September 28, 2020

In Part III of our municipal credit commentary pertaining to the health and economic crisis brought on by COVID-19 we overview the most recent data available pertaining to state revenue surveys and data from municipalities within the State of Illinois. Thus far, the data indicates that some of the most dire revenue projections resulting from the pandemic lockdowns have not come to fruition as the resumption of economic activity has been stronger than expected.

That said, the impact of the pandemic has been broadly negative. We remain cautious on the outlook for the sector and as a result are targeting high quality, essential purpose, general obligation or essential revenue issues. We believe there remains downside risk in the most vulnerable sectors and the yield compensation for this additional risk is insufficient.

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The full extent of revenue shortfalls at the state and local level as a result of the ongoing economic and health crisis will not be known for some time and will surely pressure both revenues and expenditures for years to come. In the early innings of the crisis some projections for the hit to state revenues were dire. The Center on Budget and Policy Priorities, for example, estimated revenue declines of up to 31% compared to pre-COVID projections.[1] The Federal Reserve Bank of Boston noted in July that the tax revenue for certain states could decline greater than 20% to 30%.[2]

However, recent J.P. Morgan analysis significantly contradicts the aforementioned “sky is falling” headline-grabbing projections. They found that that overall YTD tax revenue collections through July have been strong, and most states are only witnessing modest revenue declines of ~4-5%.[3]

Though revenue declines were significant during the depths of the social shut-ins, the recovery in economic activity since reopening has been robust. J.P. Morgan noted that all the states analyzed (19) recorded double digit revenue declines in April, but in July experienced an average 63% increase in income tax collections year-over-year. The State of Ohio in its recent monthly financial report noted August tax receipts were robust and that “Nonauto sales tax, auto sales tax, and personal income tax exceeded estimates by percentages ranging from three percent to ten percent.”[4] Interestingly, it noted the dynamic nature of sales taxes: following the 2Q decline, the economic climate and pandemic realities have caused “shifts in consumption away from services and toward goods.”

Information that we track for Illinois’ local government sales, income and use tax collections distributed to local governments seem to support some of the conclusions arrived at by J.P Morgan and the State of Ohio, as well. Sales tax collection data is available up to and including sales made in June 2020 – declines began in March with 17% lower collections in that month versus the same month in 2019. Declines of 30% and 23% followed in April and May. The data for June provides a less clear comparison given an apparent reporting discrepancy but still indicates that taxes may have increased as much at 13% versus the prior period. For the rolling 12-month period as of June 2020 then, sales taxes were down around 3% with significant variability at the local level (note too that this data isn’t wholly comparable to the state as it includes variations due to local sales taxes enacted by municipalities, not just a state wide tax).

Income taxes were down 50% in April versus April 2019, virtually breakeven in May and June then more than doubled the 2019 period in July before recording a 29% increase in August – on a rolling 12-month basis this amounted to 2-3% increase as of August 2020 (compared to a 6-7% decline if the endpoint was April 2020). Finally and interestingly, use taxes[5] in Illinois appear to have benefitted from internet sales and did not report a year-over-year decline on a monthly basis over the last six months, with the rolling 12-month total up 20% as of June 2020. As the state of Illinois is more reliant on income taxes than sales taxes, these results so far appear generally favorable although likely caused liquidity pressure due to the significant swings in income tax collections. At the local level, distributions of sales taxes (rolling 12-month total of approximately $4.12 billion) far outweigh income tax (approximately $1.38 billion) or use tax (approximately $387 million) distributions.

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Thus it seems that more volatile sources of operating revenue for many credits issuing general obligation bonds have performed better than anticipated, though impacts still appear to be broadly negative with the possibility of lingering cumulative impact depending on the trajectory of the pandemic.

As of now, many issuers have reacted to the revenue uncertainty by reducing discretionary operating expenses (such as travel, certain fringe benefits, training, etc.) and postponing capital spending where possible. Some have frozen or even reduced headcount. The Bureau of Labor Statistics data indicated state government employment as of August 2020 compared to February 2020 is down 4% while local government employment is down 6% – nearly 1 million jobs in total. Although these percentages are actually below many private sectors of the economy over the same period, it is important to note that the percentage increase in total private employment from July 2008 to February 2020 was 12-13% whereas state and local government increased less than 0.5%, respectively over the same time period.

Source: U.S. Bureau of Labor Statistics 

Although federal aid has certainly benefitted issuers in dealing with direct costs of the pandemic (in particular for sectors such as airports, mass transit and universities), most of the municipal sector has not seen much, if any, direct federal aid to counteract tax revenue losses (though there has been indirect support, such as increased unemployment benefit payments and the Paycheck Protection Program). Proposals for additional federal aid that in part specifically address such government revenue shortfalls have been mired in partisan disagreements about the size and scope of any stimulus plan with attempts at a compromise still ongoing.[6]  

As we noted in our Market Review, the market’s perceived timetable for another round of stimulus was far too optimistic and additional aid to municipalities may not come until after the election. Although state and, in particular, local governments largely avoided assuming the receipt of such federal aid in their budgets, those that did—such as the state of Illinois[7] – are experiencing additional budgetary pressure.

These data points indicate that while revenue sources for many issuers of general obligation and essential service revenue bonds have been negatively impacted, they still performed better than initially anticipated over the last few months of the pandemic. It is important to recognize there is significant variation at the local level and we expect this to continue. Lastly, certain municipal sectors carry significant operational and credit risk even beyond the challenges to most general obligation and essential service bond issuers:

  • Health care; in particular, nursing and retirement care
  • Mass Transit and airport revenue; in particular, credits unsupported by tax revenue or supported by narrow sources of tax revenue (the Metropolitan Transportation Authority in New York City remains on negative outlook. S&P has downgraded several airport credits over the last month while maintaining a negative outlook on most)
  • Narrowly focused, dedicated tax bonds (e.g., hotel/motel taxes, food & beverage or restaurant sales taxes)
  • Higher education; in particular, credits with a more narrow revenue pledge limited to auxiliary revenues (housing & dining services, parking revenues or even student fees). As well as regional state universities and private universities without solid national brand recognition

These types of credits remain more exposed to either elevated costs or sudden declines in revenue (or both) as a result of the pandemic. It remains to be seen, for instance, the ultimate operational impact from the pandemic on universities. Many have invited students to return to campus while many others have discouraged or forbidden students to return for the fall semester. These decisions, of course, have affected systems’ revenues collections and there is no clear solution in sight. Given universities’ ability to shift many classes online, the negative impact is ameliorated somewhat, but this approach may fail in the end if students tire of it. However, even if students remain on campus, with outbreaks remaining a persistent issue, collection of auxiliary revenue and student fees could be negatively impacted – for instance universities in Utah announced fee waivers[8] coming into the 2020-2021 year.

