Investors grab hefty yields in Illinois and Chicago bond sales

Excerpt below from “Investors grab hefty yields in Illinois and Chicago bond sales”
By Karen Pierog, Reuters, March 26

Cumberland-Advisors-Shaun-Burgess-In-The-News
Shaun Burgess of Cumberland Advisors

CHICAGO – Yield-hungry investors on Tuesday snapped up more than $1.1 billion of general obligation bonds offered by Illinois and Chicago, two of the U.S. municipal market’s most financially troubled issuers.

While the state and its largest city continued to pay a high price for their fiscal woes, their deals benefited from low supply in the $3.8 trillion market and “a ton of cash” looking for bonds to buy, according to Greg Saulnier, a Municipal Market Data (MMD) analyst.

“Yields are so low that some guys are willing to take a risk for the yield grab,” he said.

Shaun Burgess, a portfolio manager at Cumberland Advisors, agreed. “Clearly, demand is discounting some of the credit risks associated with these issuers,” he said. MMD narrowed so-called credit spreads for Illinois, the lowest-rated U.S. state, at a notch or two above junk, due to its huge unfunded pension liability and chronic structural budget deficit, in the wake of a $440 million bond sale. The state’s spreads remain the widest among U.S. states.

Chicago, which is also struggling with pension funding and deficits, increased the size of its bond offering to nearly $728 million and moved pricing up by a day. There was enough demand to allow underwriters to lower yields by 5 basis points in most maturities through a repricing.

Continue reading the full article at www.reuters.com




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% highest marginal tax rate effectively wrote off almost 40% 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% from what they paid last year. Here’s an example. Let’s say a New Jersey couple paid $30,000 in property taxes and $30,000 in state income taxes. Under the old method, their $60,000 would be reduced to $36,180 as they would have written the tax off at 39.7%, the old top federal marginal rate. Under the new method, state and local taxes are not deductible, except for the $10,000 limit. Thus, their new taxes are $50,000 ($60,000-$10,000), or 38% more.
For obvious reasons, this new tax bite has generated much consternation and many crosscurrents.

Muni Bond Standpoint
Some of the best-performing bonds in the past two years have been higher-grade issues from New York, California, New Jersey, and Connecticut. We have written on this effect, and we began to emphasize these bonds even in national accounts in the middle of 2017. As the tax bill was being discussed, it became evident that SALT was going to be part of the package. It meant that income from out-of-state bonds for taxpayers in high-tax states would have to overcome a higher yield threshold since more would be taken away by the nondeductibility of state and local taxes on a Federal return.

This past week we looked at yield curves for the high-tax states of California, New York, and New Jersey and then compared them to general market yield curves, which we show below as both nominal yields and then yields after the effects of state taxes on these out-of-state yields are factored in.

In-State vs Out-of-State Yields on an After-tax Basis

Source: Bloomberg

We can see that there is an after-tax give-up at every point on the yield curve in all three states for investors owning out-of-state bonds, with the greatest penalty occurring in California, which makes sense, since it has the highest marginal state tax rate. Clearly this situation has driven higher demand for in-state exempt bonds in all of these states as well as in other states with high state income taxes, such as Minnesota, Connecticut, and Massachusetts. With steeper yield curves in munis, the biggest give-up from a nominal interest rate standpoint is in the longest maturity end.

The most natural message from a chart like this is that investors in high-tax states should reduce the amount of out-of-state bonds in their portfolios relative to their in-state exempt bond holdings.

But it’s not that simple. There are credit issues to consider as well.

The following slides are from a State of New York presentation.



(Source: https://www.governor.ny.gov/sites/governor.ny.gov/files/atoms/files/SALT_Revenue_PP.pdf )

The gist of this presentation is that it bemoans the SALT elimination of deductibility and its impact on New York’s budget. There are presumably similar slides in other high-tax-state presentations. The nondeductibility of both the state income taxes as well local property taxes will have a greater effect on residents of high-tax states. The counterargument of conservatives is that high-tax states have raised taxes based on the deductibility subsidy provided by the federal government. In any case, the high-tax states are now facing the loss of high-tax-paying residents who leave for lower-tax states such as Florida, Texas, and Nevada (no income taxes and lower property taxes). At Cumberland we feel this issue has been holding the high-end housing market in high tax states ransom for the better part of the last twelve months, as the nondeductibility of property taxes hurts that market just as the SALT provisions hurt the higher-yielding out-of-state bonds.

