Gillian: Welcome to Asset TV, I’m Gillian Kemmerer. Municipal Bonds have been the subject of much attention with an influx of crossover buyers in an uncertain political environment impacting the fate of the sector. Municipals and treasuries have traded in a narrow range as investors weight Trump’s campaign promises with Federal Reserve policies. Where are the pockets of the opportunity and credit concern in 2017? Today I am joined by two experts who will share their view of the recent headlines and where the market is heading. Welcome to the Municipals Bonds Masterclass. Gentlemen, thank you so much for joining us here today. It would make sense to start with a quick overview of recent history in municipals. And Tom, I’m going to start with you, post the financial crisis until now how have you seen the market change?
Tom Casey: I think the market has changed quite a bit, Gillian. Certainly with the financial crisis we’ve seen a change in terms of the ownership structure, what individual investors are participating in the market. We’ve also seen changes in terms of the issuance relating to bond insurance. And we’ve certainly seen a dramatic decline in yields, longer maturities, lower quality instruments have continued to garner a lot of attention from investors as investors have gone down the curve and out the credit spectrum in an effort to replace yield that’s been lost as a result of declining yields or tightening spreads. Municipal Bond insurance was a very important topic in terms of the market. It provided a great deal of safety for many investors. In 2008 over half the market was insured by Municipal Bond insurers. Currently there is only about three active insurers in the Municipal Bond market, representing about 6% of the market. As a result I think municipal credit research is going to play a continuing important role in portfolio construction, fundamental research is critically important. We have also seen changes in terms of issuance patterns. While issuance has been volatile, we’ve also seen a greater degree of issuance associated with infrastructure spending. It’s a topic that I’m sure we’ll address later on. It is becoming a ever important topic as the amount of infrastructure investment in this country has continued to decline over time, states and municipalities due to the financial crisis and conservative financial practices have been issuing less debt associated with infrastructure spending, and as a result that need continues to grow.
Gillian: Now, you just referenced insurance, and, Adam, you come from the insurance point of view. So tell us a little bit about how your market specifically has changed?
Adam Bergonzi: I think Tom actually glossed it quite well. So pre crisis there were 7 Triple A monolines in this space, insuring anywhere between 55 and even 60% of the new issuance volume in the market. Now there are really only 3 monolines at the Double A level, which is another big difference. So that was a big change, I think also the stability of the ratings of the monolines emerging from the credit crisis was a big issue as much as the actual rating level. So it is a smaller market, Tom’s correct, I think right now we’re hovering around 6% penetration of that market, aspiring to a bit more. But the market landscape has changed for a lot of the reasons that Tom cited.
Gillian: Let’s focus in on 2016 specifically because it was a fascinating year for municipals, up the yield curve, down the credit spectrum is what you said. Tell us a bit more about why that happened?
Tom Casey: I think many investors continue to attempt to garner some type of yield from any fixed income market. The Municipal Bond market looked particularly attractive relative to other high quality alternatives. That continued to attract investors. We also saw participation from non-traditional buyers; the overseas investors or banks and property and casualty companies continue to be an important component of the market. Over the last several years the participation in terms of retail buyers buying bonds directly through brokers has declined. We have seen increases in ownership of Municipal Bonds was institutions such as property and casualty companies, large commercial banks as well as overseas investors. As rates have declined, and on a global basis there is an absence of yield the attractiveness of Municipal Bonds has continued to be an important part of the developing story.
Gillian: Okay. And, Adam, how does political risk play into the changing landscape of 2016?
Adam Bergonzi: Well, I think it’s quite large after the credit crisis, what you saw was a slight delay. Munis don’t react or respond to that type of stress right out of the box as corporates do. So it took a while for the impact of the crisis to appear in the tax spaces that support these bonds. So I would say somewhere in the 2010-11 range you saw the beginnings of some real deterioration in some high profile credits, Detroit, Stockton, and others. And this led in fact to, I think, a greater awareness of political risk as these entities have either sought, stayed oversight or have gone as far as to go into bankruptcy. And I think what we’re seeing now for, in a greater number of cases, compared to say 15 years ago, is a number of these high profile stress cases. And I think it’s beginning to redefine a little bit for buyers, sort of what that risk is and whether they’re being paid well for it. The other point I would make is the flipside of what Tom mentioned in terms of the reach for yield, which is understandable, is it has tended to mute, I think, credit selection. So what you have are a bunch of buyers who are being, returned their capital, I believe the refunding versus new money ratio in the muni market has been about 1.4 to 1, meaning there’s been more refunding activity than new money bonds. That creates sort of negative net supply. That forces people to be buyers of bonds. You have the crossover buyers that Tom mentioned, our market, I think, has benefited since the Recovery Act that Obama put through.
So now you have foreign buyers coming over, so called crossover buyers, broadening the base of our market, further increasing the desirability of munis. So you have the sort of weird mismatch between what I think is probably greater credit risk in the market than I have seen in my career, happening at the same time when the asset class is getting a lot of good attention. And I just wonder sort of where that equilibrium comes to rest.
Gillian: So the risk is getting higher but the point at which it’s valued is getting lower?
Adam Bergonzi: My perception, I’m not sure the market can … is in a position given where rates are to really fully value that risk. They just don’t have that luxury right now.
