SALT-Fueled Rally in Muni Market Faces Tax-Day Test

Excerpt from bloomberg.com article,

SALT-Fueled Rally in Muni Market Faces Tax-Day Test

By Amanda Albright
April 1, 2019

The rally in the $3.8 trillion municipal-bond market is about to face a major tax-season test. All year, analysts have credited the $10,000 cap on state and local tax deductions for driving a record-setting amount of cash into tax-exempt debt as investors look for ways to cut what they owe to the federal government. The wave of money helped propel a five-month rally that’s pushed yields on some municipal bonds to the lowest against Treasuries since at least 2001.

“The demand side has been big,” John Mousseau, chief executive officer and president of Cumberland Advisors, said in an interview. “The market is a little bit vulnerable to a backup in yields and a bit of a selloff.”

 

Read the full article at the Bloomberg website: www.bloomberg.com

 




Mousseau: The SALT (state and local taxes) conundrum

Excerpt from the Sarasota Herald Tribune’s article,

Mousseau: The SALT (state and local taxes) conundrum

There have been headlines recently describing the drop in state tax revenues versus forecasts for some of the higher-tax states such as California, New York, and New Jersey. Part of the falloff is due to an exodus of higher-income residents from high-tax states, such as the ones above, for states with low or no income taxes, such as Florida, Texas, and Nevada.

Exacerbating this effect is the SALT provision of the 2017 tax bill (in effect for the 2018 calendar tax year). It puts a $10,000 cap on the amount of deductible state and local income taxes and local property taxes. This cap, of course, effectively raises the effective rates of these taxes by an amount equal to the loss of deductiblity.

Prior to this year, being able to deduct state and local taxes in full meant that taxpayers subject to the old 39.6 percent highest marginal tax rate effectively wrote off almost 40 percent of their taxes. The SALT change means that, on a cash-flow basis, both people’s property taxes and income taxes will effectively rise almost 40 percent from what they paid last year. For obvious reasons, this new tax bite has generated much consternation and many crosscurrents.

Continued…

 

Read the full article at the Sarasota Herald’s website: www.heraldtribune.com

 




The Fed Is Guessing As it Plays With Fire: David Kotok (Radio)

David Kotok, Chairman & Chief Investment Officer of Cumberland Advisors, on what to expect from the FOMC, balance sheet, and the outlook for bonds and markets. Hosted by Abramowicz and Paul Sweeney.

Running time 12:42

 

LISTEN HERE: Bloomberg Radio

NOTE: Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.


If you like podcasts, check out this one from 2015 featuring David Kotok talking about his background and Camp Kotok with Barry Ritholtz. They also talk about the history of Cumberland Advisors since its founding, and delve into fundamental principles of investing and valuation.


Links here
https://itunes.apple.com/us/podcast/masters-in-business/id730188152?mt=2

And here
http://www.bloomberg.com/podcasts/masters-in-business/




Buyer Beware

Cumberland Advisors - Shaun Burgess - Portfolio Manager & Fixed Income Analyst

In a move that caught many observers by surprise, the Federal Oversight and Management Board (FOMB), which was created to oversee the restructuring of the Commonwealth of Puerto Rico, has requested that Judge Swain invalidate more than $6 billion of the territory’s debt. The move would affect uninsured general-obligation bonds issued in 2012 and after. The rationale for the FOMB’s argument is that the debt was issued in violation of the island’s constitutional debt limit. While others have called for this move previously, the FOMB has never vocally supported this extreme action until now. The bonds in question were apparently issued in adherence to practices used in prior debt issuances, and their validity came into question only following the island’s historic bankruptcy.

The move raises many questions. How did the island access capital markets if the debt violated the debt limit? Can the debt be invalidated if it was in compliance with practices used at the time and in prior debt issuances? If the calculations that were used were known to be incorrect, is there a case for fraud? Is there more debt the island may seek to invalidate? Is the move in line with the FOMB’s mandate of putting the island on a path to regain market access? How does this development affect other municipalities that may have used creative methods to skirt statutory debt limits? The biggest question, though, is who would be held accountable? It is easy to say that this problem affects only “soulless” hedge funds, but that is not true, especially with regard to bonds issued prior to 2012, when the general-obligation pledge was still rated investment-grade. And in any case, hedge funds bought the Commonwealth’s bonds based on the promise to be repaid. Being forced to take a haircut because of the inability to pay is understandable, but to get nothing because the calculations used were incorrect or inappropriate would be hard to stomach.