So at this point we have higher demand for IN-STATE bonds. But if these high-tax states continue to lose population, that is a credit NEGATIVE over time. Though it may sound somewhat counterintuitive, we are starting to look at DIVERSIFYING into some out-of-state bonds in the high-tax states as a hedge against potential credit erosion. We have written about the credit issue before. State and local governments will be forced to CUT taxes from their constituents to make up for some of the higher EFFECTIVE income taxes and property taxes. If declining tax revenue is not made up, there is a chance of lower debt-service coverage on bonds.

The best way to employ this strategy in the management of muni bond portfolios is to refer to the chart above. The nondeductibility effect on out-of-state bonds is the least at the shorter end where lower-yielding bonds are. To the extent that we continue to manage bond portfolios on a barbell basis, the marginal addition of out-of-state bonds should come from the shorter maturities.

And finally, President Trump said this week that he would consider some changes to the SALT provision of the tax bill (and just as quickly, Senator Charles Grassley of Iowa, chair of the Senate Finance Committee, rejected the idea on principle).

Whereas the president will find sympathetic legislators on both sides of the aisle from Northeastern states and California, we suspect that the true reason for his step-back is that with residents moving at the margin from the Northeast, reliably Republican states such as Florida and Texas become less reliable. These states are becoming somewhat bluer at the margin as we write this. It is hard to conceive of Republicans winning the White House without Florida and Texas, and we feel that is the main reason for the president to revisit the issue.

In summary, SALT has increased demand for bonds in high-tax states, put a higher penalty on out-of-state bonds in high-tax states, and hurt revenue collections as some taxpayers move to lower-tax states. The situation will gain some clarity for individuals after April 15th of this year, once taxes are paid. But in always trying to lean on the idea of better credit, we will look to diversify somewhat in the high-tax states.

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio

Gabriel Hament
Investment Advisor Representative: Foundations, Charitable Accounts & Private Individuals
Email | Bio

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


*Please note: Cumberland Advisors does not give tax advice. Please consult your tax advisor for applicability of any of the concepts listed in this commentary to your particular situation.


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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


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4Q2018 Review: Munis Turn It Around

Muni yields rose in the first six weeks of this quarter – mostly in sympathy with US Treasuries (UST). We saw the 10-year and 30-year Treasury bonds rise 20 and 25 basis points respectively. Since early November, AAA muni yields (AAA) have dropped across the board, and the 10-year Treasury yield has fallen a whopping 45 basis points in a matter of seven weeks.

 

The consternation and volatility in the stock market are the main reasons for yields doing a U-turn.

Some of the other themes affecting muni yields we discussed earlier this month:

(*) The housing market slowdown. Price gains have continued to slow for seven months in a row; and a number of Northeastern states and other previously “hot” markets have seen declines, especially at the higher end of the price range. This falloff is due to a combination of higher mortgage rates earlier this fall plus the specter of higher real estate taxes because of the lack of deductibility in the new tax bill.

(*) Concern about the rising level of debt and rising government debt service costs (see our piece “November Bond Market Bounce” from December 4thhttp://www.cumber.com/the-november-bond-market-bounce/).

(*) A general slowdown reflected by the price of oil. See graph below:

West Texas Crude per Barrel

(Source: Bloomberg)

 

The freefall in oil suggests that other prices may also be falling, so the combination of HIGHER yields earlier in November and stable-to-falling core CPI certainly made REAL yields seem much more attractive this fall.Now that yields have fallen, let’s survey the landscape.

