, not by the back-door mechanisms being proposed by the administrative branch. If Washington wants to change the tax status on newly issued bonds by states and municipalities, thats reasonable as the success with the Build America Bond has already proved, a direct subsidy to issuers is more efficient than tax exemption.

Here is more below on this issue from Barron’s ever prescient columnist Randall Forsyth.

Under the jobs bill the President sent to Congress Monday, high-income individuals and families would no longer receive interest from state and municipal bonds free completely from federal income taxes, beginning in 2013. The legislation would also reduce the value of tax deductions for taxpayers in the highest bracket.

Specifically, individuals earning over $200,000 and families earning over $250,000 would effectively have the value of tax breaks against the top 35% bracket lowered to the 28% bracket.

The proposed change would help pay the $447 billion tab for the American Jobs Act of 2011. There have been previous attempts to enact a back-door tax hike on the upper brackets. Reformers have asserted that it is unfair that high-income taxpayers receive a greater benefit from deductions; a $1,000 deduction saves somebody in a 35% bracket $350, $70 more than the same deduction saves a taxpayer in the 28% bracket.

Never before have high-income investors in municipal bonds been so targeted, however. With the exception of so-called private-purpose bonds subject to the Alternative Minimum Tax, interest on munis generally was exempt from federal income taxes.

As with deductions, the tax-free feature on munis is more valuable to investors in the top income-tax brackets. For that reason, Internal Revenue Service data show that 58% of all tax-exempt income was earned by individuals earning over $200,000, according to The Bond Buyer, the muni-market trade paper.

For instance, a tax-free bond that yields 3.50% (about the going rate on a 30-year, triple-A muni) is equivalent to a taxable bond that yields 5.38% for an investor in the 35% tax bracket. But for an investor in the 28% bracket, that 3.50% muni is equivalent to a taxable yield of 4.86%.

All else being equal, the yield on muni bonds would have to rise to compensate for the lesser tax benefit, if the Obama jobs bill is enacted as proposed. For instance, a rise of 50 basis points (one-half percentage point) would result in a price decline of about 9% for a 30-year bond — equal to $90,000 for a $1 million holding.

As a result, upper-income investors would suffer the dual blow of lower after-tax income and capital losses from their muni-bond portfolios.

That could severe repercussions for the muni market, which only in recent months has recovered from the so-far errant prediction of hundreds of defaults totaling billions of dollars from analyst Meredith Whitney.

“In my opinion, this will have a negative effect on the muni market and could start another wave of heavy withdrawals from muni-bond funds, even though many investors in these funds will be minimally affected,” says Ken Woods, who head Asset Preservation Advisors, an Atlanta manager of bond portfolios specializing in high-net-worth individuals. “The muni investor’s thought process will be, ‘the government’s next step could be the complete elimination of the [tax] exemption.’”

One of the ironies of this proposal in the so-called jobs bill is that the measure contains infrastructure spending, some $38 billion worth. It would also create an infrastructure bank to fund such projects.

But reducing demand for bonds issued by state and regional authorities that build highways, bridges, airports, water and sewer systems and transportation projections would hamper the very sort of projects the legislation seeks to encourage.

Obviously, the proposal to reduce the appeal of muni bonds to high-income investors is aimed at sentiments such as voiced recently by Berkshire Hathaway’s Warren Buffett, who lamented his tax rate was lower than his secretary’s.

If the Obama Administration wants to raise taxes on high earners to reduce income and wealth inequality, that is a legitimate question in a democracy. But it should be addressed forthrightly, not by back-door mechanisms.

And if Washington wants to change the tax status on newly issued bonds by states and municipalities, that also is legitimate. A direct subsidy to issuers is more efficient than tax exemption.

But to change the rules after the fact on an investment that has always been tax-free, as in the case of munis, isn’t just counterproductive; it’s not fair.

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Posted in bond pricing, build america bonds, obama's job bill | 3 Comments »

The US Downgrade and the Muni Bonds

Wednesday, August 10th, 2011

We have fielded many questions in the last few days about what effect the downgrade of the United States debt from AAA to AA+ and the effect on the 11,000 or so municipal bonds that S&P subsequently downgraded. Investors and professionals want to know what they should do with the muin bond portfolios.

