2011 outlook2 muni outlook 2011 risk redefined


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2011 outlook2 muni outlook 2011 risk redefined

  1. 1. MORGAN STANLEY RESEARCH Morgan Stanley & Co. Michael Zezas, CFA Incorporated Michael.Zezas@morganstanley.com +1 212 761 8609 Ashley Musfeldt Ashley.Musfeldt@morganstanley.com +1 212 761 1727 December 7, 2010 Municipal StrategyNorthAmerica Muni Outlook 2011 Risk Redefined State Budget Solutions Gap Strategy for a Market Coping with Unfamiliar 160 Risks: Despite an improved macroeconomic 140 backdrop, we anticipate the muni market will be 120 punctuated by bouts of technical volatility due to still- 100 50% elevated credit risks, an impulsive path higher for 81% 80 interest rates, and the potential for spillover from the European debt crisis. We recommend a low- 60 31% volatility strategy that facilitates opportunistic risk- 40 taking. 20 4% 13% 15% State and Local Government Credit Risks Remain 0 2011 2012 Elevated But Revenue Bonds Will Show Stability: Projected Cyclical Revenue Growth Projected ARRA Aid Other Solutions Despite expected cyclical revenue increases, Source: Morgan Stanley Research, Center on Budget and Policy Priorities substantial structural challenges to fiscal health will remain. It is our base case that austerity measures are forthcoming, but not of the scale necessary to Rate Volatility Impact on Munis offset this risk in the near-term. Most revenue bond 121 115 sector fundamentals should fare better. Munis Sell Off 120 Technical Event Risk Greater Than Credit Event 110 119 Risk: Outright defaults will likely remain low and idiosyncratic even as systemic risks continue to 118 105 Rate Volatility Spikes build. However, rising rates and curve volatility risk 117 bouts of lower demand for the asset class, offsetting 100 a key 2010 market strength. 116 95 What Happens in Europe Won’t Stay in Europe: 115 US states don’t share near-term risks of European 114 90 sovereignties in scale, but do share it in character. 10/8/2010 In our view, investors are unlikely to differentiate SP Muni Index (LHS) USD 1Y10Y (RHS) Source: Bloomberg, Morgan Stanley Research between the two, which will link muni performance, the European story, and success of states’ austerity measures. Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As Observations on the Role of CDS in 2011: We a result, investors should be aware that the firm may expect the muni CDS market to progress toward have a conflict of interest that could affect the standardization, increase in size, and converge in objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a price toward cash spreads, thus increasing the single factor in making their investment decision. relevance to traditional cash investors as a pricing gauge. For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report.
  2. 2. MORGAN STANLEY RESEARCH December 7, 2010 Muni Outlook 2011Muni Outlook 2011: Risk RedefinedMichael Zezas, CFA (212) 761-8609 Exhibit 2 MMD 2s10s Show Historical SteepnessStrategy for a Market Coping With Unfamiliar Risks 3.0We expect the macroeconomic backdrop for munis to improve 2.5markedly in 2011. However, persistent structural fundamentalissues, an impulsive trajectory for interest rates, the 2.0coincident potential for negative returns, and the potential forspillover of European sovereign concerns are more likely to 1.5yield a market defined by technical volatility than one buoyedby growth-driven stability. 1.0Accordingly, we recommend beginning 2011 with the 0.5following strategies: 0.0Technical Stress Indicators Dec-05 Oct-06 Aug-07 Jun-08 Apr-09 Feb-10 Dec-10Use sharp, upward moves in rates and/or equities as leading Source: Municipal Market Data, Morgan Stanley Research indicators of a reversal in positive tax-exempt muni demand. Exhibit 3Exhibit 1 Projected YE2011 UST CurveDemand Driven by High Muni Real Rate Advantage 6 4.00 3.50 5 3.00 4 2.50 2.00 3 1.50 1.00 2 0.50 1 0.00 0 6/ 1 6/ 3 6/ 5 6/ 7 6/ 9 6/ 1 6/ 3 6/ 5 6/ 7 6/ 9 6/ 1 6/ 3 6/ 5 6/ 7 9 8 /8 /8 /8 /8 /9 /9 /9 /9 /9 /0 /0 /0 /0 /0 0/ 0.25 0.5 2 5 10 30 30 30 30 30 30 30 30 30 30 30 30 30 30 30 3 6/ YE11 2-Dec 10Y RR to UST -1 stdev Mean +1 stdev Source: Morgan Stanley Research, BloombergSource: Morgan Stanley Research, Bloomberg, Municipal Market Data Credit AllocationCurve Positioning to Begin 2011 Overweight revenue-supported credit vs. GOs on stableNeutral to short duration vs. intermediate tax-exempt fundamentals and political risk remoteness (see Water benchmarks to take advantage of 2s10s steepness with the Rising: The Political Risk Alternative, August 2, 2010). Fed likely still on hold (see US Economics: US Economic and Interest Rate Forecast, Richard Berner et al., December Overweight BABs vs. Corporates against taxable benchmarks 3, 2010). on program extension and market growth diminishing the orphan and liquidity discount in spreads (see BABs for theShort duration vs. aggregate and long benchmarks due to Long Run, September 29, 2010) projected bear steepening of the UST curve (see 2011 Global Interest Rate Outlook, Jim Caron et al., December 3, In the near term, be a tactical buyer of GO BABs when credit 2010) and high volatility in the long end of the muni curve tensions in Europe rise: credit correlation in the price of muni due to an uncertain future for BABs beyond 2011. and European sovereign credit risk may increase, but 2011 muni default probability is low. 2
