Variable Rate vs. Auction Rate

Auction Rate Preferred’s
Many individuals and corporations use Auction Rate Preferred’s (ARP’s) instead of money market funds. These securities are typically viewed by most investors as a money market substitute, but there are some important characteristics that make them different from a true money market instrument. In fact, these securities are not money market eligible securities for money market funds.

Most money market funds invest in Variable Rate Demand Notes. These trade in $100,000 denominations. The rates normally reset weekly by the service provider who is the dealer that has the floating rate securities. The investor has the option of putting back these floaters to the dealer by giving 1 week’s notice. The security is normally credit enhanced by either an insurer or a bank. The liquidity (ability to put back the security) is normally guaranteed by a bank. These VRDN’s are bought and sold at par (100).

An auction rate security is reset by an auction process. The dealer does not set the rate on the security. It is possible (but highly unlikely) that there could be a failed auction. In the event of a failed auction, the investor would own the security to whatever the stated maturity might be. It is this possibility that makes ARP’s ineligible for money market funds.

VRDN’s are normally sold by institutional sales people who trade them in large size. ARP’s are normally sold by middle market and retail sales people in smaller-sized pieces than VRDN’s. The sales credits paid to market ARP’s tend to be higher than those for VRDN’s. This helps to explain why the yields on the Auction Rate products have tended to be lower than those for Variable Rate securities. This is shown in the chart below. The average spread has been about 4 bp’s in extra yield for the VRDN’s. Recently, this situation has changed. This change and the absolute level of rates is shown in the table below. ARP’s are now yielding about 80 bp’s more than VRDN’s. We believe there are 2 reasons for this change in the spread. First, there is a high degree of uncertainty in the money market at the present time. Investors are attempting to reduce risk in all their money market holdings. They are now realizing there is “auction” risk and are commanding more of a premium for holding


ARP’s. Secondly, many corporations desire to reduce their holdings of ARP’s over year end, because they are treated as longer maturity investments on their books. This has resulted in dealers carrying unusually high amounts of these securities coming into year-end.

Conclusion
We would expect many of these corporations to repurchase the ARP’s they have sold after the first of the year. However, we would expect the spread between these two short-term instruments to be greater for the ARP’s than VRDN’s into the foreseeable future.

The Guarantors

The Insurers

There has been considerable attention devoted to the Sub-Prime Mortgage crisis and the exposure of insurers such as MBIA, AMBAC, FGIC, and XLCA to this sector. The stocks of these companies have been hit particularly hard during the recent flight to quality rally in the treasury market. The chart below shows the price activity for MBIA during the last year.

Click on the picture for a larger view.

The stock is down roughly 50% during the last month. The stocks of AMBAC and XLCA are down even more during this same time period. The negative news surrounding these firms due to the large losses they have taken and their large Sub-Prime exposure are causing investors to question the value of insurance and the ability of these firms to cover potential losses.

Muni Bond Insurance

The insurers play a major role in the Muni market. Over 50% of all financings come with credit enhancement such as insurance. Most retail investors have come to rely upon insurance when investing in tax-free bonds. The large scale deterioration in the credits of the insurers is causing investor anxiety and raising questions as to the quality of each insurer and their ability to pay. This problem is exacerbated by falling confidence in the rating agencies to properly rate these firms.

Rating Agency Review

Fitch released a special report on 9/2/2007 which outlined the current state of the insurers. In early November, they announced a further review of the guarantors’ ability to withstand the stress of continued deterioration in the Sub-Prime market. This study should be completed in about a month. The September study showed the Capital Adequacy Ratio for each of the major insurers. These ratios need to be met to maintain the AAA rating. The chart below shows these ratios. The only company that does not meet the minimum in this chart is Radian, which is already rated AA. Fitch and Moody’s are both doing additional reviews which will

Click on the picture for a larger view.

include further analysis of the insurers’ exposure to the weakening Sub-Prime market. The table below shows their preliminary findings of the likelihood that an insurer will need to raise additional capital or use reinsurance to reduce their exposure. CIFG and FGIC show a high likelihood of needing more capital to maintain their AAA rating. If it is determined that an insurer needs more capital, Fitch will give them 30 days to comply before downgrading them to AA.

Click on the picture for a larger view.

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Munis: Kentucky vs. Davis Part 2

The Supreme Court

The Supreme Court will hear arguments concerning the Davis v. Department of Revenue of Kentucky next week on 11/05/2007, with a ruling expected in late spring of 2008. The Davis’s have challenged the existing system of preference given by the State of Kentucky to the ownership of in-state municipal securities whose interest is not taxed, while taxing the interest earned on out-of-state municipal bonds. The Davis argument is that the current practice of offering preference to in-state securities is discriminatory, and is a violation of the dormant commerce clause, which gives Congress the right to regulate interstate commerce. The Kentucky appellate court agreed with the Davis’s.

Supporting Opinion For Davis

Alan D. Viard from the American Enterprise Institute recently wrote an amicus brief in support of the Davis’s. This brief is an excellent example of the case in favor of the Davis’s. Mr. Viard’s brief is entitled, “The Dormant Commerce Clause and the Balkanization of The Municipal Bond Market”. We have provided a link to his paper for your convenience. The primary legal argument for the Davis position is that the tax is discriminatory because it favors within-state sales over interstate sales. Several cases are mentioned that support this argument. Each case quoted dealt with a corporation that was being taxed unfairly which impeded their ability to compete in a state. The trading of securities is a form of commerce, and since muni bonds are securities they should be subject to the dormant commerce clause. Since only Congress has the right to regulate interstate commerce, the current system of taxing muni interest in Kentucky is unfair and should be changed. Mr. Viard also attempts to make an economic case against the current tax treatment of municipal bond interest in this same amicus brief and concludes that “the U.S. Supreme Court can strike a decisive blow for free interstate trade in the nation’s financial markets”.

