MASTERCLASS: Municipal Bonds - November 2016

Municipal bonds have seen record inflows this year, and the outlook for increased infrastructure investing under the new administration remains top of mind. Asset TV assembled a panel of experts to assess pockets of opportunity and risk in the municipal space, touching on the sector’s most popular topics, including pension liabilities and Puerto Rico.

  • Tom Weyl - Managing Director and Head of New Business Development at National Public Finance Guarantee Corporation

  • Jeffrey Lipton - Managing Director, Head of Municipal Research & Strategy at Oppenheimer & Co.

  • Jim Colby - Portfolio Manager and Senior Municipal Strategist at VanEck

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  • 01 hr 00 mins 21 secs
Gillian: Welcome to Asset TV, I'm Gillian Kemmerer. Municipal bonds have been top of mind lately, but where do the opportunities lie? With issuance hitting record highs we have assembled a panel of experts here to tell us a little bit more about the opportunities and the regulatory and risk landscapes. Welcome to the Municipal Bonds Masterclass. Joining me today are Jim Colby, Portfolio Manager and Senior Municipal Strategist at VanEck, Tom Weyl, Managing Director and Head of New Business Development, National Public Finance Guarantee Corporation, and Jeffrey Lipton, Head of Municipal Research and Strategy at Oppenheimer & Company, thank you all so much for joining us here today for our discussion. So it's an interesting time to talk about municipal bonds. I was reading recently in one prominent financial outlet, they called it the sleeper investment hit of last year. So I want to go ahead and look backward a little bit before we look forward. So broad strokes, and Jim I'm going to start with you, from the financial crisis until now, how have you seen the muni market change?

Jim Colby: Well, Gillian, since the financial crisis there had been some significant changes in the marketplace. I'll touch upon a couple. I'm sure my colleagues will have some other thoughts as well. But one in particular that has occurred, that's having impact right now has been in the short term marketplace. One of the structured financed products that gave rise to some of the real problems that occurred in 2007/2008 were oriented and destined for the money market funds and for portfolios that were leveraging their assets in order to increase yield. These products short term in nature were structured such that there were many different, many of obligors and many different structures that needed to stay in place long term for these things to be successful, and they fell apart. Without going into any great detail, they fell apart in 2008. What occurred from that point on was an exodus from the short term money market funds, investors in short term products and were managing these money funds lacked the same product, the same depth of product in order to continue to support the assets that were significant back in 2007 for example.

And when these structured short term vehicles left the marketplace, they were left without option in terms of delivering yield and a credible valuation process to those people who depended upon money market funds for their short term investments. The thing that really occurred was, the net asset value of these money funds no longer maintained par, they were no longer valued at 100 when that occurred, that changed structurally many, many, many things. So as we're speaking right now within the last two or three weeks we've just had a revisit of that, that discussion point with rules that now allow for the money market products to find their own proper value having floating that asset value. Maybe money funds will come back to, you know, to find the same kind of value that they had back in 2007/2008 with these new rules. But coincident with that, one other structural change that occurred was imposed upon the dealer community. The investment houses and banks, suddenly found themselves under scrutiny and a new set of legislation that caused them to shrink their balance sheets, caused them to find the inventories that they used to carry with the opportunities to bid for bonds in the secondary market, changed and reduced dramatically. So we had a shrinkage, if you will, in terms of liquidity in the marketplace, and that is had, I would say a significant impact upon what the market looks like today.

Tom Weyl: I would add that those are two very large changes. I think the change in liquidity is especially profound. I think a couple other things have changed, obviously I work at a bond insurer, at National Public Finance Guarantee, pre crisis there was nine bond insurers, we all collectively insured over half of the municipal bond market. Now there's three of us, and the penetration of the marketplace is down to about 6%. So that's greatly changed the nature of a lot of the bonds, it has to do with the structures that Jim was talking about imploding, and the differences in the money market funds that have changed over that time. And the second point is that we've had a large change in the retail component of the municipal bond market. You know, as we know, roughly 50% of the bond market was sold to retail investors pre crisis, that has come down a little bit, it's down to 40/45% now in the marketplace. More importantly, rather than individuals buying the bonds we have a lot more professionals managing separate managed accounts, high net worth accounts in the marketplace. And so it changes a little bit the nature of how the bonds are sold to those individual investors.

Gillian: So, so far we've talked a little bit about structural changes, we've talked about the change in retail cash flow. We have talked about the change in the number of players, particularly in the insurance market. Jeff, talk me through what you've seen since the financial crisis?

Jeffrey Lipton: So I think another interesting element to all of this, certainly given where interest rates are today versus where they were just several years ago, we are clearly in a very low interest rate environment. And the expectation is that we're likely to sort of settle in this fairly low interest rate environment and into the foreseeable future. And what we are seeing and identifying with is we've got a whole new class of non-traditional crossover buyers that are entering our marketplace. And quite frankly many of these buyers don't necessarily need or benefit from the municipal tax exemption. But given the fact that you've got near zero interest rates abroad, even negative interest rates abroad, coming into the municipal marketplace, here is a source of yield, number one. Number two, you've got quality, you've got portfolio liquidity, and you've got portfolio diversification. We also think that taxable munis are providing a very nice investment opportunity for those again non-traditional crossover buyers that are seeking the incremental yield. And they could be buyers abroad, but also we are seeing domestic buyers, for example life insurance companies which do not necessarily benefit all that much from investing in tax exempts. So they're largely building a portfolio of taxable munis. So again here is an opportunity to come into our marketplace, add a safety investment opportunity as well as portfolio liquidity and diversification.