Gillian: Okay. So let’s take a look at some market technicals. And we’ll definitely come back to some of the examples that you’ve just mentioned. I’m going to pull up a graphic that I had on Bloomberg and it has to do with the muni treasury ratio, which is an important metric when thinking about this asset class. So it is appearing behind me. Now, munis and treasuries are trading in a narrow range, munis narrowly outperformed treasuries in February due to the limited supply and obviously continuing positive demand. How are you thinking about this muni treasury ratio? And how has it driven some of the behavior in late 2016/early 2017?
Tom Casey: I think that it has been distinct. And I think certainly if you consider Municipal Bonds tend to be less sensitive to changes in interest rates. But over the last 3 or 6 months that you referenced, municipals have actually been significantly more volatile than treasury markets, in particular the latter part of 2000. In 16, post election we saw a tremendous amount of volatility associated with the Municipal Bond market. And there were instances in the 10 and 20 year part of the curve where municipals were yielding 120/125% of treasuries. If you believe in efficient markets, that shouldn’t be the case. What happened was a reaction on the part of many traditional investors and non-traditional investors who realized that that was a unique opportunity to own an asset class, which is high quality in nature and should be stable going forward. You also had an instance in which Municipal Bond market supply picked up dramatically. So that in tandem with the uncertainty related to the election and The Fed becoming active drew some significant underperformance of Municipal Bonds. We continue to view the asset class as attractive in some of the relationships between munis and treasuries, for those maturities longer than 10 years are still 95% of treasuries. So have attracted investors who do not benefit from the exemption nor do they need the exemption, but have purchased the asset as a high quality alternative in the concept of their portfolio.
Gillian: Do you think munis will increasingly begin to perform defensively as interest rates rise?
Tom Casey: Traditionally they have. We have looked internally over the last three times when The Fed has become active and municipals have traditionally performed very defensively relative to treasuries. The beta associated with municipals is an important component, and one of the reasons that we remain constructive, even, well, with the thought of a rising interest rate environment, certainly with an upward bias on rates, municipals should behave defensively relative to other assets.
Gillian: Okay, Adam, obviously Janet Yellen just a few weeks ago raised interest rates by a quarter of a point, it’s only the third time in a decade. At what point will you consider us out of the low interest rate environment, so to speak?
Adam Bergonzi: I don’t know my pronouncement’s worth a whole lot. Look, we’ve been saying rates are going to go up for probably six years now, we’ve been wrong every year. We’ve seen a little bit of an uptake, it’s actually perhaps more muted than people thought. I think it’s kind of given back a little bit. You know, we look at lot at the spread differential. And sort of that’s how we make our money, right. So when we lend out our high credit rating to an issuer, we’re in effect sharing that differential. So they’re saving money in cost of borrowing and we’re splitting that. We take in some premium; they get savings on cost of debt. That is still not favorable. This is still an exceptionally low interest rate environment. It’s probably the sort of least constructive environment for monoline insurers that you could imagine. And I think we’re coming out of it, but it’s slow. And I don’t see any, you know, major uplift in the next few quarters. But over time, I think, given the direction where The Fed is saying they’re going to take us, you will start to see that loosen up.
Gillian: And, Tom, same question to you, when do you think we’ll be out of a low interest rate environment’
Tom Casey: I think it’s going to take quite some time. Clearly The Fed has begun a path to higher rates. However, I think that there are a number of factors which could certainly keep rates lower for a longer period of time. And our expectation is that while rates will drift higher, we don’t see a scenario where rates will spike us to a significant degree any time in the near future.
Gillian: You’ve alluded a few times to some of the demand factors that drove munis in 2016. Let’s talk a little bit about these crossover buyers that you continually reference in this growing international buyer base. How is it changing market fundamentals?
Tom Casey: It’s an excellent question. I think from a fundamental standpoint, having a broader base of buyers is an important trading partner for Standish as a firm. I think certainly many of these buyers are oriented out the curve, and certainly the high quality area of the market. Due to the BABs program in 2009 and 2010, many of these buyers developed a familiarity with municipal credit and realized the high credit quality in the distinctive nature of the revenue stream, and as a result developed a familiarity which has given them a great deal of confidence owning the asset class. When municipals get cheap as they have been certainly historically, these buyers again, owning either taxable Municipal Bonds or tax exempt Municipal Bonds, they don’t care about the status of the exemption or benefit from it. But they’re buying it because it’s a high quality asset relative to a lot of alternatives. And we have a global glut of yield, there is an absence of yield globally, these investors have an important part of their portfolios allocating high quality assets in their portfolios.
Gillian: Adam, you’ve referenced political risk before, so I’m going ask you to do an uncertainty in terms of policies now. Obviously we always ask ourselves whether or not munis will maintain their tax exempt status, but it seems like a lot of these buyers aren’t even depending on it, is that correct?
Adam Bergonzi: I think that’s right, I mean again, they’re looking for the safety. They’re looking for the asset class on a performance basis; I think versus those who are looking for the tax abatement, they’re not as focused on that. It is interesting to me just because they haven’t been here long, sort of, you know, whether they’ll be able to hold on throughout cycles, if there’s volatility. I’m not sure all of them; the ones I have met with have focused as much on some of the credit aspects that I’ve talked about. I think they think of it as a near treasury asset class. And so it’ll just be interesting to see how things go in terms of pension liabilities and some of maybe the more headlining volatility risk that we’re seeing in the market, how that class of an investor behaves, they kind of just got here.
