There have been dramatic changes to the municipal market over the last several years, creating new challenges for today’s municipal bond investor.

  

Credit, Liquidity, and Ratings:

• Current state budgetary stress in California and across the nation may lead to a greater likelihood of possible ratings downgrades or defaults.
• Pension and entitlement obligation shortfalls will add additional pressure to future budgets.
• Mono-line insurance downgrades, impairment of their claims paying ability, and doubts about rating agency credibility makes it difficult to answer the question “is an AAA-rated bond really an AAA credit?”
• The rating agencies have recalibrated the municipal ratings to the same global scale as corporate debt leading to confusion about credit quality and proper pricing.   For example, a bond that once was rated A, as a municipal credit, may now be rated AA on the global scale, however, the ability of that issuer to pay debt service has not changed.

These trends have made fundamental credit analysis, valuation analysis, and a diversified portfolio vital.   

Industry Restructuring:

• Among the money-center firms, there has been considerable consolidation within the municipal broker-dealer/underwriting business.  Lehman was absorbed into Barclays, Merrill is now part of BofA, Wachovia is now Wells, and AG Edwards merged with Wachovia and is now also part of Wells. 
• Meanwhile, regional firms, who were less affected by the financial crisis, have increased their market share. 

This restructuring of the industry may affect the investor in several ways:  (1) with more of the market share in the hands of regional firms, the ability to find bonds takes more work and (2) with fewer large firms remaining, secondary market liquidity may be compromised.  Institutional buyers potentially have a leg up on the smaller investor to navigate these waters.

In addition to the structural changes taking place in the municipal market, the economic environment for investors has become difficult to access.

Taxes:

Consensus thinking is that income taxes paid by individuals are going up.  Municipals are a good way to earn income that is exempt from state and federal taxes.  Secondly, capital gain tax rates are also likely to rise.  While the income from municipals is tax-exempt, shareholders are still subject to capital gains.  Investors should seek out a low turnover strategy that is less likely to generate large capital gains distributions.  Thirdly, the Alternative Minimum Tax (AMT) is unlikely to go away anytime soon.  Investors should be aware of potential exposure to income subject to the AMT in their municipal bond portfolios.

The Interest Rate Outlook is Uncertain:

With interest rates very low, a fixed income portfolio is vulnerable to rising rates.  In the short-term, it may be that interest rates stay low for a bit longer, however, HighMark’s intermediate outlook is that both short and long rates will rise.  Investors could benefit from a manager that is nimble and actively positioning the portfolio in anticipation of higher rates. 

Frequently Asked Questions

Q:  California’s budget issues are in the news.  Explain the difference between the State’s creditworthiness and its’ most immediate problem of liquidity? 

A:  While the deficit for the 2010-11 fiscal year is currently estimated to be $19.1 Billion, debt service on the State’s bonded debt will likely continue to be paid in a timely manner.  State cash flows are volatile throughout the year, so intra-year liquidity needs are typically met through the issuance of Revenue Anticipation Notes (RAN’s).  A budget must be in place before the State can issue the RAN’s.  This is the second year of budget stress during this recessionary period and it will again provide a confrontational summer in Sacramento, as legislators grapple with raising revenue and cutting expenditures to create a balanced budget.  Both note and bond investors will be paying particular attention to budget solutions for assurances that their notes and bonds will continue to be paid in a timely manner.

Q:  What is the latest on the California budget?

A:  As of this date, it does not appear that the parties in Sacramento are close to a solution.  The State Controller has sent a letter to the legislative leaders stating that if they do not act soon he will have to begin to conserve cash.  The Controller noted that the State appears to have sufficient resources to continue operations through August.  Inaction by the Legislature will likely lead to the issuance of IOU’s again this summer.

The Governor has proposed the following revised (as of May) budget solutions:

• $12.3B Expenditure reductions (64.6% of shortfall)
• $3.3B Federal funds (17.7% of shortfall)
• $1.2B Alternative funding (6.7% of shortfall)
• $2.1B Fund shifts and other revenue reductions (11% of shortfall)

California’s solution will be a political one.  Much of this budget solution is on the back of expenditure cuts (64.6%) which were mostly to social services, so getting legislative approval in this current form may be problematic.

Q:  Could the State of California or other states default?