There remains a possibility of a resurgence of COVID-19 in the fall to early winter similar to what many states experienced during late June and July. Additional longer-term pressure could arise depending on the efficacy of a vaccine in terms of not only initial immunity but the durability of immunity from COVID-19[9]. The less effective and durable a vaccine, the larger and more extended the negative impact on these highlighted sectors and indeed, the broader economy and municipal landscape.

Considering this, it appears downside risk remains in the municipal market and in particular, the most vulnerable sectors including health care, transportation, higher education and certain dedicated tax bonds. However, the general obligation and essential service revenue sectors of the market appear to be better positioned to weather this continued pandemic as they have done over the past several months. In particular, we continue to focus on issuers with broad tax or service bases that are better positioned to avoid social unrest and environmental stress (both of which compound the already daunting challenge of the pandemic) as well as areas less reliant on tourism and operating revenue streams less reliant on volatile types of taxes.

 

 

Brian Shea
Director of Municipal Credit

Matt Bernardi
Vice President, Investment Specialist

 

 


[1] https://www.cbpp.org/research/state-budget-and-tax/states-grappling-with-hit-to-tax-collections

[2] https://www.bostonfed.org/news-and-events/news/2020/07/cpp-covid-state-revenue-impacts-zhao.aspx

[3] JPMorgan Municipal Morning Intelligence, September 2nd, 2020

[4] https://archives.obm.ohio.gov/Files/Budget_and_Planning/Monthly_Financial_Report/2020-09_mfr.pdf

[5] According to the Illinois Department of Revenue, “Sales tax is a combination of ‘occupation’ taxes that are imposed on sellers’ receipts and ‘use’ taxes that are imposed on amounts paid by purchasers.” Refer to https://www2.illinois.gov/rev/research/taxinformation/sales/Pages/rot.aspx, https://www2.illinois.gov/rev/questionsandanswers/Pages/131.aspx, https://www.illinoispolicy.org/illinoisans-will-pay-higher-online-sales-tax-starting-in-2020/

[6] Refer to recent news articles, though this situation remains fluid:

https://about.bgov.com/news/what-to-know-in-washington-house-moderates-plan-stimulus-bill/

https://www.washingtonpost.com/us-policy/2020/09/22/congress-white-house-shutdown-stimulus/

[7] https://www.chicagobusiness.com/government/illinois-may-look-more-junk-pressure-rises-sp-says

[8] https://www.deseret.com/utah/2020/8/18/21374177/utah-public-universities-student-fees-fall-waiving

[9] Refer to https://www.cidrap.umn.edu/covid-19 and https://www.cidrap.umn.edu/covid-19/podcasts-webinars for commentary on the COVID-19 pandemic from a public health perspective

In March 2020, the COVID-19 crisis caused dislocations across world financial markets. The municipal market was not sheltered from this chaos. At the end of February, tax-free yields were sub-1% out to 11-year maturities. In mid-March, municipal bond prices plummeted, and index yields increased daily by 40-50 basis points. From March 11th to March 20th, the 10-year AA-rated municipal benchmark yield rose from 1.32% to 2.92%.

Mutual funds and exchange traded funds (ETF’s) were the cause behind the sell-off. Funds were significant net sellers during this period due to investor redemptions. These funds were forced to sell their underlying holdings in order to meet redemptions at irrationally low prices/high yields. ETF NAV values also plummeted, adding to downward pressure on bond prices. Bond fund and ETF products were caught in a liquidity trap – supply hugely outweighed demand – heightening the trading mismatch between the investment vehicles and their underlying assets. Investors in these vehicles realized significant losses during this period.

The selloff was also exacerbated by two market dynamics occurring within fund and ETF products that had been developing since the previous crisis, consequences of the low rate environment. Many tax-free fund and ETF products increased their exposure to lower quality municipal credits in order to increase portfolio yield. These types of credits are much more sensitive to the ongoing economic crisis compared to public purpose municipal general obligation (GO) or essential purpose revenue issues. Secondly, many fund and ETF products had increased their interest rate risk by increasing duration to conform to industry benchmarks.

In contrast, the separately managed account (SMA) structure proved its worth again. Our Bernardi Asset Management (BAM) tax-exempt strategies outperformed. Our SMA clients were not forced sellers and BAM’s strategy of allocating to high grade GO and essential purpose revenue bonds were two of the primary reasons. Ultimately, the SMA structure allows for greater control over portfolio activity and avoiding being caught up in the “herd” of market activity. Our BAM strategy returns below reflect this dynamic.

Below are returns of two BAM tax-free strategies compared to some of the larger mutual fund/ETF comparable alternatives. BAM’s High Income Municipal strategy received PSN’s Top Guns award for having one of the top ten returns for the quarter in its respective category.

Municipal Strategy/Product 1 Month YTD 1 Year
BAM Tactical Ladder -0.02% 0.61% 3.37%
VWIUX -1.40% -2.49% -0.56%
MUNI -1.07% -2.21% -0.35%
TFI -0.64% -1.78% 0.42%
     
BAM High Income -0.58% 0.33% 3.89%
VWLUX -2.21% -3.45% -1.46%
MUB -1.58% -2.35% -0.28%
ITM -2.29% -4.44% -1.86%

*Source: Bloomberg. Based on share price return. No dividend reinvestment. Returns as of 4/30/2020

 

 

 

The effects of COVID-19 on the nation are far different than prior natural disasters in the recent history of the United States and continue to evolve with each day. We are still learning and reacting. The national impact is significant as evidenced by presidential approval of all fifty states’ declarations of emergency. Presently, the pandemic is affecting regions of the United States to different degrees. This calls for more nuanced and tailored responses than those employed in past calamities. We believe this approach applies to municipal credit analysis, as well (more on this later).