Gillian: Does the changing face of the investor base in munis impact the way you make decisions in your business at all?
Adam Bergonzi: Well, I think to Tom’s point, it’s a different market than it was when the monolines were insuring, you know, nearly 60% of the market. It’s a more fragmented market. It is a more credit savvy market, the rise of the professional money manager. It’s still held by retailers, but there are other intermediaries now in the market, that we really are trying to reeducate as to what the value of bond insurance is. You know, five years in financial services is a lifetime, so you have people in very senior positions now who really never used the product or lacked familiarity with it. Our company really strives to bring up the visibility of the industry. I mean I’d love to plant the flag for National as a participant in that industry. But I think it’s our opportunity now to sort of reeducate the market on the value of the product, it’s not appropriate in every circumstance. It’ll never get back to what it was. I don’t think that was even a particularly healthy place for it to be. But I think there is a boutique need in the market, particularly for the one-off issuer, the infrequent issuer that may not attract the attention of a money manager. They don’t maybe have the time to review and fully diligence a small school district, a small water and sewer issuer, and we do. That is really where the business started. And I think in some sense for monoline guarantors that’s where the business is actually coming back first.
Gillian: And it’ll be interesting to talk about some of the specific sectors of opportunity, the ones that you alluded to, some of the smaller unknown issuers. A similar question to you, does the changing face of the demand for Municipal Bonds change the way that you look at your business?
Tom Casey: I think it does to some degree. Many of them have actually become clients of ours and are looking to utilize their expertise in this space. The other element is that I think it provides a unique trading opportunity. These investors oftentimes are looking at the relationship of Municipal Bonds relative to other assets such as LIBOR or treasuries. And they trade on a percentage thereof. Dedicated professionals in our market looking on a spread relationship, value individual credits relative to the strength of one another, and as a result, some of these newer investors perhaps have a different exit strategy and different group of alternatives. And as a result they may be buying bonds more expensively than they should. And in contrast to that they may be selling them too cheaply. And as a result, being able to get on the other side of that trade is going to be critically important in terms of our strategy and our success going forward.
Gillian: Okay. So we’ve talked a bit about demand, let’s talk about supply. 2017 is the year that Donald Trump may enact some of the infrastructure policies he committed to on the campaign trail. Are you expecting a tsunami of issuance?
Adam Bergonzi: No, not at the pace that that legislation effort, whatever it is, is being discussed. I think, you know, I’m quite amused when I hear the term infrastructure discussed at the federal level. The Municipal market is probably the most efficient delivery, at least at the state and below level, of infrastructure financing, right. This is what we do and it’s about a 400 billion market. So I think whatever The Fed ends up doing will be an adjunct to that if they’re wise. And I would look to harness what the muni market already does well. I think a lot of issuance form last year in the wake of the potential rate rise and the new administration got pulled into 2016. So I think when you look at sort of the consensus numbers about issuance this year, it’s probably still going to be relatively high on a 10 year basis. But it’ll be lower than last year, and I don’t really see the infrastructure debate creeping into the 2017 year. I think that’s probably a 2018 and beyond.
Gillian: Okay. Are you also seeing a lot of this pull forward and what is your outlook for 2017 issuance?
Tom Casey: It’s very similar. I think Adam gave a very nice summary. The need for infrastructure is massive. However, it is a very long lived planning in production in terms of getting those bonds to issue and getting them to market. The Municipal Bond market traditionally absorbs about 80% of the infrastructure financing. We would expect that to be the case going forward. And even though the details of the Trump infrastructure plan are quite limited. He has made reference to the fact that he considers a supplement, the Municipal Bond market. And as a result I think that, you know, the devil is in the details, there is an absence of details thus far. And once those begin to emerge, I think we can perhaps handicap a little bit better. But I do not, and certainly as a firm we do not expect it will disrupt traditional municipal finance or issuance patterns.
Gillian: One of the major drivers in 2016 was refunding activity. Do you expect the pace to continue into next year?
Adam Bergonzi: So I think it’s slowing to a degree. I think the last few years it’s been quite significant. I think the other thing to look at is since the credit crisis, municipals have been loath to issue more bonds. I think this is a political reality post credit crisis. And so I think it feeds a little bit into the infrastructure issue in that municipalities have really been building up balance sheets versus building projects. So I would expect to see or hope to see that the new money issuance would begin to pick up again.
Gillian: And, Tom, your thoughts.
Tom Casey: I feel very similarly. The analogy that I use is it’s very easy for a politician to go for the constituents and talk about we’re going to be getting a junior high school. It’s another thing to say it’s going to cost $50 million, and by the way your taxes are going to have to pay for it. So as a result I think issuance patterns have been slower than you might expect, given the austerity measures which have continued to impact municipal finance. And as a result I think as each day goes by I think there’s a greater need for infrastructure spending that we’ve discussed. And so issuance we believe will continue to be relatively robust, but I think quite manageable. And I think the Municipal Bond market has proven that to be the case the last several years.
Gillian: Okay. Another area that we have to talk about, we have already started to discuss some of Trump’s potential policies would be tax reform. Now, we can separate this both at the individual and corporate level. Tom, how do you look at each of these, do you think the impact will be similar or different?
