Bond Blog

Are States The Next Greece?

2010-07-14T16:09:00.000-07:00

Recent Events
The recent downturn in our economy has created severe budgetary stress for states, as their revenues have fallen precipitously and the demand for services has increased. The State of California with it’s politically charged budgetary process, high foreclosure rate, and high unemployment rate has received much negative attention in the media. Some are saying “California is the next Greece”. While there is little doubt California is under financial stress we believe these concerns are overblown.

A Sovereign: Greece
Greece is an independent political and financial entity and enjoys “self rule”. It is responsible for it’s budget and has the ability to issue debt and print money. Much of their debt is sold to foreigners and foreign banks. Greece is part of the European Union (EU), and their currency is the euro. The EU requires certain fiscal disciplines for member nations, such as balanced budgets, in order to use the euro as their unit of currency. Recently, it was discovered that Greece created fictitious budgets in order to become part of the EU and their financial circumstances are much weaker than previously thought. The revelation of Greece’s weakened financial state has led to a lack of confidence in their ability to re-pay their debt which has created a “debt crisis” for the country and the EU. The EU has demonstrated a willingness to bail out Greece if certain austerity programs are implemented. Resistance to these austerity measures and violent demonstrations in Greece by it’s citizens have been shown on television. Other EU countries such as Portugal, Spain, and Italy are also experiencing financial problems. Many are questioning the viability of the euro as a currency, and it has been under severe pressure as holders of euro’s look to sell and trade into more secure currencies.

A State: California
The State of California is a political sub-division of the United States. It is responsible for it’s budget, but is required by law to have a balanced budget. It is not able to print money. The U.S. government has helped the States, including California, through various stimulus packages during the last 1.5 years. Most of the debt of the State is held domestically, and is not subject to additional volatility caused by currency risk, which makes them much less volatile than Greek bonds during the last couple of years. Though
the budgetary process is cumbersome and outdated, the financial reports issued by the State comply with legal reporting standards and offer a fair representation of the State’s financial circumstances. The State has the ability to cut expenses and raise revenues to balance the budget. The rapid decline in tax revenues for the last 2 years has caused a great deal of budgetary stress for the State. The ability to make difficult decisions shows the resiliency of the State. These decisions have been made without fiscal discipline being imposed from foreigners, and without rioting in the streets like Greece. The issue of unfunded pension liabilities and healthcare benefits for public employees has not been adequately resolved, and will likely become a major issue during the next 10 years.

Differences
One of the most important differences between Greece and the State of California is the legal framework and rules for reporting. California has had fiscal discipline imposed on it by existing state and federal statutes. These statutes require a balanced budget, and set priorities for paying bills. For example, the highest priority for the State when paying expenses is to first pay those for education, next is debt service on bonds. All other expenses are subordinate to these and are paid after these expenses have been paid. Since Greece is a sovereign, it has been easier for them to avoid fiscal discipline through false reporting and false promises to their citizens. However, this has come to an end as the EU and IMF are dictating austerity measures for Greece.

Another difference is that there is a closer relationship between a State and the U.S. government, than there is between a member nation and the rest of the EU. Imagine being a German citizen and watching reports on television of the rioting in the streets of Greece, while they are expecting you to bail them out. How would you feel when you aren’t even part of the same country?

Sovereigns are also responsible for the banking system and credit conditions within their borders. Many sovereign nations are still reeling from the extensive bailout programs which were required to bail out the banks during the last credit crisis, and to stimulate their economies. In the U.S. the Federal government is responsible for the banking system. This allows the States to focus on other issues, such as education.

Conclusion
There is little doubt that many Sovereigns are riskier credits than States in the U.S. During the last 10 years, the default rate for all Muni bonds has been only 0.1%. There has not been an instance of a State default for over 75 years. The default rate for all Sovereigns during the same time period was 6.0%, which is 60 times greater than the default rate for all Munis.

(Please see chart below for Muni vs. Sovereign comparison.)

Lessons From Vallejo

2010-04-13T15:29:00.000-07:00

2008: Vallejo Under Financial Stress

In 2008 the City of Vallejo, CA was suffering from severe financial stress caused by recurring budget deficits in it's general fund. The city found it difficult to bring it's budget into balance because 74% of the budget consisted of expenses for police and firefighter salaries and pension obligations which had been growing out of control. City officials attempted to renegotiate labor contracts and benefits, but were unable to generate enough cuts to balance their budget. The deficit for 2008 was $4.3 million, with a projected deficit for 2009 of $16 million. According to a recent Wall St. Journal article which appeared on March 26, 2010 "salaries for police captains were over $300,000 per year, and firefighters averaged $171,000 a year. These same workers could retire at age 50 with a pension that guaranteed them 90% of their final year's pay."