  3. 3. MORGAN STANLEY RESEARCH December 7, 2010 Muni Outlook 2011Underweight local governments with above-average exposure Exhibit 5 to state revenues Factors Impacting Revenues After Recessions 91-92 01-02 08-09States Still Stressed; Locals at Increased Risk Peak-to-Trough GDP Decline -1.36% -0.27% -3.66% Cumulative State Gap For Following Fiscal Year ($B) $6 $75 $200Despite projections of stronger economic growth in 2011 and Last Recession Quarter 0.91% 0.30% -3.12%indications that revenues have stabilized, the states’ budgets YOY Tax Rev % Change 1 Quarter Out 2.00% -0.12% -1.57%and cash flow will likely remain stressed. While the recent 2 Quarters Out 1.30% -0.60% 0.22% Last Recession Quarter 6.60% 4.83% 9.27%swing toward political support for austerity at the state level Unemployment Rate 1 Quarter Out 6.83% 5.50% 9.63%may facilitate important first steps toward credit repair in some 2 Quarters Out 6.87% 5.70% 10.03%areas, it is our view that solutions will lack sufficient scope Source: Bloomberg, Bureau of Labor Statistics, Center on Budget and Policy Priorities,and scale to offset these risks over the next year. San Francisco Federal Reserve, Morgan Stanley ResearchAccordingly, political risk may increase while headline risk We expect the structural gaps that have persisted since FY09remains. While we maintain that, in 2011, the possibility of will continue in FY11 and FY12, but without the benefit ofstate defaults remains low and local defaults/bankruptcies enhanced federal aid that was critical to balancing stateshould be idiosyncratic in nature, ongoing fundamental budgets in FY09 and FY10 due to the spending sensitivities ofweakness erodes confidence in the asset class as a safe the Republican majority in the US House of Representatives.haven. While we recognize that many of the major revenue sources forExhibit 4 states have stabilized, ongoing growth in those sources isState Spending Outpaces GDP Ahead of Recession unlikely to provide meaningful relief. Given the historical relationship between nominal GDP growth and the growth of 48% state income, corporate, and sales tax revenues, we model an 45% estimated cyclical growth of $21 billion for calendar 2011. This extra income only closes about 15% of the projected 50-state 42% budget gap for FY12. 39% Exhibit 6 36% State Solutions Gap 160 33% 140 30% 120 2001-2008 100 50% State Spending Nominal GDP 80 81%Source: US Census Bureau, Bloomberg 60States continue to face their most significant fiscal challenges 31% 40in at least a generation. Following a period of sustained 4%increases in public expenditures that outpaced economic 20 13% 15%growth, states have suffered substantial revenue degradation 0in the most recent recession given peak-to-trough GDP 2011 2012 Projected Cyclical Revenue Growth Projected ARRA Aid Other Solutionsdeclines that outpaced the previous two recessions. Theresult was budget gaps across states that were more Source: Center on Budget and Policy Priorities, Morgan Stanley Researchstructural (attributable to an imbalance in long-term Accordingly, we expect mid-year FY11 budget revisions andexpenditure vs. revenue growth) than cyclical (attributable to a FY12 budget negotiations will have to account for thetemporary decline in economic activity). This problem was remainder of the fiscal solutions, which will keep investorlarger in scale than the previous two recessions due to focus on political and execution risk.comparatively higher budget gaps and unemployment levels. 3
  4. 4. MORGAN STANLEY RESEARCH December 7, 2010 Muni Outlook 2011Execution Risk and the Politics of Austerity consistently demonstrated a dedication to honoring long-term liabilities, meaningful risk reduction would have to come in theWhile states have a considerable amount of options in form of policies that address paying for those commitments.addressing both the projected gap and their potentiallyunsustainable long-term liabilities, the political feasibility of However, we view the potential for adoption of such policies inexercising many of those options will remain low throughout 2011 to be minimal for the following reasons:2011, in our view. Accordingly, the most likely set of adopted Budget gaps remain large and the political capital expendedsolutions will do little to mitigate these important credit risks in in their closure will leave little desire to address longer-termthe near term. issuesGiven that state budget gaps are largely structural rather than De facto deficit borrowing by paying less than the actuariallycyclical in nature, they represent stresses that will persist required contribution (ARC) to one’s pension fund shouldbeyond the current economic cycle. Accordingly, gaps that continue to be a popular gap-closing tool that also deepensare not addressed properly not only contribute to short-term the long-term liability problemliquidity risk but also decrease the long-term capacity of amunicipal government to effectively cope with the burden of The most likely set of austerity measures to be widelylong-term liabilities, such as debt, pensions and other post- employed are expenditure cuts given the current politicalemployment benefit (OPEB) liabilities. We argue