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February 2017
By Ronald P. Bernardi
10 year Treasury and S&P 500

This chart demonstrates the volatility of the 10 year U. S. treasury bond since the beginning of 2016.

This volatility causes anxiety for many and understandably leads to several questions:

  1. Will long term bond yields increase as the Federal Reserve Bank increases its overnight lending bank rate?
  2. Should one invest in bonds now or wait until rates rise further?
  3. What is a proper equity/bond asset allocation given this volatility?

These are pertinent questions and are often posed to our Investment Specialists and Portfolio Managers during the course of a week.

The matter at hand of this writing is to share our thoughts with you regarding such inquiries.

We start by describing the role we serve.

  1. We are bond specialists and focus our efforts and skills accordingly in order to help our clients and their counsellors.
  2. We manage the “mattress money” portion of our clients’ fixed income investment portfolios.
  3. Safety of principal is our primary concern; we rely heavily on our in-house municipal bond credit team to assess issuer credit quality and liquidity.
  4. Net after–tax income generation is a very important goal;  we are less concerned with short term unrealized paper gains or losses.
  5. We believe an actively managed, value oriented, tactical ladder outperforms comparable market averages and helps to accomplish #3 and #4.

We have learned over several decades of experience that it is impossible to REGULARLY predict the movement of Federal Reserve Bank controlled interest rates and the larger bond market reaction to such Fed moves.

We, like others, have our opinions, but we understand there is a significant difference between opinion and fact. There are no facts regarding future events, only opinions, and we believe it is a fool’s errand to attempt to predict these events consistently over long periods of time.

The persistent state of low rates over the last five or six years proves the point. How many pundits, how many times predicted higher bond yields over the last five to six years?

We believe you must play the hand you are dealt, instead of frequently folding to wait for a better day. Our “tactical ladder” bond portfolio strategy is a measured strategy and a conservative approach to today’s low growth/low rate environment.

Our approach avoids taking bold actions based on forecasts of uncertain future events (opinions). We believe this approach is imprudent for clients’ “mattress money” capital.

Instead, we focus, on uncovering value for client portfolios based on our municipal credit analysis (facts) and our market expertise about bond pricing (facts). We are keenly aware of what we DON’T know and our strategy, therefore, is focused on what we understand. Our litmus test for determining the success of a portfolio strategy is if it produces the desired results.

Here is how we define portfolio success:

  • Solid credit quality
  • Steady income stream
  • Low portfolio volatility
  • Minimal client anxiety

Early in my career attempting to provide a satisfactory answer to the third question above (asset allocation) was a vexing issue for me.

That changed many years ago. I will share some advice I received directly from Jack Bogle, the founder and retired CEO of The Vanguard Group.

Many years ago I dined with Jack when he was visiting Chicago. There were just four of us and we spent several hours together talking about his career, the Vanguard Group, Bernardi Securities, the financial markets and industry. It was one of the most fascinating and insightful business meetings of my career. I remember many of the things we discussed that evening including Jack’s answer to my inquiry about an appropriate stock versus bond portfolio mix.

He started his answer with many of the usual caveats including a proper allocation depends on the individual’s personality, tolerance for risk and volatility.

When I pressed him for a firm percentage he offered this allocation formula: divide your age into 100 to determine the conservative (bond) allocation. As an example, if one is 60 years old, then according to this formula an appropriate bond allocation is 60%. The remaining percentage needed to equal 100%, 40% in this example, represents the appropriate growth (equity) allocation. He acknowledged it as a simple approach. He told us the formula had worked well for him and others over the decades. Most importantly he stressed, it helps ensure that as an investor ages the portfolio becomes more conservative. He ended the topic by saying that whatever formula is applied, stick to it.

Simple and sage advice, in our view. Certainly, not appropriate for all, but definitely worth considering in these turbulent times.

We hope this writing is helpful and thought provoking. Please call us if you care to discuss and we thank you for your continued confidence.

Sincerely,

Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
February 15, 2017

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By Jeffrey D. Irish

We wish you a healthy, happy and prosperous 2017. 

We thank our many clients and friends for your continued confidence and belief in the Bernardi team, our processes and the way we approach investing in today’s volatile bond market.

The Chinese zodiac designates 2017 as the  “Year of the Rooster”.  The rooster is the tenth in the twelve year Chinese zodiac cycle. Dawn and awakening, of course, are associated with our barnyard friend.  The Chinese assign it confidence and dependability characteristics.  The phrase, “rise and shine” is  commonly associated with this year’s mascot.

And what an apt phrase and bond market metaphor the rooster portrays as we begin 2017! The market has awakened from its stupor of the last several years creating enhanced income earning opportunities for income-oriented bond investors. “Rise and shine”, indeed.