Past natural disasters caused severe infrastructure damage, relatively limited death tolls, and a fairly quick resumption of economic activity. This pandemic is different. Infrastructure is mostly unaffected while many people are unable to work with no definitive timeline on when they might safely return. Thus, while the immediate economic impact of the pandemic is similar to past disasters, the breadth and the uncertainty of its length make this one markedly different.

Additionally, the upward trajectory of any subsequent economic recovery may be much more uneven, halting and drawn out, particularly if the disease periodically resurfaces in the future after social distancing measures are relaxed. Thus – we wonder – if the pandemic and attendant economic effects may not be a single “blizzard” that only needs to be ridden out for a month or two but a “winter”  that, absent a medical breakthrough, could persist to varying degrees until a safe and effective vaccine can be introduced to the population. Hopefully, the medical infrastructure and planning is now in place to manage any subsequent “storms” of new cases, while allowing the economy to return to some semblance of its prior state.

Clearly, certain revenues states and local governments rely on have been immediately impacted: sales taxes, permit and license revenues to name a few. Moreover, states and local governments will also have to navigate collection delays—and potentially eventual declines—of other tax revenues. For instance, states with income taxes have generally followed the federal government and delayed their filing deadlines to July 15th. The delay will impact near term collections particularly since the month of April historically records larger than average receipts of income taxes. Moreover, in states with progressive income tax structures coupled with a concentration of high net worth individuals —such as California, New York and New Jersey—the elevated reliance on top earners can cause severe revenue declines during economic downturns.

“…our focus remains on our Three Pillars of Credit Analysis: deal purpose, deal structure and the underlying credit quality of the issuer”

Many states, counties and municipal entities have also enacted temporary moratoriums on late payment penalties of property taxes as well as on penalties or shutoffs that water, sewer and electric utilities may enact for late payment of their monthly bills. Delays from a significant number of payers can strain liquidity.

Actions undertaken by the federal government in terms of direct stimulus payments will assist states and certain hard-hit areas; however, much of the currently enacted support is aimed at reimbursement for items such as healthcare costs or unemployment benefits rather than supplementing potential revenue losses. Importantly, a recently enacted Federal Reserve program will enable the Federal Reserve Bank to extend short-term loans of up to 24 months to state and local governments in the form tax and revenue anticipation notes to address delayed and reduced tax revenue. Currently, direct participation in the “Main Street Lending Facilities” program is limited to states, counties[1] with over 2 million in population and cities[2] with over 1 million in population. Less than 30 local governments nationally qualify given these restrictions.  In our view, these arbitrary population thresholds are far too limiting leaving tens of thousands of local governments unable to access the program.

We have been actively urging the Fed to open the program to a wider group of local governments and are hopeful it will do so. The program has the potential to benefit a much wider range of deserving issuers and should be adjusted to accomplish this end goal. Moreover, the interest cost to the issuer remains undefined and access to the program may not be available for weeks. As a result, certain states have accessed the private market, choosing not to wait for the Federal Reserve. For instance, the state of Hawaii disclosed that on April 4th it had issued $600 million in taxable general obligation bond anticipation notes.

The dramatic impact of the pandemic and the attendant uncertainty places us in one of the most unique and challenging environments to implement our internal municipal credit analysis process. In light of impending revenue shortfalls, the underlying credit quality of a municipality entering the crisis and management’s ability and willingness to reduce certain expenses takes on significant importance. While continued federal government intervention will help alleviate the strains on state and local governments, our focus remains on our Three Pillars of Credit Analysis: deal purpose, deal structure and the underlying credit quality of the issuer (refer to “Process and Strategy” on our website for additional details).

A recently priced deal for the General Obligation Bonds (Alternate Revenue Source), Series 2020 of the city of LeRoy, Illinois exemplifies this process.

  • PURPOSE– The Series 2020 bond proceeds are for needed capital projects for the city’s water and sewer systems, an essential service.
  • UNDERLYING CREDIT QUALITY– The city’s reserves had been drawn down over the past few years, yet current levels provide a measure of flexibility to absorb increased costs or revenue declines. Management has taken steps to formulate a lean budget for the upcoming fiscal year ending 4/30/2021 and delayed final budget adoption until the end of April to better assess the impact of the pandemic and make any needed adjustments. Lastly, based on fiscal year 4/30/2019 performance, the city’s combined water and sewer systems covered debt service from operations with notable cash reserves within each system.
  • STRUCTURE– Several different taxes and utility revenues are pledged to the Series 2020 bonds including net revenues of the water and sewer systems. The bonds are also secured by an unlimited property tax general obligation pledge and levy. Finally, the Series 2020 Bonds are also insured by Assured Guaranty Municipal and interest on bonds is capitalized from bond proceeds through December 1, 2022.

In this challenging environment, we remain focused on our core sectors of general obligation and essential service utility revenue bonds.  Importantly we are making adjustments to our process of assessing credit quality within these sectors recognizing the unique credit strains due to the economic upheaval caused by the COVID-19 pandemic.

While the road forward remains challenging for state and local governments, and indeed almost any municipal issuer, there is a substantial degree of variance among issuers as to their ability to navigate this environment. Our commitment remains – rely on our credit analysis process to identify those best positioned to do so.

Thank you for continued confidence in our team. We will have additional commentaries on this topic in the coming weeks.

 

Sincerely,

Brian Shea
Director of Municipal Credit

April 20, 2020

 

 

[1] Based US Census Bureau July 1, 2018 estimates, the eligible participants would include the counties of Los Angeles CA, Cook IL, Harris TX, Maricopa AZ, San Diego CA, Orange CA, Miami-Dade FL, Dallas TX, Riverside CA, King WA, Clark NV, San Bernardino CA and Tarrant TX. Kings County and Queens County would also be eligible by population but functionally are part of New York City as the boroughs of Brooklyn and Queens.