The bonds that may be effected most include Housing bonds (bonds with the backing of federal agencies like GNMA and FNMA) will see their S&P ratings affected. Certain lease bonds with the federal government as a tenant may see their ratings downgraded, depending on the proportion that the federal government is responsible for on the leases

Pre refunded and escrowed municipal bonds, the gold standard for munis: These are generally older, higher-coupon bonds that have been defeased by their issuers. Proceeds of “refunding” issues are placed in Treasury securities to pay interest and call the older bonds at the first call date. This results in significant cost savings for the municipalities, and the older bonds are often (but not always) re-rated AAA based on the US Treasuries, which are now backing the older bonds. These bonds will see a downgrade.

What does this mean from a portfolio-management sense? In our view, it should not affect the muni market greatly. In our opinion, the United States is still the premier sovereign credit in the world. Investors will continue to own prerefunded bonds in the shorter-maturity end of a barbell strategy.

It is important to remember that both Moody’s and Fitch continue to rate the US as “AAA” including housing bonds backed by the federal government or prerefunded bonds or bonds backed by federal leases. As strange as it sounds, because state and local governments and their agencies are rated on different criteria than governments, some municipal issuers will have S&P credit ratings higher than the federal government.

The smart muni bond professionals who fly in our circle are saying the municipal marketplace will still react to the same forces it has in the past: high demand for tax free bonds propping up prices due to low supply, retail buy and hold investors ignoring much of the fray, bond fund redemptions of high quality bonds causing a pricing ripple effect on on all other muni bonds and the lack of clear insight into the why and how of credit ratings.

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Posted in municipal bond defaults, municipal bonds, Ratings, S&P's downgrade | No Comments »

Cleaning Up the Muni Market

Sunday, August 7th, 2011

Two well professors are proposing that states and localities create a national nonprofit institution that would provide issuers with independent advice on bond financings, help them disclose standardized information and take other steps to improve liquidity in the muni market. Professor Andrew Ang from Columbia University and Richard Greene from Carnegie Mellon says an independent, non-profit advisory organization for municipalities could increase transparency and liquidity in the muni bond market, sweeping billions of dollars back to taxpayers and investors. Economists and taxpayers, safe to say, always share at least one perspective: they hate to see inefficient markets because that means money is going to waste. Municipal bond markets are highly inefficient and could benefit from a good clean up to turn billions of dollars in back to investors and municipalities — and by extension, to taxpayers.

The value that is being siphoned away through the muni market, Professor Andrew Ang says, can be attributed to two flaws: the market is both highly illiquid and very opaque, costing investors and municipalities billions of dollars every year.

When states, cities, and other municipalities issue bonds to raise money for public projects, they depend on intermediary brokers to match them with buyers. These buyers face difficulties in selling these bonds if they require their invested capital back early because secondary markets are illiquid and trading costs are extremely high. Furthermore, no standard system exists to get timely, accurate information about the roughly 1.5 million bond issues on the market, or the financial condition of any of the 50,000-plus institutions that issue municipal bonds.

In practical terms, then, it’s difficult to meaningfully compare bond prices and other important market information valuable to buyers and sellers. “In any type of market where you have illiquidity and poor information, bad things happen,” Ang says. “In the muni market, that means unnecessary costs in the forms of interest expense, fees from brokers, and other transaction costs for investors and issuers.”

Ang worked with fellow economist Richard Green of Carnegie Mellon to develop a proposal for redirecting billions back to public coffers and investors. First, they documented the severe illiquidity and transactions costs in the municipal market and the lack of timely and useful information available to investors. Researchers estimate the annual amount that investors overpay combined with what municipalities are losing to administration and transaction costs at around $30 billion per year — interest costs to municipalities would be more than 1 percent lower if muni markets had the same liquidity as US Treasury bonds.

The solution proposed by Ang and Green could recoup many unnecessary costs associated with the muni market as it is currently organized, by creating an independent, nonprofit organization — CommonMuni — to advise issuers and provide better information to all players in the market.

CommonMuni would advise cities and states on best practices, for example, how to avoid refinancing that incurs long-term losses, or reduce costs associated with bond issues, or how and when to use derivatives with bond issues. Its other important activities, particularly early on, aim to increase transparency, since this would improve the quality and amount of information available to buyers and sellers, thereby improving liquidity.