_______________________

The 10 year taxable U.S. treasury bond began 2016 yielding around 2.30% and ended the year paying 2.45%.

The intervening period was generally more tumultuous for most bond investors than what the beginning and ending yield metrics otherwise suggest.  Bonds offered investors a roller coaster ride last year creating some anxious moments with some of us wondering if the progeny of the 1980’s bond vigilantes had finally arrived. Last year many bond investors learned (re-learned) what Plutarch, the great, Greek philosopher, opined on more than 2400 years ago: “ it is circumstance and proper timing that give an action its character and make it either good or bad.”

Shown below is a 3-month graph of the 10-year, Treasury Note yield. As you can see, the yield spiked immediately after the election as traders and investors adjusted to what a “Trump Presidency” might do to growth and inflation expectations. Recent movement shows a flattening trend-line, albeit at significantly higher yield levels once the initial yield increases occurred. We anticipate this trend-line will hold near current levels in the short term until the market sees some real evidence of economic growth as 2017 unfolds.

10-year Treasury yield

Municipal bond yields reacted in similar fashion and also made some adjustment to factor in the likelihood of lower income tax rates. Looking ahead, new issue supply in 2017 is expected to be healthy following a very robust new issue supply in 2016.  It is important to remember that refunding issues, which made up roughly 40%1 of the market in the past few years, may not be as plentiful in a higher interest rate environment. Supply and demand factors affect municipal yields to a greater extent than they affect Treasury bond yields.

Two months ago 20-year, “AA” rated municipal bonds were yielding around 2.70%. Today you can earn a yield to maturity of  3.30%2 on good quality, longer dated  issues.  This equates to approximately 4.50% for a taxpayer in a 28% federal income tax bracket and a more than 5.00% taxable equivalent for a 35% bracketed taxpayer.  Recently, we have seen yields approach, or equal, 4.00% on some issues that are on our approved list of credits.

If you have been sitting on cash waiting for higher yields, it may be time to allocate a portion to the market. If economic growth and projections do not materialize as quickly as some expect, rates could easily backtrack.

Please contact your Bernardi Securities Investment Specialist to discuss our tactical bond ladder strategy to potentially capitalize on these higher yields as we begin the “ Year of the Rooster”.

Again, thank you for your continued confidence.

Happy New Year!

Sincerely,

Jeff Irish
January 3, 2017

(1) Bond Buyer
(2) Source: Thomson-Reuters Municipal Market Data (MMD) Tables

By Matthew P. Bernardi

Municipalities have done an excellent job since the financial crisis in stabilizing their finances and have pulled a number of levers to reduce fixed costs. Today’s low growth environment calls for prudent management and the average municipality has taken a conservative approach, especially relative to corporations. That being said, this low growth world has exacerbated a larger – though longer term – issue in unfunded pension liabilities. Investment returns have underperformed actuarial assumptions for years and prospective returns look even dimmer. This is an issue cities and states must face, but we think a universal armageddon scenario often highlighted in the press is overplayed. In fact, in many places there is much more flexibility for adjusting and adapting to these liabilities than most investors think. Many municipalities have begun the process of reducing these obligations.

The total dollar value of the municipal market has barely grown since the 2008-2009 crisis. Outstanding debt totaled $3.77 trillion at the end of 2015, up from $3.54 trillion in 2006 (1). Corporate issuers have much more aggressively taken advantage of low rates. In fact, they have added an amount of debt almost equal to the size of the municipal market. Outstanding corporate debt has grown from $4.84 trillion in 2006 to $8.1 trillion at the end of 2015. It remains to be seen if this increased corporate leverage will lead to investment and future growth. Many point out the financing is primarily being redirected to buyback or even dividend payments.

Over time the municipal market has experienced a high level of refunding issues as a percentage of the overall issuance. This reduces the cost of debt for issuers and enhances cash flows. Limiting employment growth is another lever local municipalities have pulled to reduce costs. Total local government employment is 14.3 million today versus 14.5 million at the start of 2008 (2).

These dynamics are undeniably good news for the underlying credit health of municipal issuers. They are a prudent reaction in a paltry growth environment. Long term, however, municipalities face mounting pressure from defined benefit pension liabilities. At the end of June 2015 Wilshire Consulting reported that U.S. city and county pensions had 70 percent of the assets needed to meet their obligations to retirees.

A greater percentage of expenditures will go to service these liabilities, unless yields and investment returns pick up from today’s levels. That being said, for starters, we are talking about 30-year liabilities. Time is a friend at this point. Certainly, one could argue today’s political polarization (i.e. paralyzation) makes progress less likely. Look at the gridlock in Illinois, for example.