[2] Based US Census Bureau July 1, 2018 estimates, the eligible participants would include the cities of New York City NY, Los Angeles CA, Chicago IL, Houston TX, Phoenix AZ, Philadelphia PA, San Antonio TX, San Diego CA, Dallas TX and San Jose CA.

I hope you and your families are well. I hope everyone is safe. The current state of affairs all of us face is fluid, so I want to provide you with periodic updates. Thankfully to date, the entire Bernardi Securities team remains healthy, safe, and engaged in our commitments to our clients and enterprise.

As I wrote to you on March 23rd, our firm remains fully operational.  Our day-to-day operations are orderly as we serve our clients. We are accomplishing this through a combined system of remote access operations and lightly staffed crews at the Chicago headquarter office and downstate Peru and O’Fallon branches. Our business continuity plan has worked very well to date. It continues to evolve given the fluidity of this crisis.

Our goal is twofold: 1) help safeguard the health of our valued employees and 2) continue to serve our clients at a very high level despite unprecedented operational challenges.

We continue to provide these essential services:

  • Bond Portfolio Management Expertise for Investors
  • Market Liquidity for Investors and Issuers across the Country
  • Access to Municipal Bond Investment Capital for Municipalities, School Districts, Counties, Water/Sewer Utilities, Park and Library Districts, Hospital, College and University Systems

Over the years I’ve often written: “Municipal Bonds Build America” and we are doing our very best to help ensure an orderly, functioning market.

An orderly and functioning capital market is needed to help formulate an effective response to the COVID-19 crisis. Enacting effective safety and health solutions becomes even more difficult if investment capital flow slows, becomes prohibitively expensive, or ceases.

We will continue to play our part by supporting our clients and colleagues who have relied on us for nearly 40 years. So, rest assured: we will continue to “Keep Calm and Carry-On”…though 6-feet away from one another.

Below is our current Market Commentary.  Please call or email us if you care to discuss its content or any other topic. I thank you very much for your continued confidence in our team.

Sincerely,

Ronald P. Bernardi
President and CEO

*****

“I couldn’t do that. Could you do that? How can they do that? Who are those guys?” -Sundance Kid to Butch Cassidy in “Butch Cassidy and the Sundance Kid”, 1969

 

Befuddlement and confusion are understandable human reactions when a situation changes rapidly and profoundly. When normally effective counter measures prove meaningless, add anxiety to the mix.

Like Butch and Sundance, many bond market participants experienced similar feelings last month.  Investors, issuers, portfolio managers, traders and regulatory authorities found themselves asking at some point: “What just happened?”

Here’s a brief recap to provide some context:

On March 9th a nationally recognized index of municipal bonds (Municipal Market Data or MMD) at day’s end yielded 0.57%, 0.91% and 1.38% for AA rated 5, 10, and 20-year bonds, respectively.

On March 10th, the seemingly endless bond yield decline reversed itself a bit as the same indices yielded 0.69%, 1.04% and 1.54%.

This upward trend of bond yields continued and accelerated over the next eight trading days. (Reminder, as bond yields increase, prices decline.)

DATE 5-year 10-year 20-year
3/11 0.93% 1.32% 1.82%
3/12 1.28% 1.74% 2.32%
3/18 1.64% 1.97% 2.47%
3/19 2.14% 2.47% 2.97%
3/20 2.64% 2.92% 3.37%

For a period of four days municipal bond prices plummeted and indices yields increased daily, 40-50 basis points. Across the maturity spectrum the yield ratio of municipal bonds versus U.S. Treasury yields moved far above historical norms as sellers across most markets sold bond holdings at deep discounts.

 

It was as if the ghost of Henry Kaufman – “Dr. Doom” himself – along with a panoply of 1980’s Bond Market Vigilante cohorts had simultaneously pushed the “SELL” button on their electronic trading platform devices!

It was a spectacle rarely seen in the “boring bond world.” And it happened quickly.

For many sellers it was unadulterated bond market carnage. For all buyers it was an opportunity they may not see for some time.

As quickly as the price sell-off began, it reversed in powerful fashion once the panic subsided and lawmakers authorized the Fed to assist state and local governments’ finances and price support its debt.

DATE 5-year 10-year 20-year
3/24 2.41% 2.72% 3.17%
3/25 1.76% 2.07% 2.52%
3/26 1.23% 1.47% 1.92%
3/27 1.17% 1.39% 1.84%

Sizable paper losses that existed in investors’ portfolios and market makers’ inventories on March 23rd disappeared in a matter of days!

I used to think if there was reincarnation, I wanted to come back as the President or…a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody”. -James Carville, Wall Street Journal February 25, 1993

For most of the last 10 years the bond market has hardly been intimidating. There have been brief periods of time over these years where markets were dicey, but they were few and short lived.

The mostly bullish, tedious, and predictable bond market of the last decade changed dramatically in March.

We’ve studied trading activity during the volatile market period last month to help us better understand what might have contributed to the severe fluctuation in prices. Below is market trading data as provided by the Municipal Securities Rulemaking Board (MSRB) drawn from three reports. The Tables show daily trade activity as follows: Table A. “Customer Purchases”, Table B. “Customer Sales”, Table C. nets the ‘Purchases” and “Sales” activity.

 

Table A:

Table B:

Table C:

Trading par value volume “Sales” activity spiked upward beginning March 13 and remained elevated until month end. This put intense downward pressure on bond prices. Table C. shows multiple days during this period when sales outpaced purchases even though purchases were quite elevated above the norm (March 20, 23, 24). Note the heightened level of trading volume by par value of large block sizes ($1,000,000+ and $5,000,000+) on these days. This activity corresponds with the sharp uptick in yields. This is evidence large institutional market makers and investors were net sellers putting significant downward pressure on prices pushing yields up much higher. This trading pattern does not occur in a normalized market dynamic.

