In this commentary, we will summarize where municipal
credit quality has been, where we believe it is today,
and what our clients should expect over the near term
investment horizon. The municipal market began the year
with a tumultuous first quarter, but managed a trend
reversal during April and May before leveling off in
June. Bond price gains were driven primarily
by investors who placed their trust in credit fundamentals
and recognized the values left behind by the abrupt
municipal bond fund sell off in late 2010.
The exodus of many investors from funds was motivated
mainly by concerns that fiscal challenges facing municipalities
would lead to “sizeable” bond defaults this
year. We disagreed with that extreme view and, as we
will highlight in this commentary, current data supports
our opinion.
Recently, the robust rally has tapered off despite a
continuing decline in new long term municipal bond issuance.
As part of our research we tracked the monthly average
dollar price of the Bond Buyer Municipal Bond Index
which is based on standardized prices for 40 large,
long-term municipal bonds with an average maturity of
28 years. The average monthly price rebounded from a
low of $92.07 (YTM of 5.749%) in January to $95.18 (5.647%)
in April and $98.76 in May (5.42%). For June, the index’s
average monthly dollar price reached $100.98 with yield-to-maturity
dipping to 5.21%. The index’s smaller gain from
May to June indicates a slowing rally as well as suggests
some possible near term price stability.
More concisely, in our view there were two major factors
supporting the recent rally:
| 1. |
Investors that
rode the wave out of municipal bonds returned
to the market as positive economic news dwindled
and skepticism increased over sustained value
growth in the equity markets.
|
| 2. |
Much of the speculation regarding
significant municipal defaults occurring in 2011
simply has not materialized. Our view on this
topic is validated, in part, by municipal bond
default data provided through Municipal Market
Advisors. The data shows that through June 30th,
there were $9.6 billion of outstanding municipal
bonds in which bondholders were missing a payment.
This equates to 0.26% of the estimated $3.7 trillion
municipal market1.
|
Further evidence supporting municipal credit quality,
at least from a macro level, is shown in the graph below.
The graph highlights the cost of credit default swaps
(CDS) on 10 year bonds of three states: California,
Illinois, and New York compared to rates on 10 year
U.S. Treasuries. Credit default swaps represent the
cost of purchasing insurance against a security’s
default. Essentially, the greater the perceived risk
of default, the greater the costs to provide insurance,
as concerns dissipate -- prices fall. The cost of default
insurance on the three states has declined considerably
since the beginning of the year, particularly relative
to the movement in Treasuries. This suggests investors
have become less convinced that these municipal credits
will default; instead investors have turned their attention
to the challenges of reducing the federal deficit and
to a greater degree the national debt ceiling, as evident
from the rise in treasuries. Furthermore, the chart
also suggests that when a state or municipality shows
a willingness to raise taxes or curb spending, the market
responds quickly and rationally. Notice how the CDS
market responded to the state of Illinois after it raised
the state income tax 66% in January 2011. On January
6th, 2011 the cost of insuring Illinois’s debt
topped out at 359 basis points, only to fall 62 basis
points a week later once the legislators had formally
signed the tax increase. Since January 6th, the cost
of a CDS on a 10 year state of Illinois bond has fallen
40.2% to 214.75 basis points.
Moreover, the 2011 Q:1 report on state and local government
tax revenue released by the U.S. Census Bureau indicated
tax revenues for state and local governments were up 4.7%
over Q:1 2010. This marks the sixth consecutive quarter
of positive year over year growth. Individual income taxes,
general sales taxes, and corporate income taxes lead the
way with year over year increases of 12.0%, 5.8%, and
6.3%, respectively. These tax increases in concert with
expenditure reductions are the key factors in balancing
budgets. In fact, on the heels of the Bureau of Labor
Statistic’s May jobs report, an Associated Press
story from June 6th, noted that “
more than 467,000
state and local government jobs have vanished since the
recession officially ended in June 2009, including 188,000
in schools.”
2
To a credit analyst, these figures are bittersweet, they
are certainly undesirable from an overall economic perspective;
however, they suggest that municipalities are willing
to make the difficult choices to balance budgets. How
deep the cuts will go and for how long will be predicated
on the course of the U.S. economy.
Near Term Credit Outlook
Despite a recent downgrade cycle in the municipal
market, we expect the improving market sentiment to carry
well into the summer. We anticipate headline risk to continue
to weigh on the municipal market and its investors, although
we surmise the preponderance of hard evidence to the contrary
should provide a sufficient counterweight. We believe
there will continue to be strong rhetoric from municipal
leaders on tax increases and spending reductions, particularly
at the local level. The degree to which either will actually
occur appears tied to the U.S. economy.
As we have pointed out
previously,
yields in the municipal market are transitioning away
from the very homogenous “AAA-insured” interest
rate sensitive environment toward specific idiosyncratic
issuer credit risk. While this movement may be a bit
unnerving to some municipal investors, it is a development
that ultimately will reward those that have carefully
followed our three pillars of municipal credit research.
Investors willing to accept incrementally more credit
risk will be compensated with a boost in yield. Conversely,
investors in longer maturities will be rewarded for
accepting the interest rate risk.
I invite you to attend our next webinar;
we look forward to circulating those details shortly.
Justin Formas, CAIA
Director of Credit Research
Bernardi Securities, Inc.
July 12th, 2011
______________________
1 Jennifer Galloway, “MSRB
Launches Twitter Feed to Disseminate Municipal Market
News,” 2011
http://www.msrb.org/News-and-Events/Press-Releases/2011/MSRB-Begins-Disseminating-Municipal-Market-News-over-Live-Twitter-Feed.aspx
2 Paul Wiseman,
“Usually a Job Engine, Localities Slow US
Economy,” June 6th, 2011, Associated Press
Archive.
