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

 

The hit Netflix sci-fi series Stranger Things takes place in the fictional 1980’s town of Hawkins, Indiana. The show follows a group of middle school kids fending off other-dimensional monsters and Russian conspiracy plots. The threats are significant, though they are entirely unnoticed by society, aside from the primarily juvenile cast. Today’s global central bankers are knee-to-eyeballs deep (U.S. the former, Japan, the latter) in fighting off monetary policy monsters, as well. Unlike the broader Stranger Things society, today’s market participants are preparing for the worst.

After a year of net tightening in 2018, central banks have begun to step on the easing peddle in 2019. On Wednesday alone, three central banks cut rates (New Zealand, India, Thailand) and two cut more than expected. Yesterday, Indonesia’s central bank cut rates for the first time in two years. The Fed’s latest policy action was a cut as well, and it halted the balance sheet run-off program earlier than expected.

This latest easing cycle is based more on potential risks and theoretical possibilities than actual soft economic data. Certainly, we’ve seen weakness in Germany and China, but the United States remains on solid footing. The Federal Open Market Committee said it best in its July 31st statement:

Information received since the Federal Open Market Committee met in June indicates that the labor market remains strong and that economic activity has been rising at a moderate rate. Job gains have been solid, on average, in recent months, and the unemployment rate has remained low. Although growth of household spending has picked up from earlier in the year, growth of business fixed investment has been soft. On a 12-month basis, overall inflation and inflation for items other than food and energy are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed.[1]

In summary, growth is moderate, employment strong, inflation muted, but we are cutting rates.

Similarly, when the Reserve Bank of New Zealand cut rates by a surprising 0.50% to 1.00% on August 7th, it noted:

Employment is around its maximum sustainable level, while inflation remains within our target range but below the 2 percent mid-point. Recent data recording improved employment and wage growth is welcome.[2]

Same story – growth is moderate, employment strong, inflation muted, but we are cutting rates by even more than the market is expecting.

James Bullard, who is one of the largest “doves” on the FOMC (meaning he is relatively in favor of easing), recently implied the Fed is done with rate cuts for now. Yet the bond market continues to expect even more cuts. Fed Funds futures are pricing in another 0.25% cut in September to 1.75%-2.00% and a 90% chance of a cut to 1.50%-1.75% in December.

So what gives? There is clearly a disconnect between rhetoric and rate policy, and even more so between market pricing and central bank rate projections.

For one, supply in sovereign debt (risk free rate) is tight and this exacerbates market moves both up and down. The Bank of Japan owns about half of Japanese sovereign debt, while the European Central Bank owns about 35% of total euro-area debt. In today’s globalized interconnected markets, these central banks are driving down supply which directly impacts our Treasury market, and even down to the municipal bond market. The lack of supply forces more drastic moves in prices/yields. For example, on Wednesday the 10-year Treasury traded in a 13 basis point (0.13%) range from a 1.70% down to 1.60%, before touching 1.73% near the end of the day. There was minimal actual news during the day and, from a trading perspective, it simply felt like market momentum was the driving force.

The recent downward momentum of rates – exaggerated by a lack of supply – is further intensified by the trade negotiation saber-rattling and what seems to be the deteriorating status of talks. On the bright side – barring economic collapse in China or complete breakdown of communications– talks are still scheduled for September.

Until progress is achieved on the trade front or we see renewed economic green shoots, this latest easing cycle will continue. We are experiencing many strange things in the bond market as over $15 trillion in sovereign debt trades at negative yields (the “Upside Down”), Germany’s 10-year is currently quoted at negative 0.57%, the 47-year Belgium bond is up 46%, while the 98-year Austrian bond is up 59% this year alone.

We certainly are in a new dimension of fixed income markets.