Tom Casey: I think it will be different. Perhaps unlike some firms, we believe that the reduction in effective marginal tax rates for individuals will have a small effect, if any, on demand, for Municipal Bonds. If you look at Municipal Bonds historically, their relationship between effective marginal tax rates for individuals and demand for munis or yield more specifically, has been very inelastic. And because people own the asset class for a high quality [inaudible] that will produce a stream of income for them, the effect of marginal tax rate of those that declare tax exempt interest on their tax returns is approximately 34%. The Trump proposal thus far would lower marginal tax rates to that vicinity. And as a result we do not believe will have a material impact on demand. Unlike that, we believe that the corporate reduction effective partial tax rates for corporations may have some … a demand component associated with it, in that a significant reduction in corporate tax rates might reduce the participation of some of these more recent buyers in our market, that is to say, large commercial banks or highly taxed corporate entities. What we think will have a greater impact on the market is the potential to reduce corporate tax rates.
Corporate buyers such as property and casualty companies as well as large commercial intermediaries have been a very strong participant in our market over the last several years. And supported the market, they own about 15% of the outstanding municipal debt. If their tax rate is lowered significantly that could have an effect on the marginal buyer in our market. However, I think that if you look at the current relationships, as we’ve discussed, between municipals and treasuries, at a ratio of 95% for longer intermediate maturities that still wouldn’t have any impact on the buy base. If the relationship between municipals and treasuries are diverted to a more normalized relationship, i.e. 70% in tax rate on corporations were to decline, that could have an impact on the buy base.
Gillian: And, Adam, reorienting this a little bit to you, if we see an enormous number of tax cuts, do you think that this could impact credit quality in some of those cash strapped areas that are really dependent on some of these tax funds to come in and help to fund some of their general obligations?
Adam Bergonzi: I think that’s right. I mean what we’ve looked at a lot is the dependence in certain tax bases on a very, very small number of high net worth individuals or companies. I think you’re seeing some of this in Connecticut where you have sort of debates about whether folks should relocate or stay. And there’s sort of a bid ask with the government on, you know, what will you do for me to improve my position here relative to service levels or relative to tax levels. So we look at a tax base that is not broad, that is in effect concentrated as a credit weakness.
Gillian: Okay. And we alluded to this just a little earlier, but I want to hammer down the final point on infrastructure spending. If Donald Trump enacts his policy toward infrastructure, he’s mentioned that he might pursue something that’s deficit neutral. So we may see a big public private partnership. If a lot of private actors get involved, could this reduce maybe some of the issuance we would expect for infrastructure spending?
Tom Casey: Potentially I think that he has talked about a trillion dollars over 10 years. I think there has been a lot of discussion about attempting to entice buy issue, would not normally be interested in our market through a public private partnership. I think those investors would be focused on higher yielding or speculative types of investments or projects. And there’s also discussion about somehow developing an initiative such that they would receive a tax credit, and also the potential to tie this in with an effort to repatriate foreign balances, cash balances of US corporations. It’s a complicated topic. And again, there’s been a limited amount of details released associated with that. But I think certainly there could be an avenue to have a greater degree of participation from private corporations in particular.
Gillian: Adam, do you agree?
Adam Bergonzi: I do, although I note that here in the United States, private financing of public assets never really took off the way it did in Europe and there were several reasons for that, some of which I think are well understood, some perhaps less so. So it’s just yet to be determined how successful that will actually be. I also think there’ll be a fair amount of related municipal borrowing around some of these other projects. So you see often ancillary projects that are used to tie in to other private financing, so. But I think overall it could in fact put some pressure – some downward pressure on issuance in the muni space, I would agree.
Gillian: Are there any particular sectors of infrastructure that you’re excited about should these plans come to pass?
Tom Casey: I think you’ll see some traditional issuance in terms of roads, bridges and tolls in particular. And I think certainly anyone who’s driven around any major metropolitan area would agree that there is a need for financing. And the decay associated with our infrastructure in terms of those individual sectors, I think it’s necessary for us to continue to finance them.
Gillian: And, Adam, in some of those underserved issuers, potential?
Adam Bergonzi: I think alternative energy is an interesting space and water, probably are the things that people are thinking about that I talk to.
Gillian: Okay. Now, I’d like to move a bit into a case study and specifically of Detroit. But before we do that it would be really interesting to understand some of the pressures that actually occur on the government’s general fund, we have seen so many of these pockets of credit weakness, but to understand where they stem from. Could you talk us through the basics of how these government general obligations work?
Adam Bergonzi: Sure. I’ll talk about sort of how we think about it. I think post Detroit, without getting into Detroit, there was an interesting realization on the part of the market that not everyone was agreeing to terms about what these specific pledges meant. So you’ll often hear the term, general obligation, general obligation unlimited tax, full faith in credit. It’s really hard to pin down a defined element for that security. You also have jurisdictional elements, depending on where you’re doing the Municipal Bond. So in some sense I think the market is taking much more concern about that now in terms of what is my actual security? Are you going to just pay me from available resources? Are you going to raise taxes on your citizenry to pay me? How does this all work? When you look at the anatomy of a general fund for the average municipality, you’re looking at a number of competing liabilities. And I think the market is trying to sort through what those mean. The first that would probably receive the most attention, rightly so, is the whole debt versus pension obligation. And that’s really, I think, uppermost in the mind of most people that have to pick credit in this market. But it really doesn’t stop there. I think you also have to think about other post employment benefits, which don’t probably have some of the same legal protections as pensions, but are quite large in fact.