Vallejo Enters Bankruptcy

On May 23, 2008 the City of Vallejo filed a petition for protection under Chapter 9 of the U.S. Bankruptcy Code. According to the law firm which represented Vallejo, Orrick, Herrington, & Sutcliffe, in order to file bankruptcy a municipality must meet the following criteria:

It must be a political subdivision of the state. A state is not allowed to file for bankruptcy.

State law must allow a municipality to file for bankruptcy. About half of the states in the U.S. do not allow municipalities to file bankruptcy.

The municipality must be insolvent which means they are not able to meet their current obligations or won't be able to meet them in the next year.

The municipality must desire to effect a plan to adjust it's debts.

The municipality must show it has tried to negotiate unsuccessfully with creditors.

In September 2008 the Bankruptcy Judge Michael McManus determined the City of Vallejo met these conditions, and the Bankruptcy Appellate Panel affirmed his decision on June 26, 2009.

Collective Bargaining Agreement Is Rejected

On March 13, 2009 the judge ruled the City could reject the Collective Bargaining Agreements it had with various city unions, and the City of Vallejo began to renegotiate it’s contracts with public employees including firefighter and police.

Vallejo’s Bankruptcy Workout Plan Affects Bondholders

On December 22, 2009 the City came up with a Bankruptcy Workout Plan which called for no principal or interest payments to be made for three full years beginning January 15, 2011 through January 15, 2014 on outstanding debt. This affects all bonds that are secured by the General Fund. Bonds with dedicated revenue streams are not affected by the moratorium on debt service payments. The bonds that are still paying interest are secured by water revenues, special assessments, and special taxes. Bonds for related entities are also not affected by the Workout Plan. These include Vallejo Sanitation and Flood Control District, Vallejo Redevelopment Agency, and Vallejo Housing Authority. These are all separate legal entities from the City of Vallejo.

Why Vallejo Is Important To Bondholders

During the last 40 years most Muni bond defaults have been for housing and healthcare bonds. There have only been 3 general obligation bonds which were rated by Moody’s that have defaulted during this period. Perhaps the best known case is for Orange Co., CA which defaulted on it’s debt, because of excessive exposure to derivative trades in it’s investment pools by rogue trading by the county treasurer. Bondholders were eventually able to recover 100% of both principal and interest. Jefferson Co., AL defaulted on it’s bonds in April 2008, because of excessive exposure to variable and auction rate securities swaps which caused a large liquidity deficiency for the county when their swaps didn’t work out.

The bankruptcy filing for Vallejo is quite different. It is the result of poor governmental planning with the City lacking the political will to negotiate affordable contracts with public workers, and also making them promises they are not able to keep. Public employees and bondholders alike are watching this case with interest. Numerous municipalities across the country have significant unfunded liabilities for both pensions and healthcare benefits. This case is, thus, important to see if bankruptcy for a municipality is a way to make these liabilities more affordable for it’s taxpayers.

Vallejo: Has Bankruptcy Paid Off?

It is clear bankruptcy has not been a silver bullet for Vallejo, and the costs have been significant. Since filing for bankruptcy, Vallejo’s tax revenues have fallen 20% with further expected declines likely in 2011-2012. The City has not had the political will to reduce existing pension costs. These costs will leave the City
facing projected annual deficits of $23-$27 million once retirement costs are fully recognized. There has been a stigma for residents which makes Vallejo a less desirable place to live. This is reflected in falling property values, reduced services, and a higher crime rate. The City has also been shut out of the credit markets, and will be unable to raise funds for an extended period. The City has made progress in renegotiating labor contracts, but the cost has been high.

We believe other municipalities will look at this case with mixed feelings, and will realize bankruptcy is an option of last resort. It is not a panacea for getting rid of unfunded pension liabilities. Most municipalities are not in the dire straits which Vallejo is in, which means they are not eligible to file for bankruptcy. Fears of widespread use of bankruptcy by municipalities to lower unfunded liabilities are overblown. On a positive note for taxpayers, this case sends a clear message to organized public workers. In a bankruptcy situation their existing contracts are all up for renegotiation. This should make them more willing to negotiate on more favorable terms with municipalities in the future.

Lessons To Be Learned For Bondholders

This case provides several lessons for investors. First, Muni bondholders should realize security selection has never been more important than it is now. Improper security selection can be very punishing to investors. Next, bond investors cannot assume general obligation bonds are more safe than revenue bonds. When a municipality experiences extreme stress and enters bankruptcy, bonds with dedicated revenue streams are superior to claims on the general fund. Also, some municipal entities may lack the political will to make sound financial decisions. Even though municipalities are required to balance their budgets, there may be some situations which make it extremely difficult for them to do so. Many budgetary problems need long term solutions, but politicians are only willing to provide short term fixes. In addition, since states are not able to declare bankruptcy, it is difficult for investors to know which type of bonds have priority over other general fund obligations such as payroll and vendors. Laws will vary from state to state. For example, in California payments for schools have priority over debt service, which has priority over all other general fund expenses. Finally, the Muni market is a fragmented market of over 50,000 different issuers. It is not possible to make general statements re
garding the creditworthiness of all Munis. Pundits which make generalizations about the Muni markets should be treated as suspect. Instead, investors should be more like loan officers who realize that each borrower has different abilities to service their debt. They should consider off balance sheet obligations, wealth levels, and debt per capita before purchasing the issuer’s general obligation securities.