Not coincidentally, investors pulled a record $12.2 billion out of municipal bond mutual funds in the week ended Wednesday March 18th.  This was a continuation of the prior weeks’ negative flow trend which persisted daily until March 26th. For the most part, our clients’ Separately Managed Account (SMA) portfolios held up very well. Most portfolios reacted as we expected.

Forced selling by bond funds and portfolio managers, massive liquidations of ETFs and other bond-like products does not create realized losses if an SMA portfolio investor avoids selling.

Of course, SMA portfolio values on Friday March 23 were much lower than 7 days prior. But those lower valuations reversed themselves quickly, snapping back in subsequent days.

And for SMA managers and investors that exercised good judgement (and a bit of intestinal fortitude) and bought during this period – it was the bond market’s equivalent of the ultimate close-out sale.

Conversely, most investors in derivative (often complex in nature) type bond products:  bond funds, bond ETFs, variable rate demand notes, tender option bond trusts realized significant losses during this period – even if they chose not to sell their shares when NAV values plummeted.

Here’s the rub with these derivative bond products: There’s often a fundamental disconnect between liquidity of the aforementioned bond derivative product shares and the underlying value of the investments they hold: it’s easier for investors to sell the fund shares than the underlying bond assets determining the share price. This is not a critique, but a statement of fact. This becomes hugely relevant when selling activity far outpaces buying activity as it did last month.

This disconnect is multiplied in times of extreme liquidity driven markets – when NAV prices plummet many investors realize losses whether they sell or not.

In a rapid-fire market sell-off the liquidity mismatch feature inherent in bond funds, ETF’S and other derivative fixed income products is the bond market’s metaphorical desert mirage. The efficiency and cost-effective premise promogulated by many of them is seriously challenged.

OUR SUGGESTED APPROACH

Bond market investing entails multiple risks: credit, interest rate and liquidity to name the big three.  A successful strategy is designed around mitigating these elements.

Our bond portfolio management is conducted on a Separately Managed Account (SMA) platform only with transaction or fee-based options. Portfolios are laddered over a time period suited to the client’s needs and comfort level.  The SMA structure allows for greater control over portfolio activity. We believe it is a more efficient and cost-effective method for high-net-worth investors to be active in the municipal marketplace. The events of the past few weeks confirm, once again, that belief.

Bernardi’s management strategy is based on a disciplined municipal credit analysis process developed over the past 50 years. It enables us to identify undervalued credits and identify issues with developing financial issues.

The core of our evaluation framework revolves around our “Three Pillars” of credit analysis: Deal Purpose, Deal Structure, Underlying Credit Quality.

Solid credit quality investing within a laddered SMA portfolio structure is a conservative (some say “boring”) and time-tested approach for income-oriented investors to participate in the bond market.

Simplicity has a place in investment portfolios – for some this is critically important in tumultuous times like the present. Perhaps the market volatility is behind us. No one knows with any certainty.  But surely there will be more news and events related to COVID-19 confronting us which likely will roil markets.

Volatility can be gut-wrenching, and it provides for opportunistic investing. Municipal bond yields remain elevated and continue to offer attractive value in our view. If your “mattress money” fixed income investment allocation has dropped below an appropriate percentage level for your situation, we suggest you call us or your investment counsel to discuss the issue.

Thank you for your continued confidence in our entire team. Please call or email us to discuss issues important to you.

 

Sincerely,

Ronald P. Bernardi
President and CEO

We would be remiss to not wish each of our readers and clients safety and peace of mind during these most trying times. Following Governor Pritzker’s “stay-at-home” order, we want to let you know our firm will remain open via remote access operations and lightly staffed crews in our Peru, O’Fallon, and our Chicago headquarters offices.

We provide these essential services:

  • Access to municipal bond investment capital
  • Market liquidity for investors and issuers across the country
  • Bond portfolio management expertise

The tumult of last week’s market tested all of us.  For the most part our clients’ Separately Managed Account (SMA) bond portfolios held up well:  forced selling by others does not create realized losses in SMA portfolios. Conversely, most investors in complex derivative type bond products: bond funds and bond ETFs realized significant losses last week.

Importantly, our team reacted as I expected they would and weathered the chaos helping a multitude of our clients deal with these volatile markets.

The entire Bernardi team remains unaltered, in place and ready to help you navigate the uncertainty we are all experiencing. So please call or email us with your questions, concerns and requests.

Thank you for your confidence in us.  I hope all of you are safe and healthy.

 

Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
March 23, 2020

*****

“A plague o’ both your houses!”

Last week’s market events left very few investors unscathed.

Historical precedents that compare to today’s crisis and its impact on municipal credit is a mixture of a nationwide natural disaster and financial crisis rolled into one. That said, should efforts to “flatten the curve” prove successful as they have been in South Korea and China, the impact on our economy and municipal balance sheets will be short-lived and much more mild than what some currently fear.  Additionally, the economic snap-back could be robust.  This, of course, is mere conjecture at this point in time.

 

Our Approach to Municipal Credit and Protecting Your Portfolio

In this environment liquidity (rainy-day balances), revenue source prominence (lien priority and/or purpose), and income source flexibility are important aspects of a bond’s underlying credit quality. Our focus on public purpose general obligation and essential revenue source bonds largely provide such levels of security and is frankly why we build “mattress-money” portfolios around these types of municipal bonds. In fact, in our Tactical Ladder composite, 95% of sector holdings were invested in these two forms of bonds: GO & essential revenue source backed.

 

| In fact, in our Tactical Ladder composite, 95% of sector holdings were invested in these two forms of bonds: GO & essential revenue source backed.

 

These two sectors are generally well-positioned at the outset of this outbreak after a sustained period of economic expansion and have built up rainy-day funds accordingly. Prior to this crisis reserve fund balances were at their highest levels ever in the last twenty years (higher than before the Dot-com bubble recession and Great Financial Crisis.)

Secondly, revenues that back general obligation bonds and essential service utilities are prioritized by constituents/users during tough economic times. Property taxes are paid as people aim to retain their mortgage title and water bills are upheld to keep the faucets flowing. Even during the 2008-09 crisis – which was underpinned by a housing crash – there were no defaults in high-grade general obligations bonds, which are primarily secured by property tax revenue.