 

Sincerely,

Matthew Bernardi
Vice President
August 9th, 2019

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

[1] https://www.federalreserve.gov/newsevents/pressreleases/monetary20190731a.htm

[2] https://www.rbnz.govt.nz/news/2019/08/official-cash-rate-reduced-to-1-percent

 

 

 

 

 

Registered investment advisors (RIA) who purchase fixed income securities for clients, should have best execution in the forefront of their minds.

In July 2018, the SEC Office of Compliance Inspections and Examinations (OCIE) issued a risk alert detailing a list of deficiencies seen in various RIA best execution policies and procedures.  Additionally, the SEC watchdog, FINRA, included best execution in its 2019 examination priorities.

These recent regulatory notices and the impending “Regulation Best Interest” rule strongly indicate regulatory scrutiny regarding best execution is here to stay.

Authenticating best execution is a tedious and cumbersome process, especially in the fixed income market, where there are thousands of different issuers and bond structures.  In the municipal bond market alone, there are over 50,000 issuing authorities.

Utilizing the proper execution platform is another important consideration.  Simply purchasing(selling) bonds from(to) an advisor’s custodial platform may prove to be insufficient from a best execution standpoint and begs the question, “Has the bond market been adequately shopped?”  It is up to the advisor to ensure their clients have wide market access and to satisfy their best execution responsibilities.

For these reasons many advisors look to Bernardi for help with best execution within the fixed income markets.  We offer different platforms based on the advisor’s needs.  Those looking to:

  • outsource fixed income investing:  utilize fee-based Bernardi Asset Management (BAM).
  • manage their fixed income in-house:  utilize Bernardi Securities’ (BSI) trading desk for primary market access, additional secondary market access, and other resources.

Bernardi’s best execution procedures are intricate.  Bond pricing is analyzed across similar state, coupon, rating, and issue structures.  Past trading prices, current offerings prices, and new issue levels are compared by experts focused only on the fixed income market.  Markets are viewed across execution platforms including:  Bloomberg, alternative trading systems (ATS), brokers-brokers, broker-dealers, and BSI’s trading desk.  The process is extensive and exhaustive, but it is necessary.

The burdens of best execution are real, and they take time away from advisors’ day-to-day role of helping their clients with their broader financial plans.  Bernardi’s experience and role as an expert in fixed income markets is utilized by advisors to help ease some of the best execution burdens.

Please give us a call to learn how Bernardi can help you meet your best execution responsibilities and build customized fixed income portfolios for you and your clients.

A FOUNDATIONAL PILLAR: INVESTOR FAITH AND TRUST

The municipal bond market provides our economy with a deep pool of investment capital.  Simply stated, Municipal Bonds Build America.

Investor participation is high as both individual and institutional investors commit their savings to build our nation’s infrastructure: schools, town halls, county courthouses, airports, water and sewer treatment plants, recreation facilities, hospitals, and electric utilities to name a few projects.

It is most often a long-term commitment, an important factor contributing to the deep, dynamic, and liquid municipal bond market.

Importantly, investor faith and trust in the market is a foundational pillar on which the health and dynamism of the market relies. It’s incumbent on industry professionals to strengthen and safeguard this pillar.

 

What is Regulation Best Interest?

Currently, a major initiative of the Securities and Exchange Commission (SEC) is “Regulation Best Interest” or “Reg BI”.  The final version of the rule is expected in the latter half of 2019. The proposed regulation focuses on the conduct standards of industry professionals in their interactions with investors.  We have written about this issue over the years in our “Market Insights” (September 2015 and May 2016).

We support the Commission’s initiative on this important issue. It strengthens conduct standards for broker-dealers and investment advisers, while simultaneously preserving investor choice and access to a variety of advice and service models.

It is a complicated subject and it will be difficult for the Commission to craft a solution to placate the differing viewpoints.  King Solomon would have a difficult time figuring this one out.  But the current proposal is a significant improvement to the status quo. “Progress not perfection” is an appropriate approach and amending the rule in the future is always possible.