Conclusion

The Muni market is not a good do-it-yourself market. Proper security selection is beyond the scope of most individual investors. We also believe the financial situation of the City of Vallejo shows the danger of blind reliance on default studies, which is not a good policy in today’s environment. These studies cover a time period where most municipalities did not experience the amount of financial stress which they will be facing during the next couple of years. This stress may be caused by declining tax revenues, higher costs of providing healthcare, or unfunded liabilities associated with public employees. Instead, we plan to place more emphasis on revenue bonds with secure revenue streams and less emphasis on some general obligation bonds. This strategy is similar to the one we have used for California Muni bond investors. We will continue to seek out general obligation bonds of high wealth areas, and issuers with low debt per capita levels, and a willingness to make difficult budget decisions. But, we will also place increasing emphasis on essential service revenue bonds where the issuer has a monopoly on the services they provide.

Shared Sacrifice

2009-07-03T20:37:00.000-07:00

Turmoil In The Credit Markets
During the last 2 years there has been considerable turmoil in the credit markets due to the rapid decline in the credit quality of borrowers in the corporate, mortgage, and agency markets. The sub-prime mortgage crisis, collapse of Fannie and Freddie, banking and investment banking crises, stress on insurers and guarantors of debt, and collapse of 2 of the 3 largest auto makers are all examples of the deterioration in the credit quality which has taken place. Even the credit quality of the U.S. Government (the heretofore standard for a riskless borrower) has been called into question.

Fixed Income Credit Analysis and Risk
This decline in credit quality has made credit analysis more important than ever. Fixed Income money managers who were able to avoid major problems with credit issues have achieved superior performance to those who were unable to foresee potential credit problems. The penalty for being “wrong” on the credit of an issuer has been harsh as credit spreads blew out to very wide levels. A good credit analyst is able to identify and understand the risks in any given security. Most investors lose money because they grossly underestimate the amount of risk they are taking. The other mistake they make is “reaching for yield”. This leads to creating portfolios that consist of all the weakest credits, because they are the ones that yield the most. These portfolios do not perform well in stressful times for the markets. A good credit analyst is also able to determine what the “worst case” is for any security he owns. This is extremely important when things “go bad” for a credit. There are different layers of security for a bondholder. These include debt service coverage, the issuers ability to pay, and where the bondholder stands as a creditor in bankruptcy. In bankruptcy, there are long established rules that apply to secured and unsecured creditors, as well as to equity holders. These rules provide comfort to secured bondholders when things “go bad” for one of their borrowers. The current economic cycle has allowed the government to become involved in the economy to an unprecedented extent, which has revealed a new level of risk a good credit analyst needs to consider. We will call this ‘political risk”, which is the risk of confiscation of secured creditor assets for the benefit of a junior class of creditors. This is a risk that is more prevalent in unstable less developed countries, and was unthinkable in the U.S. until Chrysler.

The Chrysler Bankruptcy
The auto industry was particularly hard hit in the recent economic slide with both Chrysler and GM going into bankruptcy. The actions taken by the government in the Chrysler bankruptcy were unprecedented. The President introduced the concept of “Shared Sacrifice” in the media as he called upon secured creditors to take less than they were entitled to legally so that one of his political supporters, the UAW (a junior creditor), could get a larger share of the new firm. TARP participants who represented the majority of senior secured creditors were then coerced into voting for a government sponsored cram down which gave the secured creditors only 30% of the company while the junior class of creditors (UAW) received 50% of the firm. The secured creditors who did not vote for the plan were labeled as speculators and were portrayed as all around bad guys to the public. This creates an enormous amount of uncertainty for investors in fixed income securities in the U.S., because laws which were deemed sacrosanct have been rendered meaningless as assets are confiscated from one class of creditor and given to another class of creditor based on political whim instead of rule of law.

Bankruptcy Law
Existing bankruptcy law is designed to protect debtors from creditors seizing their assets without giving them time to come up with a plan to pay creditors in a fair and equitable manner. When bankruptcy is declared an estate is created, similar to when a person dies. The assets of the estate are then valued, and creditor claims are processed and organized into order of their priority. Some claims are secured, and have a priority over junior claims. A first mortgage claim is entitled to receive full payment before the second mortgage holder receives any funds. Priority of claims is a well established principle of bankruptcy law. Debtors are not allowed to pay some creditors to the detriment of others immediately prior to or during bankruptcy. The debtor in possession of the assets is allowed to form a plan which is equitable to it’s creditors, and the creditors can then vote on the plan. If a majority of the creditors vote for the plan, the dissenters will suffer what is caused a cram down, as the plan is approved over their objections. In the Chrysler case there are problems with the asset valuation process, priority of claims issues, and the nature of the government’s cram down. The concept of “shared sacrifice” violates bankruptcy law and discourages lending, particularly to weaker credits.