Whether Judge Swain agrees to the FOMB’s request remains to be seen, but the attempt raises serious questions about the direction of the FOMB and the broader implications for the $3 trillion municipal bond market.

Shaun Burgess
Portfolio Manager & Fixed Income Analyst
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Q4 2018 Credit Commentary and a Look Ahead to 2019

Has The Municipal Credit Cycle Plateaued?

Cumberland Advisors - Q4 2018 Credit Commentary and a Look Ahead to 2019

Many positive indicators suggest that the municipal credit cycle has yet to plateau. Upgrades continue to outpace downgrades; the US economy is still growing; federal tax reform boosted revenues in fiscal 2018; and rainy day funds or reserve levels in many localities are strong. However, pressures continue to confront municipalities. Pension burdens and retiree healthcare costs continue to rise, while infrastructure underinvestment and affordability of living in cities, along with rapidly changing technology, are among the other challenges. These and other factors are discussed in our Nov. 19th commentary, “Is the Municipal Market Sleepy?! Pension Doomsday?” (see http://www.cumber.com/is-the-municipal-bond-market-sleepy-pension-doomsday/). More recently, the limit on deductibility of state and local taxes, along with higher mortgage rates, seems to have driven down or slowed home price appreciation in some areas, and that trend could reduce property tax growth in the future.  John Mousseau mentions this in his recent commentary http://www.cumber.com/4q2018-review-munis-turn-it-around/.Stable may be the catchword for municipal credit over the near- to mid-term, which could indicate a plateau.

Moody’s recently released outlooks for state (Dec. 5) and local government credit (Dec. 6) over the next 12–18 months and considers them stable. Moody’s projects that states will see tax revenue increases of 3.5% to 4.5% in 2019, reflecting continued but slowing growth. Moody’s notes that this projection, if realized, would represent the tenth consecutive annual tax revenue increase. The outlook factors in continued spending pressure to fund pensions and retiree healthcare costs as well as anticipated pressure to increase education and Medicaid spending. The outlook anticipates, as a result of improved investment returns, a reduction in increases in the funded status of pension plans, a projection that may not materialize unless the market recovers. (See David Kotok’s “Stock Market and Tariff Truce,” http://www.cumber.com/cumberland-advisors-stock-market-and-tariff-truce/.)

With regard to federal funding, Moody’s outlook does not foresee large changes in spending for education and Medicaid. However, Medicaid, at 29.7% of state spending according to the National Association of State Budget Officers’ 2018 State Expenditure Report, is the largest and fastest-growing segment of state spending, at 7.3%. The stable outlook takes into consideration the buildup of adequate reserves by most states, which could provide a cushion and flexibility to manage through an economic downturn or changes in federal spending. The December 14th ruling by the US District Court in Fort Worth, Texas, held that the Affordable Care Act (ACA) is unconstitutional because of the individual mandate. However, the decision is expected to be appealed, and the case is ultimately expected to head to the US Supreme Court, while the law would remain in effect during the process. Thus, Moody’s anticipates that the decision will not have immediate credit implications for states, hospitals, or health insurers. Full repeal of the ACA would mean reduced federal spending on Medicaid and subsidies to individuals. Those states that expanded Medicaid would be most affected. Alternatively, there could be a partial repeal of the ACA or no repeal at all.

Moody’s stable outlook for local governments projects modest growth of 2–3% in property tax revenue and a 3% increase in total revenue, including sales and use taxes and state funding in 2019. Property tax revenues grew 3.7% in 2017 because many people paid their 2018 taxes early. Spending pressure is expected, mostly from increases in the personnel costs necessary for the management of pension and healthcare issues, as well as a need to have competitive salaries and benefits. Moody’s notes that most cities, counties, and school districts hold healthy reserves to manage through a downturn.

Of course, there are some states, such as Illinois, New Jersey, and Connecticut, and some cities that have outsized burdens and management and budgeting issues. Their lower ratings reflect those challenges.