37% Taxable Equivalent
(Source: Bloomberg)

The above graph shows the current muni AA curve and the Treasury yield curve. The curves demonstrate why we have used a barbell strategy, particularly on the tax-free side, where longer muni yields are CHEAPER than Treasuries yields. We believe those high yield ratios on the longer-maturity spectrum eventually go back to 100% or under – this outcome would be consistent with other Federal Reserve hiking cycles. For spread purposes we have also included a AA corporate bond yield curve and created a taxable-equivalent muni yield curve using the current top tax rate of 37%. This comparison demonstrates the advantage of munis over Treasuries for any level of taxpayer and the additional advantage of tax-free munis over corporates for high-tax payers, in the five-year tenor and beyond. The much lower default experience of munis versus corporates simply stretches this advantage.

The Federal Reserve last week raised the fed funds target yield range ¼% to 2.25%–2.5%.

The Fed also made mention of two possible increases next year and did so with less flexibility in the language, which helped to spook the equity market after the announcement last Wednesday. Our thoughts are that if core inflation remains where it has been, at 2.0–2.25%, and if there are more Fed hikes next year, the Fed will finally have gotten Fed funds to a positive spread over core inflation – where it has not been for 10 years. That would appear to be a good place for the Fed to pause. And as we get to that pause, we will begin to pick up the pace of moving very-low-duration assets out somewhat further on the yield curve to lock in rates, as shorter to intermediate rates most likely slowly work their way down.

Happy New Year to all our readers!

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
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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The November Bond Market Bounce

Here’s our first take after the midterm elections. The last three weeks of November have seen a bounce in the bond market, with intermediate and longer bond yields falling after spending most of 2018 rising.

Market Commentary - Cumberland Advisors - The November Bond Market Bounc

 

If we look at the US Treasury market (chart 1), we can see the rise in Treasury yields – across the board – from the end of 2017 to early November. A lot of this rise, in our opinion, was to give yields some competition with equity markets, which were certainly frothy early this year, in January, and then in late summer into September. In addition, better growth numbers for the economy, associated with last years’ tax cut, also helped push yields higher. However, core CPI is at 2.1% – approximately where it was at the time of the election in 2016 – though in early November the 10-year US Treasury yield was about 100 basis points higher, at 3.25%, than it was two years earlier. Thus, REAL yields had risen approximately 1% during this time period.

The November Bond Market Bounce Chart 01
Chart 01

 

Since early November we have seen 10-year US Treasury yields fall from 3.25% to 3% and 30-year US Treasury yields fall from 3.45% to 3.30%. Shorter yields have also declined. What’s going on? We think a number of factors are changing investors’ expectations about rates.
—(1) A slightly softer tone by the Federal Reserve is shifting expectations. While we expect to see the Fed raise the fed funds target in December to 2.25–2.5% percent, the markets certainly seem less married to the idea that we will see three or four rate increases next year.
—(2) Volatility in the equity markets has, we believe, led to some switching into bonds at the margin. Certainly, interest rates that are 80 basis points higher than at the start of the year and even HIGHER on a REAL basis have started to attract interest.
—(3) Previously hot real estate markets in the northeast, California, and other “hot” areas have now cooled. Homes that a year ago were often on the market for 4–5 weeks at most are now on for 4–5 months, and that time is lengthening. Bidding wars are now a thing of the past; and while the housing market may not be fully a buyers’ market, it has clearly transitioned from a sellers’ market. We think the provisions of last year’s tax bill, which dictated that state income taxes and local property taxes will no longer be deductible on federal taxes, are starting to have an effect now that we are less than six months from tax day. Clearly, areas that have high relative property taxes are grappling with what is now a higher after-tax cost of owning a home. Higher mortgage rates this year have also contributed to this cooling,
—(4) The market is reckoning with the fact that the increasing US government deficit will start to have ramifications that were not present over the past half dozen years.


In the charts above we see the growth in outstanding US government debt and Congressional Budget Office projections for future growth. We can see the growth of outstanding federal debt from $10.7 trillion in 2008 to an estimated $21.4 trillion at the end of this year. However, the net interest expense on that government debt barely budged between 2008 (at $252 billion) and 2017 (at $262 billion). But note the large jump this year and going forward. Interest expense on the government debt barely rose in the last decade because of ultra-low interest rates, particularly on shorter-term debt. The jump in interest expense going forward is a function of the higher interest rates in force today.

