The Case for AAA Underlying Municipal Bonds
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The Case for AAA Underlying Municipal Bonds Presentation Transcript

  • 1. Municipal Bond AAA Underlying
    Investment Opportunity
    Ian Welch
    *Please see the end for important
    information regarding credit ratings
  • 2. 2
    Table of Contents
    The Case For AAA* Underlying Rated Municipal Bonds
    Market Overview
    Default Data
    Non State AAA*
    State AAA*
    Bond Insurer Ratings
    *Please see the end for important
    Information regarding credit ratings
  • 3. $2.85 Trillion Tax Exempt Bond Market
    45,000 Municipal Bond Issuers 
    1.5MM Municipal Bond Issues
    169 AAA Non State Municipalities = $50.09 Billion total debt issued
    1.75% Total Tax Exempt Bond Market
    Standard & Poor's August 2009
    • 11 AAA States  =  $66.8 Billion total debt issued
    2.3% Total Tax Exempt Bond Market
    Standard & Poor's July 2010
    Market Size
    Diverse Market
    Limited AAA Quality Non-State Supply
    Limited AAA Quality State Supply
    1Standard & Poor’s Underlying Ratings (SPURs) – provides a rating for a debt issue on a stand-alone basis, without credit enhancements.
    While interest on municipal bonds is generally exempt from federal income tax, it may be subject to the federal alternative minimum tax, state or local taxes. In addition, certain municipal bonds (such as Build America Bonds) are issued without federal tax exemption, which subjects the related interest income to federal income tax.
  • 4. StrategyAAA Underlying Portfolio
    • Create AAA Underlying Portfolio
    • 5. Create Default Resistant Portfolio
    • 6. Take advantage of sell side pressure
    • 7. Take advantage of negative perception of municipal bond market to amass AAA bonds
  • Municipal Bond Holders
    *Figures for 2010 are as of Sept. 30, preliminary, and seasonally unadjusted. Dollar amounts are in billions of dollars. Components man not add to totals because of rounding.
    Source: Federal Reserve Board, Flow of Funds Accounts, Flows and Outstandings, Third Quarter 2010.
  • 8. Market Overview: Potential Municipal Bond Market Turmoil
    • Renowned Wall Street analyst Meredith Whitney has warned that the U.S. may witness between 50 to 200 “sizeable defaults” amounting to “hundreds of billions of dollars” among municipal and state governments next year, which could derail the recovery.
    • 9. Over the next twelve months, Whitney said, the U.S. government will be faced with the onerous task of bailing out debt-ridden states that are struggling financially. She compared the current fiscal health of city/state governments with that of the banking industry prior to the Lehman Brother collapse.
  • Market Overview: Cash Flight Persists
    • Tax-exempt money market funds lost a sizable $2.09 billion, dropping total net assets to $326.88 billion for the week ending Dec. 13 and erasing nearly all gains from the previous week.
    • 10. The outflows came on the heels of $3.41 billion of inflows (12/20/2010). The back-and-forth followed two consecutive weekly outflows that saw total net assets fall to $328.97 billion.
    • 11. The $494.4 billion municipal bond mutual fund industry reported $5.4 billion in market losses on its holdings last week (12/20/2010), following a $7 billion loss the previous week.
    • 12. Since the industry peaked at $527.8 billion on Oct. 20, it has bled $33.38 billion, or 6.4% of its assets.
    • 13. Mutual funds, which own more than 17% of all municipal bonds, have been transformed from a support for munis into a depressant.
    • 14. The first 10 months of this year, investors entrusted an additional $32.2 billion to municipal bond mutual funds, or 10% of issuance during that period.
    • 15. Inflows abruptly reversed to outflows in mid-November. Funds have now reported $12.3 billion in outflows the past five weeks, as well as $17.9 billion in market losses.
  • Market Overview: Cash Flight Persists
    • Mutual funds that report their figures weekly posted a net outflow of $2.73 billion for the week ended Dec. 15, according to Lipper Fund Market Insight. It was the fifth-consecutive weekly outflow for municipal funds.
    • 16. Redemptions from municipal funds lately have forced portfolio managers to sell bonds to raise cash, contributing to the drubbing for municipals, which has pushed the yield on a benchmark triple-A 10-year muni bond up 63 basis points since Nov. 10 — when the drain began.