State Ratings

Following two quarters of high activity (see our Q3 commentary: http://www.cumber.com/q3-2018-municipal-credit-commentary/), the only state rating actions this quarter were the downgrade of the State of Vermont by Moody’s from Aaa to Aa1 and the revision of two state outlooks by Moody’s. The State of Vermont’s downgrade reflects low growth prospects from an aging population, coupled with relatively high debt as compared with GDP and with shortfalls in funding for post-employment benefits. However, the still-high rating reflects a solid financial position and strong management. S&P has rated Vermont AA+ since 2000. Moody’s revised the State of North Dakota’s outlook to stable from negative as a result of progress towards structural balance coupled with rapid restoration of reserves as the economy and revenues continue to recover from the 2016 energy recession. Recent declines in oil prices will likely result in some economic and revenue volatility; however, the state’s energy economy and financial reserves are well-positioned to weather some short-term disruptions at this time. Also, Moody’s revised the outlook for Mississippi to stable from negative to reflect stabilization of revenue and economic trends and a resumption of deposits to the rainy day fund. The outlook also incorporates the expected continuance of conservative fiscal management, which will help manage elevated debt levels and potential future revenue weakness.

Midterm Elections Included Numerous Ballot Initiatives

In “Midterm Elections: The Quick Muni Note” (Nov. 7th – see http://www.cumber.com/midterm-elections-the-quick-muni-note/),John Mousseau discusses the bond-related advantages of a divided Congress. Here we recap ballot initiatives.

Medicaid expansion: Three states – Idaho, Nebraska, and Utah – voted to expand Medicaid, while Montana voters, by not approving a rise in tobacco taxes, struck down a measure to continue funding Medicaid expansion beyond the June 30th sunset date. Depending on the legislature’s actions, Montana could be the first state to end Medicaid expansion after having accepted it. Moody’s notes that 36 states, encompassing two-thirds of the US population, have approved Medicaid expansion. This broad implementation may make it more difficult to repeal or make changes to the ACA.

Infrastructure spending: Many state and local bond measures were passed, supporting housing, hospitals, education, transportation, and other infrastructure. In California numerous proposals for statewide bond issues funding housing and children’s hospitals were approved, including  a vote not to repeal an increase in fuel taxes that was due to expire and helps fund transportation spending.  However voters in the Golden State turned down a $9 billion water infrastructure initiative.  Further detracting from the spending trend, voters in Colorado, Missouri, and Utah voted down increases in taxes for roads and schools.

Restrictions in state flexibility: Six of ten ballot initiatives were passed that reduce legislative or executive flexibility to raise or manage revenue, an outcome that is generally credit-negative. For example, a two-thirds majority in the Florida Legislature will now be required to raise statewide taxes and fees, while Arizona now prohibits taxes on services, and North Carolina has voted to place limits on state income taxes.

There were numerous local bond and fee initiatives that passed as well. The results of the initiative process can affect credit quality and issuer flexibility, so it is important to watch how implementation evolves.

Trend to Fewer Ratings

The number of issuers seeking multiple ratings has declined since the financial crisis. Until the crisis, issuers often had debt ratings from two or more rating agencies. According to data collected by Municipal Market Advisors (MMA), issuers that were triple-rated (by Moody’s, S&P and Fitch – data on Kroll is not able to be queried yet) declined steadily from 55% in 2007 to 34% through 2017. Viewed another way, by the end of Q3 2018 there were 1.91 ratings assigned per dollar par issued, down from 2.29 ratings assigned per dollar par issued in 2007. The par value of bonds that are rated by just one rating agency has grown to 25% from 21% in 2007. The trend is likely a function of municipalities’ looking to reduce costs. Additionally, in the recent low-interest-rate environment with narrow credit spreads, fewer ratings on bonds have been sufficient to gain market acceptance, especially as investors chase yield. If credit spreads were to widen, a differentiation in yield might become visible among bonds with just one rating compared to those with two or more ratings, and this development could reverse the trend.

The trend to fewer ratings is a negative for investors. There could be “rating shopping” going on. The criteria, or areas of emphasis, applied by the rating agencies are different, and an issuer can choose the rating agency that it thinks will give its debt a higher rating. Having only one rating means there are fewer “eyes on” the credit and less frequent reviews. A bond with one rating is also subject to changes in the rating agency’s criteria, which could cause an abrupt change in the rating, up or down. With two or more ratings, there is more stability. This falloff in the number of ratings makes the case for active bond management and investment in higher-quality bonds, which is the strategy that Cumberland Advisors employs.

Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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4Q2018 Review: Puerto Rico Insured Bond

Cumberland Advisors - Shaun Burgess - Portfolio Manager & Fixed Income Analyst

It has been a busy quarter for the Commonwealth of Puerto Rico. Milestones included a conclusion to the Title VI restructuring of the Government Development Bank (GDB) and a plan for the restructuring of the Puerto Rico Sales Tax Financing Corporation’s (COFINA), as well as the continued rebuilding from the damages wrought by Hurricane Maria and a myriad of other developments. The conclusion of the GDB’s restructuring and the plan of adjustment for COFINA represent the most significant developments we have seen thus far in the Commonwealth’s bankruptcy saga.

The restructuring of COFINA’s debt stands as one of the most significant developments to date and will rank among the largest municipal restructurings in history, at a staggering $17.6 billion. The terms of the plan include COFINA and Commonwealth bondholders splitting sales and use tax revenues to the tune of 53.65% and 46.35%, respectively. Senior bondholders are set to receive 93 and subordinate bondholders 56 cents on the dollar, and both will exchange existing bonds for new senior lien securities backed by their respective portion of the 5.5% sales and use tax. Although the plan obviously offers considerably less for subordinate bondholders than it does for senior debt holders, the proposed workout is an equitable resolution in Cumberland’s opinion for both COFINA and Commonwealth creditors and is less likely to face significant legal challenges that could prolong the agency’s restructuring. Judge Swain’s approval of the plan’s disclosure initiated a creditor support voting process which will culminate in a confirmation hearing set for January 16, 2019, with public commentary included in the proceedings. We look forward to this date as it represents another pivotal moment in the restructuring process. Execution risks remain, as further progress will depend on the outcome of creditor votes as well as Judge Swain’s approval.

A milestone no less important was the closure of the Commonwealth’s first court-authorized workout – the Title VI restructuring of the GDB’s approximately $4 billion of debt. Although a small sum in the totality of the burden facing the Commonwealth, the restructuring still represents a significant step forward. It stands as the only Title VI restructuring thus far and the first of many restructurings we will see in the coming months and years. Bondholders received 55 cents on the dollar in new securities paying a coupon of 7.50% and maturing in 2040. Even with the GDB’s debt restructured, the risk of nonpayment at some point in the future remains high; and the market price on the newly issued securities reflects as much, with a valuation currently in the high $60s. The restructuring of the GDB offers an important lesson to bondholders, in that even securities received from a restructuring can trade to levels which could worsen initial “haircuts”.

Looking ahead, 2019 promises to be an even busier year for the Commonwealth, with the restructuring of Commonwealth-guaranteed debt and numerous agencies including the Puerto Rico Highway and Transportation Authority (PRHTA), the Puerto Rico Aqueduct and Sewer Authority (PRASA), and the Puerto Rico Electric Power Authority (PREPA) on the agenda, along with a number of outstanding legal challenges and unfunded pension liabilities still to address. We expect the focus of the Financial Oversight and Management Board (FOMB) to remain the restructuring of COFINA and Commonwealth-guaranteed obligations as these represent the largest portion of the Commonwealth’s total outstanding debt, not including unfunded pension obligations, and smaller easier to restructure agencies.

We have hit some important milestones in 2018 and think that 2019 will bring more. We still believe that carefully selected insured paper can offer terrific value for clients at tax-exempt yields north of 4%. We do not recommend blindly buying insured paper but instead carefully researching individual issues.

Shaun Burgess
Portfolio Manager & Fixed Income Analyst
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Total Return Taxable Fixed Income: 4Q 2018 Review

CA-Dan-Himelberger

After a poor start to the quarter, the Treasury market rebounded nicely over the month of December, providing positive performance across the Treasury curve as the equity market suffered from negative sentiment pertaining to geopolitical risk and concerns over the Fed’s path towards raising short-term interest rates. Political bickering over building “the wall” and threats of a government shutdown intensified the negativity, leaving equity investors bearish and running for safe-haven assets such as gold and Treasury securities.