Gillian: So in changing investor make-up is a really big point for you?

Jeffrey Lipton: Absolutely, absolutely. And we identified very closely with that.

Gillian: Great.

Jim Colby: Gillian, jumping in on the first point that Jeff was making about interest rates. Since 2008, after the spike in rates, and after the ... for the reserve, the [inaudible] Fed and other regulatory entities help settle the markets. And we entered into a period of extremely low rates. We had the emergence and here's where we had the emergence of exchange traded funds become an integral part of the municipal landscape. And ETFs were a structural change to the extent that for years and years and years investors were used to the mutual fund structure, money funds and mutual funds. And you had some choices and opportunities within those structures. But what the mutual funds, because of their fee structure couldn't support as well as ETFs was operating in a low interest rate environment. The fee structure for ETFs is dramatically on average, but dramatically lower than that of mutual funds. And we found ourselves at VanEck in the open position, I think, to introduce a new product into the marketplace. But certainly we weren't the only ones. So the emergence from a structural, a change point of view and the emergence of ETFs, I think was a significant change that occurred over that period of time.

Tom Weyl: I don't want to kill the issue, but they're bringing up some really good points and there's one last one that I'll mention. And we've all touched on it a little bit, and that's the changing composition of the investors in the marketplace. If you go back pre crisis, we had a lot less interest from banks now, so adding one more change in the composition, banks are one of the largest investors in municipal bonds over the last tree or four years. Much of it, bank portfolios at the centre of the bank, Chief Investment Officer level buying bonds, but we also have a phenomena of a lot of direct investment in the form of municipal loans going directly to municipalities, going to hospitals or higher [inaudible] facilities, really replacing what was that short term money market product that Jim mentioned earlier. And so again the composition, the investor rates has changed dramatically between these four investors, these other investors who can't use the tax exemption, the changing retail component, the addition of ETFs and the change in the nature of the banks participation.

Gillian: And this was a point I was going to drill home with you as well which is that we had 54 straight weeks of inflows this year, we just only recently reversed that, but for a week. So I'm curious to know how this has changed the dynamic a little bit, the influx of international buyers is really interesting. Jeff, can you talk to us a little bit about how the composition has changed further?

Jeffrey Lipton: Yeah, I mean, you know, again, if you look at 54 consecutive weeks of positive flows, I think that's extraordinary. I think the record was made, I believe in 2010. You know, last week we turned positive again. You know my feeling is there is a few things going on right now. You've got a number of uncertain elements that are underlying the marketplace. You certainly have the presidential election, there's, I think, concern and anxiety there. You have the Federal Reserve, which is meeting today and tomorrow, and the expectation is that they probably won't raise rates in November. They're more likely to raise rates in December. I also think that as we move forward into 2017, this whole issue of Brexit is going to be much more of a headline item. I think right now we are starting to see the emergence of some relative uncertainty abroad, the Bank of England Governor, Mr. Carney, it looks like that he has now agreed to stay on through 2018 if I'm not mistaken. I think he is not going to sign on for the full eight years. And I think the idea is that he wants to be present as the UK makes its separation from the EU. Again, there's just a lot of uncertainty.

Certainly we can talk to some extent about tax reform; Hilary Clinton has her own agenda for tax reform. Donald Trump has his agenda for tax reform. I think each individually would have its own significant impact upon the municipal market. So when I look at 54 weeks of consecutive flows, positive inflows, I'm really not bothered all that much when we have a sudden disruption in that trajectory. Also we have to keep in mind that certainly over the past two weeks, and we've had a supply build in our marketplace over the last couple of months. But certainly over the past two weeks, we've marketed, I think, something between $30 and 33 billion in new issue product, and that's quite a bit. October we know is one of the top issuance months, 2016 I think is poised to set a record issuance year. The record previously set in 2010 with $433 billion in total issuance. So I think 2016 is certainly poised to break that record. So again, you've got all of the unknowns or the uncertainties that are contributing to the market anxiety but you also have somewhat of a top heavy supply issue that's currently underlying our marketplace.

Gillian: Absolutely. And Tom can you give us a little bit of your thoughts on the issuance expectations for 2017? We've just had a really hot month, are you expecting it to continue?