    • 17. The four-week moving average for the period ended Dec. 15 for all municipal funds, including those that report their figures monthly, was a nearly unprecedented loss of $2.3 billion. That’s the second-highest tally ever recorded. The record was set by the four-week period that ended Dec. 8.
    • 18. “There is no doubt that the demand side of the market has weakened,” according to R.J. Gallo, a portfolio manager at Federated Investors.
    • 19. Everyone is aware of the additional supply that will be dumped into the long end of the tax-exempt markets as the Build America Bond program approaches its Dec. 31 expiration date, according to Gallo.
  • Market Overview: Situational Overview
    • U.S. state and local governments are currently experiencing financial stress at a level that has not been seen for decades.
    • 20. Given the prospects for limited economic and tax revenue recovery, the scheduled phasing-out of federal fiscal relief for the states, and the likelihood of continued state aid cuts and local property tax base weakness, pressures should continue.
    • 21. Credit stress can in many cases become more pronounced in the coming years.
    • 22. Downgrade activity in the sector has increased and can continue to remain at a higher level than we have seen historically.
  • Default: Historic Rates
    Past performance does not guarantee future results. There is no assurance these trends will continue. Investing involves risk and you may incur
    a profit or loss.
  • 23. Default: Data
    • Government debt levels are relatively low, debt service is a relatively small part of budgets, and bondholders’ claim on revenues for most debt is strong. Fitch evaluates a state’s debt burden as a percentage of personal income and a local government’s debt burden as a percentage of property value. The tax-supported debt of an average state is equal to just 3% - 4% of personal income, and local debt roughly 3% - 5% of property value. Debt service is generally less than 10% of a state’s or local government’s budget, and in many cases much less.
    • 24. Bond security is very strong for most debt issuances, and is provided for in state constitutions, statutes, covenants with bondholders, and local ordinances. U.S. state and local government bonds are usually secured by a general obligation of the issuer. For local governments, this is generally accompanied by an unlimited property tax pledge and such taxes are senior to the property’s mortgage obligation. Other commonly issued municipal bonds are secured by a first lien on sales or income taxes, where there is little if any legal discretion for the taxpayer to choose not to remit the taxes owed to the government.
    * Source: FitchRatings, U.S. State & Local Government Bond Credit Quality: More Sparks than Fire, November 16, 2010
  • 25. 12
    Default: Data
    • Debt service is a relatively small part of most budgets, so not paying it does not do much to solve fiscal problems (particularly as compared to the costs of such an action).
    • 26. The vast majority of state government spending is for education and social services (including Medicaid), as well as, to a much lesser degree, corrections. Local government spending covers the wide array of municipal services, including public safety, health care, sanitation, transportation, and education.
    • 27. There is a long record of governments making difficult choices to maintain budget balance while making full and timely debt service payments even in very stressful financial situations.
    • 28. The officials managing the government’s cash, in their fiduciary role, legally cannot just choose to pay other expenses as opposed to debt service; the priority of payment is generally quite high, so that a bondholder is well positioned even in financial stress.
    Default: Data
    • Security for general obligation and dedicated tax bonds is very strong, and is provided for in state constitutions, statutes, covenants with bondholders, and local ordinances.
    • 30. For local municipal issuers, general obligation bonds are secured by their power to levy and pledge property tax revenues for debt service. Special tax bonds usually have very clearly defined, segregated, or high priority payments in the flow of funds.
    Default: Data
    The spreads on CDS's have been growing and the dollar amount of CDS's on municipals has grown in the last year.  That's a clear warning sign that people are effectively starting to short the muni market.
    • As of November 2010, there were 72 defaults totaling $2.5 billion, down from 204 defaults ($7.3 billion) in 2009 and 162 ($8.2 billion) in 2008. 
  • Potential Legislative Reform
    The Moment of Truth December 2010
    The White House
    • Tax Free Municipal Bonds
    • 31. Current Law: Interest exempt from income tax
    • 32. Proposal: Interest taxable as income for newly-issued bonds
    • 33. Result: This potentially could create a finite pool of tax free municipal bonds
    While interest on municipal bonds is generally exempt from federal income tax, it may be subject to the federal alternative minimum tax, state or local taxes. In addition,
    certain municipal bonds (such as Build America Bonds) are issued without federal tax exemption, which subjects the related interest income to federal income tax.