The Argument Is Flawed

The very title of the brief refers to the “Balkanization” of the municipal bond market. One normally thinks of Balkanization as the creation of a fragmented group of hostile or non-cooperative states. This is most certainly not the case here. In a coordinated effort, every state petitioned the court to overturn the Davis ruling. Even states that have no state income tax are in favor of maintaining the status quo with each state offering preferential treatment to bond interest earned from in-state muni securities. This case is not about a company being unable to compete in Kentucky because of unfair tax practices and, thus, suffering economic loss as an injured party. Rather, this case is about taxes, and the right of a state to tax bonds differently. One could say that the injured parties from Kentucky’s current practice are the other states. But these states claim no injury and support the current system. States exist to further the public interest of their region. They have taxing power and create laws to further the public interest. Taxes are inherently often discriminatory. For example, does it seem fair that single people pay higher tax rates than married people? We feel that this is also a case about the rate of interest paid on a local security. Most states encourage investment in local muni bonds, because this investment strengthens communities and benefits the public interest. Encouraging investors through economic incentives helps to lower the net interest cost paid by local borrowers.

Conclusion

It is always risky to predict the outcome of a Supreme Court case, because it is impossible to know how the court will rule. We believe states should have the right to tax their residents, and it is not the Supreme Court’s job to rewrite our existing tax system. Next week the oral arguments begin. Will the Supreme Court agree with us? We will find out by next summer.

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Current Credit Crisis Compared to Long Term Capital Management

Long Term Capital Management

It is interesting to compare the current credit crisis to October 1998 when Long Term Capital Management created a similar predicament in the credit markets. The table below shows the Fed in a tightening mode prior to September 1998 when LTCM exploded.

(Click below to Enlarge)

The Fed quickly cut rates 3 times during September-November, reducing the funds rate from 5.50% to 4.75% until the crisis was averted. The chart below shows the rise in yields after the Fed began to ease.

(Click below to Enlarge)

Yields continued to rise into January 2000. During this time, the yield curve steepened and the economy continued to grow. The Fed had to reverse gears and tighten again beginning in June of 1999. The premature easing that took place because of LTCM proved to be an ill founded decision for the Fed.

The Current Economic Cycle

Fixed income investment returns are closely tied to inflation and economic growth. We monitor the Index of Leading Economic Indicators (LEI) as a barometer of future economic strength, and the GDP Price Deflator as a measure of inflationary trends. The chart below shows the LEI for the period from December 1995 to the present.

(Click below to Enlarge)

The index showed no signs of slowing until early 2000. This would have been a red flag that the Fed was easing prematurely. The current situation is somewhat different. The LEI has been moving sideways since the end of 2005. We will be monitoring the LEI closely for signs of future strength or weakness. If the index begins to rise, this would be a negative for bonds. Inflation has weakened somewhat, but is still near the upper end of the Fed’s target of 2%. Recently, inflation has been showing signs of slowing. If it begins to accelerate, we would view this as a negative for bonds. Gold and oil have both been rising, which is a red flag that the Fed is easing while inflationary pressures may be building.

Conclusion

The Fed has made a pre-emptive strike by lowering rates. It is unclear if this is good for bonds. The initial reaction is not encouraging, since the long bond has sold off about 1.5 points since the announcement. The bond market is concerned that the Bernanke Fed may be lowering rates when inflation is still not under control. Time will provide us with the data to see if this was a wise decision. Hopefully it isn’t an over-reaction to the current crisis similar to October of 1998 when the Fed eased because of Long Term Capital Management even though the economy was strong.

Muni Exchange Traded Funds vs. Mutual Funds

ETF’s

Exchange Traded Funds have become increasingly popular in recent years. These funds are for the most part passively managed, track indices, and have low expense ratios compared to the average mutual fund. ETFs can be traded intraday, shorted, and bought with margin. Mutual Funds do not offer the same features. There are no size minimums to invest in ETFs. This makes them popular with smaller investors. Exchange Traded Funds are usually a more tax-efficient vehicle than mutual funds because they don’t realize gains or losses when selling securities. ETF’s can be concentrated to give an investor exposure to a specific segment or market, such as precious metals, single countries, foreign currencies, and U.S. Treasury Bonds. It should be no surprise that the ETF has finally discovered the Muni market.

The Muni Bond Market

The Municipal Bond market is a highly fragmented market of over 50,000 different issues. Last year, there was total issuance of $388 billion from 12,706 different deals for an average size of $31 million per deal. The market is a collection of regional markets. Each state has different tax rates and different infrastructure needs. The Individual Investor (as a whole) is the largest investor class of muni bonds accessed via individual securities, separately managed accounts, mutual funds, and closed-end funds. These investors typically purchase munis because of the tax advantages of owning tax-free bonds.