Tom Weyl: Well yes, it certainly looks like it's going to for some time. I think one of the issues in the election and one place where we have some bipartisan agreement is infrastructure. And I know we’ve had an infrastructure deficit for some time. And I think there is pent up demand there. But we still have the overhang of the credit crisis and governments not wanting to issue a lot more debt. But I think we have a need, a compelling need that the low rates are helping to bring that need forward, and people are thinking about that. So what we've seen over the last several months is I think a little bit more of new money than refunding in the mix of this issuance. Obviously the low rates are having a dramatic effect on existing bonds outstanding. And we've seen for the last three years a lot of refunding activity, not a lot of new money. Though what's changed the last several months, or what's leading to the volume that Jeff’s talking about is much more in the way of new issue, new money in the marketplace for infrastructure. The question is how much can that be in the next several years? Now, I think we believe the fundings are going to taper off a little bit. We've got less bonds out there that are refundable, especially as we enter 2009 with the BABs that were issued starting back in 2009, which most of them are not callable. So you're not going to see a lot of refundings in that sector. So I think what we're looking at is probably going to top at a record level and come down probably to the mid 300s next year. But it's really anyone's guess which infrastructure transactions come forward, and that’ll drive the number.

Jeffrey Lipton: And that level is the more normalized level in terms of issuance. No one could expect that we're going to have these 400 billion plus years in perpetuity, that just really doesn't make sense. Speaking about the infrastructure needs in this country, and I always come back to this and I try to make the point of it when I talk to our retail FAs and our investors, that if you don't have a competitive sound infrastructure investment in your country that then becomes an issue of national security. So it's one thing to be competitive. But when you look around and you see the state of our airport and you see the state of our highways, and our bridges, and our tunnels it is clear to me that, you know, this does become an issue of national security. So I think it is very important that we do invest the money. And my hope is, my expectation is that as we get a new administration in place, there's obviously going to be, or the hope is that there's going to be a sort of a federal funding vehicle that state and local governments can leverage off of. And maybe that becomes an infrastructure bond bank of sorts, but I think then, I think state and local governments really have to pay attention to this. And quite frankly I think the unfortunate accident that had occurred in Hoboken just a few weeks ago, I believe, my humble opinion, that that's what served as the motivating force in terms of getting Governor Christie and the legislator to agree on the gas tax hike. Again, that's infrastructure centric and my expectation is that we should see more of that going into 2017.

Jim Colby: Gillian, one of the points that I just want to circle back on, we’re talking about supply and future supply. And the supply demand equation in the municipal marketplace is a very interesting one. We've had 54 weeks over the course of a couple of years here, 54 consecutive weeks of inflows. And really what does that mean when you break it down? And we try to tell our clients that in the normal course of municipal supply coming into the marketplace, very often we reach a [inaudible] we reach an equalization point. The demand comes into the muni marketplace from bonds that are called, the mature interest, coupon interest payments that come into customer accounts, create the demand and for the past, you know, three or four years has created enough demand to keep performance strong in the municipal space. One of the features that has created additional demand that accrues to the good performance that we've had over the last two and a half/three years, is the relative value of municipals to other asset classes and other fixed income asset classes. The easy one to default to is the municipal treasury ratio, the yield of triple A rated municipal bonds to treasuries.

Gillian: I believe it hit 97% last week.

Jim Colby: Last week and over the last two or three years, we have had times when that ratio, that percentage ratio is north of a 100%, which means you don't need to assess any taxable equivalent value to the munis because they're yielding as much as treasuries, if not more. So that's one of the value propositions that we at VanEck talk to our clients about, or trying to make them aware of why are munis, you know, a good asset class to hold on to and to pay attention to. So I think that, you know, supply really for our marketplace is a welcome topic, it's a welcome issue. And if as Tom was alluding to, we get out of the election and reformation of congress, some package to support infrastructure. As Jeff alluded to, we really need the infrastructure to be improved, to be made solid for economic reasons as well as national security reasons. But that will be good for municipal bonds because it attracts traditional buyers as well as non-traditional buyers.

Gillian: How is the...

Jeffrey Lipton: I just want dovetail something that you had said again, looking at that muni treasury relationship. As our market gets cheaper relative to treasures, again that serves to invite in a lot of the crossover buyers, foreign buyers. So again that's a relationship that we pay very, very close attention to, and that really speaks to the, you know, the underlying supply demand dynamic that has really taken hold of our marketplace for so many years.

Gillian: And how have we seen the shape of the yield curve change in response? I know,Jim you have a lot of things to think about when you are assembling your products, how do you think about where the opportunities are along the yield curve?

Jim Colby: Well, we actually take that relationship, Jeff was alluding to, the ratio of municipals to, not just treasuries, but other asset classes. We have, at VanEck we have a suite of municipal ETFs that span the yield curve from short to long. And what we do is we look to see whether or not the valuation of the yield that is produced by any one of those ETFs happens to look more attractive at a point in time relative to cooperates or dividend equities or other asset classes. So we chart that, we chart that relationship. The reformation of the yield curve, [inaudible] yield curve over the last six/seven weeks has been pretty dramatic, you know, 25-40 basis points may not sound like a big move, it happens to be a big move in our industry. But it’s certainly enough to cause a steepening of the curve, the spot we feel very confident about in terms of recommending is the intermediate part of the curve, 12-17 years right now happens to offer one of the best incremental yield opportunities year to year and relative value to other asset classes.

Gillian: Great, perfect. So I'd like to transition our conversation a little bit to let’s say some pockets of credit challenges and some opportunities. Pension liabilities, I think we have to start there, it's something that has really dominated the financial media and with good cause. So I'd actually like to incorporate a viewer question on this point, from an Asset TV viewer that wants to know a bit more about how we can deal with a significant underfunding of pension plans.

