State(s) of the Union

During the third quarter, high quality fixed income sectors including Municipals benefited as global growth concerns raised significant doubts about the Fed’s lift-off plans, fueling equity and commodity market weakness. For the quarter, market performance for the full municipal market was up 1.7%, while intermediates gained 1.3%, bringing year-to-date results for both into positive territory. For the quarter, the yield curve flattened with intermediate to long maturity rates falling 20-25 basis points while short maturity yields declined only 5-10 basis points. Ten-year yields have now rallied 40 basis points since their early-June peak and currently stand at just under 2%.

Despite the rally, sentiment among municipal investors remained lackluster as tax-exempt mutual funds experienced consistent capital outflows. While strong in an absolute sense, municipal returns lagged those of Treasuries. By quarter end, intermediate and long maturity Municipal-to-Treasury yield ratios crossed the 100% threshold. Although Aaa-rated municipal bonds possess neither the ultimate credit strength nor liquidity of the United States Government, the market is not assigning much value to the municipal tax advantage.

We have communicated extensively our preference for Revenue bonds over General Obligation (GO) bonds. When we do invest in GOs, we are typically state-focused, investing directly in states, in obligations supported by state guarantees, or in school districts that benefit from state enhancement programs. While market pressures from higher interest rates may have subsided, fiscal pressures in several important states have intensified. As of this writing, Illinois and Pennsylvania have still not passed their budgets. Although the State of New Jersey adopted its budget on-time, it is still seeking a long-term budget solution that includes making its full required pension contributions.

Illinois has been without a budget for over 90 days. While its GO bond payments are not affected by the stalemate, some other bonds that require appropriation steps to function properly have been. During the quarter, this lack of a budget resulted in a technical default in Metropolitan Pier and Exposition (Met Pier) bonds, leading to a multi-notch downgrade by S&P. Illinois ultimately passed legislation to release Met Pier’s funds and the market normalized quickly. The Chicago Motor Fuel Tax (MFT) Bonds are also impacted. The primary pledged revenue for MFT is 75% of Chicago’s share of state motor fuel tax, which is subject to appropriation by the state. While the pledged revenues provide ample debt service coverage, the revenues remain trapped and cannot flow to the MFT trustee because without a budget or specific legislative action, the state cannot authorize the transfer. For the quarter, MFT bond spreads remained near their post-downgrade wides.

In Pennsylvania, school districts have been caught in the crosshairs of the budget battle since delays in the budget mean d­­elays in state aid. The most prominent example is the Philadelphia School District where we own two bond structures. The first is a GO, structurally enhanced by a strong lockbox collection mechanism in which property taxes are swept on a daily basis to a trustee with a back-up pledge of state aid. The second is issued by the Pennsylvania State Public School Building Authority. This credit has a first lien on all state aid for Philadelphia’s schools, including charter schools. As bondholders, we have access to this aid before the school district itself. Although the Pennsylvania school enhancement programs have suffered downgrades, investor reaction has been modest. Most expect, as we do, an end to the budget stalemate or other legislation that will allow the flow of aid to schools. As mandated in its constitution, Pennsylvania must support education, its schools, and its children.

New Jersey bonds struggled during the quarter as the State continues to face fiscal pressures predominantly stemming from its underfunded pension system, the result of years of inadequate contributions. Over the summer, New Jersey issued $2 billion of bonds to terminate all of its outstanding swaps, eliminating any potential draws on the state’s liquidity in the event another downgrade triggered collateralization requirements. On top of the widening that had already occurred, the State needed an additional 25 basis point spread concession to place its deal. With 10-year maturity spreads of 225 basis points on its appropriation debt, New Jersey’s bonds are the widest of any state. New Jersey paid a price to issue, but we view its decision as both preemptive and constructive, though far short of dealing effectively with its longer-term, serious pension issues.

While small in geographical footprint, New Jersey possesses the nation’s 8th largest economy, the 11th largest population (and the most dense), and strong wealth measures. Importantly, New Jersey has not shown any signs of economic or demographic decline. As with the vast majority of non-energy boom states, New Jersey has grown more slowly than the national average since the Great Recession.

New Jersey's largest liabilities are post-retirement obligations, rather than bonded debt. New General Accounting Standards Board (“GASB”) guidelines place New Jersey’s pension liabilities under a stark light. GASB reporting standards punish entities that underfund their plans by first extrapolating their underfunding into the future and then by using a conservatively low interest rate to discount the net liabilities. New Jersey’s unfunded pension liability may grab the headlines, but we remain focused on the roughly $3 billion budget gap (8% of revenues) the State needs to close to achieve true structural balance — one that includes satisfying the state’s full annual pension funding requirement.

The New Jersey has actionable, concrete options available to implement changes that are sufficient in size and scope to correct its current situation. Beyond another round of benefit cuts that will reduce its long-term liabilities, more immediate measures include the down-streaming of pension payments to local governments, state aid reductions, and service cuts. This is a classic example of “ability versus willingness” in action. We admit disappointment in the State’s lack of political leadership related to pension-related funding and the structural imbalance that will exist until it does so, but New Jersey’s destiny still remains under its control. It just needs to take action.

The New Jersey obligations we own are appropriation debt. GO bonds only comprise 15% of the State’s outstanding bonds. For convenience purposes, New Jersey relies on appropriation debt as its working lien. Our bonds fall into two categories: 1) a 1st lien on court-mandated contract revenues appropriated to the Economic Development Authority in support of disadvantaged school districts (“SFC”) and 2) a 1st lien on all contract revenues to fund the state’s transportation authority (“Transportation”) — both undoubtedly essential services. The SFC bond program benefits from a law requiring its funding that has been tested in New Jersey’s Supreme Court numerous times. The Transportation bond program is supported by both supplemental constitutional and statutorily dedicated tax revenues that cover debt service and enhance credit safety, but require an appropriation step from the State, analogous to Met Pier in Illinois.

For the quarter, our composite results trailed the market primarily from underperformance of both our New Jersey appropriation debt and our floating-rate securities. Had the prices of our floaters simply remained steady, the flattening of the tax-exempt yield curve would have benefited our barbelled position. However, our floaters declined, more than offsetting the benefit of our longer-maturity holdings. In this yield-starved environment, we surmise that the lack of current cash flow generated by floating-rate notes contributes to their being out of favor. Over the long run, “out of favor” often equates to attractive opportunity – so long as the credits satisfy our criteria. Since many of our floaters pay interest at a multiple of a short-term index, we expect their return contribution to increase once the Fed raises rates. We cannot reliably predict the timing of “lift-off” or the trajectory of short rates once it occurs. As a result, we use a conservative multi-year horizon over which to judge valuation. With floating-rate bonds, we only assume rates move to 75% of their implied forwards to establish an additional margin of safety. We will patiently wait for the value we have identified in our floaters to be realized, either through higher income, higher prices, or both.

With yields again on the decline, attractive opportunities are becoming tougher to find. As a result, we have been alertly guarding our existing reserves and slowly adding to them when good selling opportunities arise. We remain wary that a serial restructuring of Puerto Rico debt looms over the market which could create significant spillover effects, though we have seen little thus far beyond modest high yield mutual fund redemptions. With rates low and credit risk lurking, the margin for error is thin, requiring both vigilance and discipline. We value our reserves and the flexibility it affords us to take advantage of future opportunities, even if they take a long time to materialize.

Sincerely,

Gregory S. Steier
Portfolio Manager