that the climate. The success of the Republican Party in the midtermlatter stresses are the most relevant to bondholders: if they elections in regaining control of the US House ofremain unaddressed, they could introduce political risk (or risk Representatives and increasing their share of stateof willingness-to-pay) to the market. For example, the Pew governorships suggests that the American people currentlyCenter on the States estimates that unfunded pension and support spending cuts over tax increases, the argument forOPEB liabilities of the 50 states are roughly $1 trillion. This which was a major plank of the party platform. This alsoequates to about nearly 150% of current annual state increases the incentive for states to continue to be creative inrevenue. Accordingly, it is unlikely this liability can be fixed their gap-closing policies to avoid tax increases. Somethrough revenue growth and/or enhancements alone. strategies are more constructive than others, such as using aFurthermore, state-driven solutions that include more rapid low rate environment to refinance outstanding debt in order toamortization of pension and OPEB liabilities would backload the term structure of maturities. However, suchsubstantially crowd out other policy expenditures. policies have consequences and risk simply compounding an already daunting long-term liability burden.Exhibit 7Crowding-Out Effect of Pension Funding Exhibit 8 Likely 2011 Austerity Solutions Fall Short of 30% Crowding Out of Policy Spending Addressing Structural Issues 25% Wide- spread Idiosyncratic Minimal 20% Positive Credit Policy 15% Options in 2011 OPEB Reductions – Current Employees X 10% OPEB Reductions – Future Employees X Pension Reductions – Current Employees X 5% Pension Reductions – Future Employees X Ongoing Expenditure Cuts X Ongoing Revenue Enhancements X 0% CA FL GA MA IL NJ Weak Credit Policy Interest Principal Pension OPEB Extra Pension Options in 2011 Deferral of ARC XSource: Center for Retirement Research at Boston College; State CAFRs; Pew Center on the States Delay of Payments XNote: Extra pension reflects full ARC based on 5% return assumption; OPEB is if states paid full Temporary Expenditure Cuts XARC today. Temporary Revenue Enhancements XThus, any solution to the long-term liability issue hinges on Debt Refinancing Restructuring X Debt Financing of Deficits Xthe choices that balance near-term operating needs withhonoring long-term commitments. While states have Source: Morgan Stanley Research 4
  5. 5. MORGAN STANLEY RESEARCH December 7, 2010 Muni Outlook 2011Thus, while the options enable states to remain default risk- Exhibit 10remote in the short term (we elaborate on this later in the Property Taxes Increased As Other Revenues Droppedreport), we see little improvement in the long-term credit 600,000conditions for states throughout the coming year. 500,000Local Governments May Ultimately Bear the Brunt 400,000of State Weakness 300,000Local governments are perhaps more at risk than their state 200,000counterparts of a meaningful deterioration in creditfundamentals in 2011. This is due to the negative impact on 100,000their fiscal burdens of the likely gap-closing solutions adopted 0by states. In particular, since our view is that state austerity in 02 07 8 M 0 N 2 3 5 N 7 8 00 3 8 Fe 5 10 -9 -9 -0 -8 l-9 -9 l-9 -9 -0 02011 is most likely to include widespread operating n- b- n- b- n- ar ar ec ov ov ct ct Ju Ju Ju Fe Ju Ju O O M Dexpenditure cuts above other options, we believe that large, PIT CIT Property Salesdiscretionary spending items are most at risk. Chief among Source: US Census Bureauthese spending items is aid to local entities, including cities,towns and school districts. Exhibit 11 Collapsing GDP/Property Tax Implies a SubstantiallyCuts in these expenditures can be particularly perilous to local Higher Burden on Property Ownersgovernments that rely heavily on state aid. As an example, westress test a generic, Aa-rated California school district and Millionsconclude that a 15% cut in state aid since fiscal 2009 (the latest 4,200 600year from which data is available) results in a budget deficit 4,000 500large enough to consume the district’s entire unreserved fund 3,800 400balance (roughly the equivalent of a tangible equity cushion inthe private sector). 3,600 300Exhibit 9 3,400 200Stress Test of Local Issuer to State Aid—Common Size 3,200 100Income Statement Based on Moodys Medians (Aa) 2009 -15% 3,000 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009State Aid 61% 52% GDP/Property Tax Revenues State AidUnreserved Fund Balance % of Revs 9.40% 0% Source: US Census Bureau, Bloomberg, Morgan Stanley ResearchSource: Education Data Partnership, Moodys, California Department of Finance Local governments that rely heavily on state aid will thereforeThis is particularly troublesome given that California’s budget lack the options available to their state counterparts and facefor FY11 calls for spending about 20% less on education than meaningful credit deterioration.FY09. In theory, local governments’ ability to tax allows them tosupplement their reserve/equity position and boost long-term Credit Event Risk Should Remain Low Next Yearsolvency. In reality, there are severe limitations given the weakmacro economy and the popularity of cost-cutting politics. Despite the substantial challenges to state and localFurthermore, the primary means of monetizing local taxing governments, we still view the risk that a meaningful creditcapacity is through property tax revenues, which we view as event will drive the market in 2011 to be low as outrightincreasingly “tapped out” given that it has already absorbed the defaults and/or bankruptcies are likely to remain idiosyncraticshortfall burden created by decreases in sales, income, and in nature. We cite the following in support of our view:corporate tax revenue, and property taxes have rapidly States’ capacity to service their long-term liabilities remainsincreased when scaled against the size of the US economy. strong 5