Viewer: Given the significant underfunding of public pension plans and the new reporting requirements, do you expect a greater number of downgrades in the near term?

Gillian: Tom, do you want to tackle this one first?

Tom Weyl: Sure. I think the downgrades have already in some cases started. I think we can continue to see that. I don’t think … and it’s really a long term issue. And I think certainly the reporting changes are going to accelerate the view on this. I think our own approach at National is that we look at all liabilities. And so I think pre crisis some people didn’t really look at their pension liability. I think now some people still aren’t focused on the healthcare liability. I think when we evaluate a transaction, when we evaluate making a 30 year guarantee of a bond issue; you really have to take into account all the liabilities, the debt liabilities, all the long term liabilities. You have to look at unfunded pension liabilities. You have to look at the OPEB. And sometimes it’s OPEB, the healthcare liability that’s a larger problem because it’s growing faster. And has a little more potential to crowd out the typical government services. But it is an issue people have to look at as both of those numbers rise, the unfunded pension and the OPEB liability. You’ve got significant risk in many areas of that crowding out of municipal services. And then the government has to act. Now you’ve got some states like California where there’s not much government can do. In Illinois we’ve had courts striking down both the changes to OPEB plans, to healthcare plans and to the pension plans. And so you have other states, like Oklahoma, I think recently just had a court ruling in its favor for changes it made to a plan. So everyone’s going to have to work that out over time. These are 30/40 year issues or longer. And it took a long time to get into trouble, we’re going to have this theme in some other credits we’ll talk about I’m sure, took a long time to get here, it’s going to take a while to get out. In the meantime, ratings volatility will be higher.

Gillian: Great, Jeff.

Jeffrey Lipton: Yeah. I mean I remember, you know, I was at another sale side firm about 20 some odd years ago. And this sort of always started to be discussed. And people were saying, “Well, don’t worry about it, this is going to be a real issue, a problematic issue 20 years from now.” Well, guess what, let’s fast forward, here we are 20 years. And we’ve already seen this coming home to roost. And I totally agree with what Tom is saying because this is going to be a longer term issue. And the question for municipal credit analysts is, well, what are the sort of the trigger button issues that we want to look at? And we can kind of parse out that there’s a distinction to be made between state credits and local credits. And I think at the end of the day we don’t see unfunded pension liabilities in and of itself as a factor that’s going to lean to lead a particular state into default. Now, as we all know, states right now cannot access Chapter 9 Bankruptcy. They are precluded from filing for bankruptcy. But state governments can certainly go into default. Now, we look at states and we think that the states have the fiscal wherewithal and it becomes the willingness to pay, you know, versus the ability to pay. So we think certainly state governments do have the ability to pay.

In Illinois, unfortunately we are starting to question the … I don’t want to say the willingness so much, but there’s just such political upheaval between the governor who is a republican and the legislative branch democrats, that they can’t seem to agree on very much these days. I think the state of Illinois can certainly experience further credit downgradings for their credit erosion. The question becomes, do we think the state of Illinois can fall below investment grade? I don’t want to say absolutely not. I think we are a long way from that point presently. But again, there are a number of tools in the toolbox that states have at their disposal, they do have effective cash management tools, they do have limitations in terms, to varying degrees, in terms of how much debt they could have outstanding. Again, to Tom’s point, I totally agree that you kind of have to look at the overall debt profile. It’s not just enough today to look at how much outstanding debt there is. You have to lump on top of that other fixed costs and then when you factor in the OPEBs, and the OPEBs, they tend to be pay as you go in most jurisdictions. So that then becomes the wildcard that I think the OPEBs become the next chute to drop.

So again, since this has been going on for 20 years, I think state governments certainly have had enough opportunity to really get their arms around the issues. The question is can they make the very difficult choices to address these liabilities? Local governments, they just tend to not have the same budgetary flexibility. They tend not to have the types of tools in their toolbox that state governments have. Again, if there’s going to be cutbacks, who is likely to suffer first? Well, if it’s going to be state cutbacks, local governments are likely to suffer first. And then if you have a limited employment base that also factors into the potential for credit erosion on top of these unfunded pension liabilities, on top of social services and education spending. So we pay very close attention to local governments and what this all means for them.

Gillian: You mentioned Illinois and Chicago and I want to come right back to that. Jim, just high level, how do you think that investors are looking at the threat of these underfunded pensions within our portfolios, underestimating, overestimating?

