The Muni Opinion Fixed income

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Claud Casey
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Strategy insights Summer 2015 The Muni Opinion Fixed income Troubled credits: buyer beware At a time of low interest rates, investors are chasing yield and ignoring credit developments.

1 Strategy insights Summer 2015 The Muni Opinion Fixed income Troubled credits: buyer beware At a time of low interest rates, investors are chasing yield and ignoring credit developments. While we see good value in the longer end of the high-grade muni market with a defensive coupon structure, reaching for additional yield at this time is unwise, in our opinion. You see this book? This book tells the future. Tells the results of every major sports event till the end of this century. Older Biff Tannen discussing the Grays Sports Almanac with his younger self in 1955 in Back to the Future Part II We begin this issue of The Muni Opinion with a quote from Back to the Future Part II, in which an older Biff Tannen discovers the Grays Sports Almanac in the then future Upon overhearing a conversation between Doc Brown and Marty McFly about the potential financial gain the almanac could provide by knowing all sports results, Biff steals the DeLorean and hand-delivers the almanac to his younger self in While we aren t fortunate enough to have a municipal credit almanac to reference, developments over recent years, and particularly in 2014, have added new risks to investing in the municipal high-yield market, in our view. In this analysis of high-yield munis and troubled credits, we will point out some of the pitfalls we ve seen emerging. We will explore concerns we have about market liquidity and weakening security provisions, analyze new sources of demand and their potential impact, and address how last year s court decisions in Stockton and Detroit have changed our view of potential outcomes for troubled credits. [Warning! Some of these comments about weaker muni credits may cause a degree of alarm. Remember, most of the municipal bond market is investment grade (81% of the market is rated A or better, according to the Securities Industry and Financial Markets Association, SIFMA.) We have observed that quality of most credits has improved since the financial crisis in However, while there are plenty of solid muni credits for investing, today s muni market requires detailed research and a prudent approach to value.] Contributors Philip G. Condon, vice chairman, Deutsche Asset & Wealth Management (AWM) Carol L. Flynn, CFA, co-head of Deutsche AWM s Municipal Bond Department Ashton P. Goodfield, CFA, co-head of Deutsche AWM s Municipal Bond Department Gene Caponi, CFA, portfolio manager and analyst, Deutsche AWM Rebecca Flinn, portfolio manager, Deutsche AWM Robert J. Fogarty, investment specialist, Deutsche AWM