Many states and cities are already taking action to reduce their long term liabilities. Additionally, there have been a number of judicial rulings supporting such actions. This progress is good to see. Not only are governments working for taxpayers (and bondholders), but it proves there are potential remedies for solving pension underfunding.

Examples of pension overhauling:

  • Oklahoma passed the Retirement Freedom Act, which closed that state’s defined benefit system and replaces it with a defined contribution model.
  • Houston, TX Mayor says the 30-year fixed plan will pay off the estimated $7.7 billion the city owes its pension fund over the next three decades, cut yearly costs and require full yearly contributions to police, fire and municipal employee pensions.
  • Arizona voters approve pension overhaul measure Prop. 124. Prop. 124 includes lower cost-of-living increases for current and future retirees and was designed to help the retirement system for public safety officers recover from a major drop in the plan’s funded status.
  • Wayne County, MI: Recently upgraded by Moody’s. The rating agency noted “substantial reductions in retirement liabilities” as one of the reasons for the upgrade.

Supportive court rulings:

  • Georgia Supreme Court upheld Atlanta’s 2011 pension reform.
  • Colorado Supreme Court ruled in 2014 that the state could roll back cost of living adjustments for its pension plan participants
  • New Jersey Supreme Court ruled 6-1 and affirmed the state’s authority to suspend cost-of-living increases in public-worker pensions. According the court’s majority opinion “The Legislature retained its inherent sovereign right to act in its best judgment of the public interest and to pass legislation suspending further cost-of-living adjustments.”
  • California appellate court in August of this year, said benefit cuts are permissible if the pensions remain “reasonable” for workers.
  • Oregon Supreme Court: though the court overturned key aspects of 2013 pension reform, it ruled that it was legal to reduce the COLA for service rendered after the reforms were put in place. That means current and future employees will see lower inflation adjustments for benefits earned after May 2013.

We are not attempting to downplay the issue of unfunded pension liabilities; it is a serious problem in many places and too often pension pressures reduce the ability of an issuer to pay for needed infrastructure investments. This is a major factor contributing to the decline of new money projects over the past several years. But unfunded pension liabilities are not a hopeless situation faced by all obligors. As displayed above, there is both the political and constitutional ability to readjust pension obligations in certain localities and we expect further realigning in the future.

As we have noted time and time again, there is no one-size-fits-all model when evaluating municipal credits. Lien-by-lien, state-by-state, bond indentures and contracts differ vastly. It is important to have a thorough understanding of these differences when investing in today’s municipal bond market.

I hope you find this commentary helpful and if you have any comments or questions, please do not hesitate to contact your Investment Specialist or Portfolio Manager.

Sincerely,

Matthew P. Bernardi
Investment Specialist

Please visit our LinkedIn page or Twitter @Bernardimuni for future market updates or company news items.

(1) http://www.sifma.org/research/statistics.aspx
(2) https://www.census.gov/en.html

By Thomas P. Bernardi

We have provided some color about the current state of the bond market below:

Worldwide interest rates have declined in the aftermath of the Brexit vote.  The bond market rally continued through Monday, June 27th, with the taxable 10-year U.S. Treasury yield declining to 1.43%.   

The process of the UK leaving the EU will take time.  This will create uncertainty and therefore, volatility in the financial markets.  We do not expect interest rates to increase dramatically in the short term, absent an extraordinary macro event.

In this type of environment, the laddered bond portfolio structure is a sound investment strategy:

–          Its fundamental discipline requires re-investment of maturing bond proceeds and interest payments

–          Its staggered maturity structure and consistent interest payment dynamic ensures a degree of portfolio liquidity, as funds are regularly available for reinvestment.

–          The strategy allows you to capture higher yields on the long end of the ladder.

A derivative strategy many of our portfolio managed clients are using in this low rate environment is our “Short Duration” strategy.   This strategy invests assets in shorter term issues currently earning between 0.50% to 1.00% yields not subject to current federal income taxes.  These yields approximate to taxable equivalent yields of 0.82% and 1.65% for a taxpayer in the top federal income tax bracket.

Municipal bonds continue to look attractive compared to other traditional safe haven investments, given recent stock market volatility and continued easy monetary policy around the world. A recent Bloomberg Municipal Market Brief confirms the sentiment:

“The muni market looks attractive and considerably safer,” said Frank Shafroth, the director of the Center for State and Local Leadership at George Mason University in Fairfax, Virginia.  “Safe and trusted”.

Please call your Investment Specialist or Portfolio Manager with any questions.

Thank you for your continued confidence in our portfolio management team.

