2013 - Quarter 1

High yield outperformed all other fixed income markets last quarter as the Fed’s zero interest rate policy forced investors into riskier assets in search of higher yields.

Returns in general were relatively weak for the quarter as many investors rotated out of bonds and into stocks. This is interesting because equities are near the highs established during March 2000 and October 2007.

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This week all eyes have been on the bankruptcy ruling by Judge Klein regarding the City of Stockton’s Chapter 9 bankruptcy filing. The judge ruled the City was eligible for court protection from creditors, and could pursue a plan of restructuring. This case is significant because it pits the California Public Retirement System (Calpers) against bondholders. We believe it is far too early to declare a victor in this case, but it is likely that some bondholders will take a hit as the City struggles to get a grip on its finances. Below is a table which shows the projected budget for the City of Stockton. The City proposed making cuts of about $80 million from the prior year. This represents budget cuts of about 13%. Even after these cuts the City is projecting a deficit of about ($26 million.) There is no question they have a serious budget problem. However, debt service only represents about 5% of the budget. The City is not over indebted...they are over obligated. Their problem is the high cost of public employees and pension liabilities.

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Cities like Stockton can no longer afford $200,000 a year salaries and/or pensions for policemen. This issue needs to be resolved before the City can move forward. Defaulting on their debt is only a temporary solution for budget imbalances. The only long term solution is for the City to get its public employees to reduce salaries and benefits to levels found in the private sector. Calpers is refusing to work with Stockton to take a reduction in promised benefits. This case is a test of whether Federal bankruptcy law will trump State pension laws. State law says pension obligations cannot be changed, while Federal bankruptcy law says the bondholders have a superior claim. In the meantime, the City has spent $5 million on legal fees which it can ill afford.

We disagree with others who expect a proliferation of bankruptcies in California. The costs of bankruptcy are too great. Crime rises, infrastructure deteriorates, services decline, and residents move to more desirable areas. Bankruptcy hurts everyone connected with the city, except the lawyers. This will be a long drawn out battle as cities across the State of California struggle to get salaries and benefits for public employees back in line with the private sector, but we believe it is only a matter of time before that will happen.

Our California Strategy
It is no secret that there are large unfunded pension liabilities and problems with public unions in cities across California. In order to avoid potential Stockton or Vallejo situations, we invest primarily in bonds for local school districts and community colleges, in essential service revenue bonds, and in some better hospital bonds. We avoid the general obligation debt of most cities, with the exception of some very wealthy areas with good credit metrics. These sectors have funds which are dedicated to the repayment of debt service and are not general fund obligations.

Charter Schools
Beginning about 20 years ago Charter Schools emerged as an alternative to District Schools. The State of Arizona has embraced Charter Schools and has passed some of the most progressive Charter School legislation in the country. These schools operate as autonomous public schools and receive State funds. Charter Schools typically receive funding on a per pupil basis. This funding is usually less than District funding, because it does not include monies for capital improvements and maintenance of facilities. They are also accountable for student achievement and do not charge a tuition.

Opportunities For Muni Bond Investors

The growth in Charter Schools has led to an increase in the number of tax-free financings to build facilities for these schools. The market for Charter School bonds is an inefficient market that offers higher yields and opportunities for knowledgeable investors. In general, this sector is perceived as a riskier sector because some of the schools have not been run properly and have been mismanaged. Most of the schools which have not done well are smaller schools with well meaning, but inexperienced management and poor results. We, however, know some Charter School groups that have been producing excellent results with their students and have sophisticated and experienced management teams. These are the types of schools we want to help finance.

Important Things To Look For
We believe the key variables for successful investing in Charter School bonds are the following:

  1. A network of existing schools. This is very important. After the first Charter School is opened, if it is successful, there will be demand for more students to attend the school and a waiting list is created. When enough students are on the wait list a new school is opened. As the Charter Group grows the record of academic performance becomes more meaningful, and a financial history is created. We like to see a network of 7 or more schools with the original charter being in existence for at least 8 years.

  2. Historical record of academic success. Charter Schools are required to be accountable for student academic achievement. This is done primarily through testing such as AIMS and PSAT/NMSQT. Schools whose students don’t score well on these tests are in danger of not having their charters renewed. To mitigate this risk, investors should only look at schools that have a record of strong academic achievement. The State of Arizona gives each school a “report card.” We would only consider schools that are rated A or B.

  3. Strong management and governance with proven track record. The Charter Groups that have already opened several schools on time and without cost overruns while meeting budget estimates are the most desirable. We look for groups which have strong boards, and experienced administrators with good track records of successfully operating within budget.

  4. Waiting list of applicants for admission. Successful Charters create strong demand for their schools. One measure of this demand is waiting lists for admission. The best schools have wait lists that are large enough for them to open another school to meet the demand.

  5. First lien and security interest in facility being financed. We like to help finance schools that have purchased suitable property “on the cheap” and give investors a first claim on the property. Revenues for the school flow from the State to the Bond Trustee through a direct intercept mechanism to protect the bondholders.

  6. Record of financial soundness at each of the schools in their network. Investors should look for Charters where each school is financially sound. This demonstrates good governance and management by the Charter Group.

Charter School Conclusion
Investors that are willing to buy longer maturity nonrated bonds are currently able to find yields in the 6-6.75% range for what we believe are some of the best and most respected Charter Groups in the country. This compares quite favorably to Charter school deals that were issued recently that were rated BBB–, due in 30 years, and had yields of less than 5.0%.

The rating agencies view Charter schools as a speculative sector because of the risk of losing a charter, and the lack of history at a new campus for an existing Charter Group. Many of these bonds are either nonrated or less than A rated. We believe there are Charter Groups with strong academic performance and proven operating histories that mitigate most of these concerns.