October 2017 Newsletter

October 2017 Newsletter

Fixed Income Return Summary
High yield fixed income outperformed with equities in the third quarter of 2017. Long and intermediate municipal bonds were also positive, followed by smaller gains in corporate and government paper. The table below shows 3Q 2017 and YTD returns for some benchmark ML indexes.

Bondholder Risks
Muni bonds continue to be a safe asset class for investors, and we work diligently to mitigate risk in our portfolios. Investing in safe bonds, however, involves assuming certain types of risk. Market risk is the risk interest rates will rise and the value of the bondholder’s bonds will fall. This risk is usually measured by duration. The higher the duration of a bond portfolio the more the value of the portfolio may decline if interest rates rise. For example, a duration of 2.5 is much less risky than a portfolio with a duration of 7.0-8.0. Most of the attention concerning bonds in the media pertains to the market risk of the investor’s portfolio. Reinvestment risk is the risk investors take when they receive proceeds from their fixed income portfolio, interest rates will be lower than they are now. Most investors give too little consideration to the reinvestment risk in their portfolios. This is unfortunate, because over long periods of time the reinvestment of bond income or maturities is a significant part of the total return of the portfolio. Credit risk is the risk of a security getting downgraded or in some cases defaulting. A bond rated AAA is the highest quality. A bond rated BBB is investment grade and bonds rated less than BBB are speculative investments. The yield of a bond is also a measure of its risk. High quality bonds have lower yields than lower quality bonds. For example, a bond which is A-rated will have more yield than a bond which is AAA-rated. This creates opportunity in the Muni market, because the default rates for A-rated bonds are not much different or higher than for AAA-rated bonds. TFS likes to operate in the A-rated space or in good investment grade quality bonds to pick up the extra yield available. These higher yields often translate into higher returns for investors, since yield is an important part of total return. Finally, Headline risk is the risk a bond will trade cheaper due to negative news in the media. The Meredith Whitney factor in 2010 and fear of widespread bankruptcies for municipalities is a good example of headline risk. Negative news about one issuer does not necessarily translate into a problem for other issuers and can create opportunities for savvy investors. For example, negative news about the State of California budget crisis during the Great Recession caused yields on local school district bonds in the State to trade at yields of up to 6%-7%. These bonds are now trading at yields of around 3.0%.

Credit: Pension and OPEB Liabilities
Recent studies show the growth in liabilities for pensions and other post-employment benefits (OPEB) are crowding out the ability of some municipalities to provide essential services to their taxpayers. One such study is “Pension Math: Public Pension Spending and Service Crowd Out in California, 2003-2030.” This study is currently a working paper for Stanford Institute for Economic Policy Research.

Here are some of their findings:

  1. Employer pension contributions have risen on average 400% from 2002-2003 to 2017-2018.
  2. These contributions are expected to rise an additional 76% from now to 2029-2030.
  3. Pension contributions have risen as a percent of the budget expenditures from 3.9% in 2002-2003 to 11.4% now.
  4. The average funded ratio of these obligations has been falling.
  5. As pension funding has increased, the monies available for other services have been reduced.

The budgetary stress caused by this increase in pension funding is cause for concern for bondholders. As other services get crowded out we are worried about the “willingness to pay” for some municipalities. In bankruptcy, pensioners and other politically favored groups are likely to be treated kindlier than bondholders. This has made security selection and monitoring extremely important. We have been avoiding bonds with large pension liabilities.

Credit: Puerto Rico
The island of Puerto Rico is currently in bankruptcy. They have about $70 billion in outstanding debt to bondholders and about $50 billion in unfunded pension obligations. As they were negotiating with bondholders for haircuts the island was severely impacted by Hurricane Maria. Many residents have been without power or water since the hurricane in September. Support is gaining to help the residents of Puerto Rico, and we expect this to come largely at the expense of bondholders. President Trump said this clearly when he said a significant amount of the island’s debt will have to be wiped out. We have always avoided Puerto Rico bonds due to their massive indebtedness, unfunded pensions, outmigration, and lack of creditworthiness. There are also lessons to be learned for bondholders of Puerto Rico Electric and Power (PREPA.) These bonds are secured by revenues from the power system.

Credit: PREPA And Asset Quality
Investors should pay attention to the quality of the assets they are funding. Puerto Rico Electric and Power Authority is an extreme, but good example of bondholders not paying enough attention to the value of their underlying asset. Bondholders have funded the utility to the tune of more than $9 billion. The recent hurricane, Maria, devastated the island and knocked out power for over 3 million residents of Puerto Rico. The storm knocked out the whole grid for Puerto Rico. An electric grid that can be totally shut down from a single storm, and which takes months to rebuild or repair is not a valuable asset. Since the island was having power outages before the storm, it appears there are major infrastructure issues with the grid in Puerto Rico and the current grid needs to be replaced. We would not want to be bondholders in an asset of this quality, and would not be surprised if investors receive less than 20 cents on the dollar for their bonds.

Conclusion
Muni bonds are relatively safe investments, but bondholders face various types of potential risks. Perhaps the greatest risk is the risk of credit impairment. Investors need to be able to identify the credit risks of all their holdings. We are always concerned about “what could go wrong and what options there are for the issuer to remedy the situation.” Large cities, some states like Illinois and Connecticut, and some territories are struggling with budgetary issues and how to deal with pension and OPEB obligations. Some general obligation bonds are not as safe as they used to be. We believe research into other types of safe-sector bonds is crucial for investors. We like to avoid bonds with large unfunded liabilities, like big cities, and favor bonds with dedicated revenue streams. It is important to be able to distinguish the safety of any particular Muni credit.