I think you have to also think about service levels within the city, we learned that in the last few stressful cases where really where the policy risk, I think, begins to take off is when service levels begin to get crowded out by these other obligations. And that has happened. The last dimension we’ve just been talking about which I think is also not talked about enough is capital projects, reinvesting in the infrastructure, basically think of it as future service levels. So those are really four competing elements, I think, for general fund resources, that anyone who is looking at either buying or enhancing debt in the municipal market needs to be thinking about.
Gillian: And of those four pressures, do you think that the pension liability is maybe the one that comes to the forefront this year?
Adam Bergonzi: I think it’s the most complicated one because it’s not a fixed target. You have effectively an actuarially determined liability. It changes based on the assumptions greatly. So, you know, I’m looking still at discount rate assumptions on pensions in the 7-8% range. I don’t know how we all think about that. I think that’s pretty aggressive. So if you normalize that for what you think may be a secular shift and the type of returns we’ll see from equity markets over the next decade or so, and adjust for that, those liabilities grow dramatically just by making a different assumption. We’re living longer, that’s been well documented. That’s an additional pressure, both for healthcare benefits and for pension. So I think it’s hard when you sit down, that that one liability is so volatile and so hard to get a handle on. I think that’s a lot of the problem the market is sort of parsing through right now.
Gillian: Okay. And let’s talk specifically about Detroit. They issued their first general obligation bonds since exiting bankruptcy midyear last year. When you think about the recent municipal stress, general obligation bonds were often considered the safest investments. Have you changed your point of view on this at all?
Tom Casey: We haven’t changed our view. However, we have always focused on revenue bonds and revenue bond subsectors in the context of our portfolios. We feel generically speaking that they are perhaps undervalued and certainly perhaps underrated. General obligations bonds have traditionally been a very, very important part of a portfolio for individuals who know that there is the full faith in credit with the underlying entity. They know the city or they know the town or there’s familiarity with them. As a result it’s easier for them to buy it, similarly, if they’re sold a bond by a broker it’s much easier to describe that and describe the area. And as a result that type of participation has really compressed spreads and driven prices up. We would generally prefer to own revenue bonds and revenue bond subsectors, while we do a general obligation bond exposure in the portfolios, it is minimal on a relative basis. And as a result, Adam correctly pointed out the tension between pensions and bondholders is one which I believe will continue to grow, particularly given the unpredictable nature of pension obligations and other OPEB liabilities. I think the market historically did a relatively poor job of identifying those issuers which had larger problems than others, both market participants as well as the rating agencies certainly have placed a higher degree of focus on that more recently.
If you look at many of the multi notch or super downgrades that have occurred in our market over the last several years, most of them have been associated with large pension or OPEB liabilities associated with them. So we look at the bonds that we buy in terms of overall [inaudible], unlike 10 or 15 years ago, when you looked at outstanding bond issues relative to revenues, now with an outstanding bond issuance servicing that debt in tandem with outstanding liabilities. So it’s a little bit different lens that we look at credits with which these days, however, I think that market participants have placed a great deal of focus, which they should.
Gillian: For an advisor that’s entering Municipal Bonds or trying to understand a bit more about this space, how would you explain to them the forces at work when it comes to revenue bonds specifically?
Tom Casey: Sure. I think it is very important that you have a defined stream of revenues associated with that service. We certainly believe that while it takes a greater degree of research and intellect to look at these individual credits, we believe that you can often find them with a more stable stream of revenues. We think that you can oftentimes find a much better credit with perhaps even a lower rating than the underlying town or municipality in which it is issued. And being able to unearth the bond covenant and identify unique and intrinsic value in individual issuers can produce a lot of valuable returns and capital appreciation for clients.
Gillian: And in terms of general obligation bonds, do you believe that even though they were once a safer investment that they’re increasingly coming under scrutiny and perhaps should be avoided?
Adam Bergonzi: I don’t think they should be avoided. I think the scrutiny is appropriate. I think it’s an evolving situation. Munis have been for a very long time viewed effectively as a tax product. I think they’re now really becoming a credit product. And if you look at the corporate market, over many, many years and litigation and all kinds of issues, you now have, I think, a clearer vision of what all those securities mean in a corporate context. In municipals I think we’re just at the forefront of that discovery period. So I liken it almost to being sort of in the awkward teenager phase. So we’re learning through Detroit and other litigation, Chapter 9, even state oversight, what do these securities really mean? And we’ve also learned that many of the corporately trained analysts, judges, restructuring professionals really don’t know our market. And they are just testing our market more so in the crucible of what they know, and what they’re comfortable with. I’m not sure that’s the right conclusion, but that’s what we’ve so far seen. So I think it’s incumbent upon our market to think a little bit about what that means. We spend a lot more time at my firm focusing on what I think I went through before, which is sort of what are the competing liabilities within that general fund? And trying to get a sense for when we think this crowding out effect is going to be coming into play. And it could be 10 years from now. So that’s where we really spend a lot of our focus. But I wouldn’t tell people to avoid necessarily the asset class. I think it’s just probably more proceed with caution.
Gillian: Okay, more so than before.
Tom Casey: And what I think is important about that, and there is a wide chasm of funding levels for pensions and OPEB liabilities. So there are many issuers which have done a very good job over the last 10 or 15 years or even longer than that, addressing those type of long term obligations. There are others which have not done a very good job, in having fundamental credit research and being able to evaluate general funds and the pressure that Adam talked about I think is a really important part of identifying individual bonds that represent a piece of value in client portfolios.