Detroit is not a high-grade credit and has not been on our list of suitable credits for decades. But it serves as a good example of the above point: the city – plagued by mismanagement and population outflows for 60 years – did not declare bankruptcy until 2013 – 4 years after the crisis took hold. Furthermore, the city’s water & sewer revenue bondholders did not take a haircut in the bankruptcy process (although Detroit initially tried to force the issue) demonstrating the importance of water/sewer bill payment priority in a normal order. The Puerto Rico bankruptcy process is challenging this precedent and perhaps the unprecedented nature of Covid-19 effects will too – but this is a topic for another commentary at a later date.

Historically, municipal credits mostly change slowly.  The general obligation pledge enables a broad suite of levers for issuer to pull in order to meet debt commitments. And we expect many state and local governments will use these in the coming months.  The most vulnerable credits are troubled entities that have been “kicking-the-can” underscoring the importance of adhering to the first Pillar of Bernardi municipal credit analysis: solid underlying credit quality.

There are many options available for solid quality government entities to help them navigate unexpected financial situations, especially compared to corporate issuers. For example, a municipality can increase revenue by raising taxes or user fees.  Arguably this an unwise action, but if undertaken it likely would increase revenue streams in many places.  Contrarily, if General Motors attempted to increase revenue by trying to sell cars at higher prices, it likely would fail.

Bottom line: the general obligation pledge enables income source flexibility and helps to better protect the underlying credit within client portfolios.

 

Credits Directly Impacted by COVID-19 Crisis

With implications of the COVID-19 pandemic on municipal operations and credit still evolving, the most immediate impact appears to be on areas such as health care, airports, public transit, sales tax bonds, and credits that have unique exposure to tourism or oil production. 

Health care sectors will be impacted as hospitals scramble to adjust their operations to cope with a large influx of infectious, often very ill, patients. While the operational impact is daunting and upfront costs will almost certainly rise, the ultimate financial impact remains somewhat uncertain as this depends on how heavily a particular system’s service area is hit. Moreover, direct federal financial assistance to the health care sector to ensure operations continue is likely given its critical position in containing the spread of the virus. If this occurs it will mute some of the negative financial impact of this crisis.

Airports have a daunting financial challenge as operations in the near term will be reduced substantially. Additional declines depend too on the possibility of any domestic travel bans imposed by the federal government. Internal liquidity will be a key challenge for major airports to weather given the significant slowdown in traffic; but much depends on how long travel remains substantially depressed. A few months may be manageable for many airport systems; beyond that, prospects become less clear. Again what, if any, federal assistance is forthcoming is unclear. Airline credits themselves are under review as of March 17th, Moody’s downgraded its corporate rating on Southwest Airlines Co and placed its rating, along with the corporate ratings of American Airlines Group Inc., Delta Air Lines, Inc. and United Airlines Holdings, Inc, on review for downgrade. 

Public transit systems have also experienced an immediate impact as individuals are either staying home or utilizing more isolated means of transport. Similar to airports, a decline lasting a relatively short period of time will be manageable, while longer sustained declines will be more challenging. The Metropolitan Transportation Authority of New York, NY (MTA) issued a recent material event notice detailing significant declines in ridership in mid-March of this year compared to the same period last year and its severe financial impact.

Municipal bonds whose sole security is sales tax revenue will likely be impacted by the decline in economic activity–and therefore sales–as a result of social distancing and sheltering at home due to the pandemic. Likewise, the narrower the sales tax, the more acute the impact could be. For instance, if the sales tax only applied to tourism or entertainment related sales instead of all taxable sales. That said a recent Supreme Coutry ruling allowing states to collect online sales tax revenues will offset these pressures.

Bonds impacted by a hit on tourism. A prime example of such an area is Hawaii, which has a high concentration to tourism-related industries.

Moreover, the oil price decline sparked by disagreements between OPEC members Saudi Arabia and Russia at the beginning of March may have by itself led to a downturn in oil producing regions. Those areas may now have to contend with a prolonged slump in oil prices in addition to the economic contraction from the COVID-19 pandemic. Municipalities within the states of Pennsylvania, North Dakota, Oklahoma, Texas, Kansas and the state of Alaska, itself, are some prime examples.

 

Near Term Outlook and Approach

In the broadest sense, the impact on municipal issuers will depend on the severity of economic contraction related to the pandemic. The more prolonged the extreme measures taken to combat the spread of COVID-19 are, the greater the impact on virtually all issuers will be.

Although the pandemic is an idiosyncratic challenge and differs from virtually any other that government officials have faced, local governments and essential service providers are generally on solid financial footing. Additionally, the general obligation and essential service revenue bonds of these issuers provide notable security provisions. Constructing healthy portfolios is as much about as what you buy and what you don’t buy and we will continue to be wary of bonds backed by volatile, economically sensitive, or low priority revenues.

If you have any questions about the underlying credit within your portfolio or the market in general please contact your Investment Specialist. As we have communicated to various clients over the previous week, we find the current market as a tremendous buying opportunity given current, liquidity-driven, price dislocations (higher yields).

 

Thank you, be safe and healthy,

 

Sincerely,

Bernardi Securities, Inc.
March 23, 2020

Matthew P. Bernardi
Vice President

Brian Shea
Director of Municipal Credit

 

Good afternoon everyone.

We are all experiencing unprecedented events and uncertainty resulting from the COVID-19 health threat.

I am writing to provide a brief summary of actions we undertook last week to ensure our firm remains fully operational to serve our clients while protecting the safety and health of our valued staff.

Over the last handful of years, we have prepared and practiced a firm-wide contingency plan. Last week, we performed it – for real – when it mattered and the results were extraordinary for our clients and firm.

We are fully operational with portions of the Bernardi team working at our Chicago headquarters, two downstate offices while many team members are working remotely on a staggered rotation. Our contingency planning efforts and investment over many years is helping to ease uncertainty during these challenging times. Our response time may be a bit slower than the quick turn-around times you are accustomed to, but please bear with us if that occurs.

We have made adjustments to the plan and will continue to do so as we experience new, unprecedented events.