Most importantly, CommonMuni could provide independent, high quality advice backed by its large resources to municipal issuers that would be prohibitively costly, or difficult to access, for individual municipalities to access on their own. Better structuring of municipal issues and lower issuance costs mean substantial savings to taxpayers.

CommonMuni would encourage the creation of simple bond issues, discouraging clients from structuring bond issues in overly complex ways and encouraging standardization. This would make it much easier for investors to compare bond features and prices, in turn facilitating buying and selling. Increased standardization could allow CommonMuni to pool small bond issues into larger pools, which would give smaller municipalities stronger footing in the market by broadening their potential market of buyers.

CommonMuni would help municipalities standardize, collect, and distribute financial reports, another activity aimed at improving information and transparency. CommonMuni can encourage the creation of centralized exchanges where muni bonds could be bought and sold, which would allow investors to cut out intermediaries, reducing costs.

In proposing CommonMuni, Ang and Green took many cues from the CommonFund, an investment advising nonprofit that was founded in 1971 by the Ford Foundation to help originally fewer than one hundred — now thousands — of colleges and universities pool endowment funds and obtain investment advice. The CommonFund has helped these schools dramatically reduce the costs of administering their investment programs, grow endowments, and increase endowment contributions to offset operating expenses.

Ang and Green estimate $25 million would be required to start CommonMuni. That is less than 1/10th of 1 percent of the total projected annual savings they estimate would be generated by the project. “There are few places where states and municipalities can find billions of dollars per year for effectively nothing, especially in this environment,” Ang notes.

By attracting private grant money to fund start-up costs, CommonMuni would minimize conflicts of interest that could arise with a city-, state-, or intermediary-funded effort. It would start small, offering basic services to a modest initial client base, adding services as it attracts more clients. In the beginning, some municipal officials might be reluctant to move to CommonMuni, if only out of simple resistance to change. But, once CommonMuni starts to become successful, by lowering the borrowing costs of its founding members, other municipalities will be drawn in further improving liquidity and information for all investors and issuers.

Retail investors should welcome CommonMuni as they are able to transact at better prices in more liquid markets. However, broker-dealers and financial intermediaries may lose money in a more transparent and liquid muni market, but in the long term, they would be fine, says Ang. “We once didn’t have very good disclosure for public companies. But the New Deal improved disclosure, and now everyone is better off.”

“CommonMuni is common sense, but there are a lot of players in this market who have a vested interest in the status quo and don’t want things to change,” Ang says. “But that money need not go to financial intermediaries; it belongs to taxpayers and investors.”

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Posted in Bond Ratings, transparency | No Comments »

BondView Announces Interest Rate Stress Test For Municipal Bonds

Monday, May 2nd, 2011

The threat of rising interest rates is not welcome news for municipal bond investors. As the economy comes out of recession, the threat of inflation may result in interest rate increases. This will consequentially lead to a lowering of bond prices as bond yields rise. To determine the possible effect of changes in interest rates on municipal bond prices, the BondView Stress Test calculator was created to easily allow a user to vary interest rates, in 50 basis point increments from +/- 550 basis points, and show the resulting price change in a municipal bond, or a whole bond portfolio, given the current price, coupon rate and maturity.

The interest rate was increased by 550 basis points to change the estimated price of this bond.

A Stress Test, also known in the bond industry as a “Shock Test“, uses two financial concepts to calculate changes in bond prices as interest rates change: 1) Modified Duration and 2) Convexity. Using duration, it’s possible to approximate how much a bond’s price is likely to rise or fall when interest rates change. As interest rates increase, a bond’s price decreases. Duration measures how quickly a bond will repay its price. The longer it takes, the greater exposure the bond has to changes in the interest rate environment. Therefore, the longer the duration, the higher is the interest rate risk (as opposed to default risk).

The effect of a 500 basis point movement on the bonds price

Modified duration, uses the duration to calculate the price change of a bond based on the change in yield, maturity and current price. Convexity is a measure of the curvature (non-linear) relationship of a bond’s price change to yield changes. As yields increase, bond prices fall at a decreasing rate. That is, the price fall is not directly proportional to the change in yield as the case using modified duration. The BondView stress test adds a convexity correction to the modified duration to account for this.