Gillian: Let’s stay here for a moment. There was a headline recently that the Dallas City Council drafted a resolution to divert one-eighth of its city sales tax revenue to some of its pension obligations. What would you say are some of the best in case examples of municipalities that are dealing with this the right way?
Adam Bergonzi: Well, I think we’re early innings with Dallas. I think that surprised the market a little bit, not only the size of the liability, but some of the plan design issues, which I think again, the market s still coming to grips with. And if you look at some of the new GASB rules on disclosure, I think that disclosure is getting better. So I think they’re doing a good thing by trying to fix it. I think you’re seeing municipalities looking for discrete revenue sources to pledge against those liabilities. There’s the ever popular discussion of whether Pension Obligation Bonds work, where you’re effectively trading not a fixed liability for a fixed one. That has worked out in some cases, and in other cases it’s not worked out all that well. It’s a bit of a market timing issue. I think what we look for is again, a recognition of the problem, prudent budgeting, conservative estimation of the liability and hopefully they’re making headway on keeping up. The question is at what point does underfunding matter? And it’s a big matter of debate, is an 85% funding level okay? That’s what a lot of municipalities are. You also have certain municipalities that have discretion over how they fund this liability on their own. You have others where that liability is funded for them at the state level. So, New York, for instance, where we sit today does more of a funding at the state level. They’re actually quite well funded. I’m sure it causes budgeting issues at the lower government level. But effectively they’re not far behind. So it really depends on the jurisdiction. I think again we’re looking for recognition of the problem, and people who are dealing with it in a non-political way.
Gillian: Okay. We would be remiss not to talk a little bit about Puerto Rico. I know we’re all a little sick of talking about it, but we have to go there. And I’m going to pull up another graphic; it was called The Long Road to Recovery. It was recently on Bloomberg and I thought it was very funny the way that Bloomberg positioned this story. It was called A Funny Thing Happened on the Way to the Pay Day. And it was this idea that investors were absolutely thrilled when they installed a Fiscal Oversight Board recently to help with the debt servicing, but on March 13th that same board approved a budget that devoted a lot less money to some of these debt investors. So, Tom, how are you approaching Puerto Rico at the moment?
Tom Casey: I think Puerto Rico is a very interesting case study. First and foremost what I think is critically important about Puerto Rico is that Puerto Rico is a very unique unusual circumstance, in there has been no type of contagion associated with what has gone on in Puerto Rico, with the rest of the Municipal Bond market. As I said, the situation is very unique. And I think there was some concern several years ago that there would be a contagion of sorts with regard to the rest of the market. Investors have realized that this is an unusual circumstance. And as a result it trades as if it’s its own asset class now. The Puerto Rico situation took many years to get here, there are large structural problems associated with pension obligations, OPEB liabilities, demographic trends, lack of national resources. And also I think the silver bullet associated with Puerto Rico, which I have yet to see a solution to, is improving economic activity. And until such time they can develop a plan that will initiate or ignite better economic activity, I remain very skeptical that the commonwealth will be able to solve their fiscal and financial problems, certainly in the short or intermediate term. So there’s been a lot of speculation about a resolution to the Puerto Rico debt crisis, and certainly bondholders have experienced a tremendous amount of volatility associated with the individual credits. My opinion is that I remain very pessimistic about certainly a solution in the short and long term for the commonwealth of Puerto Rico. And I think investors will unfortunately continue to see a lot of volatility associated with the individual credits that they own.
Gillian: And the graphic we have behind us is no better, a demonstration of said volatility, this particular one has to do with the bounce that happened in Puerto Rico bonds. But unfortunately after March 13th it appears that they’re back down again. So, Adam, you join us literally from the Halls of Congress on this point, tell us the latest.
Adam Bergonzi: Well, I’m going to keep my comments to the public, because we are involved. We have a significant amount of Puerto Rico exposure. Look, I agree with a lot of what Tom said. I think this is going to take a long time to fix. It took them over a decade to get to this point. I don’t see a quick fix or a silver bullet or anything even in any particular quarter which is going to turn this around. I’m not as sanguine that this is a debt crisis. I know that’s an unpopular view to go against what I think has been a common buzzword. I think they do have an absolute liquidity crisis. They are shutoff from the market, they cannot issue. That is having an absolute palpable effect down on the island. In terms of what you mentioned before, the fiscal plan that was accepted by the Board of PROMESA is not a debt restructuring plan. I think there’s a little confusion in the market and they’re saying, “Well, so, you know, there’s 25% available in the budget for bonds, that’s where we all start on various impairment.” That is not the case. I think this is a starting point. I analogize it somewhat to the early days in Detroit when geo bondholders were told they would get basically 10% recovery. And that was dependent in fact, on growth milestones. I would note that in this particular financial plan, they were specifically asked, they, Puerto Rico to leave federal funding for Medicaid out. That is a huge number.