I am very proud of the Bernardi team: its professionalism, perseverance, diligence, common sense approach and its courage.

Our obligation is to take care of our clients and our employees. And that is exactly what we are doing and intend to do going forward.

Please call us with your questions and concerns. Our protocol may be different, but our aim to help you remains unchanged.

If you need to meet us in person, please call us in advance to schedule an appointment. We want to ensure we have appropriate staff on site to support your needs and we also want to act with an abundance of caution to ensure your safety and that of our staff.

There is more to come, no doubt and we continue to prepare for what we can reasonably expect. Rest assured, Bernardi will continue to work through this as a team: hour by hour, day by day, just as we have done since last week when markets became quite uncertain.

We will get through this – our nation is still developing. It is a land of remarkable resources, ingenuity and opportunity.

I thank you for your deep confidence in us.

 

Sincerely,

Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
March 17, 2020

Contagion risk is gripping society and financial markets alike. Year-to-date the S&P 500 is down nearly 15% while oil dropped 25% yesterday alone. Treasury bond yields have dropped precipitously and at one point every rung of the Treasury yield curve traded at a yield below 1%. The Fed attempted to provide reassurance on March 3rd by implementing a 50 basis points (0.50%) emergency rate cut (from 1.75% to 1.25%) – the first since the crisis in 2008. And the VIX Index, a measure of the 30-day expected volatility of the U.S. stock market, is up over 208% since February 20th.  Some now worry that these market conditions themselves are enough to induce a recession, let alone the coronavirus’s unknown toll on consumer spending.

We too are not taking the potential implications from the coronavirus outbreak lightly (both at an individual health and financial market level).  Although this type of market is unwelcome, it serves as a good reminder of why any high-net-worth and conservative investor should own high-grade municipal bonds.

 

Muni’s are what we thought they were! (see Dennis Green)

Broadly speaking, the municipal market has rallied (higher prices/lower yields) concurrently with Treasuries. The 10-year, AAA-rated municipal benchmark yields 0.78%. It started the year at 1.44%. Therefore, municipal bonds have served their intended purpose as a portfolio ballast during uncertain and volatile times.

Furthermore, our separate account portfolio approach (vs. mutual funds) provides investors another level of protection through direct ownership and customization of holdings. Given the volatile nature of these markets, any forced selling or buying within a mutual fund (induced by outside investors within the fund), is likely not advantageous for the individual investor.  A separate account structure benefits in these situations.

Tenor Treasury %* Open MMD** Muni/ Treasury Ratio
2YR 0.43 0.45 105%
5YR 0.54 0.49 91%
7YR 0.64 0.61 95%
10YR 0.65 0.78 120%
30YR 1.09 1.38 127%

*Taxable Treasury rates on 3/10/2020 @ 9:45 AM.
**Tax-Free Municipal Market Data average yields on 3/10/2020.

Value still to be had

The municipal market on a relative basis is ‘cheap’ compared to other high-grade fixed income alternatives.  The 10-year taxable treasury yield closed yesterday at 0.57%, while the 10-Year, AAA rated tax-free municipal is paying 0.78%, or a taxable equivalent of 1.24% at the highest federal tax bracket. The tax-free municipal yield is 137% of Treasuries, even before the tax benefit is considered.

Now certainly is a good opportunity to find relative value within the municipal market.

As always, we are here to discuss any questions you have about your portfolio or the market. Please reach out to your Investment Specialist or Portfolio Manager.

 

~Tom Bernardi, CFA – Portfolio Manager

2019 municipal bond market performance has been stellar as its safe-haven status persisted in a year packed with monetary policy easing from global central banks. The Bloomberg Barclays long-term tax-exempt index is up 7.54% YTD.[1] While 4Q information is not available, Bernardi Asset Management’s (BAM) High Income Strategy was up 6.32% at the end of the 3Q. Demand has been buoyed by portfolio rebalancing as stocks touch ever higher valuations and by the double tax-exempt status of municipal issues in high tax states. This rising tide has lifted all municipal boats, including long term bonds issued by the financially challenged State of Illinois – which trade at a 128 basis points spread (1.28%) over the benchmark, the lowest level in 5 years. Will it be smooth sailing in the years beyond? Likely not. And this piece overviews where some risk lies.

State of Illinois GO Bond Trading Spread to Bloomberg Benchmark

Source: Bloomberg

The two most evident risks faced by municipal bond investors are credit risk and interest rate risk. Your allocation to municipal bonds is generally meant to protect against the former due to their time-tested resilience to economic cycles, while interest rate risk is an inherent, double-edged sword risk faced by all bond investors. Interest rate risk is two-parted; simply, rates can go higher or lower. A long-term duration (longer term maturities) strategy will suffer should rates move higher (prices lower) and a short-term duration (shorter term maturities) strategy will suffer (in terms of opportunity cost) should rates move lower. Timing these cycles is near impossible and is why we i) generally adhere to the ladder structure to keep you invested and ii) aim to build portfolios customized to your income/asset allocation goals, rather than based on where we/you think the economic cycle is going. We are value managers seeking to capitalize on market inefficiencies. But attempts at market timing – another risk (behavioral investing) faced by all investors – is mitigated by the ladder strategy.

These textbook risks are typically factored in when investors make investment decisions. However, there are two other factors investors need to consider, which are just as vital and have grown in importance due to the change in the bond market landscape over the past ten years.

Investors also need to be cognizant of the:

  • investment vehicle their assets are invested in
  • negative side effects of low interest rates. Specifically, tight credit spreads and managers going beyond their mandate by reaching for yield (euphemism “yield hunting”)


Risk: Investment Vehicle

We often preach about the benefits of the separately managed account (SMA) in how it enables customization, control, and transparency. It is your own mutual fund, as you own and control the assets within it entirely. Purchases and sales of bonds within the portfolio are at the direction of our portfolio managers based on what we believe is best for your portfolio allocation or due to your personal cash flow/principal needs. We are not forced to sell (or buy) assets within the portfolio when other investors make withdrawals (deposits). Additionally and importantly, an SMA portfolio is not an index fund so what you own is very different than what oftentimes the masses/passive vehicles own.