2 Recent historic developments in municipal bankruptcies should change the way investors look at troubled fallenangel credits in the muni market. The Detroit, Michigan, and Stockton, California, bankruptcies have not settled how municipal bankruptcy actually works, therefore investors need to reexamine the previous expectations that troubled muni credits will be bailed out by the state or somehow find a way to avoid default and/or filing for bankruptcy protection. While retail muni investors have been known to overreact to general credit concerns in the past, other buyers (the smart money ) have stepped in to buy these credits believing that municipalities do not default or go bankrupt. It is true that investment-grade munis have a significantly lower default rate than corporate bonds, and municipal bankruptcies remain rare. But what has changed, in our opinion, is that municipal bankruptcy is now occasionally being contemplated as an acceptable way for troubled credits to resolve their problems, when in the past it was considered out of the question. Municipal credits that are struggling to address large, unsustainable legacy costs (such as pensions) appear to be most at risk for seeking to renegotiate their bond obligations. Historically, many investors assumed that the secured general-obligation (GO) bond of a declining credit would work out in the long-run. Now there is less certainty, considering that in Detroit s bankruptcy settlement taxpayers, employees and pensioners bore much less of the pain than the seemingly secure investors. Before we proceed, we have to pause to remind readers of our analysis of bond structure. Municipal bonds typically have long maturities and are priced to calls in 10 years or less. Unlike A- and AA-rated bonds, however, the cushion that bonds rated below BBB offer (should interest rates rise) is relatively small. Extension risk should be considered that is, the risk that the duration of the bond extends when the market rate rises above the coupon rate, therefore increasing the price volatility of the bond. Two market factors could cause this to happen: an increase in overall interest rates and a widening of lower quality credit spreads. Muni defaults are low, but bondholder security provisions have trended weaker The number of municipal defaults has steadily declined since the aftermath of the credit crisis. Recent bankruptcies have included smaller project-finance deals and some notable high-profile credits such as Detroit and Stockton as well as San Bernardino, California and Jefferson County, Alabama. However, compared to corporate bond defaults, municipal defaults have historically been much lower, especially in the case of investment-grade munis, and we expect that relationship to continue. (See Figure 1.) However, recently we have observed weakening security provisions for new issues, particularly in the lower-creditquality segment of the muni market, for which we wave the caution flag. Here are a couple of examples: A charter school borrower issued non-rated bonds with no history of charter license renewals, an debt-toappraised value ratio of greater than 100%, a low 30- day liquidity covenant requirement and a 1x historical additional bonds test. A startup senior living facility issued non-rated project bonds when it had not yet received from the county its final master building permits for the structures. A hospital system issued BBB-rated bonds that included no debt service reserve fund or liquidity covenant. Figure 1: Muni defaults have been historically rare ( ) 70% Muni defaults Corporate defaults 60% 50% 66.02% 40% 30% 40.48% 20% 10% 0% 0.00% 0.49% 0.00% 0.99% 0.05% 2.73% 0.32% 4.61% 3.53% Aaa Source: Moody s Investors Service as of 5/7/ % 15.14% 14.64% Aa A Baa Ba B Caa-C Troubled credits: buyer beware 2

3 These weaker provisions didn t get in the way of demand; all three were heavily oversubscribed. But if an issue such as one described above should enter financial difficulty, what will happen to the price? What rights, remedies and recovery will a bondholder have if the issuer defaults? Well, you could just sell the bonds if you see that coming, you say? Changing liquidity dynamics What changes have we seen in liquidity factors in the high yield muni market that could impact trading, particularly concerning a problem credit? One is the Wall Street regulatory climate and risk aversion; another is different investors with different interests. First, because of increased capital requirements imposed on bond dealers trading desks, bond inventories are considerably lower today than they were before the financial crisis. Sellers cannot rely upon dealer counterparties to provide liquidity to the same degree as before the crisis since dealers often are reluctant to stock as many bonds as in the past, particularly bonds that could be more difficult for them to turn over due to credit concerns. Second, muni investors have often relied on the low default and bankruptcy statistics of the investment-grade muni market to understate the risk of the high-yield muni market. While we believe many investment-grade muni-market credits are improving, we believe that the increased use of bankruptcy or threats by issuers is becoming a problem. The seeming lack of willingness to pay by some issuers is resulting in the lack of willingness of investors to trust or rationally work with troubled credits. We re seeing restructuring professionals enter into discussions with issuers at an earlier stage than in the past. Hedge funds and so-called vulture funds have increased their participation in the high-yield muni market in recent years. Clearly, there are operational differences between hedge funds and mutual funds as well as different stated investment objectives. Mutual funds tend to focus on long-term total return with an emphasis on income while some hedge funds focus on short-term price return by purchasing bonds at substantial discounts to their intrinsic value (namely, vulture funds). These alternative investors often have different capital constraints and time horizons than typical open-end mutual funds, which have concerns about daily pricing and consistent income. Hedge funds and vulture funds benefit from client lockup periods. Many of these nontraditional buyers are indifferent as to the taxexempt nature of their municipal investments, a distinct difference from muni mutual funds. The different investment goals and constraints of these nontraditional buyers can impact their buying and selling behavior as well as their negotiating position during a workout situation. In some cases, these buyers intend to hold credits under the worst-case scenario (default or bankruptcy) and seek to settle with a favorable workout situation. Vulture funds have snapped up bonds after headline risk events such as Puerto Rico led to severe price volatility and attractive entry points. However, as the next distressed debt opportunity comes along, there s no telling how long hedge funds will hang on to the current investment opportunity. While these hedge funds can add to near-term liquidity in distressed debt, they can also add to volatility. The growth of high-yield exchange-traded funds (ETFs) has added another new dimension to high-yield muni-bond liquidity. If high-yield munis fall out of favor, and investors sell their ETF shares, then these funds must sell. Their structure doesn t allow the same degree of strategic trade execution as mutual funds and other alternative investors. They don t keep a cash reserve, they don t have sizeable lines of credit and they must maintain a relatively steady concentration of high-yield vs. high-grade positions. This sort of forced selling could cause high-yield spreads to widen faster than they otherwise would. The implication for muni investors and mutual-fund portfolio managers may be to use caution in buying the dips as credit problems arise and retail investors sell. If the ultimate value of a troubled credit is determined by court rulings, and the interim buyers are vulture and distressed-debt funds, the price will likely find a lower bottom. The expected recovery rate for a defaulted security is likely to be lower than in the past. What is the value of a dedicated income stream if the rate covenant is ignored and the revenues available are based on the willingness to pay? When fundamental analysis is thrown out the window and credit analysis is dependent upon forecasting political or legal events, how is valuation determined? These are questions we have asked but do not feel comfortable putting our shareholders capital at risk for. Troubled credits: buyer beware 3