The November Bond Market Bounce Chart 04

For example, the above graph shows 5-year US Treasury yields going back more than a decade. Bonds that were issued in 2007 at 5% could be replaced when they matured in 2012 at a little more than 0.5%. We are now going the other way. Five-year notes that were issued in the middle of 2013 at around 1% were being replaced this year at almost 3%. This extra interest expense could act as a wet blanket on an economy that is still growing because of lower unemployment and tax cuts.

We think all of this activity has caused investors to ratchet down expectations. We have extended durations within our barbell strategy during the past two months and believe there are forces that should keep intermediate and longer-term interest rates in a trading range, with a bias to going lower. We believe that, with long Treasuries at 3.30%, longer tax-free municipal bond yields in the 4% range still represent excellent value – particularly in high-tax states that will be grappling with the SALT provisions of the tax bill.

We wish all our readers a great holiday season.

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
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


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The California Wildfires’ Financial Toll

Excerpt below from “The California Wildfires’ Financial Toll”
By Randall W. Forsyth, Nov. 16, 2018 1:06 p.m. ET

Cumberland-Advisors-Patricia-Healy-In-The-News

In every disaster, natural or man-made, a price is exacted first in human terms. From the relative safety of where I write this, I can recall the damage from superstorm Sandy that crippled the Northeast six years ago, and from which many in the area have yet to recover. Yet that pales next to the wildfires that have engulfed California, which follows this year’s crop of hurricanes in the East. The toll isn’t only human, either; our foster dog rescued after Hurricane Florence just left for her permanent home on Thursday.

One has to wonder, though, what effect the seemingly annual wildfires will have on the perceived livability of California and on the state’s population trends, Patricia Healy of Cumberland Advisors writes in a client note.

If California were a sovereign nation, its gross domestic product would be the fifth largest in the world, ahead of Britain’s. Given that, California’s strengths and resilience are formidable. Even so, Healy points out, municipal-bond investors should diversify among credits within the state—something the wild fires have emphasized again.

Taxes are a powerful incentive for California muni investors to stick with in-state credits, which are exempt from state and federal taxes. The top state income tax bracket is 13.3%, and under the new tax laws, the federal deduction for state and local taxes is capped at $10,000. Diversification among various types of credits and sectors, from tax-supported general obligations to revenue bonds for water and health-care systems, can mitigate risk for investors sticking to their home state, she adds.

There are considerations other than dollars and cents, however. Philippa Dunne of the Liscio Report, who grew up in Malibu, writes that the fires were a central part of her childhood. Dragging panicked horses from their stalls for the safety of the beach when fires raced through her area was her job, which provided a unique perspective.

Read the full article at www.barrons.com




Puerto Rico Oversight Board, Rosselló tussle over Christmas bonus

Excerpt below from “Puerto Rico Oversight Board, Rosselló tussle over Christmas bonus”
By Robert Slavin, November 15 2018, 3:27pm EST

Cumberland-Advisors-Shaun-Burgess-In-The-News
Shaun Burgess of Cumberland Advisors

Puerto Rico’s Christmas bonus is again under the spotlight as the Oversight Board pressures Gov. Ricardo Rosselló to identify spending reductions to offset the cost of his plan to pay the annual benefit.

The clash between the board and Rosselló comes more than two years after Puerto Rico stopped paying its general obligation debt. Since July 2016 Puerto Rico has defaulted on most of its other bonds. The continuation of the Christmas bonus has been a sore point for some bondholders.

Puerto Rico’s government must live within its budget regardless of its cash balances, Oversight Board Executive Director Natalie Jaresko said in her letter. A failure to cut the bonus, other payroll, or other operating spending sufficiently before the end of the current fiscal year may “imperil… the commonwealth’s ability to make payroll for its employees.”