Historical Problems Creating Muni Indices

The fragmentation of this market has caused problems in the past with the creation of a viable index for munis. Due to the wide bid/ask spreads and tax consequences of trading, individuals tend to buy and hold muni bonds to maturity. This strategy means that after a bond deal is issued, the amount of trading in that security diminishes rapidly over a short period of time. This makes price determination difficult for any individual security, because actual trades do not take place. It is this lack of actual price determination through trades that has caused problems with Muni indices in the past. This was evident with the Muni bond contract. The CBOT finally stopped trading this contract in 2006, because of problems with the index that led muni dealers to look for alternative hedge vehicles to hedge their inventory.

There are currently several indices money managers use to measure performance which work well for their purposes. These indices are priced daily and are meant to reflect changes that have taken place in the market. The CBOT muni index was a live index that needed to be priced continually. The current plan is to price the relevant ETF index on a daily basis. Most ETF’s in other markets trade continuously and can be compared to a transparently priced index which also trades continuously, such as the S&P Index. Without transparent continuous pricing, muni ETF’s may be subject to some of the same issues that brought down the CBOT muni contract: manipulation by hedge funds and lack of pricing relevancy.

Portfolio Construction And Performance

The ETF faces constraints which will affect its ability to offer good value to its shareholders. The ETF must only purchase bonds from large deals. The table shows the different size limitations of the deals they may purchase. This will limit their ability to invest in any cheap smaller regional issues that may come to market. The purpose of this restriction is to make sure they are investing in liquid names. There are also limitations as to the issue’s purpose. For example, some ETF’s can’t invest in tobacco bonds, hospitals, or housing bonds. Neither one can invest in AMT bonds.

ETF Advantage May Not Apply to Muni Investor

Marginal tax rates determine the attractiveness of muni bonds for any given investor. High Net Worth Individuals with significant levels of taxable income find munis especially attractive. These investors normally have large sums of money to invest and don’t benefit from the ability to invest small sums of money in an ETF. There may be adverse tax consequences of selling holdings in these funds, so it is unlikely that the ability to liquidate holdings intra-day would offer much benefit to these investors. When we compare the tax free ETF to Vanguard mutual fund, we see little benefit to purchasing the ETF, and our guess is that the ETF will have difficulty generating higher returns than the mutual fund because of its constraints.

Conclusion

It will be interesting to see how successful the muni ETF is in the future. We expect this success to be somewhat dampened due to difficulties in index construction and the nature of the muni investor.

Click on the table for a larger view

The Case for Intermediate Treasuries

Taxable Fixed Income

For most conservative investors, an intermediate bond strategy represents a sound choice. There are advantages to this strategy compared with either holding cash or long-term bonds. Intermediate US Treasuries have offered significantly higher historical returns than 30 day T-Bills with little additional risk, and have provided annual returns that are only slightly less than long US Treasuries.

A History of Returns

Fixed Income and Equity returns are readily available for the last 81 years through data compiled by Ibbotson. The table below shows a comparison of returns for Intermediate (5 Yr) and Long (20 Yr) U.S. Treasury bonds for the period 1926-2006.

The Long maturity treasuries outperformed shorter bonds by .30% (5.60-5.30%) annually.

Intermediates, thus, captured about 95% of the return of the Long bonds. During this period, Intermediates outperformed the 20 Year bonds in 44 out of 81 periods or about 54% of the time. Long bonds had 21 periods of negative returns, while Intermediates only had 8. Thus, 5 Yr treasuries had positive returns 90% of the time. The duration or market risk of these bonds is compared in the chart below.

An Intermediate treasury has about 37% of the risk of a Long bond. This implies that the risk/reward of owning Intermediate bonds is very attractive when compared to Long bonds. The chart below shows that Intermediates have captured 95% of the return of Long bonds, while taking only 37% of the market risk during the last 81 years.

Conclusion

Portfolios consisting of intermediate maturity taxable securities are suitable for conservative investors’ fixed-income portfolios. These portfolios have generated positive returns about 90% of the time, are much less risky than portfolios of bonds with long maturities, and capture most of the return of a long bond portfolio. While we cannot guarantee that history will repeat itself, there is certainly a compelling case for investing in Intermediate Bond portfolios. This is a non-market-timing strategy that works well when combined with other riskier asset classes. The bonds provide income and dampen the volatility of the overall portfolio.

Why Not Manage A Bond Portfolio For Income?

Role of Bond Portfolio
Most investors own bonds to provide income and to dampen the volatility of the overall portfolio. We manage our bond portfolios for total after-tax return in order to accomplish both of these objectives. Some investors view their fixed-income portfolios solely as a source of income. The income approach to the portfolio often leads the investor to underestimate the additional risks that they take, and is a less desirable approach to managing bond portfolios. Income is only half of the equation. The total return of any bond is the income plus the price change. Income without consideration of the change in asset value is of particular concern when investing in low quality bonds. These bonds have a high correlation to equities. This means that an investor with a large position in these types of bonds has done little to dampen the volatility of the overall portfolio, because when stocks go down, high yield bonds go down as well. This is contradictory to the basic principle of diversification. The investor has added to his equity risk, rather than reduced his risk.

Increased Risks From Income Approach

Credit Risk
Lower rated riskier bonds generally have higher yields. Investors that are chasing yield often end up with these securities. It is similar to a bank robber who gets caught. When asked why he robbed banks his answer was, “because that is where the money is!” Junk bonds are like a magnet for investors who are only looking at the yield the bond might pay. There is no riskier strategy for most individual investors than to take too much credit risk. Why risk 100% of your money to get an additional 1% return? We advise investors to avoid credit risk, and put that money into a higher return asset class, such as equities, where the potential returns are much higher.