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Posted in Bondview Interest Rate Stress Test, duration | 1 Comment »

Chicago Federal Reserve Says Dont Worry About Muni Defaults

Monday, May 2nd, 2011

There is good news and bad news from the Chicago Federal Reserve which said that 2011 will be a tough year in local government finance. Minimal growth or outright declines in property tax revenues, reduced assistance from state governments, and requirements to make larger payments to underfunded public pension funds will loom large for many local governments. However, if history is any guide, few local governments will either default on their municipal bonds or end up in bankruptcy. The aftermath of actual local government bankruptcies—such as that of Vallejo, CA, in 2008—suggest that governments are hurt badly when they emerge from bankruptcy, particularly in their ability to issue debt. And so, in all but the most dire cases, local governments under stress are likely to take alternative steps to shore up their fiscal positions.

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Posted in Market Commentary, municipal bond defaults, municipal bonds | No Comments »

Why Municipal Bond Insurance Still Matters

Friday, April 1st, 2011

Municipal Bond Insurance: The Basics

If you are considering buying municipal bonds, you mayl need to decide whether to buy bonds with insurance policies designed to protect your investment.

What is municipal bond insurance?
It is simply a guaranty that the holder of a municipal bond will receive scheduled interest and principal payments when due, even if the municipal issuer fails to make these payments. It is literally an insurance policy against an issuer’s payment default.

Does it matter which company provides the bond insurance?
Well yes and no. Almost all municipal bond insurance companies are on the brink of collapse except Assured Guaranty. But no matter which insured bonds you own, you may not not get the long term benefit of insurance payments if there were to be say 20 large defaults or bankruptcies. That said, there are other benefits to having a strongly rated insurance company backing bonds such as loan collateral requirements that give the insurance company strong leverage powers during a default proceeding. This is the case with Assured Guaranty (AGC) and the now defaulted Harrisburg PA. incinerator project bonds. AGC has the hypothetical right to require the municipalities that backed the bond (Harrisburg, Dauphin County, etc) to sell other assets such as parking garages or to even force a tax increase.

Do I still need municipal bond insurance?
While municipal bond defaults have been rare, they occur more frequently in periods of economic stress. In 2009 there were about 250 defaults accounting for several billion in assets. That doesnt mean these bonds are dead, just that they need to work out a new payment plan. Most probably will. But few individual investors hold enough different municipal bonds to make this risk inconsequential, especially because they typically concentrate on bonds in their home state to gain the maximum benefit from the tax-exempt status of many municipal bonds. The decision to buy insured bonds will depend on your circumstances and risk tolerance. Here are some questions to ask yourself and related reasons that you might prefer bonds with insurance:

“How well do I know the municipality’s fiscal condition and the structure of the bond?” Insured bonds have been pre-selected for soundness by the guarantor. Guarantors back up their opinions with an obligation to pay interest and principal from their own capital if the issuer fails to do so. Additionally, by choosing insured municipal bonds, you gain the benefit of a professional surveillance staff whose only job is to keep tabs on the issuers of the insured bonds. In many cases, these professionals spot trouble ahead of time and can call upon, or even require, the municipality to take remedial steps before a default looms.

Who provides municipal bond insurance?
Only financial guaranty insurance companies may write bond insurance. You may hear these companies called “bond insurers,” “financial guarantors,” “monoline insurance companies” or just “monolines.” All these terms refer to the same group of companies, which operate solely as guarantors of financial obligations and are subject to specialized regulation.

“Would I be able to tolerate a drop in market value, or even the potential inability to sell my bonds, if a municipal issuer’s financial condition deteriorated?” Although bond insurance does not guarantee a particular market value, distressed issuers’ bonds insured by highly rated guarantors have historically held their trading value better than comparable uninsured issues.

“If a municipality missed one or more interest or principal payments, could I afford to be without the cash flow for a number of years until I could obtain a recovery?” If a municipality cannot make a scheduled payment on an insured bond when it is due, the bond insurer is obligated to make prompt payment in full.

How are bond insurers regulated?
As insurance companies, financial guarantors must be licensed to write insurance by the state insurance department in each state where they insure bonds and must meet their obligations to policyholders before other creditors. Additionally, financial guaranty insurers must restrict their business to financial guaranty and related types of insurance (hence the name “monolines”). Under financial guaranty statutes, financial guarantors must comply with capital, liquidity and reserving requirements as well as limits on their financial guaranty exposures.