  • 34. Lack of AAA Underlying Rated Supply
    • 11 AAA States  =  $66.8 Billion total debt issued
    • 35. 169 AAA Non State Municipalities = $50.09 Billion total debt issued
    • 36. For municipal bond fund shareholders, there is a dearth of bond availability…[there are] no longer enough AAA-rated bonds.”
    • 37. There is relatively few bonds that are rated AAA based on the creditworthiness of the underlying municipality or state.
  • 17
    Non State AAA Municipalities
    General & Special Obligation Bonds
    Unlimited & Limited
  • 38. AAA Municipalities Key S&P Data and Ratios
  • 39. AAA Municipalities Key S&P Data and Ratios
  • 40. AAA Municipalities Key S&P Data and Ratios
  • 41. AAA Municipalities Key S&P Data and Ratios
  • 42. AAA Municipalities Key S&P Data and Ratios – by State
  • 43. 23
    State AAA
    General Obligation
  • 44. U.S. States Bond Ratings: Fitch, S&P, Moody’s
    State Fitch Moody's S&P
    Alabama AA-plus Aa1 AA
    Alaska AA-plus Aa1 AA-plus
    Arizona Aa3 AA-minus
    Arkansas Aa1 AA
    California A-minus A1 A-minus
    Colorado Aa1 AA
    Connecticut AA Aa2 AA
    Delaware AAA Aaa AAA
    D. C. AA-minus A1 A-plus
    Florida AAA Aa1 AAA
    Georgia AAA Aaa AAA
    Hawaii AA-plus Aa1 AA
    Idaho AA(Lease) Aa1 AA
    Illinois A A1 A-plus
    Indiana AA-plus (Lease) Aaa AAA
    Iowa AAA(Implied GO) Aaa AAA
    Kansas AA(Lease) Aa1 AA-plus
    Kentucky AA-minus (Lease) Aa1 AA-minus
    Louisiana AA Aa2 AA-minus
    Maine AA-plus Aa2 AA
    Maryland AAA Aaa AAA
    Massachusetts AA-plus Aa1 AA
    Michigan AA-minus Aa2 AA-minus
    Minnesota AAA Aa1 AAA
    Mississippi AA-plus Aa2 AA
    Missouri AAA Aaa AAA
    Montana AA-plus Aa1 AA
    State Fitch Moody's S&P
    Nebraska AA-plus
    Nevada AA-plus Aa1 AA-plus
    New Hampshire AA-plus Aa1 AA
    New Jersey AA Aa2 AA
    New Mexico Aaa AA-plus
    New York AA Aa2 AA
    North Carolina AAA Aaa AAA
    North Dakota Aa1 AA-plus
    Ohio AA-plus Aa1 AA-plus
    Oklahoma AA-plus Aa2 AA-plus
    Oregon AA-plus Aa1 AA
    Pennsylvania AA-plus Aa1 AA
    Puerto Rico A3 BBB-minus
    Rhode Island AA Aa2 AA
    South Carolina AAA Aaa AA-plus
    South Dakota AA(Lease) AA
    Tennessee AAA Aaa AA-plus
    Texas AAA Aaa AA-plus
    Utah AAA Aaa AAA
    Vermont AAA Aaa AA-plus
    Virginia AAA Aaa AAA
    Washington AA-plus Aa1 AA-plus
    West Virginia AA Aa1 AA
    Wisconsin AA Aa2 AA
    Wyoming AA-plus
    Source: Bond Buyer as of July 1, 2010, State General Obligation ratings. Lease notation represents appropriation requirement
    Please see the end for important information regarding credit ratings
  • 45. 25
    Bond Issuer Ratings
    Currently, less than 10% of new municipal bond issues are insured, which is down from about 50% in 2008. (Municipal Securities Rulemaking Board)
  • 46. Bond Issuer Ratings
  • 47. StrategyAAA Underlying Portfolio
    • Potential political targeting of tax exempt status on newly issued bonds may create high demand for existing bonds
    • 48. Potential Future extension (2012 – beyond) of Build America Bond Program may limit supply side for tax free bonds
    • 49. Large Defaults could create extreme selling pressure and a flight to AAA quality
    • 50. Higher tax rates may create demand for tax-free investments
    • 51. Sell side pressure creating inefficient market; bids not reflective of yield/ quality
    • 52. Lack of Tax Shelters for wealthy individuals should continue demand for tax exempt bonds
  • StrategyAAA Underlying Portfolio
    Potential Challenges
    • Unprecedented AAA State default
    • 53. Willingness by State’s to target senior bond debt holders
    • 54. Legislative changes in General & Special Obligation definitions
    • 55. Legislative changes in tax exempt status for existing bonds
    • 56. A potential lack of federally subsidized bond programs
    • 57. The possibility of decreasing real estate values, high unemployment, and higher default rates still exist.