  6. 6. MORGAN STANLEY RESEARCH December 7, 2010 Muni Outlook 2011While local governments are more at risk, mid- and large-size Exhibit 13 investment grade issuers retain meaningful options to keep Local Medians them financially viable in 2011 US Cities Unreserved General Overall Net Adjusted DebtMuni pricing tends to act independently of isolated, small Fund Balance as % of Debt Per Burden as % of scale defaults Revenues Capita ($) Full Value Quick Ratio 2009 14.7 2,781 2.7 3.5 2008 14.6 2,708 2.7 3.6An important truth, in our view, is that reliance on capital 2007 17.0 2,690 2.9 3.3markets for funding is minimal for US states. Because states, 2006 16.3 2,491 2.9 3.1like most muni market participants, have historically issued 2005 15.3 2,334 3.1 3.1 2004 13.9 2,300 3.0 2.6debt in serial rather than bullet form, they pay a portion of 2003 13.6 2,056 3.0 2.0their outstanding debt principal down annually along with 2002 13.1 2,000 2.9 4.3interest payments. This makes for a smooth term structure of Note: Cities with more than 100,000 population and $100M in outstanding debt. Source: Moodysdebt maturities that allows states to use a manageable portionof their revenues annually to service debt, diminishing the US School Districtsneed for capital market access to honor long-term liabilities. Unreserved General Overall Net Adjusted Debt Fund Balance as % of Debt Per Burden as % of Revenues Capita ($) Full Value Quick RatioExhibit 12 2009 8.6 2781 1.7 3.1Comparative Rollover Risk 2008 8.2 2708 2.3 3.6 2007 7.8 2690 2.4 3.5 2006 7.5 2491 2.3 3.3 60% 2005 7.5 2334 1.9 3.6 50% 2004 7.0 2300 1.8 3.2 2003 6.7 2056 1.3 2.5 40% 2002 7.0 2000 1.9 0.7 Note: School Districts with more than 100,000 population and $100M in outstanding debt. 30% Source: Moodys 20% Though we see an elevated risk for these fundamentals, we 10% do not believe there will be any meaningful credit events as a result in 2011. This is because most state-aid reliant local 0% governments are, in our estimation, only on step two of a pre- Y ly A FL PA G IL Ire al nd J H A A TX Po ec e n A default path. Their fiscal cushion and taxing capacity is N ai N C M G W Ita O g la rt u Sp re increasingly at risk, but they maintain several short-term time- Interest Principal buying strategies that can carry them through 2011 evenSource: State CAFRs, Morgan Stanley Research under more adverse economic conditions.Therefore, states do not face the same deadline-driven Exhibit 14funding needs of their European counterparts. Anticipation of Pre-default Path of Aid-Reliant Local Governmentsthese deadlines was often the driving force behind negative Healthymarket sentiment toward troubled sovereigns. We do not Step 1: Initial State Spending Cutsexpect any meaningful change in states’ revenue bases Reactionary Policy - Can be considered temporary Step-back Options - Economic reboundand/or the term structure of their debt maturities, and - Trim non-essential spending - Use of reserves as needed - Build immediate structural balance on assumption of lower baseline of state aidaccordingly do not see meaningful credit event risks for states - Cut capital expenditures Step 2: Multiyear State Spending Cutsover the next calendar year. Reactionary Policy Step-back Options - Possible Reserve Depletion - Above-trend economic growth - Core operating/personnel cuts - Gain concessions in long-term contractsLocal governments also enter the year with relatively strong - Tax/fee increases - Creative accouting - Build immediate structural balance on assumption of lower baseline of state aidcredit fundamentals. - Use non-essential asset sales to fund long-term budget restructuring Step 3: Sustained State Spending Cuts Reactionary Policy Step-back Options - Substantial tax increases - Renegotiation of labor and other long-term, - Substantial operating/personnel cuts non-bondholder contracts - Deficit financing - Sale of core assets - Emergency external assistance Bankruptcy Source: Morgan Stanley Research 6