Jim Colby: I think for a long time they have underestimated, and not been acutely aware of the impact or the immediacy of solving some of the problems, like Jeff, 20 some odd years I was at another firm where, we analysts were raising the flag about this particular point. And I know it was a topic of discussion, but not one that anybody was willing to grapple with at that point in time. And from a high level point of view I would say that coming out of the recession I think one of the things that is popular and positive about the muni asset class is how resilient it has been overall through downturns and the taper tantrum and things like that. And credit quality has not diminished appreciably to the general viewer of what’s going on in the municipal marketplace. And I think I have often wondered, while things are okay, if we’re in the midst of an economic recovery, why haven’t we as market participants seen more issuance? Back to the infrastructure topic, why haven’t we seen more road repairs programs and the schools rebuilt and water systems refurbished? And then I think about the unfunded pension liabilities that exist, very much a topic of discussion and awareness for politicians, whether it’s state or local. And they may be saying to themselves, “Now we’ve got to make a choice. What are we going to do? Are we going to not commit capital, are we not going to commit taxpayers money to these projects that we need to get done? And now we’ve got to figure out a way to support our pensioners.” So from a 40,000 foot level, it makes me wonder whether or not that’s of course bringing us to this point in time when pension obligations are very much a topic of discussion and doesn’t really dovetail with the issuance in question.

Tom Weyl: I have a slightly different take and slightly different answer to your question. It’s actually almost a commercial for Jim. I did mention earlier the move in the retail sector to manage munis. And I think that’s … one of the reasons you’re seeing that is because issues like the bond insurance industry and what happened pre crisis, the post crisis and issues like pension and OPEB become too difficult for the individual investor to analyze. So instead they hire professionals. They move more into ETFs now as an alternative for the old individually owned municipal bond portfolio. They move into the separately managed accounts into other areas. And I would add also they should look at insured bonds, because all of these different asset classes now all have professional staffs of experts to analyze the credits. And then have a large portfolio, so you have a distribution of different risks that you can then use to augment any one problem that comes up. And so I think that’s one reason why we saw the trend toward managed munis, and that will continue because some of these are too difficult for the individual investors to analyze. And so they should move to ETFs to separately managed accounts and they should always buy insured bonds.

Gillian: Lovely, great points. Go ahead; did you have something to add?

Jeffrey Lipton: Well, I just want to add to Tom’s point, I think my perspective might be somewhat interesting because I have spent time on the sale side as well as on the buy side. And it really is amazing how when you’re on the buy side what your views are with respect to the municipal bond insurers. So, yes, we are on the buy side and we’re looking at a particular bond, we would prefer, again, on the buy side not to have that insurance policy in place. We would roll up our sleeves, get down and dirty, and conduct our own analysis and benefit from the incremental yield. Again, back on the sale side, it is amazing just how many conversations I have with retail FAs as well as retail investors, who understand where bond insurers have been, where they were in 2008, 2009, and where are they are today and where they want to be. So it’s been an educational process. And I talk to a lot of people, actually go out and they parse through the websites, which I think is a wonderful thing. I mean there’s just so much that I can do in terms of providing the time and the information, the fact that they independently go out and look at the website and they are trying to educate themselves. And I think municipal bond insurance penetration is somewhere north of 6%.

Jim Colby: It dropped below 6%.

Jeffrey Lipton: It dropped below 6%. If I get asked the question, “Well, where do we think we go from here?” My typical answer would be, “Well, I could see a 10%, maybe a little bit north of 10%.” I don’t think we get back to the 60/65% market penetration. But then again we have less players in the marketplace. So the view that I have on, well, how do the bond insurers grow market share? I think that’s going to be largely driven by retail because I think it’s a nice belts and suspenders approach. Again, I don’t see the institutional audience per se necessarily supportive of the bond insurers. And maybe you have some additional color on that.
Tom Weyl: Well, I don’t think there’s anything wrong in what you said. I think that, especially the institutional investors with a good deep staff in this low interest rate environment, they are looking for more incremental yield. I think though as a former 20 year buy side credit analyst and Director of Research, I think there is a portion of a portfolio that were insured always makes sense. And I don’t think it’s 6%. I don’t think it’s 50%. I think the number is a little higher, it’s in the teens, it’s closer to 20%. I think there’s good room, both institutional and retail for that. I think it’s one, a function of rates right now. And two, it’s actually interesting, because of the unique nature of the product and the way we fell off after the crisis, when it was only one insurer actually writing bond insurance, we actually have to reeducate the market, as you’re talking about. There’s a lot of new people we need to talk to. Think about all the generation of bond underwriters, traders, credit analysts who came of age in this business post crisis and don’t understand what municipal bond insurance has to offer and what we’ve done over the years. And so if you look at the marketplace right now, there’s really probably 10-15 more points of penetration, even at these low yields on transactions that would make sense with bond insurance, and investors that would buy them because of the supply demand imbalance right now.

And the demand for bonds being so high that you can sell, even if the investors would rather have that 10 extra basis points in yield, or 20 extra basis points without the insurance, they still buy the bonds. Over 60% of the bonds that are insured with our name were bought by institutional investors. And they’re buying them up on any bond issue that’s sold. So I think the future is good. It’s not going back to 50% and 100 basis points in extra yield in the marketplace would help all three firms greatly.

Jim Colby: Well, I think, Tom, if you get to, you know, 10 or 15%, there is a place for your product embedded in the ETF structure. We just need more product to make it work, but there’s certainly no reason why.
Jeffrey Lipton: More product, higher rates.

Jim Colby: Higher rates.

Jeffrey Lipton: That’s the key, right, absolutely.