The bearish outlook in the equity market created a nice opportunity in the fixed-income space, as a “flight to quality” sent yields across the Treasury curve lower. After the high on the 30-year Treasury, at 3.455%, on November 2, the yield dropped 49.5 basis points to 2.96% on December 20. The 30-year yield has since settled in around 3.04%. The drop in yield was even more pronounced for the 10-year Treasury, which dropped 51.8 basis points, from 3.238% to 2.72%, and has settled in around 2.78% currently. This December rally in the Treasury market has added a nice boost to the performance of the long end of our barbell strategy and is a testament as to why we continue to manage portfolios using this approach. Below is a graph of the Treasury actives curve, showing monthly dates within the fourth quarter of 2018.

Source: Bloomberg

Not all taxable fixed-income asset classes benefited from the flight to quality. One that suffered during the fourth quarter was the corporate bond market (both investment-grade and high-yield). Corporate bonds tend to be more correlated than other taxable fixed-income sectors to the equity market, and as negative sentiment grew, spreads widened, causing underperformance versus the other sectors. The Bloomberg Barclays US AGG Corporate OAS Index widened 45 basis points from +105 to +150. Allocating only a small portion of our assets to the corporate space helped our taxable fixed-income strategy, as taxable municipal spreads did not suffer widening to the extent that the corporate space did. The lower historical default rate and higher overall credit quality of the municipal space helped limit the spread widening in comparison with corporate issues.

At the December 19th FOMC meeting, the Fed raised the fed funds target rate 25 basis points to a target range of 2.25–2.50%. This marks the ninth hike in the cycle and puts the fed funds rate at the highest level since October 2008. The Summary of Economic Projections seen in the Fed’s “dot plot” provided a dovish surprise as the baseline for rate hikes in 2019 dropped from 3-1 in September to 2-1. The post-meeting statement continued to point out “strong” growth and job gains, with the inflation projection unchanged at near 2%. The upper-bound drop in rate hikes from three to two is in line with our projection for 2019. There is the risk that an inverted yield curve could threaten economic growth, and the Fed will need to be cautious and data-dependent in its approach to raising short-term interest rates in order to avoid putting too much pressure on the market.

As for Cumberland’s Taxable Total Return portfolios, we will continue to implement our barbell strategy and look to take advantage of opportunities on the long end of the yield curve when they are available. We are still in a rising-interest-rate environment, but we no longer expect the Fed to hike rates at the pace that it did in 2018. While we continue to navigate this rate environment, the story remains the same. Our goal is to remain defensive in our approach to investing while making our investment decisions conservatively and extending durations to pick up additional yield as opportunities in the market become available.

Daniel Himelberger
Portfolio Manager & Fixed Income Analyst
Email | Bio

Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Is the Municipal Bond Market Sleepy?! Pension Doomsday?

Today’s municipal bond market is anything but “sleepy,” as Spencer Jakab characterized it in his Wall Street Journal article “Prophet of Muni Market Doom Wasn’t Wrong, Just Early” (10/26/2018). The Prophet of Doom he referred to was Meredith Whitney, who shortly before the financial crisis successfully predicted the damage to Citibank by bad mortgages. In 2010, on 60 Minutes, she contended that municipal market participants were not addressing or recognizing pension risk that would contribute to “50 to 100 sizable defaults” on municipal bonds over the next year. This comment caused a rout in the municipal bond market, but we now know that a large number of defaults did not materialize.

Market Commentary - Cumberland Advisors - Is the Municipal Bond Market Sleepy - Pension Doomsday
The market is heterogeneous. There are over 80,000 municipalities in the United States, and each of those entities can issue various types of debt, from general-obligation bonds backed by the taxing power of the municipality to revenue bonds that are secured by user fees such as water and sewer rates. Municipal bonds fund everything from fire trucks to schools to major road projects. Bond maturities can exceed 30 years. Thus, there are many investments to choose from. Municipal bonds offer tax-exempt income and can be used for impact investing,  because municipal bonds finance projects that have environmental, social, and governance (ESG) implications.

Many participants in the marketplace are aware of pension-funding shortfalls as well as the growing burden of providing healthcare to retirees and paying for long-term debt. They understand that if the problems aren’t dealt with, the financial implications down the road could be severe. Jakab’s article does not mention the states and municipalities that are taking action to improve pension funding status and what those actions are. That perspective could have helped WSJ readers and others, whether they are taxpayers, pensioners, or bond investors, to understand their towns and states better and take some action instead of being afraid.