So if you start talking about actually divorcing them from federal aid, that most states receive, which has not been the course that they’ve been working on over the last few years, I do think you have a problem. But I’m not sure we can expect that that’s going to continue. So I think that this is an early stage setting up of a discussion around what the island can afford. And we haven’t even gotten to a number of credits that were not really covered in that fiscal plan. The fiscal plan was really focused on the general commonwealth credits, not so much on the electric utility, the water and sewer. So you have to look at sort of the above the line impact of that fiscal plan. And the fiscal plan was silent as to priority, so whatever dollars are available, we still don’t know how they’re going to be applied. If we look to PROMESA, the statute, it says you must respect those leans and priorities. So again, I think there’s a lot left to be discussed. I think people like to latch on to that quick newsflash because it’s sexy and it sells. But this is going to be a long, long process. I think if done correctly it should be a long process. This should not be a quick process. And I also want to indicate, PROMESA, the statute’s goal is to restore fiscal accountability and market access. So I have a hard time understanding how you’re going to go from those type of draconian cuts to market access. The commonwealth will need market access. It needs it to grow. And they’re only going to get out of the problem they’re in if they do grow their way out.
Gillian: So market access and stimulation of economic activity, two big points here. You alluded to potential contagion; obviously the market you said has not been seeing this. But do you believe in the concept of credit clusters? Do you think that some of the actions happening in municipalities are having a contagious effect to others in the US, for example?
Tom Casey: I don’t think there is a tremendous correlation between them. We certainly believe that diversification of credit risk as well as geographic diversification is critically important in the construct of any individual client portfolio, unlike though this recessionary period that we’ve come through. If you look at economic studies you’ll often see that recessionary periods are localized or regional in nature. And as a result I think it speaks volumes about the need for diversification in the individual portfolio, not only in terms of sector, in terms of credit, in terms of yield curve distribution. And I think, you know, the avoiding the type of clusters is also an important component in terms of reducing risk in a client portfolio. I think there’s an opportunity set for … you mentioned Illinois earlier and Chicago. I think that you’ve seen some taint associated with the fiscal and financial problems associated with those two individual credits in other Illinois credits. So I think you can buy very, very strong credits in the state of Illinois, that are certainly are trading a little more cheaply than they should, given the problems associated with the state and city.
Gillian: Okay. And the same to you, what do you think about the concept of credit clusters? And to what extent will there be contagion versus won’t there be?
Adam Bergonzi: I have again a pretty different view. I think what’s happening in Puerto Rico is very important for the market. I think I bought the argument that it had less to do with the domestic market prior to the set up of the Federal Board to oversee, similar to what happened in DC years ago. I think you are looking at the federal government struggling with a unique problem in that they are a territory. But I think you could set a lot of these same facts up and look at any of the state stress that we’re looking at. I can make an argument that Kentucky, New Jersey, Connecticut and Illinois are sort of in the zone of harm. And could run into a situation, I’m not advocating they need necessarily Chapter 9 bankruptcy, but you could get to a point where if things are frozen enough, that someone needs to intercede. And I think that might be the federal government. You might see something similar to what you’re seeing down with the PROMESA Board. So I think this is a dress rehearsal. And the problem with clusters is you don’t know what they are today. It’s really easy to look back and see the interrelationship. But you know, Detroit water and sewer, this was a perfectly well secured revenue bond deal that ultimately got through relatively unscathed, but did get pulled into the bankruptcy. And it was even more remarkable in that the city was not the only credit there. They shared that credit with the other counties in that area. We’ve seen some of the impact of that in Michigan.
You mentioned before, Detroit came back to market. It really hadn’t come back to market. Detroit came back with a distributable state aid pledge from the state of Michigan. They have not come back on their own credit and probably shouldn’t come back on their own credit for a while. So I think when selectivity is back in the market and that has to do back again with the rate rise we discussed at the beginning of the program, I think you’re going to start having some winner and loser credits. I think it’s not going to be safe swimming for everyone as it’s been pretty much in this market since post World War 2, I think you’re going to begin to see credits that either are unable to access this market in a conventional way or are going to be able to access it but at a much higher cost than previously. And so that’s why I think, you know, right now, I’m not sure the market can technically respond in that way. But I believe that that is coming in the next few years. It may not be next year or two, but I think in the next five or six years, in a different rate environment munis are going to have a little bit of a crisis point in this regard.
Gillian: Speaking of winners and losers, it would be interesting to get your thoughts on what some of the winners of 2017 might be, what are you keeping your eye on?
Tom Casey: I think we continue to focus on revenue bonds and revenue bond subsectors. I think that there are many individual credits that I think are poised to do reasonably well. I think I’m hard pressed to predict a scenario in which income oriented credits underperform higher quality alternatives that trade more in line with the market. We do have an expectation that rates will increase modestly during the course of the year. But I believe that carry will be an important component of portfolio returns over the course of the next year. And I believe that fundamental research will be the backbone of strong performance in generating alpha in 2017.
Gillian: Okay, so due diligence is key. Adam, what are some of the opportunities you’re looking at, particularly among maybe some of those lesser known issuers?
Adam Bergonzi: Well, we define success a little differently; if everyone pays their debt we’re very happy. So to some degree performance isn’t probably the right way to think about it. But in terms of what I said before about us concentrating on what we think is perhaps where an underserved market where monoline insurance is still of value, it would be again on those idiosyncratic issuers, the once every three year issuers, there’s not a lot of liquidity in their name. Again, it may be a small school district, a small water and sewer or a land bond deal in California or Texas. We think this is where we basically shine, by rolling up our sleeves, doing the due diligence that maybe some of the other players in the market don’t have the time or the focus to do. And thereby assigning our insurance and giving that liquidity, that name support and the credit uplift, I think that’s where we’re focused right now.