4 Figure 2: Recoveries from bankruptcy or default Completed restructurings Security Jefferson County GO warrants and swaps 88% Sewer revenue warrants 54% Lease obligation Special tax school warrants Harrisburg GO; GO guarantee 66% Stockton COPs/leases; six series 50% Pension-obligation bonds 50% Detroit GO ULT 74% Proposed restructurings GO LT 34% COPs 14% Water and sewerage revenue Distributable state aid (GO ULT, LT) San Bernardino COPs 1% Approximate bondholder recovery 100%; distressed exchange Unimpaired Distressed exchange unimpaired Secured debt obligations 100%* Source: Moody s, DeAWM and Bondbuyer as of 5/7/14. COPs are certificates of participation. ULT refers to unlimited-tax GO bonds, and LT refers to limited-tax GO bonds. * Impaired by lengthening the debt service repayment period. Willingness to pay vs. ability to pay must be weighed Over the years, however, we have learned that each GO pledge is different. If we were to use the 2011 Central Falls, Rhode Island, Chapter 9 filing as precedent-setting, we would conclude that stakeholders would prioritize credit-market access and future GO bondholders would remain unimpaired while pensions would bear most of the adjustment. In Detroit, however, most GO and certificate of participation (COP) bondholders did get impaired, some significantly relative to pensioners. In the Stockton bankruptcy, COP bondholders were impaired while pensioners were not. However, as we depict in Figure 2, each case is unique. These changing factors may have an impact not only on the traditional high-yield muni market, but also on a declining investment-grade credit on the cusp of entering junk rating territory. In 2005, 57% of new supply was insured, and today it is only 6%, as Figure 3 illustrates). Investors can no longer rely on insurance for principal and interest repayment for most new issues. Hedge funds and vulture funds may have a bid for larger, better-known names, but for smaller issuers, they re less likely to do the homework and time will tell. We believe a gap in credit spreads could develop more quickly than before when a credit is viewed as nearing junk ratings. The City of Chicago is a good example. Chicago GO bonds traded like a low-bb credit prior to the Moody s downgrade to the equivalent of BB+ on May 12. After the downgrade, some Chicago GOs were trading roughly 50 basis points (bps) cheaper in yield overnight, similar to a B-rated credit! Figure 3: Insured new supply has declined New money Refunding Combined Bond insurance $500,000 $450,000 $400,000 $350,000 $300,000 $250,000 $200,000 $150,000 $100,000 $50,000 $ (f) Source: DeAWM as of as of 5/31/15. F refers to forecast. There is no guarantee that forecasts will be realized. 60% 50% 40% 30% 20% 10% 0% Troubled credits: buyer beware 4