How do I get bond insurance?
You generally do not buy the insurance directly. Instead, you buy bonds that were issued with insurance. (Issuers arrange to have their bonds insured in order to attract more investors and improve the efficiency of their bond offerings.)

A new twist is that dealers may purchase insurance for bonds already trading in the secondary market, typically for larger positions.

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Muniland and Pensions, (2/15/11)

Friday, April 1st, 2011

“In December, projections by Meredith Whitney, the banking analyst, about possible municipal defaults began to rattle the $2.86 trillion municipal-debt market. Investors withdrew $1.2 billion from U.S. municipal-bond mutual funds, the 13th-straight outflow, Lipper U.S. Fund Flows said about the week ending Feb. 10. About $24.8 billion has been redeemed since the week ended Nov. 17, including a record $4 billion in the week ended Jan. 19, the most since Lipper started compiling data in 1992.” Source: Bloomberg, Feb. 14.

Panic-driven mutual fund redemptions continue to depress the prices of high-grade Munis. To us, this means the buying opportunity for well-selected issues is intact. Remember, this is an idiosyncratic securities sector. Broad-brush painting of “all Munis are going to default” is specious.

Forced selling by mutual funds depresses the pricing references that are used by the pricing series. Most Munis do not trade every day. Hence, the drop of a few prices lowers the estimated prices of all Munis. This perception issue has created a misunderstanding in the market and resulted in exacerbation of the selloff.

Think about it this way. Let us examine the case of a single mutual fund that must sell to meet redemptions. The fund manager needs the cash at once. He sells his liquid and highest-credit-quality names, which allows him to get cash as once. These same bonds are used to price the entire universe of Munis. The next day all Muni reference prices are lower, even though most of them did not trade. Since the mutual fund holds many bonds, its share price reflects the new pricing, and hence is lower. That alarms more shareholders and another round of selling triggers a downward spiral. This has been going on for 13 weeks.

Some say the cause of the selling is the opacity in the unfunded pension systems of the states. Maybe so. Moreover, maybe that is part of the hype. We think the pension issue is clear. One only needs to do the homework.

In a state like Delaware, the pension system is nearly fully funded. The credit rating of the state is AAA. There is no pension issue in Delaware. The same is true for many states.

There are 218 separate state pension plans among the 50 states. There are 2,332 local pension systems. Thank you, Natalie Cohen of Wells Fargo for the data. Natalie notes the differences by illustrating Indiana. The Indiana Public Employee Retirement Fund is about 94% funded. The Indiana teacher plan is only 43% funded. In NJ, which was just down-graded by a rating agency, Natalie reports the public fund is 56% funded, the local fund is 71% funded, and the teachers’ plan is 64% funded. As we have been saying for months, broad brushing Muniland does not work. One must drill deeply into the data.

Estimating the present value of an unfunded pension obligation is imprecise. It takes a lot of assumptions and falls into the murky realm of actuarial science. Moody’s offers that “a 100 basis point movement in the discount rate results is an inverse movement in the obligation of approximately 8-12%.” Current rules allow much flexibility to states and local government in making assumption choices.

That is about to change. The Government Accounting Standards Board (GASB) is issuing new rules on accounting and reporting liabilities for pensions and other post-employment benefits. These are in draft form now. The rating agencies are combining the actual bonded indebtedness of states or local governments with the unfunded liability estimates. That is why NJ was recently downgraded.

In addition, there is legislation at work to force pension disclosure to be more consistent and transparent. Public Employee Pension Transparency Act or H.R.6484 is under discussion in the House of Representatives. It will require timely information on al governmental pension funds and it will impose penalties for failures to disclose. Rating agencies are endorsing such legislation. So do we. The effect will be to improve funding and force clarity. We expect this to become law in this congressional session.

At Cumberland, we already look at the unfunded obligations and the assumptions. We are glad to see this issue being addressed by states and local governments and by the rating agencies. It has been a long time coming.