Inflation Risk
Some investors may say “when rates are at 5% I am going to put my money into long bonds and forget about them”. This leads to increased market risk and the risk that inflation will erode their future earnings stream. Economic conditions need to be monitored to make sure that inflation doesn’t become a problem again. A better strategy is to have some shorter maturities so that if rates rise maturities can be reinvested in higher yielding securities, and some longer maturities to help protect the income stream in case rates fall.

Reinvestment Risk
In the search for additional yield it is not uncommon for investors to ignore call features on the securities they purchase. This leads to reinvestment risk. A long bond with a short call is very undesirable. If rates rise you are locked into a long maturity at a low yield. If rates fall you have your bonds called away. Either way the investor loses. Who wants to play that game?

Tax Risk
Often muni bond investors will buy bonds that are subject to the Alternative Minimum Tax. These bonds pay a little higher rate than a regular muni, but the consequences of owning the AMT bond are disastrous if the taxpayer’s status changes and he/she finds themselves subject to the AMT. In that case, the interest is then taxed as if it were a taxable bond. We have found that most investors are better off not purchasing AMT bonds.

Components of Total Return That Are Ignored

Yield Curve Shifts
Prices in the bond market change daily. We call these changes in market value due to changes in yield for each maturity, yield curve shifts. When the bond market is volatile, these shifts are a significant part of total return.

Changes in the Composition of the Yield Curve
When money is tight, the yield curve normally flattens. When the Fed eases, the curve normally steepens. These changes are important aspects of the portfolio’s return. Sometimes the best strategy is a barbell strategy. This works well in a flattening curve environment.

Credit Quality Spreads
After tightening during the last 3 years, quality spreads were recently blown out to more traditional levels. Holders of virtually all high yield bonds saw significant declines in the value of their holdings. While these bonds declined in value, high grade bonds rose in value. We experienced a flight to quality rally in the U.S. Treasury market.

Conclusion
Bond performance consists of two parts, income and price change. It is a mistake to manage a portfolio only for income, because income is only half of the story. This approach often leads to higher levels of portfolio risk, and poorer relative performance than a total return approach. This is not the style of most professional bond managers. So, who would take this type of approach? We see this style primarily when an individual is managing his/her own portfolio and is working with a broker who is selling them securities. These individuals are captivated by the higher yields, and don’t know that there is more to managing a bond portfolio than clipping a big coupon.

Bond Insurance:MBIA

Insurance Risk
Last year, over 60% of all Muni Bond issuance was credit enhanced by either insurance or bank LOC’s. Since a guarantee is only as good as the one who guarantees it, the credit-worthiness of an insurer is very important. Last month, Barron’s ran an article about MBIA insurance. In the article, Pershing Square Capital Management justified their short stock position in MBIA by saying the insurer has significant exposure to the sub-prime mortgage market, delinquencies are on the rise for these loans, and MBIA’s insurance exposure is much greater than the rating agencies would like for you to believe. As fixed income money managers, we are less concerned about how well the firm’s stock does. What matters to us is the company’s ability to pay claims as well as the likelihood they would be required to pay these claims.

Breakdown of Insurance In Force

Insurance exposure can be broken down into the following categories:

U.S. and Non-U.S. Public Finance
U.S. and Non-U.S. Structured Finance

The chart below shows the amount and the relationship of this exposure. Default studies would suggest that the exposure to Public Finance is quite manageable. Total Public Finance insurance in force was $706.3 billion at the end of 2006.

The insurance in force for Structured Finance was $254.5 billion for the same period. This includes:

Collateralized Debt Obligations (CDO's)
Mortgage-backed Home Equity
Mortgage-backed Other
Mortgage-backed First Mortgage

The next chart shows the breakdown percentages for Structured Finance. According to a recent S&P report, MBIA has $5.78 billion of sub-prime exposure in Mortgage-backed securities, and about $431 million is speculative.

The chart shows 62% of their Net Insurance for Structured Finance is in CDO’s. The same S&P report said MBIA has $16.605 billion of Insurance Exposure to CDO’s with sub-prime exposure, and $2.059 billion of this is for sub-prime mortgages. If we combine this total with the $431 million of speculative Mortgage-backed, the total is $2.49 billion of sub-prime insurance written by MBIA.

Ability to Pay

S&P calculates the ability to pay this insurance exposure by looking at the following:

$13.3 billion in claims paying resources
$6.6 billion in qualified statutory capital
$819 million in earnings last year

S&P argues that any future claims are likely to be less than 1 year’s earnings. Their reasoning is that the firm’s exposure to $431 million of speculative grade sub-prime mortgages is about 6.6% of total statutory capital ($6.6 billion), and less than half of 2006 earnings. We find some problems with this analysis because:

1. None of the $2.059 billion in CDO sub-prime exposure is included in their analysis
2. Default rates for higher quality sub-prime Alt A mortgages are also rising. Currently, 2.9% of these mortgages in CDO’s are 60+ days delinquent and 1.08% are foreclosed.