Conclusion
We believe the government has now re-written bankruptcy law in this country. Since the Chrysler case, GM has been put into bankruptcy. A similar approach to a rushed asset valuation process has been taken in GM as well. Virtually every secured creditor in the country has now found their position in bankruptcy lowered, as the government ignores the established rules of bankruptcy law. We were fortunate that we did not own any bonds for the auto companies, because our credit analysis deemed them too risky. We also avoid high yield bonds, because they are very highly correlated to equities, and don’t offer enough diversification to the investor’s overall portfolio. However, even though we dodged the Chrysler bullet, we are still very concerned by the government’s actions and our level of “trust” for our system has been shaken. Why would any investor want to invest in high yield fixed income with the additional risk of confiscation in bankruptcy? Without the established priority of claims in bankruptcy there is now no such thing as a secured or priority claim. “Shared sacrifice” does considerable harm to encouraging lending during these difficult times, because it makes it nearly impossible to determine the lender’s worse case. It makes more sense for the lender to avoid lending to riskier firms, because a secured loan to a struggling creditor suddenly has become much riskier.

Nominal GDP and Inflation

2009-05-20T19:20:00.000-07:00

The Current View of Inflation
Investors have become increasingly concerned about future inflation due to massive governmental intervention and growth in the money supply. These investors argue that the large increase in money supply has to go somewhere, and it will cause inflation. They may also argue that this increase in money will cause the dollar to go down, which will in turn cause prices to rise even further. They frequently feel compelled to throw in their thought that the deficits we are currently running are so large, that the only way out of this situation is to inflate our way out. This is currently the consensus view. While this view may be intuitively obvious to most investors, we believe high rates of inflation are not necessarily a foregone conclusion.

Review of Inflation
The chart below shows the annual rates of inflation as measured by the U.S. CPI Index for Urban Consumers on a non-seasonally adjusted basis since 1926 through 2008.

This information is available from the U.S. Department of Labor and may also be found in the Ibbotson SBBI 2009 Yearbook. The average annual rate of inflation during this time period was 3.0%. During the period from 1926-1933 we experienced deflation. In fact, it took until 1945 for the Consumer Price Index to get back to the level it was at in 1926. During the 1950’s and 1960’s inflation experienced a slow rise. The 1970’s saw inflation rise until it peaked at 13.3% in 1979. This was the year gold reached $850.00 per ounce and silver peaked out at $50.00 an ounce as Bunker Hunt tried to corner the silver market. WIN buttons were passed out which stood for “Whip Inflation Now”. OPEC proclaimed an oil embargo and the price of oil went shockingly high. This was an inflection point for inflation. During the 1980’s inflation steadily declined and this trend continued through the 1990’s until last summer when oil reached $150.00 a barrel. Since then the economy has continued to decline and price increases have been under control. Last year the CPI was only up 0.1% even though gas prices had reached prices of over $4.00 a gallon during the summer. Last summer many investors “knew” inflation had returned and feared interest rates were going higher. So far, during this year the index has increased 1.3% through April. The chart below shows the average annual inflation rate by decade since 1926. By looking at inflation over longer time periods the data is smoothed and we are able to see the long term trends more clearly.

Inflation and Economic Growth
Our research shows a high correlation between economic growth and inflation when the economy grows faster than trend. We used data from the Bureau of Economic Analysis to measure growth of GDP. GDP grew at an average annual nominal rate of 6.68% during the period from 1926-2008. Let’s call this the trend rate of growth for the economy in the U.S. In the chart below we compare the annual rate of growth of nominal GDP minus the trend rate by decade, and compare this growth versus trend to the CPI. The results show a high correlation. During the 1930’s the economy contracted below trend and we had deflation. During the 1940’s, 1970’s, and 1980’s the economy grew above trend and we had high levels of inflation. Economic growth during the the 1950’s and 1960’s was at trend and inflation was low. The last 20 years has shown growth below trend with declining rates of inflation.

Conclusion
Investors would be wise to pay attention to indicators which
are leading indicators of the economy such as the LEI Index or the Chicago Fed National Activity Index. These indicators are currently still showing economic weakness which is way below the trend rate for the economy of 6.68%. Inflationary pressures are not likely to appear until growth in nominal GDP approaches levels in excess of trend.

The Government To The Rescue?

2009-03-15T05:21:00.000-07:00

Some large cities and states are seeking help from the federal government. So far, help has not been forthcoming. We expect this to change soon, because budgetary cutbacks by municipalities will put additional pressure on an already weak economy. There is increasing talk of helping municipalities with infra-structure needs such as bridges, roads, and energy.