A:  Yes, but it is unlikely.  A default serves the best interests of no one, the least of which would be the state, which would be penalized when it needed to access credit markets in the future.  Additionally, a state default would likely re-price risk for the entire national municipal market, resulting in higher interest rates for all municipal issuers.  The last state to default was Arkansas during the Great Depression and eventually, those investors were paid in full.  Prior to that period, several states defaulted during and prior to Reconstruction.

Q:  Is bankruptcy of a state possible?

A:  No.  Bankruptcy is a legal status that is not available to states. 

Q:  What is the priority of payment for California General Obligation (GO’s) Bonds?

A:  GO’s are paid out of general fund revenues, which carry the full faith and credit obligation of the State.  GO’s are second in line only to Prop 98 funding for K-14 education.

Q:  What makes California’s budget issues so challenging?

A:

• The state has less flexibility than other states in its budgetary process.  Structural challenges include the requirement to have a super-majority to pass a budget and earmark funding.
• The State has a highly progressive tax system which leads to revenue volatility during recessionary times.

Q:  Are there any positives to the State of California outlook?

A: 

• The State’s debt burden is modest on a per capita basis and low as a portion of total personal income. 
• The debt is structured in a conservative way, with little variable-rate debt that could be exposed to rising interest rates. 
• The State is important on a national level, as it contributes 13% to US GDP.  If it were a country, it would be the tenth largest economy in the world.

Q:  Is HighMark buying State of California GO’s for its managed accounts?

A:  No, not at the moment.  We are looking for greater clarity on forthcoming budget solutions.

Q:  How have other bonds issued within the State been affected?

A:  Bonds issued within the State have suffered, as bond buyers across the country have avoided California-issued debt, causing yields to rise and prices to fall. 

Q:  What tax-exempt bonds within the State are you recommending for clients?

A:  GO’s (other than those issued by the State) and essential service revenue bonds such as those for water, sewer, and electric system projects, which provide good security, and in the case of essential service revenue bonds, a revenue stream dedicated to paying debt service.  Currently these types of bonds are attractively priced compared to similar bonds in other states.  Over time, as California’s prospects improve, we believe these bonds will likely out-perform their national counterparts.

Q:  What impact will the uncertain future of the municipal bond insurers have on the municipal market?

A:  It will require firms to do what HighMark has always done:  rely on the credit quality of the underlying security rather than on an insurance wrapper.  Additionally, before the crisis, the municipal market had become commoditized, with the majority of bonds rated AAA because of insurance.  Now, there are many more opportunities for an active manager to find value because bonds are priced to reflect the creditworthiness of the issuer rather than the creditworthiness of an AAA-rated insurance company.

Q:  Where should I be positioned on the yield curve?

A:  We are currently positioning our portfolios for a rising rate environment using what we call a “managed ladder”.  We define this as a laddered structure of maturities augmented by clustering or over-weighting maturities in areas of the yield curve we believe to be particularly attractive.  Generally, we manage our portfolios with an intermediate style because we believe 70% of the available yield in the municipal yield curve can be captured by maintaining an intermediate term structure while lowering volatility.

Contact Information:

Jon Davis

Jon.Davis@highmarkcapital.com

(213) 236-6820

HighMark Capital Management, Inc., a SEC registered investment adviser (HighMark), is a wholly-owned subsidiary of Union Bank, N.A (Union Bank).  HighMark manages institutional separate account portfolios for a wide variety of for-profit and non-profit organizations, public agencies, public and private retirement plans, and personal trusts.  It also serves as investment adviser for individuals, mutual funds, common trust funds, and collective investment trusts and also sub-advises certain of Union Bank’s collective funds.  Union Bank, a subsidiary of UnionBanCal Corporation, provides certain services to HighMark and is compensated for these services.  Investments in the funds and investments recommended by or employing HighMark strategies are not bank deposits, are not FDIC insured or guaranteed by any agency of the U.S. government, and involve risk, including the possible loss of principal.  Past performance is not a guarantee of future results.

 

This discussion is for general information only and is not intended to provide specific advice to any individual. Individual account management and construction will vary depending on each client’s investment needs and objectives. Some information provided herein was obtained from third party sources deemed to be reliable.  Specific securities identified and described do not represent all of the securities purchased, sold or recommended for advisory clients, and you should not assume that investments in the securities identified and discussed were or will be profitable.

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