A Mixed Message From The Fed

Federal Reserve Chairman Ben Bernanke appeared before the Joint Economic Committee on Wednesday, May 22 and offered this testimony:

“For some months, the FOMC has been buying longer-term Treasury securities at a pace of $45 billion per month and agency MBS at a pace of $40 billion per month. The Committee has said that it will continue its securities purchases until the outlook for the labor market has improved substantially in a context of price stability…….At its most recent meeting, the Committee made clear that it is prepared to increase or reduce the pace of its asset purchases to ensure that the stance of monetary policy remains appropriate as the outlook for the labor market or inflation changes.”

“Clarity” is a word rarely used to describe Fed speak; oftentimes clarity requires singularity. The Chairman’s May testimony lacked both, was confusing to many and it upset both stock and bond markets. To us, there is a disconnect between present day bond yields and non-Fed induced macro-economic reality.

Our suggestion to income oriented, mattress money bond investors: NOW IS NOT THE TIME TO DEVIATE FROM A WELL THOUGHT OUT BOND PORTFOLIO STRATEGY AND REACH FOR YIELD, INCREASE PORTFOLIO DURATION BEYOND NORMAL LIMITS OR INVEST IN UNTESTED, HYBRID DERIVATIVE INVESTMENT BOND PRODUCTS.

To make the point, we share with you again our August 2007 writing, “The Bond Market Can Intimidate Everyone”. Granted, much time has passed since late summer of 2007 and today’s financial market landscape would have been unimaginable by most back then. Yet, several parallels of the two time periods exist and are noteworthy, in our view.

“What’s past is prologue”, to quote a favorite bard of ours; perhaps the summer of 2007 offers a clue as to what lies ahead for some bond investors.

SOME PROGRESS IN ILLINOIS WITH MUCH WORK TO DO

The dismal days of March have passed and this month brought some good news to the Prairie State. On May 9, the state auctioned $300 million taxable, sales-tax backed bonds rated “AAA” by Standard & Poor’s. There were 11 separate bids with the winning bidder submitting a true interest cost bid of 3.286%. The 10 year maturity initially yielded 2.60% approximately 80 basis points greater than the yield on the 10 year U.S. Treasury bond at the time.

In comparison, last month the state issued lower rated, taxable general obligation bonds and paid 4.31% for the 10 year bond. That yield was 245 basis points over the 10 year Treasury rate at the time. Clearly, the state paid an interest rate penalty to borrow on its general obligation bond pledge.

May’s auction results were a positive development underscoring the fact certain investors are seeking strongly structured, quality bonds and are willing to lend at low rates for issues like the state’s sales-tax backed bonds.

Additionally, the state began the fourth quarter of its fiscal year in April with $8.5 billion in unpaid bills and was able to reduce the backlog to $5.8 billion by May 1st. An infusion of tax revenue was primarily responsible for the decline. This too is a positive development, although the scheduled, partial expiration of a recent income tax increase for fiscal 2015 suggests the backlog will increase absent balanced operating budgets and a solution to the state’s underfunded and growing pension shortfall.

THE HOUSE MOVES ON PENSION REFORM

The urgency for pension reform cannot be understated: annual pension payments will increase by $900 million next year to $6 billion. This sum represents about 17% of the state’s general fund. This past month NASRA published a national study that found about 3% of all state and local government spending is used to fund public pension benefits. The study found Illinois governmental units are allocating 4.89% on average to fund public pension benefits.

On Thursday, May 2 the Illinois House passed a pension reform package sponsored by House Speaker Michael Madigan by a vote of 62-51. Plan sponsors claim the reform measure will reduce the current $97 billion unfunded pension shortfall by $30 billion with overall savings of $150 billion over a 30 year period at which time it would be fully funded. Currently, the state’s public employee retirement systems are approximately 43% funded.

The bill limits annual cost of living increases and raises the retirement age for state employees currently under 45 years of age. It caps benefits and phases in a 2% increase in employee contributions over a two year period and it strengthens the pension payment commitment from its appropriation status to second in stature only to debt service payments.

Governor Pat Quinn and many Democratic legislators support the bill as do House Republican leaders Tom Cross and Senator Christine Radogno. A coalition of public employee unions oppose the bill.

THE SENATE MOVES ON PENSION ISSUE TOO- SHOWDOWN LOOMS

One week after the House passed its pension reform bill, the Senate approved its version of pension reform (Senate Bill 2404) by a vote of 40-16. The Senate bill is less comprehensive than the House bill. The proposal is projected to save approximately $46 billion in pension costs over the next 30 years and trim about $10 billion off the state’s $97 billion of unfunded liabilities. Recently, the state’s pension system released its calculations of the bill’s savings showing only $5 billion in savings, 50% less than projections. The Senate bill calcualtes the plan will be 90% funded in 30 years. The plan offers employees a set of choices of health care and retirement options.

Senate President John Cullerton believes his plan is consistent with the state’s constitution. He believes the House bill is unconstitutional. AFL-CIO Illinois President Michael Carrigan supports the Senate plan while the Illinois Retired Teachers Association opposes it and threatens to file a lawsuit if it is signed into law.

The constitutional issue is far from simple. Both Mr. Madigan and Mr. Cullerton believe their plans will stand up to any constitutional challenges.

Substantive progress needs to be made on this issue. We will have to wait and see how this plays out.

Please call us with your questions and comments.

Sincerely,
President and CEO
Bernardi Securities, Inc.
Ronald P. Bernardi
May 30, 2013