Conclusion
It is easy to see how MBIA’s earnings may be negatively affected in the future due to increasing default rates in the sub-prime area. However, as bond holders we are more concerned about the firm’s ability to pay and maintain their AAA rating. We still have confidence in MBIA’s ability to pay, but feel deteriorating credit conditions are much worse than S&P’s report would suggest. The rating does not appear to be in danger at this point, but we would rather invest in underlying securities unlikely to ever need the insurance. We feel bond insurance is good when there is a localized event, such as Hurricane Katrina. Investing in junk and relying on insurance to bail you out if something goes wrong is not a formula for success. Insurance is no substitute for research if global credit conditions worsen.

How to Decipher the Cover Sheet of an OS

Introduction

In the previous post, we discussed how to obtain an official statement on a municipal bond issue. Now, we will explore various areas of relative importance on the cover sheet of an OS. The particular Official Statement used in this analysis is the Glendale Arizona Industrial Development Authority Hospital Revenue and Refunding Issue dated in 2007 (The file can be downloaded here). On this document, there are numbers next to the highlighted information that can be used as a guide. Throughout this post, we will explain various parts on the cover page of this Official Statement.

Please note: Not all OS’s are created the same. These sections are not necessarily in the same order as other Official Statements. The goal is to showcase the wide array of information on the cover of an OS.

Details

1. The upper right corner of this Official Statement is the rating(s) on the bond. Some issues may be non-rated (NR). The three largest rating agencies are:

a. Moody’s

b. S&P

c. Fitch

2. There is an opinion from bond counsel on the exemption status for several areas of taxes:

a. Federal

b. State

c. Alternative Minimum Tax (AMT)

d. Corporations

3. This section contains:

a. the Size of the Deal

b. the Issuer

c. the Type of Issue (Revenue, General Obligation, Certificate of Participation, etc.)

d. the Particular Series

4. A few key points in this area are:

a. the quantity and increments in which the bonds can be purchased

b. the dates of the year in which interest is paid to the bondholder

5. A subject to redemption prior to maturity is noted in this section. More information about the provision can be found inside the OS.

6. This division consists of descriptions of the obligator, the trustee, and agreement specifications.

7. The Maturity Schedule for the various series of bonds is displayed which includes:

a. Due Date

b. Principal Amount

c. Interest Rate

d. Yield

e. CUSIP

8. This piece includes the specifics of who are not the obligators.

9. Investing in the municipal bonds involves various risks. These risks are disclosed within the Official Statement. The table of contents in the OS allows the reader to efficiently search for a variety of topics such as the risks involved in the municipal bond deal.

10. Appendices are mentioned in this section, which are located towards the conclusion of the OS and can include items such as:

a. General Information

b. Financial Statements

c. Certain Provisions

d. Opinion of Bond Counsel

11. This section notes various counsel involved in the municipal deal such as:

a. Bond Counsel

b. Disclosure Counsel

c. Financial Advisor(s)

12. The manager of the deal and co-managers (if applicable) are located in this segment. If an investor is interested in buying this deal, he/she should give their order to one of the managers.

13. The date the OS was created for distribution is included for recordkeeping purposes.

Conclusion

It is important to navigate through research material in an effective and efficient manner when evaluating potential investment opportunities. The cover page of an Official Statement includes valuable information on the bond issue, but is meant to be a supplement to the entire statement as opposed to a substitution when performing due diligence.

How to Obtain an Official Statement

Introduction

There is a wealth of information available to research municipal bonds. One resource with a plethora of information about a municipal bond issue is the Official Statement (OS). This can be used to become more familiar with the credit of a municipality (issuer). The OS includes such items as the purpose of the deal, the maturity schedule, the status of tax-exemption, sources of payment, debt service requirements, financial statements, and any other pertinent data. The underwriter / senior manager puts together the Official Statement for distribution to dealers, advisors, and investors. The OS is the disclosure notice for a municipal bond issue.

How-To

One might ask, "Where do I find Official Statements?" This brief process will explain the steps needed to retrieve an OS.

1. Go to the website http://www.investinginbonds.com (A picture of the webpage is shown below).

2. Under the Markets in Depth section, there is a subsection titled Municipal Markets. Click on the hyperlink: See Municipal Market At-A-Glance (The section of interest is highlighted in the picture below).

3. Next is a page where you can either select the bonds traded today category, the bonds traded yesterday category, or the bond history category. If you choose bonds traded today or bonds traded yesterday, go to 3A. If you want to enter a CUSIP into bond history, go to 3B.

a. By clicking on bonds traded today or bonds traded yesterday, the page following will show the history of municipal bond trades. In the example below, the State of Arizona was chosen to view bond trade history. You can select a particular bond in the history. On the right side of the page, there is a column labeled More Info. One of the links in this column is Statements (See 4A for further instructions).

b. If you know the CUSIP for the bond you are interested in, you can type it into the bond history box. The following page should show the actual bond and it's description. Click on the hyperlink below the column titled # of Trades.

This will take you to a screen shown below (See 4B for next step).


4. a. By clicking on the Statements link, the site will take you to a page where you can download the Official Statement for this particular issue. The user has an option t0 download the cover page, the entire OS, E-mail the document, or download part of the document. The picture below shows an example of what this page looks like.


b. If you click on the link for Search Munistatements.com, you will come to a page that allows you to download the Official Statement. The user has an option t0 download the cover page, the entire OS, E-mail the document, or download part of the document. The picture below shows an example of what this page looks like.


Conclusion

After the Official Statement is available for viewing, the next step is to research the particular issue. The following post will begin discussion of how to go about performing due diligence on a municipal bond issue beginning with deciphering the cover page of an OS.

What Happened To Bonds?