Cumberland Advisors Portfolio Manager Shaun Burgess said, “It doesn’t surprise me that the commonwealth is moving ahead with paying the bonuses. I suspect the commonwealth’s elected officials would have done whatever is necessary to pay them since not doing so would have been a deeply unpopular move.” Cumberland owns insured Puerto Rico bonds.

The Puerto Rico Oversight, Management, and Economic Stability Act, which governs the board’s capabilities, says that the board is to review the compliance of the local government’s actual spending with the board’s approved budget. If the board finds that it is inconsistent, the act says the board is to inquire with the government for more information about the spending and future spending.

Subscription Required: read the full article at www.bondbuyer.com




Midterm Elections – The Quick Muni Note

Here’s our first take after the midterm elections.

Market Commentary - Cumberland Advisors - Midterm Elections – The Quick Muni Note

The polls actually got it right, with the Democrats taking the House of Representatives and the Republicans enjoying a slight pickup in the Senate.

Divided government, with different parties in control of the House and Senate, has sometimes led to gridlock.  It also tends to keep spurious legislation from being passed; and so overall, markets are OK with this outcome.

 

Regarding munis, we feel that this election certainly eliminates the concern that a Republican House would have introduced legislation to cut income taxes further.  With the Dems in control of the House, that notion is off the table; and fears that tax-exempt munis would suffer price erosion from lower marginal tax rates should dissipate.

From a spending standpoint, the divided Congress will most likely keep the President’s spending in check, and this may slow the current rise in the deficit (a good thing from our perspective).

We’re still checking final results, but we know that California voters rejected almost $9 billion in bonds for water projects, and Colorado rejected over $3 billion in a transportation bond.  There’s more to come on this issue of bond rejections, but our thought is that the specter of the SALT provisions of last year’s tax bill is forcing voters’ hands. If state income taxes and local property taxes are no longer deductible, anything that raises the level of spending and potentially higher taxes is likely to get a cold shoulder, as people’s EFFECTIVE taxes will rise in any case with SALT provisions.

We do believe that with the current low unemployment level, a national infrastructure program with federal subsidies is not needed and is now more unlikely with divided government.  We have seen large infrastructure bond deals done in the past year in the municipal market, and the issuers have had no problem selling the bonds.

Coming out of the elections, we feel especially constructive about longer-term tax-free bonds. With longer tax-free munis yielding over 4%, and with a taxable equivalent yield of 6.35% and muni/Treasury yield ratios of almost 120%, we feel longer tax-free paper is a real bargain and continue to manage portfolios in a barbell fashion, with longer-maturity bonds being a focal point.

The large December and January reinvestment periods are almost upon us. Supply is running 15% behind last year, and that will be another positive force for the market, along with the core inflation rate, which has been dropping for two months.

More to come.

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
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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Why the time is ripe for tax swaps

With municipal yields rising more than they have in years, investors should be poised to take advantage of a rare opportunity for tax swapping as the fourth quarter gets underway, municipal experts said.

Cumberland Advisors John Mousseau

Demand for extra yield will be another key theme in the fourth quarter as investors’ expectations have been buoyed by the weakness in Treasurys, according to John Mousseau, president and chief executive officer of Cumberland Advisors.

“We’ve seen rises in longer-term Treasury yields after three quarters of a year of mostly flattening,” he said. On Oct. 2, the 10-year Treasury yielded 3.07%, while the 30-year yielded 3.22% — slightly lower following last month’s record-setting weakness.

With ratios of municipals to Treasurys expensive on the shorter end of the yield curve, and cheaper on the long end, Mousseau expects any additional rise in long-term yields will be more muted in municipals than in Treasurys.

The ratios of municipals to Treasurys ranged from as low as 72.5% in one year to 84.6% in 10 years and 100% in 30 years as of Oct. 2, according to Thomson Reuters data.

“We think part of that is the hangover of supply from earlier in the year and the erosion of the buying base in the longer end, between banks and insurance companies buying less,” Mousseau said.

If you have a subscription, you can read the full article at The Bond Buyer website.


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.