In this writing we discuss key issues surrounding the SEC’s proposal.  Importantly, the proposed rule allows for investor choice and avoids forcing a “one size fits all” solution on investors, advisers and broker-dealers. We also describe what Bernardi Securities is already doing to address this important issue.

Recently the RAND Corporation conducted a survey on behalf of the SEC. It queried more than 1,800 individuals.  Not surprisingly, the results show investors seek information about the investment fees they are charged and the types of conflicts of interest their advisers and brokers may have in their dealings with them.  The survey included a “Customer Relationship Summary” (CRS). Under the proposed rule, registered investment advisers and broker-dealers serving retail customers would be required to deliver the CRS to investors.

The RAND survey, along with others, have found many investors are confused whether they are dealing with a broker-dealer or an investment adviser. Investors should understand these differences since there are important distinctions how the two groups interact with them and each have different mandated requirements and market access. For example, the study showed many respondents did not understand the meaning of the term “fiduciary.”

It’s incumbent on industry professionals and their firms to clearly define roles and avoid confusing the issue with a plethora of titles and unclear marketing.

 

What’s the Difference Between a Broker-Dealer and a Registered Investment Adviser?

As noted above, cost is one of the most important factors for individual investors when deciding on a manager. Investor misunderstanding regarding how a professional is compensated likely increases the possibility expectations will not be met and it may end up costing them more too.

Typically, registered investment advisers charge clients an ongoing fee (fee-based) calculated as a percentage of assets under management.  Normally, their clients also pay additional brokerage fees and mark-ups for trades the adviser executes in their accounts. The adviser monitors the account and, in most cases, understands the broader financial goals and helps plan accordingly.

Broker-dealers charge clients for each transaction they recommend and execute (activity-based). Investor cost is fundamentally transactional based, a “pay-as-you-go approach”. The broker may or may not monitor the account over time: this depends on the extensiveness of the platform of services offered.

Under current law a different legal standard applies to how an adviser and a broker-dealer interact with clients.

A registered investment advisory firm and its registered personnel are subject to SEC regulations and are subject to a fiduciary duty. This is the highest standard and generally means any advice offered must be in the client’s best interest and is subject to a duty of care and loyalty. The advisor must fully disclose any material conflicts of interest and must obtain the client’s informed consent of any conflicts the advisor or company have.

It is important to remember conflicts exist in any successful enterprise.  An advisor’s duty of loyalty does not prohibit conflicts but does require disclosure and client consent when material conflicts exist.

A broker-dealer and its personnel are subject to a regulatory regime overseen by several agencies including: the SEC, Financial Industry Regulatory Authority (FINRA) and the Municipal Securities Rulemaking Board (MSRB). Thousands of regulations mandate professional standards for a broker -dealer.  As examples, a broker-dealer is required to adhere to FINRA Rule 2111 (Suitability Rule), FINRA Rule 5310 (Best Execution) and FINRA Rule 2121 (Fair Pricing and Commissions) when interacting with clients. A broker-dealer and its personnel are not subject to the fiduciary standard.

Neither the fiduciary or suitability standards prohibit recommending a principal transaction or one that will result in a more lucrative transaction for the firm.  Importantly, the governing SEC, FINRA, and MSRB regulations require the standards of “Suitability “and “Best Execution” be satisfied regardless of the investment source and its bottom-line result for the firm. 

Broker-dealers and their registered employees are subject to capital requirements, licensing, registration and continuing education requirements. Broker-dealers are required to maintain a certain amount of net capital (Exchange Act 15c3-1) and carry a Fidelity Bond.

Advisory firms do not have either such requirement, although many do carry Errors and Omission insurance policies.

FINRA generally examines its broker-dealer members no less than every 2-3 years. Historically, the SEC examines registered investment advisers less frequently.

As a practical matter, broker-dealers are subject to considerably more regulatory oversight and generally have more available resources if a problem occurs.