One group that objects strenuously is the public employee unions. They are now the largest organized labor faction in the US, and they are trying to preserve the status quo. There is where the political rubber hits the road. We expect this to be a state-by-state fight. We saw the first salvo fired in Illinois as the retirement age was extended. Major changes proposed by NJ Governor Christie currently are stymied in the state’s legislature. Watch what happens as the NJ budget fight gets down to the last minute.

In our view, these issues will get resolved because they must get resolved. State and local governments cannot continue to fund promises they cannot afford. The tide has changed. We expect nearly all of them to alter their budgets, and we expect austerity to be imposed. The notion of electing default or bankruptcy as an option seems politically dead to us.

We continue to buy well-selected Munis at tax-free yields in excess of the taxable yield references. We are witnessing a generational opportunity and want to seize it Muniland and Pensions

David R. Kotok, Chairman and Chief Investment Officer

Published with permission by our friends at Cumberland Advisors

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Posted in municipal bond defaults, municipal bonds, Uncategorized | No Comments »

Muni Defaults: Whitney and Roubini (3/26/11)

Friday, April 1st, 2011

“The rule on staying alive as a forecaster is to give ‘em a number or give ‘em a date, but never give ‘em both at once.”

–Jane Bryant Quinn, Reader’s Digest, 1 Dec. 1980

Meredith Whitney broke the rule. This now haunts her to the point that she declined to appear before a Congressional committee that wanted to discuss Muni default issues. Nouriel Roubini is a skilled economist. He knows this rule. He, therefore, used modifiers to adhere to it.

Let’s talk about Whitney’s forecast first. With great media fanfare, she predicted “50 to 100” sizeable muni defaults, totaling about $100 billion, in 2011. That is correct: she said this year. The year in which the economy is in some sort of recovery and when the interest rate is held near zero by the Fed.

Meredith did not know about any oil shock when she made this forecast. While the current MENA turmoil is a serious new development, the resulting oil price shock will not help her be right in her forecast. In our view, there is nearly zero chance that there will be 50 to 100 sizeable Muni defaults amounting to $100 billion in the calendar year of 2011.

Nouriel Roubini suggested that there may be “close to $100 billion of defaults over five years, but typical 80% recoveries are far higher than on corporate bonds.” Nouriel outlined his view of trouble in the Muni world and attempted to measure the exposure in a very thoughtful way. He noted that most of the bonds he expected to default were in the high-yield or junk-bond category. His base-case estimate of defaults over five years for the investment-grade sector was under $30 billion, with “ultimate recovery” of nearly all the losses. Nouriel reminds us that “governments cannot be liquidated” like corporations.

Bloomberg’s Joe Mysak observed the following about Roubini:

“And so noted doomsayer Nouriel Roubini joins the numerous commentators who have opined about the municipal bond market, the most famous, of course, being Meredith Whitney, who in December on the CBS show ‘60 Minutes’’ blurted out the prediction that there would be ‘hundreds of billions’’ of municipal bond defaults in 2011. That $100 billion estimate from the Roubini firm isn’t in the same league as the Whitney call. What’s more, it may not be so outrageous, depending upon how you count defaults. The record year for municipal bond defaults was 2008, when 167 issues totaling $8.5 billion went bust, according to the Distressed Debt Securities Newsletter. In 2009, more municipal bonds defaulted, 207, on a lower dollar amount, $7.3 billion. In 2010, 82 deals failed to pay on $2.7 billion in bonds. The $100 billion over the next five years isn’t outside the realm of possibility. How are you counting? The people at Distressed Debt Securities, who have been doing it for decades now and who are the only ones with a historical database over that time, and who use a consistent methodology in their approach, count new defaults only in their calculations, which I think is the correct way to do it. Some analysts, scanning the daily material event notices at the Municipal Securities Rulemaking Board’s EMMA web site, count all notices of default that are posted by issuers. And by doing it that way, by counting bonds that are already in default, you can come up with many more billions of dollars in defaulted municipals every year. That’s because it takes years to cure some of these things. In the case of so-called dirt-bonds, used to finance infrastructure improvements to real estate developments, for example, bondholders have to wait until the real estate is foreclosed upon and sold before they see any end to their money woes. Dirt bonds are the overwhelming majority of those that have defaulted over the past few years. The same long wait is true for bonds used to build speculative projects like toll roads, or de-inking mills, or aquariums, or any of the other various quixotic stuff that has been financed in the municipal market. Actual municipalities, that is, cities and counties, rarely default on their obligations. When they do, they usually cure them in pretty short order, in months if not weeks. Jefferson County, Alabama, which defaulted on almost $4 billion in sewer debt several years ago, is an outlier. If history is a guide, it probably will remain so. So, $100 billion over five years? That’s the headline number. It’s not impossible, especially if you count continuing defaults. Still, that’s quite a crystal ball.”