  • StrategyAAA Underlying Portfolio
    Portfolio Creation
    • Identify target bonds
    • 58. Identify yield curve advantage. 10, 20, 30 yr maturities
    • 59. Volume trading advantage. 100M,250M + purchase size
    • 60. Identify maximum investment amount per issue
    • 61. Determine approximate size of end portfolio
    • 62. Hourly monitoring of national inventory for targeted bonds
    • 63. Compile CUSIP number database for targeted bonds
  • Disclaimer
    Past performance does not guarantee future results. There is no assurance these trends will continue. Investing involves risk and you may incur a profit or a loss. Municipal bonds are subject to credit risk, the risk that the bond obligor will be unable to make interest payments or repay principal when due .Municipal bonds sold prior to maturity may result in a gain or loss of principal. Income from municipal bonds is not subject to federal income tax but may be subject to AMT, state or local taxes. U.S. Treasury securities are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and guaranteed principal value.
    Credit ratings are forward-looking opinions about credit risk. Standard & Poor’s credit ratings express the agency’s opinion about the ability and willingness of an issuer, such as a corporation or state or city government, to meet its financial obligations in full and on time. Credit ratings can also speak to the credit quality of an individual debt issue, such as a corporate note, a municipal bond or a mortgage backed security, and the relative likelihood that the issue may default. Issue credit ratings are based, in varying degrees, on Standard & Poor's analysis of the following considerations:
    • Likelihood of payment, capacity and willingness of the obligor to meet its financial commitment
    on an obligation in accordance with the terms of the obligation;
    • Nature of and provisions of the obligation;
    • Protection afforded by, and relative position of, the obligation in the event of bankruptcy,
    reorganization, or other arrangement under the laws of bankruptcy and other laws affecting
    creditors' rights.
  • 64. Disclaimer
    Ratings assigned by Fitch are opinions based on established criteria and methodologies that Fitch is continuously evaluating and updating. Therefore, ratings are the collective work product of Fitch and no individual, or group of individuals, is solely responsible for a rating. Ratings are not facts, and therefore cannot be described as being "accurate" or "inaccurate". Users should refer to the definition of each individual rating for guidance on the dimensions of risk covered by such rating.
    Fitch's opinions are forward looking and include analysts' views of future performance. In many cases, these views on future performance may include forecasts, which may in turn (i) be informed by non disclosable management projections, (ii) be based on a trend (sector or wider economic cycle) at a certain stage in the cycle, or (iii) be based on historical performance. As a result, while ratings may include cyclical considerations and typically attempt to assess the likelihood of repayment at "ultimate/final maturity", material changes in economic conditions and expectations (for a particular issuer) may result in a rating change.
    Because it involves a look into the future, Moody’s credit ratings are by nature subjective. Moreover, because long-term credit judgments involve so many factors unique to particular industries, issuers, and countries, Moody’s believes that any attempt to reduce credit rating to a formulaic methodology would be misleading and would lead to serious mistakes.
    That is why Moody's uses a multidisciplinary or "universal" approach to risk analysis, which aims to bring an understanding of all relevant risk factors and viewpoints to every rating analysis. Moody’s then relies on the judgment of a diverse group of credit risk professionals to weigh those factors in light of a variety of plausible scenarios for the issuer and thus come to a conclusion on what the rating should be.