 

What is Bernardi’s Approach?

We recognized the issue of today’s discussion years ago and formed Bernardi Asset Management (BAM). BAM is a SEC Registered Investment Adviser and is a wholly owned subsidiary of parent company Bernardi Securities (BSI).  We are a dually-registered firm: we provide investors with options to access our bond market expertise.

We offer these bond portfolio management alternatives:

  • Fiduciary, fee-only portfolio management under the BAM platform
  • Transactional, mark-up/down management under the BSI platform

Our internal policies and procedures for both platforms embody these three principles:

  1. provide investment advice and recommendations we believe are in the best interests of investors
  2. charge fair and reasonable compensation
  3. avoid making misleading statements pertaining to fees, compensation, recommendations or existing material conflicts of interest

These principles along with our internal procedures guide and direct our management team. Under both options our clients have access to a multi-step, fair and transparent portfolio management platform.

Over the years we have learned several things from our clients:

  • Investors want management choices based on their needs and market knowledge
  • Most appreciate having a choice as to how they engage us
  • Investors appreciate our transparency, our clarity, and understand the differences between the two platforms

At Bernardi we operate and design our policies and procedures with an overarching goal to align our interests as best we can with our clients.

We recognize:

  • Conflicts are endemic to any successful enterprise: both advisers and broker-dealers confront them
  • There is nothing inherently wrong with conflicts
  • The result is often a good outcome

Specifically, there is nothing inherently wrong with a broker-dealer or adviser acting in a “principal” capacity. Years ago, the SEC wrote interpretive guidance on this topic (SEC “Interpretation of Section 206(3) of the Investment Advisers Act of 1940”, SEC release No. IA – 1732).

Similarly, there is nothing inherently wrong with a fiduciary, fee-only adviser sourcing all of its clients’ bond purchases from its custodian – provided the adviser adheres to its fiduciary and best execution responsibilities.

Trust and transparency are the foremost principles of a healthy client relationship: it is as simple as that. This is fundamental to the way we operate our firm.

Investors should ask many questions of their financial professionals and not simply rely on a “fiduciary” or “best interest” moniker.

Regardless of the final form of Regulation Best Interest we will continue to serve our clients faithfully.  We have adjusted our business model many times over the years to better serve our clients. An innovative spirit abounds at Bernardi so we will continue to do our part to improve how we conduct our business interactions.

We appreciate any constructive feedback and commentary. Thank you for your continued confidence in our team.

 

Sincerely,

Ronald P. Bernardi
President & CEO

April 11, 2019

January 18, 2019

By: Matthew P. Bernardi

There are many facets and varieties of our active management approach to municipal bond portfolios. Credit analysis, ladder positioning, strategies offered, and tax-loss harvesting to name a few. Another important aspect of active management is the allocation to (and avoidance of) specific geographies relative to the benchmark. Considering the pitfalls of bond benchmark construction, tax reform, state-by-state tax regimes and credit trends, we believe geographical positioning plays a crucial role in providing investors higher levels of income relative to passive securities (index funds).

 

“Inherently faulty benchmark construction may be the fire boiling the passive pot of bond investors (frogs) over time. “

 

Unlike stock benchmarks, bond benchmarks are often misaligned with the average municipal bond investor’s investment profile. Company stocks within the major equity benchmarks – such as the S&P 500 – are weighted based on market cap.[1] The market cap of a stock is determined by the historical success (or lack of) of a company. Therefore, the most successful companies such as Microsoft, Apple, Amazon, and Google (2 share classes) are the largest components of the S&P 500. So, when you buy the SPDR S&P 500 ETF (ticker: SPY) – which is passively indexed to the S&P 500 – you are automatically allocated in such a way to today’s largest and most successful companies (though this does not necessarily mean tomorrow’s). Bond benchmarks work much differently.