We believe it is important for readers to understand the term default. Here is the official definition from the Municipal Securities Rulemaking Board (MSRB). Remember, bondholders are concerned about monetary defaults. Non-monetary defaults are important because they tell you about the management of the organization or its political structure. These non-monetary defaults actually can provide a bond buyer with opportunity for a bargain if he is willing to do the homework.

“DEFAULT–A failure to pay principal of or interest on a bond when due or a failure to comply with any other covenant, promise or duty imposed by the bond contract. The most serious event of default, sometimes referred to as a ‘monetary’ default, occurs when the issuer fails to pay principal, interest, or both, when due. Other defaults, sometimes referred to as ‘technical’ defaults, result when specifically defined events of default occur, such as failure to maintain covenants. Technical defaults may include failing to charge rates sufficient to meet rate covenants, failing to maintain insurance on the project or failing to fund various reserves. If the issuer defaults in the payment of principal, interest, or both, or if a technical default is not cured within a specified period of time, the bondholders or trustee may exercise legally available rights and remedies for enforcement of the bond contract.”

MSRB reported a Fact Book on the hundreds of thousands of items and on the 10.5 million muni trades for 2010. There were 371 disclosures of a principal & interest delinquency; these involved 1951 securities. The overwhelming majority of them were in project-specific or otherwise non-rated or “junk” bonds. So if you count them on the default list, the list gets bigger.

Does that mean you have to buy any of these bonds? Certainly not. Does delinquency mean an actual monetary default will occur? Maybe yes, maybe no. Each case is different.

When it comes to actual defaults in 2011, the statistics, so far, are improving. “Municipal-bond defaults in the first two months of 2011 are down 50 percent from the same period last year, Standard & Poor’s said. Eight bond deals totaling about $222 million have entered default this year, compared with 16 totaling more than $329 million during the same period of 2010,” said J.R. Rieger, vice-president of fixed-income indexes for S&P in New York (Bloomberg, March 4).

The media has been filled with talk about municipal bankruptcy. This is a serious subject, of course. But it, too, has been overblown. Evidence from the 2008 Vallejo, California bankruptcy demonstrated how costly this is for a city or county. Vallejo has spent nearly $10 million so far and has nothing to show for it. The Bond Buyer, a trade publication, reports that “Vallejo bonds backed by non-general fund revenues amount to $62 million of debt. They have been paid in full and on time throughout the bankruptcy proceeding. They include securities with dedicated income streams including water revenue bonds, tax allocation bonds, and assessment and improvement district bonds.”

So far, in 2011, there has been just one Chapter 9 filing. Bloomberg reported it:

“Boise County, Idaho, with a population of about 7,450, filed for bankruptcy, making it the first U.S. municipality to file Chapter 9 this year. The county sought protection after a federal jury in December found the county violated federal fair housing law in its conduct related to a developer’s plan to build a 72-bed residential treatment facility for teenagers, the Idaho Statesman reported. The jury awarded a $4 million judgment to a developer, which hasn’t been paid. The county’s budget this year is $9.3 million. The county estimated its liabilities at less than $10 million, according to a March 1 filing in U.S. Bankruptcy Court in Boise. Alamar Ranch LLC, the developer, was the largest unsecured creditor with the $4 million claim. Idaho is one of 26 U.S. states that authorize municipal bankruptcy. Like Chapter 11 under the federal bankruptcy code, municipalities allows debtor to adjust debt. Unlike corporate bankruptcies, creditors can’t force municipalities into liquidation and the bankruptcy court has little oversight of municipal operations. Six municipal entities filed for Chapter 9 last year, most of them small utility or sewer districts. The capital of Idaho, Boise, is in adjoining Ada County.”