  7. 7. MORGAN STANLEY RESEARCH December 7, 2010 Muni Outlook 2011Thus, market triggers based purely on credit events, such as trade and retail activity (US Economics: US Economic anddefault or bankruptcy, remain a lower risk compared to Interest Rate Forecast, Richard Berner et al., December 3,technical factors in 2011. 2010). Airport bonds stand out from the group as potentially weaker if inflation comes in the form of cost-push rather thanRevenue-supported Debt Shows Greater Credit demand-pull, driving fuel costs and ticket prices higher thanStability passenger demand warrants and creating a slowdown in air traffic (see The Great Transmission: From DM QE to EMBonds secured by dedicated revenue streams, particularly Inflation, Greg Peters et al., October 15, 2010). On the whole,those of essential service public enterprise systems, should though, overall fundamental stability for enterprise-drivencontinue to demonstrate credit stability vs. state and local munis warrants overweighting revenue-supported creditgovernments in 2011. Operating margins, debt service versus state and local credit in 2011.coverage ratios, and debt burdens have remained stable athealthy levels throughout the economic downturn. Technical Event Risk Greater than Credit Event RiskExhibit 15 Technical risks to the tax-exempt market remain high, in ourStable Debt Service Coverage view, and are more likely to force a re-pricing reflecting higher 3x credit risk than an actual credit event, the potential for which, as previously discussed, we deem to still be low over the next 12 months despite ongoing deterioration of fundamentals. In 2x particular, we view technical risks in 2011 to be attributable to: An expectation of a volatile path higher for US Treasury rates, which may increase the frequency of tactical changes in 1x portfolio duration for muni investors The same expectation drives the potential for periods of sharp 0x negative returns, which undermines what had been 2003 2004 2005 2006 2007 2008 2009 overwhelming demand for munis over the past two years Total Senior DS Coverage (x) Total DS Coverage (x) MADS Coverage(x) Increased volatility in the shape of the tax-exempt yield curve,Source: Moody’s, Morgan Stanley Research which reduces investor conviction and increases defensive portfolio positioningExhibit 16Stable Margins and Reserves The failure to ease fundamental stresses in state and local 100% governments in 2011 will compound this volatility effect by diminishing general confidence in the asset class, thereby 80% elevating the discount needed to attract marginal buyers. Recent muni market moves highlight the technical issue, 60% which pits perceptions of munis as a bullet-proof asset class 40% against the reality of weakened fundamentals and the potential for a smaller real pre-tax yield advantage over 20% Treasuries. That tension threatens the market dynamics that supported the post-2008 rally and spread tightening in tax- 0% exempts, which was largely demand-driven as evidenced by 2003 2004 2005 2006 2007 2008 2009 sustained, strong fund flows. In our view, flows were largely Net Take-Down (%) DS Safety Margin (%) Debt Ratio (%) Unrestricted Res as % of O&M attributable to ongoing asset allocation toward fixed income, aSource: Moody’s, Morgan Stanley Research, Company Reports high real pre-tax yield advantage toward Treasuries, and perception of the asset class as safe (see TechnicalMore cyclical securities, such as port and sales tax bonds, Knockout, September 7, 2010). However, when one of thoseshould also see more stability than GOs in 2011 given conditions is violated, it has the power to undermine demandprojections for meaningful global economic growth that drives and meaningfully move the market. This is essentially what 7
  8. 8. MORGAN STANLEY RESEARCH December 7, 2010 Muni Outlook 2011occurred, beginning at the end of the week of 11/8/2010, Exhibit 19when a sharp move higher in 30-year UST yields eroded the UST Volatility Impact on Munismuni yield advantage and introduced quick, negative returns 121 115to tax-exempts. The result in the following week was an Munis Sell Off 120accelerated sell-off in tax-exempts and coincident fund 110outflows even as Treasuries began to rally. 119Exhibit 17 105 118 Rate Volatility Spikes30-year UST Spike Preceded Recent Sell-Off 117 100 121 4.5 116 120 4.4 95 115 119 4.3 114 90 118 4.2 10/8/2010 SP Muni Index (LHS) USD 1Y10Y (RHS) 117 4.1 Source: Bloomberg, Morgan Stanley Research 116 4 The tax-exempt curve may deal with the additional pressure 115 3.9 of BAB market extension uncertainty. While at the time of this 114 3.8 publication, the Build America Bond program has not been 10/8/2010 10/21/2010 11/3/2010 11/16/2010 11/29/2010 reauthorized for 2011, comments from key lawmakers SP Muni Index (LHS) US 30 YR (RHS) suggest the program is likely to be extended at a lowerSource: Morgan Stanley Research, Bloomberg subsidy rate for one more year as part of a negotiated extension for the existing income tax structure. Assuming thisExhibit 18 extension, we expect the long end of the muni market will beFund Flows vs. Munis susceptible to elevated volatility based on speculation about 1,000 121 the certainty of the program beyond 2011. The following 0 120 exhibit shows how the steepness of the curve beyond 10 119 -1,000 years has reacted during prior periods of BABs market 118 -2,000 117 consideration. -3,000 116 Exhibit 20 115 -4,000 Munis 10s30s Shows BAB-related Volatility 114 -5,000 113 ARRA Passes 2.1 -6,000 112 Post- 10/8/2010 10/21/2010 11/3/2010 11/16/2010 11/29/2010 1.9 Lehman SP Muni Index 5 per. Mov. Avg. (ICI Flow) Liquidity 1.7 Crisis BAB Renewal FearsSource: Morgan Stanley Research, Bloomberg, ICI 1.5Thus, sharp oscillations in the interest rate environment put 1.3the tax-exempt market at increased risk for these types ofaccelerated sell-offs. We expect this type of movement to be 1.1prevalent in 2011 given the dueling pressures of Fed Treasurypurchases and a rebound in economic growth. 0.9 0.7 Aug-08 Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10 Source: Morgan Stanley Research, Municipal Market Data 8