Unlike the stock market where the index is dedicated to the winners, municipal bond indexes are allocated to the largest issuers of debt. Often, higher debt issuance is inversely related to credit health. Additionally, the bulk of the largest issuers have tax regimes that make it unappealing for out-of-state investors to own their bonds (high state income tax rates + double tax-exempt bonds).

The Barclays 7-year municipal benchmark and top state allocations are as follows:

State %
CA 15.76%
NY 15.60%
TX 9.10%
IL 4.95%
FL 4.28%

Source: Bloomberg

Concurrently, Vanguard’s passive Tax-Exempt Bond ETF (Ticker: VTEB) is similarly invested:

State %
NY 20.00%
CA 14.00%
TX 10.80%
NJ 5.00%
IL 4.90%

Source: Vanguard

From an income perspective, if you are a resident of a state with no or a low state income tax rate (i.e., Florida, Texas, Illinois, etc.), there are ample reasons to avoid investing a significant percentage of your portfolio in high state tax issuers like New York and California – which offer double, sometimes triple, tax-exemption to investors residing within those states. These two states alone, make up over 31% of the benchmark and 34% of VTEB. These tax regimes, paired with the recent tax reform and the need for tax-exempt income, cause the average NY or CA bond to trade at yields very close to the benchmark. See the “Sprd” (spread) column in blue below, which notes the difference in yield between the given state’s 10-year bond and the AAA-rated Bloomberg benchmark tax-exempt yield. You will notice that the State of New York trades 9.1 basis points (0.091%) below the benchmark.

A non-NY resident does not benefit from double tax-exempt New York bonds and, therefore, should largely avoid them and the benchmark. There are plenty of opportunities for higher tax-exempt yields elsewhere.

However, when one passively invests (such as in VTEB or the MUB iShares ETF) in the municipal market you are in fact often allocating funds to larger, lower yielding issuers. Bernardi’s active Separately Managed Account (SMA) approach not only aims to avoid these overvalued states (for out of state residents), but aims to allocate to undervalued geographies, as well.

 

Don’t Be the Proverbial Frog

The dangers of bond benchmark construction and passive investing may become apparent in the coming decades as it pertains to U.S. Treasuries. The U.S. government’s projected budget deficit is expected to widen from fiscal-year 2018’s 3.8% of GDP to 4.6% in 2019.[2] This means more debt issuance is needed to fund the deficits, and this is paired with a Federal Reserve offloading its Treasury holdings by $30 billion per month (plus $20 billion in mortgage backed securities). How the market will digest the additional debt is one of the most prominent questions for current bond investors. As the Treasury floods the market with issuance, it will not only crowd-out other forms of debt, but it also means a larger percentage of passive investment vehicles will be allocated to Treasury bonds.

This situation has two major implications for investors. First, because passive benchmarks continue to grow in popularity and will be robotically buying more Treasuries, this dynamic may lessen the impact of “runaway deficits” and resulting spiking yields forecasted by contemporary bond vigilantes.

Secondly, investors may be exposed to an unattractive allocation of bonds as they’ll be forced to own a greater percentage of Treasury bonds simply because the Treasury is issuing more debt. Unless the federal government can attain a more stable fiscal path, it is not implausible for it to lose the coveted Aaa rating by Moody’s. S&P rates the credit AA+ after downgrading in 2011 during the debt ceiling crisis. If the U.S. government’s credit trend continues to regress, inherently faulty benchmark construction may be the fire boiling the passive pot of bond investors (frogs) over time.

 

 

 

 

 

 

 

 

 

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[1] Side note: This is why the Dow isn’t the greatest indicator of market moves as the index is weighted based on the nominal price of the stock, not market cap. For example, 3M has almost double the weighting of Microsoft simply because the stock trades at $194 per share vs. $107 for Microsoft. Microsoft is a much larger company, however, with a market cap of just under $825 billion vs. $113 billion for 3M.

[2] Moody’s Weekly Market Outlook, December 20th, 2018. https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1155649