We believe the best option for the government in assisting municipalities is to create some sort of replacement for the bond insurers. This would help reduce borrowing costs for municipalities, and would ensure that financing would be available to issuers who need to borrow. It would also help to restore confidence in the financial system by eliminating the de-leveraging that has been taking place in most asset classes.

What Did The Government Do Wrong Last Year?

When the government let Lehman go down in mid-September, the strains on our financial system were so great the credit markets ground to a halt. The counter party risk involved with Lehman and other counter-parties were revealed to all, and resulted in widespread fear throughout the system. The government greatly under-estimated the systemic risk they were taking when they let Lehman collapse.

The government also didn’t understand how important the bond insurers were to our funding mechanism for credit. Our system relied on guarantees to create AAA credits in the short term markets. These AAA ratings were the key to cheap funding by all sorts of borrowers. The demand for money market eligible paper was so great, a financially strong issuer could borrow at low rates. This system worked well for years and allowed for various leveraged strategies to exist which lowered borrowing costs for most borrowers. The financial shock to our system from rising default rates of Sub-Prime mortgages, and falling housing prices put immense stress on guarantors who had become over-exposed to this market. As insurers got downgraded, investors began to panic in the short-term markets. First, funding dried up for SIV’s which funded Sub-Prime mortgages. Next, investors sold insured notes by FGIC and XLCA, and bought notes guaranteed by MBIA and AMBAC as it became clear these companies were going to lose their AAA ratings. This steady stream of downgrades of guarantors created an absolute panic in the short term markets as they realized no AAA rating was safe. This resulted in the collapse of the Auction Rate Securities market. As funding costs sky-rocketed in the short-term markets de-leveraging took place in earnest in all fixed income markets. We believe the government’s lack of understanding of the importance of guarantees in the short-term markets led to our funding mechanism breakdown last year. This created a crisis in confidence, de-leveraging, and the decline in asset values.

Inflation Worries

2009-03-15T05:12:00.000-07:00

Investors are becoming increasingly concerned about inflation as a result of the massive governmental intervention which is taking place. Their argument is that “the government is running large deficits and the money supply is growing out of control”. They feel sooner or later we will experience inflation, and they are worried about a dramatic fall in the dollar and the possibility of hyper-inflation as a result. We feel inflation fears are currently overblown since the economy is still contracting and is very weak. The chart below shows the Chicago Fed National Activity Index. It is a combination of several leading indicators and shows how we are doing

compared to the long term trend growth rate of the economy which is represented by the line at 0. Inflationary warnings flash when this indicator is at 0.7%, and recession is likely to occur when the index falls below –0.7%. The current reading is about –3.4% which is nowhere near the inflationary warning level of 0.7%.

Most investors have grossly underestimated the deflationary forces at work in the economy due to deleveraging caused by tight money conditions in a highly leveraged economy. The cheap funding through the short-term markets which allowed leveraging to take place has disappeared, because the bond insurers are no longer AAA rated credits. This has reduced the supply of credit dramatically because the “borrow short and lend long” trades no longer work. These trades represented the “Shadow Banking System” which funded leveraged buy-outs, no money down housing loans, and hedge fund activity. The contraction of this form of financing has led to economic weakness, which has caused the velocity of money to fall, which has offset the increase in the money supply. It will most likely take a long period of time for these forces to work themselves out before inflation becomes a problem.

Pushing On A String?

2008-07-10T18:12:00.000-07:00

Is The Fed Too Easy Or Too Tight?
There has been much talk recently about the need for the Fed to raise rates to stop rising global inflation. Our work shows that money is still tight, even though the Fed has lowered the Fed Funds rate to 2.00%. The Fed surveys senior bank loan officers about lending practices at banks. This information is gathered through the “Federal Reserve Board’s Senior Loan Officer Opinion Survey on Bank Lending Practices”. The Fed conducts this survey quarterly with about 60 large domestic banks, and 24 U.S. branches of foreign banks. The information from this survey is quite interesting in today’s environment. The chart below shows the availability of credit and the cost of credit as shown through the Fed’s survey. As you can see

the credit lending standards have become progressively more restrictive. This is shown by the blue line in the chart. As bank lending standards have grown stricter, the cost of credit has been climbing rapidly (shown by the red line). In fact, the percentage of senior bank lending officers who are raising credit costs to businesses is currently higher than at anytime since the survey began in June 1990. It is interesting that banks have been tightening credit during the same time that the Fed has been trying to ease credit conditions. The chart below shows the cost of borrowing plotted vs the Fed Funds rate during the same period of time (6/1990-6/2008).

The chart shows the expected lags in bank lending costs, but recent developments are an anomaly, since borrowing costs are soaring as the Fed continues to lower short term rates. This implies that the Fed is currently “pushing on a string”. The tool of using rates to control the economy is no longer working as it has in the past. This is an alarming development, because it shows the seriousness of the current credit crisis in the U.S.