  9. 9. MORGAN STANLEY RESEARCH December 7, 2010 Muni Outlook 2011Finally, while we forecast supply to be lower for 2011, the Important perceived commonalities between European anddecline is not likely to be substantial enough to provide a US state credit difficulties include:technical tailwind by offsetting potential drop-off in demand. Structural budget imbalances driven by an escalating fixed-(Please see Appendix A for more information on our supply cost baseforecast.) Opacity of financial reporting relative to the private sectorExhibit 21Projected Supply Questionable capacity to meet large, long-term liabilityBln. commitments500450 Perceived lack of political will to undertake meaningful400 austerity measures in response350 Taxable Lack of control over the supply of currency in which their debt300 is denominated means that both entities are unable to Tax-exempt250 mandate their debts away200150 Given our view that closing state budget gaps will be100 politically difficult and that meaningful risk-mitigating austerity 50 measures are not forthcoming, we expect the investors’ 0 linking of US states and Europe to be reinforced by headline 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 est. Forecast and fundamental developments in 2011. The following exhibit demonstrates this relationship by showing the trend towardSource: Morgan Stanley Research, The Bond Buyer increasing excess correlation between BAB spreads and European sovereign CDS vs. investment grade corporateDespite Important Differences, Market May Focus CDS.on Similarities between US and Europe Exhibit 22It is our view that credit-oriented investors, particularly BABinvestors, are likely to focus on the common drivers of Excess Correlation of BABs to SovX vs. IGCDXelevated US state and European sovereign credit stress in 0.6 Excess Correlation w/ SovX (IGCDX)spite of the relatively small scale of US state difficultiesrelative to those of Europe. We cite the following in support of 0.4this view: 0.2Elevated interest rate volatility and allocation to fixed income among the retail investor base suggests ongoing risk 0 aversion N ov- 09 Feb- 10 May- 10 Aug- 10 -0.2Likely continuation of volatility in the long end of the tax- -0.4 exempt curve coupled with opacity of financial reporting will leave investors grasping for explanations in an -0.6 informationally inefficient market -0.8States share similar, easily identifiable macro-level risks with S M S l R h Bl b Source: Morgan Stanley Research, Bloomberg their European sovereign counterparts, which are of increased focus among institutional investors Accordingly, BAB investors are more directly exposed to this risk than their tax-exempt counterparts, but we caution thatGiven Morgan Stanley’s view that the European sovereign sustained, negative linking of BAB spreads to Europeancrisis will continue to intensify (see The Global Monetary sovereign spreads should, over time, induce similar behaviorAnalyst, On the Question of QECB, Joachim Fels et al., in tax-exempts.December 1, 2010), the linking of states with conditions inEurope, and the resulting correlation, increases the downside This may outweigh a key truth, in our view, that Europeanto munis in 2011. reliance on the capital markets for funding dwarfs that of US 9
  10. 10. MORGAN STANLEY RESEARCH December 7, 2010 Muni Outlook 2011states. As we argued earlier, states typically maintain a Exhibit 24smooth term structure of debt maturities that allows states to State and Local Investment Tracks Employmentuse a manageable portion of their revenues annually toservice debt, diminishing the need for capital market access 1,450.0 19900to honor long-term liabilities. Conversely, sovereigns face 19800 1,320.0substantial near-term maturities that from a practical 254 250 19700standpoint require capital markets financing, making rollover 1,190.0 243 254 19600risk and capital market access issues of great creditimportance. The exhibit below, which we also highlight earlier 1,060.0 19500in the report, visually demonstrates this condition. 1,147 1,154 19400 930.0 1,073 1,096Exhibit 23 19300Rollover Risk Lower for States than Europe 800.0 19200 2007 2008 2009 2010 Est. 60% Structures Equipment and software Employees 50% Source: US Census Bureau 40% However, the impact on infrastructure spending related to 30% roads, utilities, and the like is less certain. Increased 20% Republican control of governorships suggests the possibility 10% that large scale, debt-financed projects may be tabled, as was the case in New Jersey with Governor Christie’s decision to 0% cancel construction on a multibillion dollar transit tunnel to FL A A A Y TX A J PA ly H IL n Ire a l Po ece nd New York City. However, remaining dedicated funds from the N ai C N M G W O Ita g la Sp rtu re G American Reinvestment and Recovery Act (ARRA) may boost Interest Principal infrastructure spending elsewhere as an offset. Thus, we areSource Morgan Stanley Research, State CAFRs not willing to concede that this type of spending willTherefore, we reiterate that states do not face the same experience meaningful declines in 2011.deadline-driven