During the last month, the bond market has weakened dramatically. This is particularly evident in maturities from 10-30 years. The 10 Yr Treasury yield went from 4.63% on May 8 to an intra-day high yield of 5.25% on Friday (6/8) before ending the day at 5.14%. The Treasury market has suddenly become big news, and dominates the talking heads on TV. Investors would do well to ignore the trader talk on TV about bonds, and concentrate on the long-term fundamentals for bonds.


The Fundamentals

The two most important determinants of bond yields are:
1. Inflation expectations
2. Strength/weakness of the economy

The Fed has been concerned about reining in inflation, and raised the Fed Funds rate from a low of 1.0% on 5/4/2004 to the current level of 5.25%. This target was established almost 1 Yr ago on 8/8/2006. Since then, they have been in a holding pattern as inflation has fallen from 2.4% to 2.0% on the core PCE price index. The Fed would like this measure to be within the 1-2% target band. We view the progress on inflation as a positive for bonds. There is no evidence that the recent decline in the bond market is linked to an increase in inflationary expectations. The economy has slowed from about a 2.5% growth rate in August of 2006 to a recent weak 0.6% for the 1st quarter of this year (while the Fed has been on hold). This slowing in the economy is also a positive for the bond markets. So, the economic fundamentals are still positive for bond investors.


The Technicals

Since the long-term fundamentals are still positive for bonds, the most likely explanation for the sharp rise in bond yields last month is to be found in short-term changes or the technicals that pre-occupy the minds of traders. Here are some of the technical developments of the last month:

1. The amount of 10 Yr Treasury securities purchased at the last quarterly refunding on 5/8 by Foreign Central Banks was the highest since November 2005. This appeared to be a positive technical development for the market. These bonds sold at 4.63% at the May auction.
2. Shortly after the auction, the Fed stated it was still concerned about inflation and began to raise doubts that it would ease rates soon. These doubts increased during the month as several hawkish comments were made by different Fed Governors. The chart below from a 6/8 Citigroup report shows the change in expectations for a Fed easing over differing time periods.


As recently as 4/18, the market was pricing in an easing of 75 bp’s this year. This probability has now declined to a 0.0% chance. We believe this change in perception is the primary catalyst for the sell-off this month.
3. There has been Foreign Central Bank tightening by the European Central Bank and the Bank of New Zealand, which has added to the change in psychology of bond traders. Their logic is, "how can the Fed ease when the rest of the world is raising rates?" Were we overly optimistic about the Fed cutting rates 75 bp’s this year?
4. Mortgage durations have been rising in lenders' portfolios as ARMS are replaced with longer fixed rate mortgages by borrowers. This has led to hedging activity by lenders such as FNMA, selling 10 Yr Treasury securities to help shorten the duration of their huge loan portfolios.
5. Traders who look at charts feel that the 20 year bond market rally has ended and are shorting bonds. This has contributed to the weakness in the market.
6. The yield curve has steepened significantly which has been caused by large curve flattening trades being liquidated and replaced by curve steepening trades. This is very plausible because during the time long term yields have risen, short term yields have fallen modestly. Since 3/2/2007, the yield curve has gone from being inverted by (60) bp’s to having a positive slope of 17 bp’s on 6/1/2007. To implement this trade, the trader sells the long bond and buys shorter maturity bonds. This has contributed to the recent rise in rates.


Conclusion

There have been several technical factors that have contributed to the recent rout taking place in the bond market. This has driven yields to attractive levels for investors. This is a good time to ignore the traders on TV. Traders frequently change their opinions and have different time horizons than the investor. These same traders were telling us less than 2 months ago that there was a high probability that we would see a 75 bp's cut in rates this year by the Fed. Now they think there is no chance for a cut in rates. Future actions by the Fed are data dependent. If inflation continues to slow and the economy stays weak, rates will fall. The recent rise in rates should have a dampening effect on the economy which could lead to lower rates in the future. We feel the current sale in the bond market represents an opportunity for investors to add to their fixed income positions.

Muni's vs. CD's

Many investors are investing in CD's because of relatively high short-term interest rates. For some investors, municipal bonds may be a more appropriate and tax-efficient alternative to CD's. The following is a comparison of the two investments.

Liquidity Risk & Quality

Since CD's are meant to be held to maturity, they are less liquid than traditional bond instruments if the investor needs his/her money before maturity. The bid-ask spread on CD's is greater than municipal bonds, so it is more costly to liquidate CD's. Investors should also remember that only the first $100,000 invested in a CD per issuer is insured by the FDIC.

Reinvestment Risk

Most people buy shorter CD's with maturities of 2 years or less. This decision is similar to making a bet that rates will rise by the time the CD matures so the investor can invest at supposed higher rates. The investor is assuming reinvestment risk, because he/she is not protecting their income stream in case rates fall. It is important not to fall into the "rate trap" of purchasing only cash equivalent investments when short term rates are high. A study was completed by Ibbotson Associates in 2005 regarding long-term annual returns from 1926-2004 for fixed income instruments. They came to the conclusion that a portfolio of intermediate bonds has higher expected returns than a portfolio of cash or CD's. The table below showcases the results:

*These are returns on taxable securities and illustrate the higher expected returns for intermediate bond maturities compared to Cash Equivalent investments. On average, intermediate bonds have generated 5.40% annual returns compared to 3.70% returns for cash equivalents (such as CD's).

