Guilt By Association

The healthy returns Municipal Bond investors have enjoyed for the last year-and-a-half ended in the second quarter. With a stark shift in sentiment, Municipal Bonds generated their worst quarterly results since the “taper tantrum” of 2Q13. For the quarter, the yield curve steepened with intermediate- to long-maturity rates rising 35-40 basis points while short-maturity rates performed comparatively better, increasing only 15-20 basis points. Market performance for the full Municipal index was down 0.9%, while intermediate returns fell 0.7%, bringing year-to-date results to just above zero. Our composite results generally fell below the market as we faced a number of difficult headwinds from our overall term structure position and some poorly performing credits. Two notable detractors were the Chicago Park District general obligation bonds and Chicago Motor Fuel Tax (MFT) bonds. Despite their inherent credit strengths, the market tainted them as guilty by association following Moody’s downgrade to junk of the City of Chicago.

There are some similarities between 2Q13 and 2Q15 – a Fed marching closer to tightening, net mutual fund redemptions, and high profile credit stress. In the Spring of 2013, the Fed publicly discussed preconditions for tapering their asset purchases. This instilled a sense of fear in those who had become accustomed to ongoing central bank rate suppression. Today, market consensus estimates the first Fed tightening during the next three to six months, which seems reasonable to us. We have come a long way since the depths of the Great Recession and believe that emergency monetary policy measures are no longer necessary. Instead, we worry about the unintended consequences of forestalling normalization.

For the past couple of years, the Municipal market has benefited from a dearth of supply and steady capital inflows. During the second quarter, the market was pressured by a weakening, if not a reversal, of both of these trends. New issue supply this year has surprised most analyst estimates on both a gross and net basis. Rather than forecast supply, we prefer to react to market conditions and the values that we can identify. While we were more active than usual in the new issue market during the first quarter, our activity reverted back to normal this past quarter. Historically, we have observed that municipal flow cycles have persisted for one to two years on average.  While too early to draw any conclusions, this is a development worth watching. Today, broker-dealers possess little ability to stabilize markets in the event of redemption driven volatility. Frankly, we view this as a positive development for our strategy. Historically, we have acquired many attractive values for our clients during volatile periods when others have been forced to sell.

This year, Illinois has become the center of much media attention. The state’s struggle to fix its vastly underfunded pension system came to another roadblock when the State Supreme Court overturned its landmark pension reform legislation. Further complicating matters, the court’s ruling did not provide any type of roadmap the legislature could follow for future reform attempts. Shortly after this ruling, Moody’s downgraded the City of Chicago to junk, highlighting the city’s own pension burden and ongoing financial imbalances. Concurrently, Moody’s downgraded other Chicago-area credits, including two that we own – Chicago Park District and Chicago Motor Fuel Tax (MFT) bonds.

The rating actions on Chicago Park District (CPD) in particular illustrate Moody’s more expansive view of the obligations borne by tax payers. Moody’s approach to rating local government debt has evolved over the years. Instead of just evaluating an entity’s direct debt, Moody’s now takes a broader view of a tax base’s economic debt service burden, including pensions and the obligations of other issuers that share the same tax base. In its rationale for the CPD downgrade, Moody’s cited the overlapping tax base with the City of Chicago and the Chicago Board of Education — both of which are heavily leveraged and require significant revenue enhancements. Moody’s reasoned that if enacted, residents of Chicago would face a serious tax escalation which could provide a political hindrance to the Park District’s ability to raise taxes in the future, thus the downgrade.

The CPD is an independent special district created by the State of Illinois with separate finances, governance and taxing authority from the city. It issues its own audits with its next release due in August. The Park District does not need permission to raise taxes and, most importantly, given the strong state of its finances and its operating flexibility, does not need to. Although the District’s Board is appointed by the Mayor, we view their management’s actions as consistent with their legal independence. As reported in its most recent audited financials, the Park District has a reserve balance of over 70% of revenues. Unlike the city, the Park District has been prudently increasing reserves to help offset increased pension payments in order to avoid a tax hike. Lastly, park programs are largely discretionary, with recreation maintenance expenses, totaling about 80% of the district’s budget. These areas are easy to reduce, if necessary —much easier than cuts to city spending on public safety or cuts to Board of Education spending on schools.

Our MFT bonds are primarily secured by 75% of the city’s allocation of motor fuel taxes from the state. Moody’s downgrade is a direct consequence of their dedicated tax methodology. In order to de-couple a dedicated tax bond’s rating from the city’s, Moody’s requires that the flow of pledged revenues to a trustee be statutorily protected. In the case of MFT, the flow of funds is instead protected by the bond indenture. Although we view this as a positive from our perspective because the pledged revenues are not commingled with Chicago’s other funds, it was not good enough for Moody’s to hold the rating. From our perspective, the two primary risks we face in MFT are the adequacy of the pledged revenue stream and an appropriation step at the state level to commence the flow of funds.

Despite ongoing automobile efficiency enhancements and tepid growth in traffic, our bonds possess ample coverage of roughly 2.5 times. This implies that over the life of our securities, pledged revenues can decline over 50% and our bonds will still mature on time and intact. For context, the largest observed peak-to-trough decline has been 23%. Regarding appropriation risk, we consider ourselves in good company as our bonds share the lien with a federal transportation loan whose maturity is much longer than ours. An action that would hurt us would also hurt the Federal Department of Transportation, likely jeopardizing funding for future projects. Additionally, failure to appropriate at the state level affects all entities who receive motor fuel taxes which include the state as well as other counties and local governments around the state. We view these as strong mitigating factors against non-appropriation risk. Irrespective of Moody’s rating actions and the associated market risk, we remain comfortable with both of these positions.

In another development, credits from Puerto Rico continue to stumble toward a restructuring. When Governor Padilla stated at the end of June that the Island’s debt “is not payable”, the Municipal market reacted swiftly. Debt from Puerto Rico remains widely held and we would not be surprised by further redemption-driven forced selling. Since we neither own, nor would own debt from the Commonwealth, we will continue to play the role of spectators unless redemption activity drives indiscriminate sales of better quality credits.

For the quarter, our managed portfolios generally underperformed our performance benchmarks. Our portfolios’ barbelled yield curve exposure detracted from performance in the face of the aforementioned steepenening. As a reminder, we have de-emphasized fixed rate holdings inside of five-year maturities in favor of floating rate securities and longer-term credit opportunities. Despite rising yields, our floating rate positions did not benefit. While they are theoretically of greater worth because of higher implied forward rates, their yields remain held down by Fed Policy. Our floaters probably will not be fully appreciated by the market until the Fed ultimately raises rates.

The wide breadth of Municipal issuers and bond structure intricacies makes effective generalizations difficult and often unwise from an investment perspective. We often find attractive opportunities in securities whose valuations are disconnected from their fundamentals because they have been misunderstood, mis-associated, or mis-judged. Last quarter, we wrote about school districts and the tendency for the valuations to more closely reflect a struggling district’s financial condition rather than the state-supported credit strength of their bonds. This underpins our thesis behind Detroit and Philadelphia School Districts, which remain among our largest issuer exposures.

Likewise, both Chicago Park District and MFT bonds satisfy our criteria as durable credits, but have been punished by recent downgrades. We entered into positions in these credits when they possessed attractive yield, but their risk premiums jumped even further during the quarter. The performance of these two credits reinforces our notion that opportunities emerge when the market is too quick to judge. There is no presumption of innocence in the bond market. With valuations finally loosening, we are excited about the prospects of additional volatility and new opportunities. We stand ready to capitalize.

Gregory Steier

Head of Tax-Exempt Portfolio Management