funding needs of their European counterparts, The private sector may also experience enhanced exposurethe anticipation of which often drove negative market to European sovereign difficulties through munis. Highsentiment toward troubled sovereigns. Nevertheless, while correlation of the perception of state and local governmentthe market apprehension about munis may not match the credit risks with those of peripheral Europe will likely exposeseverity of concerns about Europe, we still think investors will sectors to the Europe story if they are holders of muni creditlatch onto the easily identifiable similarities. risk. These industries potentially include:Economic Impact of State and Local Weakness Life InsuranceThe ongoing impact of state and local austerity measures and Property & Casualty Insurancecorrelation of muni pricing to conditions in Europe is likely to Financial Servicesbe expressed in particular segments of the US economy. Weanticipate the push toward a lower expenditure base will result Nevertheless, the real drag on economic growth for 2011in a smaller piece of the capex pie going to services that should be minimal given our view that there is only modestsupport government workforces. For example: risk of a major credit event in the near term. (See State & Local Fiscal Problems: How Big a Headwind?, June 25,Office technology support, including computers, servers and 2010.) long-term service contractsSchool and office building constructionHeavy equipment 10
  11. 11. MORGAN STANLEY RESEARCH December 7, 2010 Muni Outlook 2011 caution that while spreads have widened in this market, actualObservations on the Role of Muni CDS in 2011 defaults are still rare, and much of the default and recoveryIn 2011 we expect to see further developments in the assumptions necessary to price many credit derivativesmunicipal CDS market. First, we expect the market to remain largely theoretical for municipals.undergo some sort of standardization, similar to whatoccurred in the corporate CDS market in 2009, known as the What Is a Credit Default Swap?“Big Bang” or SNAC protocol. The coupons on trades were Earlier this year, we published an extensive primer on thestandardized, auction settlement – whereby every CDS and credit default swap market in general (The CDS Lifecycle – Aindex contract gets settled at the same recovery rate if a Market Primer, May 2010), with a focus on the corporate CDScredit event occurs – became the standard setting, and other market. Municipal CDS is much the same mechanically: it iscontract changes occurred, making the market more fungible. an OTC contract between the seller and buyer of protectionWe see many benefits to the municipal CDS market if this sort against the risk of default on a set of debt obligations issuedof standardization were to occur. by a specified reference entity. A municipal CDS is triggeredAdditionally, we expect to see an increase in volumes in both if, during the term of protection, an event that materiallythe single-name and index markets, as more non-traditional affects the cash flows of the reference debt obligation takesinvestors enter the market. Given the attention the municipal place. Exhibit 25 summarizes credit events across assets.market is getting and that the taxable nature of the BABs The MCDX index comprises 50 individual municipal creditproduct allows new investors to look at the municipal market swaps, with the intent of serving as both an investment vehiclein ways that were not profitable before, we expect to see the and a barometer of market activity. By buying protection on theinvestor base of the municipal market as a whole to continue index, an investor makes quarterly premium payments, and into develop, and with it, the municipal CDS market. return, if any of the credits in the portfolio were to experience aFor those investors who are already involved, this additional credit event, the investor would receive par – recovery for thatstandardization and liquidity should only bolster market depth reference entity. The underlying portfolio is static and does notand help cash and CDS spreads converge further. We highlight change. It does, however, roll to a new series every six months,that while there is still a basis between CDS and cash bonds, it at which point the new index may contain new referenceis converging and CDS is becoming a better barometer as time entities. Unique among credit indices, thus far each series hasgoes on. For those investors who are not planning to use this had the same list of constituents as the one before it, and themarket for hedging or expressing long views, we highlight that only change is that the maturity of the index is rolled out sixthis corner of the municipal market can still be useful, if only to months. Additionally, as the liquid single-name municipal CDSprovide another source of pricing information and thus market only includes a handful of names at this point, not all ofsomething to watch closely this year. the constituents of the index are liquid. Exhibit 25Why Are Investors Interested? Sample Credit Event Triggers Across AssetsThe development of the taxable market has coincided with aglobal rise in credit risk premiums and an increase in liquidityin non-corporate credit derivatives, particularly sovereignEuropean debt. Thus while the muni CDS market has beenaround for several years, it is in the last 18 months or so thatwe have seen increased interest in this market from a broaderbase of market participants.In many ways, the emergence of the BABs market and thesimultaneous growth in the CDS market could be interpretedas the municipal markets’ transition from a largely rates-basedproduct to one that is more credit premium driven. The creditrisk premium priced into municipals has widened alongsidethe overall credit market, and in line with deterioration in riskassets as a whole over the last several years. However we Source: Morgan Stanley Research 11