Gillian: So let’s talk a little bit about Puerto Rico, it’s a bit of a pivot, but it’s one of the most important spots in the municipal bond market right now. Puerto Rico earlier last month in October made a claim and a fiscal plan to its oversight board that it cannot pay its debt service in the next 10 years without help. Jim, starting with you broadly, how have you looked at your Puerto Rico exposure?

Jim Colby: Well, Puerto Rico at its height had issued something north of $70 billion in bonds in the marketplace. And because we run two high yield municipal ETFs, it had a very prominent place in our indexes and thus in our portfolios. And in fact going back one or two years, it was part of the investment grade products as well. So we paid very close attention to Puerto Rico because of the uncertain nature of its finances, its relative instability of its government and its policies. And as the deterioration of the credit forced prices to begin to plummet, raised awareness, I mean, Puerto Rico was in the headlines every week, if not, almost every day, as new revelations about the instability of its credit worthiness and the inability of some of the local issuers to collect their taxes, their revenues, meet their obligations. We’re very concerned about how it would impact the ETFs. At one point in time, Puerto Rico as an issuer represented more than 25% of the reference high yield index that we were managing too. And that was unsustainable and unreasonable for anybody thinking to invest in our high yield ETF. The index manager, fortunately he decided that it made sense to reduce that exposure, the explicit exposure in the index, which meant we could reduce our exposure in the portfolios. It was a concern and certainly one that we needed to talk to our clients about on a regular basis to let them know we were paying attention. This is not an actively managed product, so I wasn’t actively buying and selling, you know, those securities as much as monitoring what the positions were and trying to make informed, if not, sensitive decisions with respect to what we held and how much we held.

Gillian: Absolutely. And we’ve seen their assumptions of future cash flow consistently being revised on the downside. So, Jeff, I’m curious to know how you’re thinking about Puerto Rico right now.
Jeffrey Lipton: Yeah. Puerto Rico is an interesting sort of quandary for us. And I guess at the end of the day we’re really not sure just how many credits are going to be involved in this broader restructuring. It seems as though now that the general obligation bonds have actually gone into default, you know, that was sort of the, you know, viewed as the quintessential credit, among Puerto Rico credits, it had the constitution protection.

Jim Colby: And still may be as we go through this.

Jeffrey Lipton: And still may be … and still may be, although, you know, I do have people that say to me, “Well, what about the COFINA credit?” Which is the sales tax backed bond, right. I mean wasn’t that sort of the darling among Puerto Rico credits? And you know, I kind of understand that because just sort of the given that the credit construct and the fact that you’ve got this lockbox mechanism. And then you’ve got the senior leans and you’ve got the first subordinate leans, and you’ve got both resolutions by the way throwing off a, you know, a fair amount of coverage. So historically speaking, you know, this was the credit that everyone really gravitated towards. So now the question becomes and, you know, I don’t think this is the appropriate form for me, to kind of give my prognostications on specific Puerto Rico credits. But something that I am thinking about is, okay, well, how broad is this restructuring going to be? But what I will say about Puerto Rico is this; it’s great that they now have a mechanism in place, thanks to the US government, where they can restructure their outstanding debt. We’re still looking at the Prepper credit to see, because they’re sort off on the sidelines, working on their own independent restructuring. And there’s just been, you know, a number of litigation issues that’s sort of undermining that and preventing that restructuring from coming to fruition.

But they can restructure, in my humble opinion, Puerto Rico can restructure all of the debt that they want to without addressing the economy and without introducing economic growth engines. It really doesn’t matter. They have to stop the bloodletting in terms of the population out migration. I think they have to more proactively … the government has to more proactively go after the underground, the informal economy which represents about a third of the economic base. They have to come up with a way and I firmly believe that this is going to require the participation from our congress and from the next administration. We have got to come up with a way to create an attractive environment for corporations to want to come back to the island to make a decision to do business, with the elimination of the 936 tax benefits, which largely was sort of a tax incentive program for manufacturing companies, largely pharmaceutical companies, that was phased out over a 10 or a 15 year period. So they have to come up with a way to attract a corporate presence back to the island. So restructuring that, that’s only part of it, that’s not all of it. Without addressing the economy it doesn’t matter.

Gillian: Yeah, great points. And, Tom, do you want to add anything?

Tom Weyl: Yeah. Lots of talk about here, I’m going to turn it back to your original question. But before I do that I’d just like to say that National does have exposure to a number of the credits that Jeff just mentioned. And we’re not going to touch on those specifically. But I think I’ve been involved in Puerto Rico credits for 15/20 years. And I’ve only been at National for two. So I’ve got, you know, some knowledge of what’s gone on there as Jeff’s just described. And I think it’s mostly correct. With the governor’s pronouncement, understand that two years ago the same governor said, “We cannot default, it’s illegal, we cannot possibly default.” And so we just have to take comments like that in the manner he’s using them and in the political theater of what’s going on between unions, the taxpayers, the ratepayers, the folks on the island, the board, congress. They’re the new Promesa Board and all that. And understand again that there’s an election going on down there, and most likely whatever this governor’s proposing will be changed. And some of the advisors will change. And so it’s a dynamic situation down there. But more importantly, I think, I’ve always looked at it as more of a liquidity problem and an economic problem. I have never really viewed it as a debt problem. Debt became a problem because of the continued shrinkage of the economy. And so over time that became a piece of the issue, part of the issue, but I’ve never really thought attacking the debt alone solves their problems down there.