Pension obligations are long-term and large. Just as an ocean liner takes a long time to turn, so, too, municipalities must anticipate in advance how to proceed. The pension issue does need to be addressed; however, it may not be an immediate threat in many jurisdictions. Actions that can improve pension funding include lowering the assumed rate of return on investments and fully funding or overfunding the actuarially required annual contribution (ARC) to the pension, (funding at this level keeps the funded level growing to meet future obligations). The municipality can alter certain pension benefits, for example by reducing cost-of-living adjustments or changing the level of benefits for future employees – all difficult decisions. Because liabilities can mushroom, it is important for municipalities with underfunded plans to make changes sooner rather than later. An increasing pension burden, just like your personal credit card debt, can balloon if you do not make more than the minimum monthly payment.  These payments can compete for spending on other items.

States that have been able to implement pension reforms include Ohio, Colorado, Minnesota, and Kentucky. Although the Kentucky changes are being challenged, there is now more recognition in the state that something needs to be done.

Many observers look at the unfunded status of a plan. For example, Pew Charitable Trust annually calculates those figures.  The average funded level of a state pension fund based on 2016 data is 66% with the lowest funded at 31% for New Jersey and Connecticut and the highest funded plan was Wisconsin at 99% funded.  Moody’s calculates an Adjusted Net Pension Liability (ANPL) by making changes in assumed rates of return, among other variables, to all state pension funds.  This makes state funded levels more comparable and realistic. Moody’s uses discount rates between at 3.0%–4.0% while most pensions still assume 6.5% to 7.5%. A lower discount rate increases the unfunded status of a plan so is more conservative.  Moody’s compares the ANPL with state revenue to rank the states based on the metric.  The highest ratios are for Illinois (600%), Connecticut, Kentucky and New Jersey (290%) while North Carolina, North Dakota, Wyoming and Utah have ANPL well lower as a percent of revenue at 45% or under.

Other post-employment benefits (OPEB), mostly healthcare, were historically funded on a pay-as-you-go basis. OPEB liabilities are now required to be recognized in accordance with accounting standards recently implemented for periods beginning after June or December of 2017, specifically Governmental Accounting Standards Board (GASB) Statements 74 and 75. This is a positive development, allowing a municipality and its citizens a more transparent view of fiscal health. It is even more important as retirees live longer and the cost of healthcare rises. Many healthcare benefits are not contractually fixed, as pension benefits are; however, reducing benefits may be politically unpopular, in effect making healthcare benefits almost as difficult to change as pensions are.

Technological improvements have helped improve efficiency at municipalities, but the improvements have also led to there being fewer current employees to support a growing retiree population, which further exacerbates the pension issue. Further developments in technology may give municipal managers pause as they determine which direction to invest in for the future.

There are other risks to the long-term economic viability of municipalities – exploding pensions are just one of them. There is the widely publicized issue of deferred infrastructure spending, which reduces livability and could be a negative for economic development and a safety risk to a community. Deferred spending also makes projects more expensive. In addition, there is the prospect of having to prepare for sea level rise, coastal erosion, and more extreme weather and fire events.

The increasing wealth gap and affordability issues affect social service spending and tax-rate and service-fee-rate increase management. Municipalities have many competing spending needs.

I’m not trying to paint a dire picture, but I am trying to impress upon readers and casual observers of the municipal market that market participants are in fact aware of long-term challenges. Ratings and credit analysis are based on many factors, including the strength of the service area economy, financial operations, long-term plans, and management performance. Ratings are not based on one item unless that one factor is overwhelming.

The fear of widespread municipal defaults in 2010 and the ensuing rout in municipal bond prices created a buying opportunity for investors that knew the market. For many investors, the timing of when to exit a bond is the issue. Do investors exit as soon as they see the light of the pension crisis train barreling down the track, or just before the train wreck? Conservative investors generally do not invest in the state obligations of Illinois, New Jersey, or Connecticut because of those states’ burgeoning pension and OPEB obligations (additionally these states suffer from slow or negative growth in population and dysfunctional governance). Cumberland, as a conservative investor, has avoided the bonds that would have suffered from the multiple downgrades of those states.

Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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California, Land of Natural Disasters?

Last week we conducted a review of our California municipal bond holdings along the San Andreas Fault looking for holdings that may be more susceptible to credit deterioration in the event of a disaster. At the time, little did we know that wildfires would engulf large swaths of California.