  12. 12. MORGAN STANLEY RESEARCH December 7, 2010 Muni Outlook 2011Sizing Up the Municipal CDS Market amount to the buyer of protection in the event of default, in our experience most investors are using this more as anThis market began trading in limited size around five years instrument to take a view on the asset class by syntheticallyago, and has grown considerably since then. Net notional risk replicating the cash market. In the corporate IG space, theoutstanding peaked earlier this year, at which point the largest rolling 10-year cumulative average default rate is around 2.8%reference entities in the market had an outstanding net (according to Moody’s), which, while much higher than thenotional of around $3.5 billion. While this may seem like a G.O. municipal market, is still very low, and yet investorslarge number for a young market, consider that the municipal routinely buy protection there as well. They do this for amarket as a whole is approximately $2.8 trillion in size. Even number of reasons; some want to hedge some exposure theyjust examining G.O. debt vs. CDS risk in Texas for example, have in their portfolio, others have a directional view on creditwe see that CDS net notionals outstanding are around $130 spreads, while others may want to make some sort of relativemillion today, peaking late last year at just over $450 million. value play on one credit vs. another. Thus the emergence ofAccording to the Texas Bond Review Board, as of the end of investors who buy protection on municipal CDS does not2009, the State has G.O. debt outstanding to the tune of $34 necessarily indicate an increase in investors who believe thatbillion. Compare this to the corporate market, where, in many defaults in the market are imminent, but rather that they haveinstances the net notional of CDS protection far exceeds the a view that the credit spread component of the municipal bondcorporate cash bonds outstanding. yield will increase. This is particularly pronounced in theThe MCDX index has also been part of the growth in the muni municipal market as there is no other way to express a shortCDS market. Net notionals outstanding are around $4 billion view on the underlying assets.across series, up from under a billion two years ago, and we A better way to think of CDS spreads is that they should, inexpect activity in the index to increase. MCDX notionals are theory, simply represent the spread of the underlyingmost comparable to SovX, which has around $11 billion net municipal cash bond over and above the appropriate risk-freenotional across series. Both are naturally dwarfed in size by metric. So for BABs, this would be the difference betweenthe corporate CDS index market – the CDX IG index has over BABs and Treasuries; for tax-exempts this would be the$50 billion net notional outstanding in just the most recent spread over MMD. CDS spreads are elevated in today’sseries alone, which has been trading for only 2 months. market partly because there is a perceived increase inExhibit 26 municipal risk given budget constraints, and also partly due toNet Notional CDS Outstanding by Reference State an increase in risk premium across all risky assets. 3,500 New York City Texas St The Municipal Basis 3,000 California St Florida St One thing to look at when considering the pricing of municipal 2,500 Illinois St New Jersey St CDS is where it trades relative to cash bonds. In theory, an New York St investor should be indifferent between buying a cash bond 2,000 and selling protection on CDS and funding it with a Treasury- or LIBOR-based instrument. If the basis is negative, or CDS is 1,500 trading tighter than cash, then an investor could buy a bond and then buy protection, and thus earn a spread while being 1,000 effectively “credit risk neutral.” As illustrated in Exhibit 27, the 500 municipal CDS-cash basis is currently positive for most names, indicating that muni CDS in general is trading wider 0 than the cash bonds for the GO debt of those states. Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10Source: DTCC, Morgan Stanley Research There are many reasons for the basis to be positive or negative, and we have seen examples of both in the longerMunicipal CDS Pricing history of the corporate CDS market (see Basis Basics in a Normalized World, March 19, 2010 for more details). TheIn a market with so few historical defaults, we get a number of basis can turn negative when investors are wary of usingquestions regarding what, exactly, the contract represents. funded instruments, as we saw during the credit crisis inWhile the contract does, in fact, pay out a par minus recovery 2008. In the early days of the corporate CDS markets 12