Sincerely,

Thomas P. Bernardi, CFA

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By Matthew P. Bernardi

Our descriptive Three Pillars is an over generalization of our approach to municipal credit analysis. When we look under the hood of each bond, numerous variables come into play, including: State statutes, taxing capacities and limits, the real or perceived unsecured status of the lien, political trends, and many others. This is what makes investing in municipal bonds laborious and nuanced – but fun – and financially fulfilling for your portfolio when the work is done effectively. It also demonstrates the importance of active management in a market where not all bonds are created equal.

Another variable that impacts our opinion of a credit, and its relative trading value, is the long term demographic trends of the municipality or surrounding region. The U.S. Census Bureau [1] provides great insight into current trends.

It is no surprise where most of the growth is occurring: Texas, Arizona, California and Florida. Actually five of fifteen the fastest growing cities (above 50k people) are located in Texas.

15 Fastest Growing Cities

The southwest and snowbird states are not the only areas that have solid demographic trends. Take Ankeny, IA for example, which experienced the third fastest growth rate in the nation. Ankeny is a suburb of Des Moines and the current population of 56,764 is up 11,182 since 2010. It has more than doubled the last 15 years. Murfreesboro, TN and Mount Pleasant, SC are two other notables that have benefited due to their proximity to budding cities. Murfreesboro is a Nashville suburb – which is now the largest city in Tennessee after surpassing Memphis- while Mount Pleasant, SC abuts Charleston.

A city experiencing explosive growth needs to be looked at closely, however. Sometimes the level of growth is a temporary factor, while politicians’ growth assumptions are more permanently baked into projections and fixed costs. Should growth subside, the resulting structural deficit is not always easy to cure politically and financially.Chicago’s pension liability is a recent and relevant example of how projections do not always hold up and the resulting structural inadequacies that follow inaccurate projections. Due to underfunding, generous benefit structures, and subpar investment returns, the city is faced with a significant liability. Also, it is the only city in the largest 15 to lose residents last year – losing 2,890 people.

Top 15 Population Change

Of the sixty largest cities, seven lost population. Five of the seven are located in the Midwest.

Cities losing Population

Detroit experienced over 40 years of 1.70% annual population decline[2] before it faced bankruptcy in 2013. This demonstrates that the trends are important, but not necessarily a near-term worry for cities that have conservatively managed their budget. For cities like Chicago – and even still Detroit – population decline will add further pressure to already stressed financial situations.

That being said, the other five cities that experienced population decline last year are all approved credits. Though one aspect (population trend) of the “Underlying Credit Quality” Pillar is weak, these cities have been able to balance their finances. We also look to the other two pillars (structure and purpose) to provide relative strength due to weakness in the demographic trends.

I hope you find this commentary helpful and if you have any comments or questions, please do not hesitate to contact your Investment Specialist or Portfolio Manager.

 

Sincerely,

 

Matthew P. Bernardi

Investment Specialist

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By Michelle Bernardi Landis

I have spoken to a number of clients recently regarding the impact the Department of Labor’s (DOL) Fiduciary Standard ruling will have on their qualified plans.  Even though the DOL ruling only affects retirement accounts, it became clear to me during the course of these conversations that investors are confused about the differences between a Fiduciary Standard and a Suitability Standard. I thought it would be a good idea to offer some clarity on these differences and explain how these standards relate to your account and our portfolio management process.

Bernardi Securities, Inc. (BSI) is a registered broker-dealer, is regulated by Finra/SEC, and is subject to Suitability Standard industry regulations. Bernardi Asset Management (BAM) is a subsidiary of BSI, is a SEC registered investment advisor (RIA) and is subject to Fiduciary Standard industry regulations. We offer both options of bond portfolio management services to our clients.

Many clients choose the BSI bond portfolio management option.  Under this platform, clients are charged a one-time mark up and for many investors this option is a more cost effective choice for them.  As a broker-dealer, BSI is subject to the Suitability Standard.  The Suitability Standard require the broker dealer to deal fairly with investors, perform due diligence to ensure an investment is reasonably suitable for a specific client based upon his or her needs, sophistication, risk tolerance and financial circumstances (Finra rule 211). We utilize the BSI Investor Profile, Bond Offering Profile and Statement of Understanding documentation as a step in our process to help ensure we are meeting and exceeding our suitability requirements for client relationships held through our broker-dealer arm.   Additionally, BSI is also subject to “Know Your Customer Rule” which requires it to know of and understand a client’s financial situation making it more likely an investment recommendation is suitable (Finra 2090).  Recent implementation of the Best Execution rule  require the   broker-dealer to use reasonable diligence to ascertain the best market for the subject security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under the prevailing market conditions ( Finra rule 5310 & MSRB rule G-18).  Numerous articles have been written implying that a Suitability Standard is somehow an inferior business model.  These rules provide a glimpse of the many industry regulations designed and enforced to protect investors who conduct business through a broker-dealer model.