Market Commentary - Cumberland Advisors - California, Land of Natural Disasters
The Advanced Rapid Imaging & Analysis (ARIA) team at NASA’s Jet Propulsion Lab in Pasadena, CA, created these Damage Proxy Maps (DPMs) depicting areas in California likely damaged by the Woolsey & Camp Fires.

First, our hearts and prayers go out all those affected by the wildfires and their loved ones and friends, including firefighters, volunteers, and those housing the displaced.

We monitor our portfolios on a regular basis. The majority of our holdings are in AA-rated credits that have economic diversity, good wealth and income indicators, and strong financial management, exemplified by ample reserves and liquidity.  During the monitoring process we look for changes in credit quality of our holdings and we evaluate bonds that new clients have sent us to manage; and if they do not meet our credit parameters we sell them.

A state of emergency and a major disaster have both been declared in California. The declarations by the governor of the State of California (and the governor elect) and the president ensure that the Federal Emergency Management Agency (FEMA) will provide funding and other resources to help rebuild and provide shelter and other aid in the wake of the fires. We have seen from other disasters that the rebuilding effort generally produces an increase in spending and other economic activity, such that sales taxes and other revenues flow to the municipalities in the state and sometimes improve credit quality in the long run.

Many areas of the state have been affected, including the town of Paradise, which lies in ruins, and no socioeconomic class has been spared. See this CNN piece on the fire damage: “44 dead in California fires as the Camp Fire becomes the deadliest in state history,” https://www.cnn.com/2018/11/12/us/california-wildfires-woolsey-camp-hill-missing/index.html. And here is a Bloomberg report: “California Ablaze: The State’s Devastating Wildfires in Pictures,” https://www.bloomberg.com/news/photo-essays/2018-11-09/massive-wildfires-rage-across-california. Statewide, damage estimates are large and continue to grow. Some of the damage will be covered by insurance proceeds and local money, in addition to FEMA funds.

The state and many local California governments do have the liquidity to foot the initial costs – though as we have written, some municipalities do not have reserves as robust as might be expected this far into an expansion. See our Q3 municipal credit commentary: http://www.cumber.com/q3-2018-municipal-credit-commentary/http://www.cumber.com/q3-2018-municipal-credit-commentary/. So there could well be initial financial stress as communities address the damage.

The continual onslaught of disasters afflicting California this year, on top of the fires last year, gives us pause. What do these events mean for the livability of the state, and what will be the effect on population flows going forward? The past has shown that the state remains desirable, but from time to time growth and related financial stability have varied. We should also remember that California is the fifth largest economy in the world in terms of GDP. It has substantial financial wherewithal to mitigate concerns.

Diversification is a tenet of investment management. The proverbial “Don’t put all your eggs in one basket” comes to mind. Cumberland strives to construct diverse portfolios of municipal bonds, including state-specific portfolios where the client benefits from state tax exemption. The portfolios of many of our California clients are also state-specific, because of the high local income taxes charged in the state. We look for geographical diversification, including having out-of-state bonds in state-specific portfolios. We also diversify among types of credits or sectors, from general-obligation to water or healthcare-system revenue bonds. In addition we diversify through bonds that have been prerefunded (secured by US obligations in an escrow account) or that are insured. Diversification provides a level of insulation from a regional disaster or an industry dislocation, among other risks.

Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
Email | Bio


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MOUSSEAU: The Cumberland World Series Theory of the Bond

Most investors have heard of the “Super Bowl Theory of the Dow.” This theory, first proposed by sportswriter Leonard Koppett in the 1970s, according to Wikipedia, posited that when a team from the “old” NFL (the current NFC, plus the Colts, Browns and Steelers, who joined the AFC in 1970) won the Super Bowl, the Dow Jones Industrial Average would advance in the year following the game. If a team from the AFC won the Super Bowl, the Dow would decline.

Amazingly, this theory has worked out almost 80 percent of the time, though the February 2017 Super Bowl, won by the Patriots (AFC), did NOT accurately predict the stock market (up in 2017).

The correlation, of course, is just a coincidence: There is no connection between a conference winning the Super Bowl and subsequent returns in the stock market, and thus there is no reason to think that the Super Bowl can be used to predict markets.

Read the full article at the Sarasota Herald’s website: www.heraldtribune.com

Or read the full commentary here: www.cumber.com/the-cumberland-world-series-theory-of-the-bond/