The Party’s Over
Over the last few decades the Fed has gained enormous credibility as an institution with the ability to manage our economy out of recessions in a non-inflationary way. The Fed as lender of last resort created the “Greenspan Put”, which meant when things got bad the Fed would be there to make things better. This policy has not, however, been without costs, and has only postponed the inevitable. This led to an incredible leveraging of our financial system, the creation of the shadow banking system, and massive amounts of debt being accumulated by the consumer and guaranteed by our financial institutions. The lax lending standards and cheap credit shown in the first chart during 2005-2007 helped create the debt hangover we are currently suffering. Rising delinquency rates and massive write-down's of loans have created deteriorating balance sheets for our banks and investment banks. They want to forget about the lax credit party that got them where they are today. The Pushing On A String chart shows the party is over. Banks are in no position to party again any time soon. Their hangover is too great. We should expect them to concentrate on re-building balance sheets, by raising capital, deleveraging, and cutting back anyway they can. The thought that money is easy, because the Fed cut short term rates is a misconception. Money is tight and will remain tight until the financial system begins to recover from the excesses of a couple of years ago.

Auction Rate Securities: What Now?

2008-06-14T15:44:00.000-07:00

The Background
Auction Rate Securities (ARS) are typically either a debt instrument with a long-term maturity or preferred stock in which the interest rate is determined through an auction process. These rates normally are reset either weekly or monthly through periodic auctions. The ARS market reached about $350 billion at its zenith. About half of this market was for tax exempt securities. The issuers of tax-free ARS are municipalities, closed-end muni funds, and corporations that qualify under the “public purpose” provisions of the tax code. The ARS market was designed to act as a low cost funding mechanism for these issuers. Since early this year this market has been in disarray due to liquidity disruptions. Many investors have had their funds frozen because of a rash of failed auctions. At one point, over 80% of all auctions failed. When an auction fails the investor receives the penalty rate which is disclosed in the initial offering papers for the security. This penalty rate varies widely from a very low rate up to 20% depending upon the terms outlined in the offering documents of each issue. These securities normally come in $25,000 denominations.

Who Was At Fault?
Bankers and other Public Finance types get paid by generating revenues. The ARS market, just like Sub-Prime structured products, grew out of this need by Investment Bankers to generate out-sized year-end bonuses. The ARS market needed a “hook” to be successful. The “hook” for the issuer was cost savings from the ability to avoid paying for another bank to provide liquidity for their money market securities. The “hook” for the investor was that they would receive better than money market rates for taking virtually no risk of a failed auction, because their broker’s firm always made sure the auctions were successful. These securities were appealing to ignorant and greedy brokers who were now able to get bigger commissions on “money market” alternatives. For awhile this strategy worked and the Bankers were able to create a $350 billion market that was a fee generating machine. Unfortunately, early this year investors and issuers both discovered that the Emperor had no clothes. When auctions failed, issuers found that their costs were much higher than the Bankers had promised, and the investors lost access to their funds despite being told “they were as good as money markets, no they were even better than money market funds”.

How TFS Avoided The ARS Debacle?
Virtually all credit crises were caused by investors underestimating the amount of risk they were taking. The ARS market meltdown is no exception. Our perception of risk helped us to avoid ARS. We chose to invest in Variable Rate Demand Notes (VRDN) instead of ARS, because we knew we were not getting paid to take the additional risk of a failed auction. The chart below shows that prior to the ARS meltdown we actually received on average about an extra .04% yield by purchasing VRDN’s instead of ARS. These instruments are money market eligible and trade in $100,000 denominations. They are issued by many of the same issuers that also issue ARS. It is common knowledge that ARS are not money market eligible, because the investor does not have their liquidity guaranteed when he/she desires to liquidate their securities. Institutional investors know that a VRDN is money market eligible, because there is a liquidity facility guaranteed by a Standy Purchase Agreement. We reasoned, “why would anyone buy an ARS at a lower yield when it is an inherently riskier investment?” The only explanation for this enigma is that investors were unaware of the liquidity risk in these securities, and they let their brokers spin them around by selling them something with more risk than they thought they were taking. This situation clearly shows the conflict of interest that may exist between a broker/salesman and the investor.

Prospects For The Future
The ARS market has rapidly shrunk to half its former size. The cost savings the Bankers promised have turned into additional expenses instead. So, issuers have called outstanding issues of ARS with high penalty rates and replaced them with VRDN’s, put bonds, or long-term bond issues. This trend will likely continue for the next 6 months until most investors’ ARS funds have been freed up, and issuers have escaped the fiasco known as the Auction Rate Securities market.

Is There More Inflation In The Future?

2008-05-29T14:30:00.000-07:00

Inflation Outlook
Recently, there has been much talk in the press about inflation. The argument is made that the recent rise in food and energy prices has to filter into the inflation numbers sooner or later, and that interest rates have to rise because inflation is so bad. Frequently this argument is further editorialized with comments such as “I don’t know why the Fed only looks at core inflation. After all, don’t we all have to eat and drive to work? Of course, if you take out everything that goes up, we won’t have any inflation at all!”. This is commonly followed by snickers, as if they are the only ones who could figure this out.