Similarly, many clients choose the BAM/RIA bond portfolio management option. Under this platform, clients are assessed an annual fee based upon assets under management.  As a RIA, BAM is subject to a higher, Fiduciary Standard of care.  The Fiduciary Standard requires the investment manager to put their client’s interest ahead of its own, avoid conflicts of interest and fully reveal all compensation for investments it recommends.  This platform is the gold standard in our industry and many clients prefer a fee based platform and are willing to pay an ongoing fee for this standard of care.

In either case, both platforms offer our expert bond portfolio management approach to ensure a professional, fair and transparent process.  One of our primary goals is to offer our investors a choice because “one size does not fit all”. I would urge you to contact your investment specialist to discuss our various bond portfolio management options to determine which option is best suited for your needs. As Chair of our Standards Committee, I can assure you whether you are a client through BSI or BAM, we are continually evaluating and adapting our processes in order to meet industry changes, reviewing and resolving any potential conflicts of interests and always striving toward a common goal of aligning our interests with the interests of our clients.

Thank you for your continued confidence in Bernardi Securities, Inc. and Bernardi Asset Management.

Sincerely,
Michelle Bernardi
Senior Vice President

 

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Are you thinking of selling some of your bonds?

Selling bonds is an infrequent exercise for most retail investors and even many institutional clients.

A vexing question for many is, “How do I know I am getting a fair market price for my bonds?” At many firms in our industry, the sale process is needlessly opaque and confusing.

Years ago we realized this as an industry shortcoming so we developed and implemented a transparent and cost efficient “bid wanted“ process. We believe this process is superior because it ensures the transparency and efficiency our clients seek.

Here is a snapshot summary of our process when clients sell bonds through our trading desk: Our trading desk will put your bonds out for bid on one or more of the available, nationwide, bid wire services ensuring your holding will receive nationwide attention. After a couple hours ‘on the wire’ the bids are reviewed and our trading desk may or may not bid the bonds.

The results are input to our bid template and then sent to the client for review. A sample of this template is shown below:

There are several things this transparent bid report reveals: 

  • The number of bids each CUSIP receives.
  • The second place (or cover) bid and how far behind it is relative to the high bid. We often then add color as to what we think this means.
  • Whether or not Bernardi Securities, Inc, trading desk is bidding the bonds.
  • Our public mark–down schedule clearly enumerates our gross profit (your cost) we charge to run bid process for issues sold to the high street bid.
  • If the CUSIP has recently traded, the report shows if the received bids are representative of current market levels. Are the bids fair?

These are all valid and important questions and for these reasons we developed and implemented this practice several years ago.

Our goal is to make the sale process as transparent as possible. Given the arcane nature and many nuances of the municipal bond market, we believe our method provides excellent execution for our clients.

If you are thinking of selling or if you need price discovery for regulatory purposes, we ask that you call us and we can discuss our process in greater detail.

 

 

 

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By Ronald P. Bernardi

IDES OF MARCH 2016 – ET TU, PUERTO RICO?

The Ides of March, the 15th of the month, represents the monthly midpoint of the Roman calendar.   Julius Caesar was assassinated on the Ides in 44 BC by his friend Marcus Brutus and others.  As he lay dying, Caesar uttered these words to his friend, “Et Tu, Brute?” (You, too, Brutus).

Caesar’s assassination transformed Roman history – it was the central event in marking the transition from the Roman Republic to the Roman Empire.

Which brings me to today’s topic – Puerto Rico’s financial state and the repercussions for the municipal market.

The financial chaos unfolding in the island paradise, El Borinquen, may prove to be transformative for bond investors’ psyche – just as Caesar’s demise changed the arc of Roman history.

Here is our premise: if Puerto Rico attempts and succeeds in treating the interests of General Obligation bond investors in a cavalier fashion similar to the way Detroit succeeded, the repercussions for average and below average quality municipal issuers will be negatively impacted. Some in this group will lose access to public capital markets, while others will have access at an inflated cost that is paid by local tax and rate payers.

Issuers in these groups (Chicago Public Schools, for a recent example) are typically more dependent on the capital markets than stellar credits. Liquidity is often an issue and the bond market provides the liquidity they seek. Generally speaking, Detroit’s treatment of general obligation bonds has created doubt in the minds of investors. Many are closely watching how Puerto Rico acts.