Tax Ramifications

Many investors are unaware of the tax consequences of an investment in CD's. Taxes have a significant impact when determining the after-tax value of CD's. For example, the table below shows after-tax returns when comparing a CD to a muni for Federal taxpayers in the highest tax brackets:

State taxes can also have a significant impact on returns for muni bonds. In high tax states such as California, the outcome looks like this when both State and Federal tax rates are included for investors in the maximum tax brackets *:

The CD is much less competitive in an after-tax yield comparison in high tax states. Below, a chart is displayed showing the results for a California resident in the upper bracket:


The municipal bond is more attractive compared to the CD in this example, both with and without state taxes included in these calculations.

State Tax-Exempt U.S. Agencies

Another fixed income option with competitive performance is an agency security such as a Federal Home Loan Bank or a Federal Farm Credit Bank. These two agencies are exempt from state taxes, whereas Fannie Maes and Freddie Macs are state taxable. Below is a table stating the various yields over multiple maturities for a state tax-exempt agency and a CD*:

For a chart with the yields from the above table, see below:

We have assumed an even yield for the state tax-exempt agency across the curve. The chart shows the CD yields increasing as the maturity increases. Even at 10 years, the agency has greater after-tax performance than the CD.

*These tables use the maximum tax brackets for the federal level.


Conclusion

Those who are investing in CD's may want to consider investing in other fixed income instruments such as municipal bonds or state-tax exempt agencies based upon the information provided in this post. For some investors, municipal bonds may be a more appropriate and tax-efficient alternative to CD's.

Munis: Kentucky vs Davis

The Supreme Court has finally agreed to hear the Kentucky vs Davis case which challenges the ability of a State to tax out-of-state muni bonds while giving preference to in-state securities which are not taxed. This case will be heard sometime after the next term begins on October 1st. We are still expecting this case to maintain the current tax system where 40 different states give preference to their own in-state securities. For further information please check our post on April 30 regarding the Supreme Court ruling against the trash haulers.

General Provisions for Illinois School Districts

This information is provided by Andrew Cubria from Hutchinson Shockey in Chicago. Huthinson Shockey is an expert on school district financing in the State of Illinois. Andrew works in the Public Finance area of the firm and thought this post would give investors insight into the issuance of public debt from the Public Finance perspective. This summary from Chapman Cutler deals with the Local Government Debt Reform Act for the State of Illinois and shows the complexities of rules and regulations regarding debt issuance. It is important for the Investment Banker to be well aware of these rules and to be able to work with the officials of the issuing municipality to ensure compliance with the law. Occasionally a banker will overlook one of these provisions before pricing, and a deal will not be able to close because of his/her oversight. This is a very rare event.

Courtesy of the law firm Chapman and Cutler L.L.P.

School Finance
General Provisions for Illinois School Districts

The Local Government Debt Reform Act of the State of Illinois, as amended (the “Debt Reform Act”)

Generally, the debt limit for elementary and high school districts is 6.9% of the equalized assessed valuation of the district and for unit school districts is 13.8% of the equalized assessed valuation of the district. Even though these are the standard debt limits, certain exceptions to the debt limit exist.

Tax anticipation warrants, general obligation warrants, state aid anticipation certificates, personal property replacement tax notes, revenue anticipation notes and, generally, alternate bonds do not count against the debt limit of a district, but bonds, installment contracts, leases, debt certificates, judgments, tax anticipation notes and teachers’ orders do count against the debt limit.

As written in the Debt Reform Act, whenever a school district is authorized to issue bonds without referendum, the district may add issuance costs at the expense of the issuer. Typical issuance costs which school districts are required to pay may include underwriter’s discount, bond insurance or other credit enhancement costs.

The Debt Reform Act also allows a school district to use bond proceeds for capitalized interest on its bonds for a period not to exceed the greater of two years or a period ending six months after the estimated date of completion of the project. One reason where it would make sense to capitalize interest is if a revenue bond is issued to fund a project where the stream of cash flows that are generated from that project do not exist for another 18 months. If this were the case, capitalized interest could be used so the issuer is able to meet principal and interest payments.

The Debt Reform Act also permits school districts to sell bonds at a discount. Whenever bonds are sold at a discount, the bonds must be sold at a price and bear interest at rates so that the true interest cost (TIC or yield) or the net interest rate (NIC) received upon the sale of the bonds does not exceed the maximum rate otherwise authorized by applicable law.
The Debt Reform Act extends the time within which a tax levy for general obligation or limited bonds must be filed. Prior to the passage of the Debt Reform Act, a school district was required to file any debt service levy with the county clerk on or before December 31 of a given year in order to have taxes extended for the payment of the bonds in the following year. The Debt Reform Act provides that districts are authorized to levy a tax for the payment of debt service on general obligation or limited bonds at any time prior to March 2 of the calendar year during which the tax will be collected. County clerks are required to accept the filing of such tax levy prior to March 2 notwithstanding that such filings occur after the end of the calendar year next preceding the calendar year during which the tax will be collected.

In extending taxes for general obligation bonds, the county clerk must add to the levy for debt service on such bonds an amount sufficient, in view of all losses and delinquencies in tax collection, to produce tax receipts adequate for the prompt payment of such debt service.

Whenever the authorization of or the issuance of bonds is subject to either a referendum or a backdoor referendum held after August 13, 1999, the approval, once obtained, remains (a) for five years after the date of the referendum or (b) for three years after the end of the petition period for the backdoor referendum.