We pay close attention to inflation, which is a lagging economic indicator. Studies show inflation tends to peak at about the same time the economy is bottoming. It has been our opinion that we are in a temporary cyclical upturn in inflation, and we should see inflation come down as the economy slows. The chart below is a Fed model (Chicago Fed National Activity Index)

which shows economic activity and the likelihood of increasing inflationary pressures. The blue line is the value of the index and is charted against the axis on the left. We have added an index of inflation to the graph. The gray area is a graph of the year over year Personal Consumption Expenditures Index. This is the Fed’s preferred measure for inflation and the axis on the right shows the inflation rates. The CFNAI uses 85 different economic indicators as inputs which measure:

1. Production and Income
2. Employment, Unemployment, Hours Worked
3. Personal Consumption and Housing
4. Sales, Orders, Inventories

The Fed model uses a 3 month moving average to smooth the data. The index is designed to be 0.0 when the economy is growing at the long term trend rate. The index is positive when the economy is growing rapidly, and is negative when it is growing slowly. When the index is below –0.70 it is increasingly likely we are in recession. The index has been below –0.70 for the last 5 months. The current value is –1.25. This suggests a continued weak economy in the future. When the index is above 0.7 after the economy has grown for more than 2 years it is likely inflation will rise. This model shows the strong correlation between the overall strength of the economy and inflation. Since the index is in negative territory, this model shows it is likely that inflation will moderate in the future.

Conclusion
Investors should not become distracted by the chatter in the press about the need for interest rates to rise because of inflation. High oil prices and inflation are certainly today's problem, but the leading indicators show inflation is likely to moderate in the future, because of the weak economy.

The End Of The Muni Carry Trade?

2008-02-18T14:46:00.000-08:00

Supply/Demand Imbalance
There has been steady growth in the assets held by Tax-Free Money Market funds since their inception. During the last 10 years the holdings of these funds have more than doubled in size as their assets increased by about 123%. Last year about $430 billion was invested in short-term Tax-Free funds. The chart above shows the “gap” between assets held by money market funds and the amount of issuance of short-term tax-free securities that are available for them to purchase. These securities have maturities of 13 months or less, or are longer maturities that have floating-rates and a put that gives short-term liquidity to the debt. Most of these floating rate securities are issued as Variable Rate Demand Notes. This money market supply gap has continued to widen over the last decade.

The Muni Yield Curve
The strong demand for short-term paper by money market funds causes munis to trade “richer” in the short-term part of the yield curve relative to U.S. Treasuries than in the longer part of the curve. This means that munis have a long history of having a positively shaped curve, even when treasuries are inverted by Fed induced tightening measures. The chart below shows the spread between a 1 year muni and a 30 year muni over the last 3 years. When the Fed was
in a tightening mode the curve flattened to a low of 40 bp’s on 2/27/2007. During that same period of time the Treasury curve was inverted. Since the muni yield curve has a history of having a positive slope even when money is tight, it works well for strategies that borrow short and lend long.

The Muni Carry Trade
Tender Option Bond programs (TOB’s) and leveraged Closed End muni funds both borrow short and lend long in the tax exempt marketplace. TOB strategies are funded by money market eligible instruments that allow the programs to purchase long muni bonds by employing leverage. The amount of leverage varies by the entity that is employing the strategy. The muni “carry trade” has become increasingly important over the last 10 year period. The chart below shows the holders of municipal debt as of 12/31/2007. Banks held about $193 billion at the end of last year and Closed End funds held about $92 billion of munis. During the last 3 years the growth in assets held by each category of investor can be seen below. Commercial Banks grew their holdings by about $50 billion since 2004. Much of this growth came from a few large banks that employed carry trade strategies in the muni bond market.

The chart below shows the increase in holdings by the 7 largest holders of muni debt by commercial banks over the last 3 years. The 5 largest holders were all significant purchasers of munis during this time period and accounted for about 50% of the growth in holdings by all the commercial banks. The addition of these large positions of muni debt in such a short time period can only be explained by the use of leveraged TOB strategies. In addition to the TOB’s issued by the commercial banks, there was considerable growth in the number of these strategies employed by hedge funds/arb accounts. It is estimated that Merrill Lynch’s TOB is about $40 billion. Many of these strategies were offered as Alternative Investments or as Fund of Funds strategies. Data on the size and number of these programs is not readily available, but the amount is impressive. Closed End muni funds had little impact and did not experience much growth during this time period. These funds are leveraged through the use of Auction Rate Preferred securities which are not money market eligible, because their liquidity is not guaranteed.

