Cumberland Advisors Market Commentary – Cumberland Responds to Barron’s

Three of us have collaborated on this discussion. Our views are pretty much aligned. We think Congress is hobbling an economic recovery by delaying the funding related to COVID-19 and now, additionally, funding related to the wildfires. We think many municipal entities are under extreme stress. And federal help is needed now, or these entities will have to reduce staff, swelling the ranks of the unemployed across the nation and reducing municipal services at the very time that demands for those services are at record levels.

We will identify the author of each part of this collaborative effort.

Cumberland Advisors Market Commentary - Cumberland Responds to Barron's
David R. Kotok writes:

Barron’s has described the $1 trillion funding gap in US states and local governments. Much of that gap is created by or worsened by COVID-19. See “Cities and States Are Facing a $1 Trillion Budget Mess. There Will Be More Trouble Ahead.” Barron’s, https://www.barrons.com/articles/cities-and-states-are-facing-horrific-budget-holes-there-will-be-more-trouble-ahead-51598638702.

So what can be done and how to do it are now key policy questions.

Here are the general outlines of a proposal. The federal government can use its guarantee to back up to a $1 trillion municipal issuance. That would enable worldwide purchases, just as the US federal guarantee enables mortgage lenders like Fannie Mae to issue debt for global market purchases. The federal guarantee also allows the Federal Reserve to purchase such debt and to maintain orderly markets in it.

The debt can be issued by states and their agencies with the guarantee. The debt can be of the self-liquidating type; thus, it is eventually paid back by the states and doesn’t permanently increase the federal deficit. The US Treasury can set rules and the use of funds purposes description. That purpose of issuance can be well-defined (infrastructure, public health, water-sewer, etc.) or left to states’ discretion. Debt type can be inflation-indexed or conventional or zero-coupon or sinking-fund or floating-rate or a mix. The self-liquidating structure is typical in municipal bond issuance and there is no reason to change it. Maturity length can be out to 30 years or even longer. There already is a mature market for long-term Munis.

With the issue, credit pressure on states and their regional and local subdivisions will be buffered, and they will be able to advance and finance the many services that COVID-19 and post-COVID-19 economic recovery will require. We believe the Barron’s estimate of $1 trillion is sufficient to close the funding gap and carry the recovery process for as long as the next two to three years and until the vaccine/treatment issue is resolved with some trust and clarity for the whole population.

We believe that if we want US business to recover and our nation to flourish again, we must get the 90,000 state and local political jurisdictions onto a stable funding platform. The longer we wait, the more difficult a business and economic recovery will be. Now is the time for action. Let me pass this discussion to my colleagues.

Here’s John R. Mousseau on muni markets.

The Barron’s cover story for August 31, 2020, “The Trillion Dollar Hole,” made some good points – the most important being the long-term track record of municipal credit. The article correctly noted that Arkansas was the only state to default on its debt in the Great Depression. What was missing was the fact that Arkansas went that route in order to aid local towns and cities that would have had a harder time recovering on their own, and the decision was made that the state could more easily recover its financial balance than these juridictions could on their own. By the way, Arkansas subsequently cured the default and paid everything it owed to bondholders.

This is not to say that challenges aren’t there for states. We know those – underfunded pension plans, insufficient rainy day funds in many states, and a number of states on the wrong side of “the Laffer curve,” where further tax increases (think combined state income taxes, state sales taxes, and local property taxes) result in a DROP in total revenue to the state, not an increase. For example, New Jersey has been experiencing this phenomenon for several years.

The key for a number of these municipalities and states, and for some troubled issuers is to cut spending to tread water through the remainder of the pandemic and to access the capital markets where available. As we saw with the State of Illinois, as well as with New York MTA in May, issuers may not like the rate that the market affords them, but access has still been robust. Both deals were multiple times oversubscribed; and today, four months later, these bonds still trade well more than 100 basis points lower in yield than they did when they came to market. For example, in May of this year, the State of Illinois (BBB-) had a deal where bonds in 2045 came to market at a 5.85% yield. Those bonds have recently traded at a 3.60% yield to a 10-year call. This happened when the general market had shifted down only about 45 basis points in yield. This is not to say that the market does not back off for more challenged credits. But the market has clearly embraced the federalism we have seen in the wake of the pandemic, whether that takes the form of the Treasury’s special vehicle or the Federal Reserve’s direct purchasing of notes (Illinois and MTA) or the yet-to-be-passed infrastructure program.

The course and tenor of municipal finance changes markedly with the broad distribution of an effective vaccine, though not right away; the changes will be a step function. High-grade credits are already back to pre-pandemic levels, and in the case of shorter-term yields they are well below pre-pandemic levels, because the Fed has cut short-term interest rates. We would expect a general narrowing of credit spreads as a vaccine begins to be accepted and administered nationwide. More-troubled credits such as convention centers, smaller colleges, student housing, airports, transit systems, and sales tax bonds in general should all start to move up on a relative basis.

Also, many municipalities have seen their property tax base increase in value, with COVID-led demand for single-family homes continuing to push housing prices northward along with the pace of sales. So there is room for many local general-obligation bonds to soldier on or perhaps to have a higher tax base. In addition, municipalities are innovative in deriving new revenue sources. Think of a financial transaction tax going to New York City, or of states or counties extracting a “toll” on drones that traverse the airspace above their roads (which the municipalities control). The idea is that lower sales taxes in some areas can be replaced by usage taxes in other areas

We expect to see some creative financing, especially from larger issuers. We know that New Jersey advanced $7–$9 billion in financing. What if you were to sell an inflation-indexed 100-year bond, non-callable, such that the supplemental inflation payment was in the form of tax-exempt coupons. Then have the federal government back the principal of the bonds but the state or city be responsible for the coupon payments and supplemental inflation payments. With thirty-year US Treasury TIPS at a yield of -0.3%, even a troubled issuer like the State of NJ could get away with a real yield of 1–1.5%. For longer-view investors we think that would be attractive as an inflation hedge. It might appeal to pension funds that don’t need the tax exemption.

