Back to School
The first quarter reminded us of an important value investing lesson — you never know when or where attractive opportunities may arise, only that they will; so be patient and alert. While students everywhere excitedly await spring break, school is always in session for us.
On reflecting on our activity during the first quarter, our focus shifted back to school bonds. In recent years, we have written time and again about our investment emphasis on revenue credits relative to general obligation bonds. That remains the case but, in a turn, it was the general obligation and lease-backed debt of school districts where we disproportionately concentrated our investment activity. Several attractively priced new issuances allowed us to significantly build our existing exposures in Detroit and Philadelphia School Districts, and establish a new position in the Broward County, Florida School District.
Public education ranks among the most important mandates of state and local governments, easily satisfying the definition of an essential service and a public good. Hockey rinks and parking lots do not. As a local school board member and resident of New Jersey, I have seen firsthand the difficulty posed by recent education reform measures. In addition to classroom challenges, school districts across the country have also faced a litany of financial challenges including cuts in state aid, slowly recovering property values, and rapidly rising pension and healthcare costs. For well-managed districts, ample reserves and conservative spending have provided the financial flexibility to weather these challenges relatively unscathed, and many easily satisfy our criteria for durable credits. For others, state enhancement programs that serve to insulate investors from a district’s budget challenges help provide much-needed market access to fund various projects.
An example of a well-run district is Broward County School District in Florida. This district benefits from solid operations and a strong resource base that can support its mandates. In particular, we are impressed with how effectively the district managed through the Florida real estate market downturn following the financial crisis. During the first quarter of this year, there was a flood of Florida county school district refunding issuances that provided an attractive entry point for us.
For the majority of other districts we own, compelling value comes from a common source — an apparent dichotomy between a struggling school district’s finances and a strong state enhancement program for its bonds. This dichotomy often results in wide spreads stemming from the headline risk based on the district’s name despite the state-supported credit strength of the bonds. These enhancement programs aim to ensure full and timely payment of the bonds and to facilitate market access, upon which many districts rely.
Each state has its own program(s) with unique mechanics and eligibility criteria. With that said, each school district enhancement program generally provides support in one of three ways: 1) through state guarantees such as in the case of Michigan for Detroit, 2) via state aid intercepts such as in the case of Pennsylvania for Philadelphia, or 3) from the backing of an asset pool such as in the case of Texas with their Permanent School Fund (PSF). In the first two program types, bondholders are effectively taking the credit risk of the higher quality state even though the name on the bond says differently.
This is the case for both Detroit and Philadelphia School districts, as they enjoy strong enhancement mechanisms and offer yields well in excess of direct obligations of their respective states. Our Detroit School bonds benefit from the Qualified School Bond Loan Fund (QSBLF) program. Through QSBLF, our bonds are backed by the unconditional, unlimited general obligation pledge of the State of Michigan, a state whose credit we view as strong. If the guarantee mechanism is triggered, the State Treasurer is empowered and obligated to pay from any available funds or, in the unlikely event that sufficient funds are not available, to issue general obligation debt to provide funds to make such a payment. This action is written in the Michigan constitution and the Treasurer is able to carry it out without any further legislative or voter approval.
In Philadelphia’s two school district credits, the enhancement mechanisms are more complicated. The district’s general obligation bonds benefit first from a strong lockbox collection mechanism and second from the ability to intercept state aid. Every day, the school district must deposit accrued debt service with a trustee and failing to do so triggers the immediate intercept of state aid.
Philadelphia Schools’ lease bonds issued through the Pennsylvania Public State Building Authority benefit from a structure in which all state aid flows directly to a trustee and that the bonds have a first take on the state aid. This results in a credit that offers over 20 times debt service coverage. Absent a change in legislation, all aid associated with charter schools is also controlled by the Philadelphia School District and is available for debt service. In both cases the bonds benefit from having a statutory lien on their revenue streams.
Stepping back from these individual issues, the Municipal market as a whole generated a return of 0.8% during the first quarter, with intermediate maturities returning 0.6%. Municipals started the year off well in January, extending the market’s winning streak to a record-tying 13 consecutive months of positive returns. Since then, the market has been noticeably weaker and more volatile. Yields gyrated through the quarter, as market participants kept adjusting their expectation of Fed “lift-off”. We view the debate about tightening monetary policy a useful one, as today’s “emergency” level rates grow harder to justify by the day.
At roughly $100 billion, new issue supply exceeded most, if not all, analyst forecasts and represented a year-over-year increase of over 50%. Most of the quarter’s new issuance represented refunding activity, but a respectable $20 billion represented net new supply. Just as we found it unusual that our investment activity was heavily tilted away from the revenue sectors, we found the degree of our new issue participation equally unusual. During the last two years, roughly 15% of our purchase activity had been in the new issue market. Last quarter, the figure was just under 40%. If yields stay low, refunding supply should remain elevated.
For the quarter, the market’s steepening yield curve shift proved unfriendly to our results. Our portfolios’ barbelled yield curve structures that emphasize floating rate bonds and longer 10-15 year maturities underperformed the rally in 5-10 year maturities. The performance of our floating-rate bonds, including auction-rate securities where permitted, also modestly detracted from returns. We are comfortable with the bond-specific opportunities we have identified that comprise this yield curve position and look forward to their values materializing over time.
Overall, the investment environment remains challenging from a value perspective. With yields low, supply picking up, and the Fed slowly moving toward a tightening of monetary policy, we remain alert and on-guard. We never suffer from a lack of homework as we prepare for the uncertainties that lie ahead and the new opportunities that a period of rising volatility is likely to deliver.