Continuing with our Caesarean analogy, we wonder if Puerto Rico and the municipal market are at the banks of the Rubicon and ask, Et Tu, Puerto Rico?

In the following pages we discuss:

  • Puerto Rico
  • Detroit’s reality post Chapter 9
  • A Congressional role in Puerto Rico
  • Ideas to improve investor confidence
  • Strength of the municipal market

PUERTO RICO IS NOT DETROIT

Detroit’s court approved plan is not a template for a solution to Puerto Rico’s problems because:

  1. Puerto Rico cannot file for bankruptcy; some have asked Congress to grant it this power. Congressional sentiment on the issue is divided.
  2. Puerto Rico’s problems are different; debt structure, security pledges, pension issues are not the same.
  3. Some in the island’s leadership have stated they want to honor payments to general obligation and revenue bond investors and that a debt repayment waterfall structure is needed. Detroit’s position was the polar opposite and problems persist post-bankruptcy because the unfunded pension issue was not resolved.   (i)These comments are thoughtful and a good starting point, acknowledging the devil lies in the complicated details. Puerto Rico needs affordable investor capital (absent a federal bailout) to help it successfully emerge from its crisis.

A DIRECTION of ORDER is IN ORDER

All stakeholders must come to the table in order to enact an orderly restructuring.

The problems for the island exist both due to its cost-structure and level of financial liabilities. Therefore, every constituency, debtor and creditor, will need to make concessions in some form. Giving Puerto Rico broad, unilateral powers through bankruptcy, without any oversight to write down its debt, while favoring public pensions, would be a mistake. In the long run, this approach will harm its citizens, its investors and the broader market.

Clarity and guidance on certain issues is needed and it seems to us that Congress is the body to provide it. Its leadership will better ensure an orderly and sensible re-structuring plan for Puerto Rico.

Why should Congress get involved?

  1. Chapter 9 law, to a great degree is being written now. Legal precedent is scant. Bankruptcy judges in Stockton, Detroit and San Bernardino have been reluctant to interject their legal solutions.

A federal judge’s power in Chapter 9, while significant is limited to making narrow determinations. The judge cannot order a municipality to raise taxes, as an example. Judges Klein (Stockton) and Rhodes (Detroit) avoided altering the debtors’ plan. Judge Rhodes offered guidance by stating Constitutional protections did NOT protect pensioners’ contractual rights in bankruptcy, but chose not to alter Detroit’s plan that clearly protected pensions over general obligation bond creditors. If judges in future Chapter 9 cases fail to add legal clarity to the process – outcomes for investors will not be good.

Congress can clarify a great deal by establishing statutory precedent in Puerto Rico’s situation. Its statutory methodology could serve as a template for other distressed situations.

2. There is no uniformity in Chapter 9, so generalizing about solutions is difficult. There are 50 states with different laws. There is no Uniform Commercial Code in the municipal space. This was problematic in Detroit, San Bernardino, and Stockton because the debtor (distressed municipality) unilaterally files its re-organization plan, which drives the mediation process. If the judge takes a hands-off approach, it is up to a creditor group to negotiate the best deal it can. There is no transparency in these mediations, unlike in a courtroom. The entire process is opaque so it is difficult to tell why creditors settled for what they got. Once a deal gets cut in mediation, it is done. It will not be re-cut because another creditor class objects to it.

This lack of clarity and lack of creditor priority is not good for debtors or creditors. Investors that have been jilted by the process will invest their capital elsewhere.

A FEW IDEAS TO GUIDE THE PROCESS

  1. Make it clear that Special Revenue bonds are inviolate.  Detroit initially attempted to cram down losses on this investor group. It backtracked when confronted with litigation, most likely because it knew its position was illegal. The issue, however, was not decided in court.  A clear statement on this topic would be helpful.
  2. Provide guidance regarding “classification” and “unfair discrimination” rules. These are two areas where judges possess significant power in the bankruptcy process. People are uncomfortable being classified as an unsecured creditor because of the lack of protection for this class in the Bankruptcy Code. Stockton placed investor Franklin Funds in the unsecured class, while refusing to do anything to its pensions – it called the shots. The Judge chose not to reverse this unilateral action. Franklin took an approximate 90% haircut in the final settlement. The weakening of “unfair discrimination” rules in the Detroit case is vexing to many. Chapter 9 allows for similar credit classes to be treated differently if there is no unfair discrimination. Judge Rhodes stated it is the judge’s sole discretion to decide this issue provided the disparate treatment does not violate “the moral conscience of the court”. We are unsure of what that means, but we are certain on two points:
    • The standard is totally subjective.
    • The standard is dangerous and makes investors very nervous; as a result, investment capital becomes more expensive for certain issuers.