For example, as of 9/1/2019 the average issue size of each security within our BAM Tactical Ladder composite was $17.3 million. This compares to the iShares MUB ETF where the average issue size of the securities within the fund is nearly $1 billion.[2]  Oftentimes we purposely avoid the larger issuers due to tight trading spreads and high market coverage. Often a $5,000,000 local electric utility bond issue provides better value than the $500,000,000 general market deal. Because of their size and for scale purposes, many funds often need to target liquidity rather than yield or credit.

Index funds have grown massively over the past 10 years and often own very similar – if not the same – bond issues. Therefore, holdings are more concentrated than ever. And this dynamic is paired with a shrinking brokerage industry.

What will the bid market look like for these issues if/when a large number of funds need to sell similar holdings simultaneously? Will these investment vehicles offer good liquidity and avoid fire sale price selling in this possible scenario?

With the total number of FINRA-registered firms in decline, (it has decreased from 4,067 in 2014 to 3,607 at the end of 2018, an 11.3% decrease. Over the past 10-years the decrease is nearly 24%.[3]) we would expect to experience a buyers’ market in such a situation. Generally, good for SMA investors, bad for other investors, in our view.

A separately managed account is a way to differentiate from the crowd and protect against a muni bond market sell-off.


Risk: Consequences of a Low Yield Environment

The cause of today’s low yields (compared to “recent” history) can be attributed to a combination of low growth and ultra-easy global central bank policies. Why growth rates are so low and if rates are going to rise is not up for debate here. What is definite though, is that investors’ psychology, investment decisions, and allocations are (re)shaped by low rates.

Low yields and a long-in-the-tooth economic cycle have cued catch phrases such as “reach for yield”, “fixed income alternatives”, “non-transparent ETF”, or “covenant-light” bond issues. All of these pose risk for investors and begs a question: For the “mattress-money” portion of a portfolio, does this mean investors are going outside of the traditional asset allocation or accepting more risk for the same/less yield?

Institutional investors are human, of course and it seems many have succumbed to the urge of reaching for yield. A recent Bloomberg story noted that 30% to 35% of the high yield (i.e. junk) municipal bond market is owned by “high-grade” mutual and exchange traded municipal bond funds. Many fund investors who think they own a high-grade municipal bond fund, actually have 30%-35% of their assets invested in junk rated securities, which may finance economically sensitive and privately backed projects (not essential purpose revenue and/or ad valorem property tax backed). This is clearly a reach for yield and a “mandate creep” on behalf of these fund managers. Unfortunately, many investors are misinformed about what they own.

Dangerously, never have yields been this low and spreads this tight for high yield asset classes. Meaning never have investors lacked so little return compensation for junk rated securities. This statement isn’t an argument against owning such an asset class as part of your overall asset allocation, but more to point out that compensation for owning it is low and – given that such securities are sensitive to the economy or have concentrated risk – they are not high-grade fixed income alternatives.

 

Why give in to low yields? You cannot have your cake and eat it too!

We understand yields are low, but they are low for a reason. The 15-year AA rated benchmark currently is priced at 1.89%, or a TEY (taxable equivalent yield) of 3.00% at the 37% tax bracket. Given the 30-year treasury is 2.33% and 2x as long, municipal yields are an attractive high-grade asset class. Though these yields are understandably lower than what many retired investors envisioned for income levels 5-10 years ago.

But we must realize these low nominal yields are a reflection of the tax-exempt status and very healthy underlying fiscal dynamics across the average municipality. Tax revenues are growing, pension reform is taking hold in many localities, and rainy day funds are higher (as a %) than they were pre-crisis.

In fact, according to Moody’s: More state and local governments were upgraded in the third quarter than were downgraded, marking the ninth consecutive quarter of such a trend.

You could argue municipal credit is on better footing than it ever has been. Hence yields are low, demand high, and the importance of owning municipals for your “mattress-money” allocation still extremely appropriate.

 

Happy Holidays and almost New Year from all of us here at Bernardi Securities and Bernardi Asset Management!

 

Sincerely,

Matt Bernardi
December 30, 2019

 

 

****************************************

[1] Source: Bloomberg.
[2] Source: Bernardi Asset Management & Bloomberg
[3] Source: https://www.finra.org/sites/default/files/2019%20Industry%20Snapshot.pdf

Jason Zweig’s October 4th article underscores that transactions costs should not be the only metric investors use to evaluate investment platforms. Additionally – and as importantly – they need to consider opportunity costs, the portfolio management process, and market access (the latter, especially for munis!).

The latest news is that Schwab, TD, etc. are cutting single stock commissions to $0. So, these discount brokerage platforms are entering the not-for-profit industry? Not exactly. Zweig notes that these firms make very little revenue off of commissions. In fact, a newfound and burgeoning area of revenue growth for these firms is bank sweep accounts (as an alternative to money market funds), which is an enormous opportunity cost for investors.

The article highlights that “most sweep accounts pay measly rates—sometimes as little as 0.05%.” Compare this to tax-exempt money market funds, which currently yield (7-day as of 10/11), anywhere from 0.57% to 1.28%.

On $1,000,000 that is a $5,200 to $12,300 difference.
Below the signature is an overview of the current money market funds we utilize paired with the YTW of our Ultra Short strategy (as of 9/30).  Please call us if you are interested in receiving complete details.

Bernardi does not use bank sweep accounts, as we are not a bank. As a cash alternative, we offer money market funds and our Ultra Short strategy for portfolios – because they yield more than most bank sweep accounts. Increasing yield on cash positions is one of the many factors of our portfolio management process. This, paired with security selection, yield curve positioning, credit analysis, and market access, all help add value to client portfolios.

Oftentimes, the lead is buried by our industry. But thankfully, journalists like Jason Zweig are there to help investors understand the full picture and what matters for their portfolios.

We believe Bernardi offers investors various ways to optimize municipal bond portfolio construction and minimize opportunity costs. Please call us if you have any questions about your portfolio or our portfolio management process.

 

Sincerely,

Bernardi Securities & Bernardi Asset Management
October 14, 2019