I think what I like about Promesa is I’m not … I don’t think of it as a restructuring board, I think of it more as … although that will end up being a part of the process, I think it’s more important that we get, similar to New York City, similar to other situations in Washington DC, to where we get another level of expertise on the situation to tell us what’s really needed here. And is it really debt restructuring? Because again, many of the different pieces of debt, the Prepper as you mentioned, [inaudible], the highways, have their own utilities effectively. They have their own dedicated revenue sources. Their revenues cannot be taken and moved as maybe we’ll find out in court whether the highways could be taken the way they were. But the fact is, many of these are self-sustaining entities that have their own revenue sources. They can pay their debt, okay. So that takes that off the table. When it comes to the GO debt, legally that is the highest structure in the commonwealth. Their commonwealth constitution purportedly, this will be tired out in court, and this will be tried in front of the Promesa Board, purportedly they pay their debt first, they pay other expenses after that. They’ve actually … that’s the constitution; they have actually passed the law that prioritizes different payments at different levels, that again has the debt being paid first. And so they are ignoring that right now, this will all be resolved and we’ll find out. But I think overall over time there’s a right level of mix of economic measures, fiscal measures, management measures and perhaps debt restructuring that’ll fix this. Without the economy coming back it’s really hard to say how much of it matters and where it goes.

Jim Colby: One of the interesting things that still is a part of the discussion about Puerto Rico credits is the triple tax exemption. For the bonds that are still paying or able to pay coupons, could maybe come January 1st, there will be some coupon payment made and that will be still triple exempt. That is one of the points that accrues to Puerto Rico and other territories that issue bonds. But it’s one of the reasons why it found itself in so many different portfolios across the country and cross different asset managers. Since the default, I haven’t heard anybody talking about, does the tax exemption still remain in place if they do a restructure? And if it does, it speaks to one of the reasons why this is such a hotly contested item and will be hotly contested issue when the courts are allowed to continue the adjudication.

Gillian: And it’ll be interesting to see how that continues to play out. I feel like we could devote an entire masterclass just to Puerto Rico [inaudible]. Staying on the geographic point but I just want to move a little bit to risk and diversification before we go. I’ve got one last viewer question for you and it has to do with the contagion across geographical … across geographies and in terms of how we deal with credit clusters. So let’s listen.

Frazer Rice: Hi! I’m Frazer Rice at Wilmington Trust. We’ve seen downgrades by rating agencies with issuers in various geographies that may have systemic issues, even there may be legal entities that are separate. I’m thinking in terms of Puerto Rico, Detroit and Chicago, what do you do in terms of defining clusters of risk? And do you look at geography as a group setting in terms of how you look at that risk?
Gillian: Anyone want to tackle this one first?

Tom Weyl: Sure.

Gillian: Go for it.

Tom Weyl: We absolutely do look at geography and take that into account when we’re evaluating credits. And we have limits to individual names. And we have limits for regions and even when there aren’t set limits it’s a discussion at a credit committee level, or even before we think about insuring a transaction do we want to add exposure in this area given the economic risks etc? One of the lessons that came out of the recession and the events in what the bond insurance firms went through is that you can assume you’re always going to be growing, and a rapidly incremental growth in your business over years will make positions look smaller over time. And so you have to think about what the future looks like and what’s the right level of risk to put on in a certain area with a certain name. And so that is now a large part of … imagine all the bond insurers’ portfolio mix, I know it’s the case at National.

Gillian: Jim, how do you think about geographical diversification within your products?

Jim Colby: A little bit differently, and that’s really just because of the structure of the products that we manage at VanEck. And ETFs are highly diversified. The indexes are thousands of different securities in our portfolios trying to mimic those indexes, end up with hundreds, if not thousands of line items as well. So for the active portfolio manager and I was one of those at one point in time. It’s a hard question to deal with. You do have to look at geographical representation. Where does the supply come from? Where is economic activity improving or diminishing? For the ETFs, we’re looking at the indexes. And the indexes say the issuance of the state of Florida represents a .5%. The issuance coming out of New York State represents 9.3%. We manage those portfolios to those characteristics, taking away sort of that active thought process, if you will. And it’s just one of the features in ETFs, you’ve got broad diversification. You have geographic representation based upon the traditional supply of bonds coming out of the different areas. So, I’m thinking, I put on my active hat and say, “Yes, it makes a difference, I don’t necessarily think that there is contagion, Detroit to Chicago or New Jersey to Illinois. But knowing that there are regional ebbs and flows of economic activity does lend some credence to the notion.
Tom Weyl: Right. To differentiate us just slightly is, because bond insurance penetration is always 6% of the market, we can, if we’re not watching that, we can get treetop exposure in areas that may be problematic because of self-selection or selection bias, and what goes to the insurance marketplace which is the direct opposite of what you’re going to see in a national ETF.

Gillian: Sure. An important distinction, and Jeff.