5 If the rules are changing, so are the opportunities and risks Bankruptcy is not as uncommon as it used to be. Yet, there are still many reasons why it won t be widespread: It s not allowed in about half of the states, it impacts public image, it is time consuming and expensive (Detroit s legal and advisory fees amounted to $170 million), it doesn t necessarily solve problems (Detroit still has a difficult road ahead) and most importantly, it likely impacts affordable credit access for future infrastructure projects. Again, the muni market has plenty of strong credits. Out of the 40,515 six-digit CUSIPs in the market, the top 500, or roughly 1%, account for 50% of the total outstanding debt in the market. We have a preference to stick to these larger issuers due to their frequent market access, liquidity and continuing disclosure. We have a favorable outlook on the market overall, particularly in investment-grade credits with longer maturities. But we re not seeing a good value proposition in certain high-yield muni credits for a variety of reasons. The fact that the changes we outlined are occurring in the muni market at a time when credit spreads are historically tight and overall interest rates are very low makes the case for caution in the higher-risk muni market all the stronger. If investors aren t careful and prudent when investing in munis and troubled credits, it could be an unpleasant surprise. In investing, there s no going back to the future. Troubled credits: buyer beware 5

6 Definitions One basis point equals 1/100 of a percentage point. Credit quality measures a bond issuer s ability to repay interest and principal in a timely manner. Rating agencies assign letter designations such as AAA, AA and so forth. The lower the rating, the higher the probability of default. Credit quality does not remove market risk and is subject to change. Credit risk refers to the risk that a borrower will default on any type of debt by failing to make payments which it is obligated to do. Duration, which is expressed in years, measures the sensitivity of the price of a bond or bond fund to a change in interest rates. The Committee on Uniform Securities Identification Procedures (CUSIP) is a nine-character alphanumeric code that identifies a North American financial security for the purposes of facilitating clearing and settlement of trades. Spread refers to the excess yield various bond sectors offer over financial instruments with similar maturities. When spreads widen, yield differences are increasing between bonds in the two sectors being compared. When spreads narrow, the opposite is true. Yield (or current yield) is the income generated by an investment divided by its current price. Yield ratio is a comparison of the expected yield of one bond to the expected yield of another. Yield to maturity is the rate of return anticipated on a bond if it is held until maturity. The opinions and forecasts expressed herein do not necessarily reflect those of Deutsche Asset & Wealth Management, are as of June 2015 and may not come to pass. Important risk information Bond investments are subject to interest-rate and credit risks. When interest rates rise, bond prices generally fall. Credit risk refers to the ability of an issuer to make timely payments of principal and interest. Investments in lower-quality and non-rated securities present greater risk of loss than investments in higher-quality securities. Inverse floaters are derivatives that involve leverage and could magnify gains or losses tax-free investments. Investments that generate federally tax-free income may have a portion of their distributions subject to federal, state and local taxes, including the alternative minimum tax. Investment products: No bank guarantee Not FDIC insured May lose value Investment products offered through DeAWM Distributors, Inc. Advisory services offered through Deutsche Investment Management Americas, Inc. Deutsche Asset & Wealth Management represents the asset management and wealth management activities conducted by Deutsche Bank AG or any of its subsidiaries. Clients will be provided Deutsche Asset & Wealth Management products or services by one or more legal entities that will be identified to clients pursuant to the contracts, agreements, offering materials or other documentation relevant to such products or services. DeAWM Distributors, Inc. 222 South Riverside Plaza Chicago, IL service@db.com Tel (800) Deutsche Bank AG. All rights reserved. PM (6/15) R MUNI-OPIN-JUN RETAIL-PUBLIC

MUNI OPINION Fixed Income

STRATEGY INSIGHTS MUNI OPINION Fixed Income OCTOBER 2012 The price of a defensive portfolio Investors are programmed to seek out investments that have low prices. But in the muni world the price of a bond