 3. A sensible, defined “waterfall payment” structure for creditors is needed. Creditors in one class should not be threatened with a similar, low recovery when their interests would receive a greater recovery in a hypothetical liquidation.  As examples, voter approved, full faith and credit general obligation bond investors have a specific “millage” securing the interest.  As long as the tax is collected, why should a bankruptcy plan threaten this class with a haircut so that these monies can be used for other purposes? Going further, general obligation bond investors with a security interest in general fund monies but lacking a specific tax levy may enjoy significant protection but it is diminished compared to the first group. General obligation debt is not monolithic and a debtor’s plan should recognize this fact.

4. Make clear restricted funds and intercept structures are immune from Chapter 9 machinations.  Restricted funds should be viewed the same as special revenue and are not the municipality’s property. Similarly, when a municipality agrees to an intercept, its intent is to provide special protection to investors; decisions are made because this mechanism is in place. Both issues remain unsettled.

BERNARDI’S APPROACH – NOT WAITING for GODOT

We have spent many hours studying, discussing and developing a practical approach to these issues.  We focus our efforts on a sensible application of our strategy to deal with reality. We and our investor clients do not have the luxury of time waiting for a federal judge or Congress to clarify or solve these issues – acting that way is the bond market’s version of “Waiting for Godot”.

Municipal bankruptcies remain incredibly rare occurrences.  Municipal defaults recently have averaged less than 0.04% annually. They usually can be anticipated by periodic, thorough credit analysis. Historically, corporate bonds default at a much higher percentage.

Generally, we remain bullish on municipal bond credit quality because the vast majority of bonds are solid credits. The fact that the market today is more complicated and volatile compared to the past, underscores the importance of our municipal bond market expertise and our belief that sound portfolio management begins with thorough credit research.

We remain steadfast in our focus on the Three Pillars of Municipal bond credit research:

  • Underlying credit quality
  • Deal purpose
  • Deal structure

 

When we decide a credit is weak in one pillar, we look for strength in the other two. We use different interactive strategies surrounding the three pillars to guide us so that collectively they result in sound credit quality for a particular credit. Our strategies in this area are evolving in response to current events and those we anticipate.
We believe it is difficult to have a “safe” credit in a distressed situation.  Our goal is to avoid entirely, suspect credits, but credit quality changes over time. This is a reality of investing.

We do our best to address this dynamic by adhering to our time tested municipal bond credit research process and adjusting it as changing times demand. This is a major component of the value we bring to a client relationship.

After all, if a credit possesses and maintains solid underlying credit quality, essential deal purpose and solid deal structure then the Chapter 9 discussion is moot.

Thank you for your continued confidence in our team.  We welcome your comments and inquiries.

Sincerely,

Ronald P. Bernardi
President and CEO
March 16, 2016

 

(i) Recently Detroit’s mayor, a mere 14 months after emerging from Chapter 9, stated the biggest fiscal threat facing the city is its pension fund deficit –  $490 million which must be closed by 2024 as part of the “Grand Bargain” legislation. This legislation drove its bankruptcy plan and ostensibly, solved its financial problems. The approved plan requires the city to contribute $111 million in 2024. The Mayor, in his State of the City speech last month, said the required amount due in 2024 has grown to $194 million.

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By Matthew P. Bernardi

According to the ICI Institute, municipal bond fund inflows amounted to $857 million for data ending February 24th.[1] This is now twenty-one straight weeks of inflows into municipal bond funds and we are on pace to see the highest annual inflows since 2012. Our firm’s separate account platform is experiencing a similar trend since 4Q15. This flight to quality corresponds to widespread fears of a global slowdown and a potential recession in the U.S. Since the start of this year, the 10-year AA rated municipal bond has fallen in yield (increased in price) from 2.12% to 1.92% today. The 10-year Treasury has fallen from 2.27% to 1.77%.

The flock to high-grade asset classes has largely left corporate bonds by the wayside, as investors consider the massive amount of issuance post-crisis and fear declining profitability metrics going forward. Pressure in the high yield market has spread beyond the distressed oil sector, as well.

We will not dare to speculate if the trend lower will continue, or if this is merely a hiccup in today’s QE-crazed world. We do believe, however, even with the rally in municipals (lower-yields), and spread widening in corporate bonds (higher yields), municipals continue to offer attractive risk-adjusted returns and should continue to play the foundational “mattress-money” role of your overall asset allocation.

Municipals compare favorably on a taxable equivalent basis with similarly rated corporates in the highest income tax-brackets. When you take into account the overall credit health of the high-grade municipal market and much lower historical default rates versus corporates, municipals continue to offer attractive risk-adjusted taxable equivalent returns for investors in the 25-30% income tax brackets, as well.

