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Munis, Defaults, Chicago

David R. Kotok
Wed Jul 12, 2017

In her quarterly missive, Cumberland’s Patty Healy offered a terrific summary of credit conditions in the US muni market. Here’s that John Mousseau furthered a dissection of the subject on Asset TV. See

Let’s add to this conversation and end with an investment conclusion.

On June 27th, Moody’s issued a massive report entitled “US Municipal Bond Defaults and Recoveries, 1970–2016.” This 101-page document is a wealth of information and a muni bond manager’s bread and butter reference. For those able to obtain this report, we highly recommend it.

Moody’s notes that last year’s $22.6 billion “debt affected” total constituted “by far the highest annual default volume in the 47-year study period.” Puerto Rico was the poster child among defaulters and is likely to retain that dubious distinction this year as it continues its huge debt-restructuring process. Note that Cumberland has a specific PR bond management program utilizing certain insured PR debt, and all payments of interest and principal have been made to the bondholders in a timely way on the bonds held in that strategy. We advise that each bond be deeply researched: Just blindly buying any insured PR bond is not advisable. There are many nuances involved in this credit work.

Ex-PR, Moody’s notes that “defaults and bankruptcies have become more common in the last decade, but are still rare overall.” The five-year municipal default rate since 2007 was 0.15%, as compared to the five-year global corporate bond default rate, which was 6.92% since 2007, according to Moody’s.

At Cumberland, we favor muni credit in both tax-free and taxable forms, although we do use corporate credit in a managed portfolio structure where a client has authorized it. Muni credit is complex and requires skillful analysis. That is one of the strengths of our firm, and we have over four decades of hands-on experience. This writer recalls that his first tax-free muni issue advisory role was in 1974.

Perhaps the biggest looming muni credit problem is the one plaguing the State of Illinois. Illinois must contend with about $15 billion in unpaid bills and about $250 billion of unfunded pension and retirement benefit promises. The state is a prime exhibit in dysfunctional governance. It is losing population and has been shrinking a tax base, but its legislature is working to raise taxes, out of necessity, on who and what remains in this very large and once highly creditworthy state.

At Cumberland, we will not own bonds issued by such a political construction, so our Illinois muni positions are very limited to specific issues that are protected by priority claims for essential-services revenues. Note the contrast with an AAA credit like Utah, with its growing population and expanding tax base.

Now we see the Chicago school system deciding to issue new debt without a rating and with an interest cost over 7%.  That's right.  Non-rated, tax-free over 7%. Compare with the true AAA credit of a state like Utah and one can see that the price of dysfunctional governance is over 4% per year after all taxation to the bond buyer has been removed. Think about that estimate and how it translates to those who have to pay the taxes to support the Chicago school system. BTW, Cumberland did not buy any of this junk credit bond. And Cumberland verified that certain bond insurers would not insure it.

All states are certainly not alike. There are a half dozen troubled ones and another 10 whose trends are negative. Again, deep credit analysis is justified.

One coming favorable development for high-grade munis (not Chicago or even State of Illinois GO) is a rule change proposed by Treasury Secretary Mnuchin and likely to be implemented when the Trump administrative apparatus finally fills appointments at the Treasury and on the Federal Reserve Board of Governors. That new rule will allow banks to hold certain high-quality munis as level 2b assets as they undergo testing for compliance with requirements for liquidity coverage ratios (LCR) and high-quality liquid assets (HQLA). This change is long overdue. Why should a sovereign credit like Italy qualify to be held by a European bank but a far more creditworthy Utah not qualify to be held by an American bank just because it is a sovereign state within the US instead of a national state within the European system?

We think the forthcoming rule change expands the universe of munis two ways. For American citizens and American banks, it improves demand for munis. For foreign “crossover buyers” who seek a higher yield, it expands the availability of permissible bonds they can hold in their US-dollar allocations.

Most importantly, the change will be bullish for our clients, who engage us to navigate their tax-free and taxable muni portfolios in this $4 trillion asset class with 90,000 distinct issuers.

In sum, there are opportunities in muni land. Sorting out those opportunities requires work. We like doing it. We don’t find it boring.

Kudos to Moody’s for their report. Thanks to Capital Economics for population breakdowns of states and migration patterns among them. As for the Windy City, you still have a long road to travel. We wish you success but not at our expense.