We know that many of the troubled credits out there (Illinois and New Jersey, even before the pandemic) have a LIQUIDITY issue (a need for cash to pay bills as normal collections are less from sales taxes, ridership revenue for transportation credits, etc.) but not an INSOLVENCY issue. That is an important distinction and one that contributes to the overall extremely good track record of municipal debt. Continued access to the capital markets, combined with realistic choices and belt tightening, should pave the way for better days for municipal issuers and for the market as the economy comes back.

Here’s Patty Healy on how a federal backing that raised $1 trillion would help the existing $4 trillion municipal finance sector to stabilize and would lower borrowing costs for most jurisdictions in the United States.

State and local municipalities received $150 billion in CARES Act funds, and the action was swift, delivering aid to the hardest-hit sectors and to states and large municipalities. Presumably, the state funds could be downstreamed to localities. The funds, however, were not without strings and could be used only for COVID-related expenses, not for revenue replacement, though revenues had plummeted dramatically. Other programs were designed to help businesses retain employees, and unemployment benefits were increased so that bills could be paid and some level of consumption could continue as the economy shut down to battle the pandemic.

Municipalities, which are on the forefront of addressing the pandemic, having seen a substantial drop in revenues, have had to cut budgets and personnel and in some cases reduce planned capital expenditures. Some may not even make the annual payments required to keep their pension funding levels from decreasing. If they don’t, pension funding becomes more expensive in the longer run – a vicious cycle that has caused the loss of financial flexibility for some and credit downgrades for others. Higher leverage and credit downgrades do increase borrowing costs.

According to the Bureau of Labor Statistics, state and local public employees make up approximately 13% of the American workforce, with municipalities alone employing nearly three million people nationwide. The Center on Budget and Policy Priorities noted that total nonfarm payroll employment (private plus government) fell by 22 million jobs in March and April, wiping out a decade of job growth. Despite job growth since then, including 1.0 million jobs added in August, private payroll employment remains 10.7 million jobs below its February level while state and local government payrolls remain 1.1 million jobs below their February level. The history of the financial crisis showed that the loss of municipal employment was a drag on the economy and lengthened time to recovery.

Congress has been dragging its feet in providing additional aid to municipalities, and many hope some aid will arrive shortly; otherwise, budget cuts will continue, services will be reduced, and the recovery will be slowed. The Center estimates that states, excluding local governments, need $555 billion, with the shortfall expected through fiscal 2022. If municipalities could plan on some aid, even phased-in aid; and if funds are not immediately available, at least budgets could take into consideration additional future aid and minimize the number of layoffs and service reductions.

Any mechanism to get needed funds to state and local governments – and soon – would help retain state and local public employees. A guarantee fund could be useful, lowering funding costs for municipalities close to the cost of Treasury bonds. The September 16, 30-year Treasury bond yielded 1.45% at the end of the day (Sept 16), while AAA-rated municipal bonds yielded 1.72%; the 10-year was at 0.67% compared with AAA yields of 1.16%. Shorter-term yields recognize the short-term risks that the market perceives in the municipal market. Debt repayment could be stretched out so that the additional debt-servicing burden would be minimal. Already a number of issuers are refinancing higher-cost debt and in the process reducing the amount of near-term maturities. They are also extending the final maturity of the bond, a move called “scoop and toss” in Muniland. While in good economic times scoop and toss is a signal of stress at a municipality that opts to do it, during an extreme situation it becomes a tool for the municipality to manage through the crisis.

Bottom line from our three authors: We are not in business-as-usual financial times. State and local governments need help, and the federal government has the ability to help them. The time for that action is now.

David R. Kotok
Chairman of the Board & Chief Investment Officer
Email | Bio


Virtual Event Thursday, Sept 24

Cumberland Advisors is an Annual Sponsor of

the Global Interdependence Center

GIC - Monetary Policy with James Bullard, Ph.D.

GIC’s next Executive Briefing will explore monetary policy with James Bullard, Ph.D., President & CEO of the Federal Reserve Bank of St. Louis. Join them Thurs, September 24 at 12:00 p.m. ET.
Complimentary registration: https://bit.ly/33DvgLX


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HeraldTribune.com – Mitch McConnell as Meredith Whitney

The Sarasota Herald Tribune featured this commentary in their business section.

Market Commentary - Cumberland Advisors -McConnell as Meredith Whitney (Mousseau)

Mitch McConnell as Meredith Whitney

By John R. Mousseau, CFA
Posted Apr 27, 2020


Senate Majority Leader Mitch McConnell was reported last week by Bloomberg News saying that he “would certainly be in favor of allowing states to use the bankruptcy route” rather than giving them a Federal bailout. This reminded us of 2010 when Meredith Whitney, a noted bank analyst, predicted that there would be hundreds of billions of dollars of municipal defaults in 2011. She caused lots of market damage and outflows from municipal bond funds before sanity resumed.

Cumberland wonders what the majority leader had in mind, in that his statement is at best disingenuous and at worst inflammatory at a time when both houses of Congress, the administration, and the Federal Reserve are all engaged in the business of helping all parts of the economy get through the economic downturn caused by COVID-19.

There are also legal problems with McConnell’s position. <Continued at SHT website…Continued at SHT website…>

Continued at Sarasota Herald Tribune: https://www.heraldtribune.com/business/20200427/mitch-mcconnell-as-meredith-whitney


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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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4Q 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

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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


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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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




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