Corporations have certainly taken advantage of the low-rate environment since the crisis. Bond issuance has skyrocketed. Total corporate par-amount outstanding has grown from $5.25 trillion at the end of 2007 to $8.24 trillion as of 3Q15.[2] This is a growth of 56.97%. This compares to our nominal GDP growth since 2007 of only 23.90%.[3] Municipal issuance, on the other hand, has flat-lined, as many localities have conservatively balanced their books and reduced debt in this low-growth environment. The total par-amount outstanding for municipalities is up only slightly since 2007, going from $3.42 trillion to $3.71 trillion 3Q15.

We will admit the low nominal yields in today’s high-grade markets are frustrating.  In many ways it seems investors are buying bonds for two reasons… for consistent cash flows and as insurance given the volatility throughout global asset classes and prices (disinflation/deflation). The low relative yields, however, are a testament to the health of the average municipality and investors’ concerns about other credit markets.

I hope you find this commentary helpful and if you have any comments or questions, please do not hesitate to contact your Investment Specialist or Portfolio Manager.

Sincerely,

Matthew P. Bernardi
Investment Specialist

[1] https://www.ici.org/
[2] http://www.sifma.org/research/statistics.aspx
[3] http://www.bea.gov/national/index.htm#gdp

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By Ronald P. Bernardi

Let’s slow down a bit before jumping to conclusions.

Here are several observations about the October 30th, Wall Street Journal article How Muni Bonds ‘Yield’ 4% in a 2% World.

Author Jason Zweig makes a valid point in asserting that yields cited in a typical custodian brokerage account statements may be misleading.

In our view, the typical custodian statement’s reporting of “current yield” – coupon divided by current market value – is inadequate and needs amplification.  We have long held this view and, for that reason, over fifteen years ago began providing our portfolio managed clients with a proprietary quarterly portfolio report to complement their custodian’s statement.  In concert, the custodial statement and Bernardi’s proprietary quarterly report provide an accurate, transparent, and thorough description of portfolio metrics.  These include various yields an investor can reasonably expect to earn. 

The author’s powerful assertions aside, keep in mind he is writing about CUSTODIAL statements.  The article fails to discuss industry-wide regulations as to how bond offerings must be presented to investors upfront.  Regulatory disclosure requirements, coupled with our own self-imposed internal procedures, offer robust protections to investors.

There are many required disclosures (MSRB Rule G-15). The rule exists to protect investors and requires financial industry participants to clearly disclose a bond’s yield to maturity and its yield to call/worst, if applicable.  These yield calculations account for the inevitable premium amortization as a bond approaches maturity.  Additionally, the executing broker-dealer is required to send the client a confirmation that details the yield to worst and the yield to maturity for premium bond trades.  Regulations also require broker-dealers obtain fair and reasonable prices for the client given current market conditions (MSRB Rule G-30).

Therefore, an alert investor is well aware of a bond’s expected yield at the time he or she makes any financial commitment in a bond investment.  The author’s not so subtle implication that broker-dealers and advisors are fooling investors by selling them illusory yields is disconnected from industry rule requirements.

At Bernardi, we strive to provide complete transparency throughout our investment process.  Below are two examples that help demonstrate our transparent and complete investment process and reporting.  We use these documents in concert with one another in order provide investor clients with a thorough and robust description of portfolio metrics so they are comfortable with our process and how we report to them.

The graphic above is our portfolio management recommendation document.  As you can see, the issue presented trades at a premium price.  Yield to worst and yield to maturity metrics are featured as they represent the relevant yields. There is no mention of current yield in our presentation for reasons cited by Mr. Zweig.  The “ANNUAL INCOME” figure cited for the premium issue represents actual income earned in the first year; the portion of cash flow representing amortized premium has been removed from the reported sum.  This income figure is calculated by multiplying the yield to call/worst (2.40%) by the principal dollar investment ($131,922.00).  Therefore, the client has all pertinent yield information to consider BEFORE he or she approves the recommendation.  A trade confirmation is provided separately.


This last graphic detailed is a page from a Bernardi proprietary quarterly report. This report complements the custodial statement.  Please note the sixth, tenth, and twelfth columns (highlighted).  These show yield to maturity at cost, yield to call/worst at market, and yield to maturity at market.

Investing in bonds and reporting on bond holdings is not a simple endeavor.  We purposefully provide a lot of detail offering our clients clear and robust reports.

The WSJ article is insightful, but, incomplete and misleading in certain respects.

We would love to discuss this topic with anyone interested.  Thank you for your continued confidence.

Sincerely,

Ronald P. Bernardi
President/CEO