Gillian: Okay. Tom, when you’re talking to clients that are interested in adding municipals to their portfolio, how would you advise that they fit in to the larger fixed income allocation?
Tom Casey: I think that they’re a cornerstone in many peoples’ portfolios. We consider it an anchor to win in the context of an overall portfolio that is devoted to a group of assets that have strong correlations or weak correlations with other asset classes. And I think that you can construct a portfolio that will produce a very, very solid stream of tax exempt income as well as one that can improve from a fundamental standpoint. I think avoiding the losers is critically important and also identifying state credits that are stable to improving, and are priced appropriately. I think the Municipal Bond market in general is one in which you can hit home runs. Our view at Standish is to avoid those individual incidences and try and hit singles and doubles. It’s a baseball cliché, but I think that’s why we’re hired in producing that type of income stream for investors that has correlated appropriately with other asset class is going to be a very, very important part of client success.
Gillian: Okay. Adam, we have referred to it slightly before, it has to do with the penetration of the market for bond insurers. What do you think has limited some of the growth of this market, and what is your expectation moving forward?
Adam Bergonzi: I think as I said before, the availability of the actual product from fewer providers, the hopeful stability of the Double A. I think it’s a Double A market now for monolines for the next decade at least. I think understanding as I mentioned, that folks are not familiar with the product that were familiar say in 2008. And so we need to reach out and sort of evangelize the product again and talk about where it works and why and prove up our value. And this tends to be a very conversation by conversation effort. So you have to meet with those who are pricing the bonds and convince them that they’re going to get better execution by using insurance in that circumstance. Clearly it’s a rates business. We need rates, I think to come up. That is a big issue. It’s certainly heading in the right direction. But it’s been at an all time low now for a few years. And that spread differential so that the investor, whoever they are, begins to see the belt and suspenders of the product being worth investing in versus holding onto that yield. I can’t spare that extra 5 or 6 basis points, whatever it is, I’m going to take without. You would think that with all the drama in the market and the credit concern, I think we’re actually well poised to be an important part of the market as a place to go to intelligently lay off risk as a buyer. So those are the things I think about when I think about the resurgence of the product.
Gillian: Okay. We’re coming toward the end of our discussion. So I want to give you each the opportunity to offer some closing remarks, both on the market generally, your expectations and really where do you stand out? What is your competitive advantage as a firm? So, Tom, I’ll start with you.
Tom Casey: Sure. We touched on at the beginning, what’s occurred over the last 10 years or so in the muni market has been certainly unique. I think the Municipal Bond asset class has proven to be exceptionally resilient. And I believe that there has been a lot of uncertainty as it relates to the Trump administration and the impacts on the Municipal Bond market. I would say that if you believe that the Trump administration will be stimulative in nature, less regulation. Pro growth, potentially lower tax rates, I think that that construct bodes very, very well for fundamental research, identifying, for example, special tax bonds, water and sewer bonds, those with a dedicated revenue stream, monopolistic power over a service area. And to the extent that economic activity continues to grow, these credits will improve. And populating a portfolio with an emphasis on those, I think will be critically important. I also believe that we are very constructive on the market. One of the reasons for that is being able to identify individual credits that are stable to improving fundamentally, individual credit research is critically important. Having an appropriately sized staff and having a trading breadth in opportunity to trade in large block sizes and participate in small idiosyncratic credits and also those which are attempting to utilize to position portfolios appropriately. And so I think that being conservative in terms of credit and displaying a degree of expertise in terms of portfolio construction and risk control will keep investors well suited.
Gillian: Okay, that’s great. Adam, same to you, how do you think the municipal markets will look when we get to the end of 2017 and have this conversation again, and why insurance?
Adam Bergonzi: I think you’re going to see continued gains among … in penetration of the product. I think the story of the industry is one that went through a tremendous challenge. And we are one of the firms that came out the other side. We’ve honored every commitment presented to us. We are built for the long haul. I think like Standish, we think of ourselves as a credit shop. I think that’s our value proposition that we’re going to get in and roll up our sleeves and apply our nearly 40 years of experience in this market. And I think this is probably the beginning of a mini golden age for bond insurance, where it makes sense, because that protection, that additional liquidity, having an institution like ours who is there for a workout, so that the bondholder doesn’t necessarily have to worry about that. I think those are the values that are sort of coming to the fore, after people digest the headlines, I think insurance has performed well in distress. And I think it’s worth a look.
Gillian: Well, gentlemen, thank you so much for taking the time to discuss this with us today. And we look forward to having you back in to see how all of the predictions fair at the end of this year. Thank you. And thank you for tuning in. From our studios in New York, I’m Gillian Kemmerer. This was the Municipal Bonds Masterclass.
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Bonds are subject to interest rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines. The amount of public information available about municipal securities is generally less than that for corporate equities or bonds. Legislative changes, state and local economic and business developments, may adversely affect the yield and/or value of municipal securities. Other factors include the general conditions of the municipal securities market, the size of the particular offering, maturity of the obligation, and the rating of the issue. Income for national municipal funds may be subject to state and local taxes. Income may be subject to state and local taxes for out-of-state residents. Some income may be subject to the federal alternative minimum tax for certain investors. Capital gains, if any, are taxable.
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