Jeffrey Lipton: So the way I would look at it, I work with a retail system quite a bit in terms of helping them structure individual municipal bond portfolios. I will also take a look at municipal bond portfolios held away from Oppenheimer & Company, very standard, we do that all the time. So the way I kind of look at it is I will look at a portfolio and for example, let’s not pick on New Jersey, but I’m going to pick on New Jersey. So the portfolio may have New Jersey general obligation bonds. But the portfolio may also have certain school district bonds issued from within the state of New Jersey that may very well benefit from the school bond reserve. So the issue that I have there is, so I’m looking at from a diversification point of view, how much exposure is directly linked to the state’s general fund. And in many instances for me, it’s an educational process because a lot of people don’t necessarily understand the nuance or the distinction. They may think, well, it’s a local school district, totally separate and distinct from the state. That may not necessarily be the case. Another case in point, if I’m looking at a New York portfolio, what is the percentage exposure to New York State’s general fund? So I may be looking at a number of school districts issued from within the state of New York that get a certain amount of state aid. So again, that’s state general fund related but in my mind I kind of lump that all together saying, “Hey, here is your sort of full exposure to New York State or here is your full exposure to the state of New Jersey.” So that’s what I’m attempting to do as I’m going through these portfolios, because again we want to be in a position to recommend sort of diversification options for our clients. And I think that’s very, very important.

Gillian: I can’t believe I’m about to say this but our conversation is coming to an end. And it’s been a great discussion. But I want to give each of you the opportunity to give us maybe 30 seconds of your final thoughts, one thing that you really want viewers to take away from this discussion about the municipal bond market moving into next year. So, Jim, I’m going to start with you, what’s your final thought?

Jim Colby: Well, I would say, I touched on it earlier, that this marketplace is very resilient, despite the [inaudible], despite some of the headlines that suggest difficulties. The municipal marketplace is 3.7/3.8 trillion, whatever the number is, deep, representing municipalities and issuers that they are trying, they care that they meet their obligations. And that it’s a complicated asset class to be involved with on a personal level. And what we’re trying to do with an ETF is simplify the process, you know, provide a spot on the credit spectrum, provide a spot on the yield curve, find your comfort level and not worry about, you know, the day to day judgments that you may read about in the paper.

Gillian: Perfect. Tom, final thoughts.

Tom Weyl: Well, I think very similar to Jim’s point, it is a very resilient market. Whatever happens in the election, whatever happens as The Fed tightens as we move forward, as supply and demand changes, governments do a good job of managing what they do, providing services to the people and pay debt service back. We’ve seen some situations like Detroit and Puerto Rico and I still think those are the anomalies in the marketplace. And there’s not a lot of systemic risk out there. People should be comfortable with a rising rate environment. They should understand if they’re buy and hold investors, which most individual investors are, that they’ll get their principal back at the end. And the final thing is and Jeff mentioned this earlier, we didn’t talk about it at all is, I wouldn’t be too concerned about talks about tax reform, we will take a lot of time up in the marketplace in the next year, two years talking about tax reform, who’s ever the president. But as long as congress is divided, it’s very difficult to get anything done because the fundamental differences between what the democrats think about the tax reform and what the republicans think about. So there’ll be a headline issue, but with divided congress it’s not a likely issue to worry about.

Gillian: So one time to maybe rejoice in gridlock.

Tom Weyl: I guess, gridlock is good.

Gillian:ow, And, Jeff.

Jeffrey Lipton: Yeah. I mean I would just add that, yeah, as an asset class I think most people, even those people that tend to be less sophisticated, they could identify with, they can relate to municipal bonds. You know, they’re driving on the roads, they go in to their local hospital, they’re sending their kids to the school, they’re utilizing the area airports. And so much of this, so much of this infrastructure is financed with municipal bonds; this has been going on for a long, long time. And guess what, this is going to continue out into the future. And it’s a great way to invest in our infrastructure. Again we’ve sort of talked about this quite a bit in today’s discussion. And unless you invest in your infrastructure then I think you put national security at risk. I keep coming back to this portfolio diversification, I think that’s very, very key. I think you have to understand what it is you own in the particular portfolio. And there’s a lot of good sectors out there. There’s a lot of sectors that have been getting hit by negative headlines. But it’s a matter of sort of picking and choosing, and this is where we could help as providing research support to our retail system, you have to sort of pick and choose. I think the power of the internet and with the power of the internet it’s become easier for people to look at offering documents themselves.
They can go out to the EMMA website which is a repository for municipal material event notifications, financial disclosure documents. And I am always amazed just how many of the folks in our retail system that actually go out to the EMMA website; they pick apart these financial statements. Now, they may not necessarily be all that well versed in terms of understanding what the presentation is showing, but at least they’re making an effort to go out and look at this information. So before they come to me they have some general sense of what it is they’re talking about. And it helps them to better formulate the question for me. So again I think it’s a great asset class. It’s one that’s not going to go away and it’s just so easily identifiable.

Gillian: Perfect. Well, thank you so much for taking the time to discuss with us; we really appreciated sharing your viewpoints with our audience. Thank you so much for joining us on this edition of Masterclass.