A school district whose aggregate principal amount of bonds outstanding exceeds $10mm may enter agreements for interest rate swaps and other interest rate risk management tools with respect to any issues of its bonds. The bonds must be identified to the swap. Net payments under swap agreements are treated as interest for the purpose of calculating the interest rate limit applicable to the bonds, provided, that for this purpose only, the bonds are deemed to bear interest at taxable rates. Swap agreements and the payments to be made under swap agreements do not count against a districts debt limit.

Credit ratings for school districts are determined by rating agencies such as Fitch, Inc., Moody’s Investor’s Service or Standard & Poor’s. A credit rating is not legally required, but a favorable rating may reduce the interest rate paid by a district. The rating agencies review the overall management, debt and financial picture of the district, including recent audits and fund balances. Bond insurance may also be used to reduce interest rates paid by a district.

School Districts may also enter into credit agreements to provide additional security or liquidity, or both, for the bonds, including municipal bonds insurance, letters of credit, lines of credit, standby bond purchase agreements and surety bonds. A district may also enter into agreements for the purchase or remarketing of its bonds providing a mechanism for remarketing bonds tendered for purchase. The term of the credit agreements or remarketing agreements may not exceed the term of the bonds, plus any time period necessary to cure any defaults under the agreements

Under Section 265(b)(3) of the Tax Code, banks and certain other financial institutions are not allowed any deduction for interest expense attributable to tax-exempt debt acquired after August 7, 1986, unless the “small issuer exception” applies. The exception is applied if a school district reasonably expects that it will not issue more than $10 million of tax-exempt debt during the calendar year. If a district stays under this $10 million limit, “bank qualified” status is received, and the restriction on the deduction for interest expense does not apply.

Muni Bonds: The Kentucky Case

Waste Haulers and the Dormant Commerce Clause

An important decision was made today in a court case involving municipal government. The case dealt with waste haulers (such as Waste Management, Inc.) suing local governments over directing waste to preferred dumping facilities. The purpose of these facilities is to dispose of the waste in an "environmentally friendly" manner. The Supreme Court ruled against waste haulers who didn't want to be steered to higher cost dumps by local governments. These governments charge the waste haulers "tipping" fees, but don't allow them to dump at less expensive facilities in other areas. The fees collected are then used as security to pay bondholders. The waste haulers argued that this process was "unfair" and violated the Dormant Commerce Clause which prohibits States from discriminating against out-of-state commerce. The Supreme Court ruled that States, indeed, have the right to force haulers to pay higher fees without allowing them to dump in other areas.

Many have argued that the reason the Supreme Court has not heard the Kentucky case is they wanted to rule on this similar case first. The Kentucky case centers on the State of Kentucky giving preference to in-state municipal securities while taxing out-of-state muni bonds. Davis, the plaintiff, and the Kentucky Appellate Court have argued that this discriminates against out-of-state commerce and is in violation of the Dormant Commerce Clause. Most states give preference to in-state muni bonds and tax the interest on out-of-state munis. The tax-exempt mutual fund industry has created a myriad of state preference funds. A negative ruling on the Kentucky case would rewrite the way states are able to tax muni bonds.

We feel these two cases are very similar. They both center around the "public interest" of a local community. In the trash hauler case, local governments force haulers to pay fees that may be higher than other nearby municipalities charge, but the public interest is served by a cleaner regulated environment. The public interest of the citizens of Kentucky is served by lower interest costs for local governments in the State of Kentucky. We agree with the Supreme Court in this case, and expect the court to use the same logic in the Kentucky case. Thus, Waste Haulers and the Dormant Commerce Clause An important decision was made today in a court case involving municipal government. The case dealt with waste haulers (such as Waste Management, Inc.) suing local governments over directing waste to preferred dumping facilities. The purpose of these facilities is to dispose of the waste in an "environmentally friendly" manner. The Supreme Court ruled against waste haulers who didn't want to be steered to higher cost dumps by local governments. These governments charge the waste haulers "tipping" fees, but don't allow them to dump at less expensive facilities in other areas. The fees collected are then used as security to pay bondholders. The waste haulers argued that this process was "unfair" and violated the Dormant Commerce Clause which prohibits States from discriminating against out-of-state commerce. The Supreme Court ruled that States, indeed, have the right to force haulers to pay higher fees without allowing them to dump in other areas. Many have argued that the reason the Supreme Court has not heard the Kentucky case is they wanted to rule on this similar case first. The Kentucky case centers on the State of Kentucky giving preference to in-state municipal securities while taxing out-of-state muni bonds. Davis, the plaintiff, and the Kentucky Appellate Court have argued that this discriminates against out-of-state commerce and is in violation of the Dormant Commerce Clause. Most states give preference to in-state muni bonds and tax the interest on out-of-state munis. The tax-exempt mutual fund industry has created a myriad of state preference funds. A negative ruling on the Kentucky case would rewrite the way states are able to tax muni bonds. We feel these two cases are very similar. They both center around the "public interest" of a local community. In the trash hauler case, local governments force haulers to pay fees that may be higher than other nearby municipalities charge, but the public interest is served by a cleaner regulated environment. The public interest of the citizens of Kentucky is served by lower interest costs for local governments in the State of Kentucky. We agree with the Supreme Court in this case, and expect the court to use the same logic in the Kentucky case. Thus, it seems likely the current system of taxing out-of-state munis and giving preference to in-state bonds will survive this challenge in Kentucky.