Whitney’s report does not delve deeply into the recovery history of Munis and into the technical details of default. Nor does she examine the complexities of Chapter 9 bankruptcy.. That is a shame, since she does deserve credit for publicizing the important issue of budget stress in Muniland.

Roubini does examine recovery. He offers estimates and methodologies. And he thoroughly describes the issues involving Chapter 9. His conclusion is that Muni recovery is much higher than markets seem to be pricing and that the widespread use of Chapter 9 is unlikely.

We believe the Roubini report is straightforward and worthy of respect. It is serious research work. It examines nearly two centuries of development in state and local government debt in the United States. It explains the methodology that it used to reach conclusions and estimates. We are less respectful of the Whitney report.

Roubini also attempts to estimate the price adjustment needed in the market in order to normalize the Muni-treasury spread. He notes that the financial crisis sell-off brought Munis to “absurd panic levels.” He reminds readers that, while things are improved since these wide spreads, the Muni market is still under “extreme strain.”

Cumberland agrees with Roubini’s conclusion that the “ratio of Muni yields to Treasuries remains elevated.” We continue to be buyers of well-structured, high-grade, tax-free municipal bonds and of corresponding taxable municipal debt. They remain cheap, and spreads still have a ways to go before normalcy in pricing is attained.

David R. Kotok, Chairman and Chief Investment Officer

Published with the permission of our friends at Cumberland Advisors

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A Tale of Two Sectors: BABs and Everyone Else, (4/1/11)

Friday, April 1st, 2011

Peter Demirali is a portfolio manager and heads Cumberland’s taxable fixed income area and is a long time veteran of taxable fixed income markets. He is a member of Cumberland Advisor’s Management Committee. His bio may be found at www.cumber.com. Comments on this article may be directed to peter.demirali@cumber.com.

The taxable bond market appeared to have a rather uneventful quarter, looking at where the quarter started and where it ended. Yields were a touch higher at quarter- end, but not significantly. However, there were plenty of crosscurrents, speed bumps, and turbulence along the way. Economic data in general showed growth domestically as well as globally. The industrial sector continued to chug along at a brisk pace, although the durable goods report for February showed some surprising weakness. Business surveys report growth, and optimism recovering. The employment situation has improved somewhat, with the private sector adding to payrolls while state and local governments continued to shed workers. A very mixed picture.

Build America Bonds took home the Oscar for Best Sector in the U.S. investment- grade bond universe for the quarter. As of March 31, 2011, this sector returned 2.41%, according to the Merrill Lynch Build America Bond Index. There were a number of reasons for this outperformance. The primary reason was the scarcity premium. The Build America Bond program (BABs) was introduced in the first quarter of 2009 and expired on 12/31/10. The program was a resounding success, allowing state and local governments to lower their borrowing costs for infrastructure projects, as well as expanding the investor base in municipal bonds to include pension funds, taxable bond funds, and foreign investors. Lack of supply and continued demand caused prices to rise and spreads to narrow. Another reason for the outperformance is the substantially higher yields BABs offer when compared to similarly rated corporate bonds. Triple-A-rated BABs can offer spreads 25-50 basis points higher than triple-A-rated corporate debt. Single-A- rated BABs often offer 75-150 basis points higher yield than A-rated industrial or utility bonds. Those higher-coupon BABs bonds generate significantly more coupon returns in a market that is more or less unchanged. Another justification for why these bonds have performed so well is that BABs provide diversification and high credit quality (low default risk relative to corporate debt) that money managers and pension funds cannot get elsewhere. Many of these managers have been underweight this sector relative to the benchmark and needed to add these bonds to the portfolios they manage.

Cumberland Advisors was one of the earliest to capitalize on the generous yields and high credit quality of BABs. Our decades of managing tax-free portfolios gave us a jump on other money managers and pension funds in allocating to this sector, as we were quite familiar with many of these credits. Most of our taxable-bond portfolios have a significant overweight to this sector. Since most of these bonds have a longer duration, the added yield and steepness of the yield curve (difference between short-term and long-term rates) have allowed our portfolios to generate returns in excess of the benchmark. We anticipate this trend of narrowing spreads and higher prices will continue for at least another quarter or two.

Published with permission from our friends, Cumberland Advisors

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Posted in build america bonds, municipal bonds, Nuveen | No Comments »

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