Filling The “Gap”
The leveraged strategies employed by TOB’s are primarily funded by the tax-free money market funds. For example, La Salle Bank would purchase a large block ($15-$50 million) of long muni bonds and deposit them into a trust. The trust splits these bonds into 2 different parts:
1. The short-term holder gets a weekly floating rate security that is money market eligible and can be put back to the marketing agent on 7 days notice.
2. The residual certificate holder (La Salle Bank) receives the difference between the rate paid on the short-term piece and the rate received on the long bonds that were purchased.
This is a “carry trade” for the Bank, because they borrow short and lend long. The steepness in the yield curve has made this a desirable trade for the Bank and the shortage of money market eligible paper has made it beneficial for the tax-free money market funds. The residual holder assumes the market risk of the bonds, and the short-term holder assumes the credit risk of the securities. The credit risk is minimized through the use of insurance or guarantees. The market risk for La Salle Bank is hedged with derivatives. Historically, this strategy has worked well for both money market funds and TOB programs. This type of funding has been useful in filling the “gap” between demand and available supply for the Money Market funds.

Auction Rate Securities
Closed-End funds and Municipalities both issue auction rate securities. The Closed End funds primarily fund their leverage through the issuance of Auction Rate Preferred (ARP’s)securities. These are high quality securities that are secured by the assets of the fund. These are not money market eligible securities, because their liquidity is not guaranteed by anyone. Instead, the rates and liquidity are set by an auction process. Auction Rate Preferred’s are purchased mostly by individuals and corporations. Municipalities issue Auction Rate securities (MAR’s) that are also not money market eligible for the same reason as the ARP’s. These securities are usually either credit enhanced by an insurer or bank, or are of very high quality.

Crisis In Confidence
The huge write downs by municipal insurers of CDO’s with sub-prime exposure has called the creditworthiness of the insurers into question. The rating agencies are imposing tougher rating standards and are calling for more capital from the insurers of municipal credits. Moody’s has downgraded FGIC from AAA to A-3 and Fitch lowered XLCA from AAA to A. This has led to serious disruptions in the short term muni markets. Money Market funds are only able to hold securities (Variable Rate Demand Notes) that are AA rated or better. These funds are not able to hold weaker underlying credits with an insurance wrap that might get downgraded below AA. This has caused Money funds to “put back” weaker credits whose insurers are likely to get downgraded.

In the Auction Rate market, many auctions have recently failed. This is due to liquidity concerns, rather than credit concerns. Dealers have been unable to provide enough liquidity for all of the auction rate securities. Roughly $10 billion of auctions failed during the last 2 weeks. The sudden lack of confidence in the auction process has led this market to unravel. This is causing financing costs to increase for issuers of these types of securities, because when an auction fails the holder of the security gets the maximum rate payable according to the original documents. These rates have been as high as 12-20%. This is causing issuers to look for alternative modes of financing instead of using the Auction Rate marketplace.

Recent Developments
We have noticed these developments due to the distortions in the short-term muni market:

1. There is extreme pressure on banks, dealers, and hedge fund TOB programs due to downgrades of securities that can no longer be funded in the short-term markets. There is constant fear that these programs will be or are unloading long munis to unwind trusts due to downgrades. There is also pressure caused by increased financing costs for these programs. Cheap funding in the money market arena has given way to much higher financing costs. This increase in costs has made the carry trade unprofitable for some hedge funds, which has led to liquidation of some of their long bond holdings. This has caused the long end of the market to underperform relative to Treasuries.
2. Issuers are searching for ways to lower soaring financing costs of Auction Rate securities. Some of these will be converted to VRDN’s and will be bought by the Money Market funds. Others will be reissued as long term debt. Since rates are low on an absolute basis, we expect many of these loans to be converted to long term bond deals.
3. There is now a severe shortage of acceptable money market eligible paper for the funds to purchase. This has led to short-term rates for quality paper falling rapidly to levels around 1%. This is below levels that are justified by current tax rates for taxable accounts. Money has continued to flow into Money funds during this recent scare. Assets are now up close to $500 billion.
4. The Auction Rate market has suffered a serious setback from the large number of failed auctions. Some investors, who are not concerned with liquidity, have been attracted by the high rates currently available in this market.
5. The muni yield curve has continued to steepen which will provide an incentive to investors to extend to pick up yield when the market returns to normalcy.

Conclusion
Guarantees of liquidity and credit are an integral part of the short term muni market. The current disruptions have been caused due to concern about the credit-worthiness and dependability of these guarantees. This has led to a contraction in the supply of capital as a funding mechanism for carry trades. We do not expect this shift in supply to be reversed any time soon. This will make it much more difficult for TOB’s to do carry trades in the future.

Ambac Insured Auction Rate Securities

2008-01-24T10:11:00.000-08:00

What Do I Own?
Some investors have become concerned because they own securities that are AMBAC insured and Fitch recently downgraded the insurer to AA from AAA. We are not particularly concerned about munis that are strong credits on their own. However, there may be instances when an investor should be concerned.

The example below is for Arizona Public Service Company and is in a weekly Auction Rate mode. It is important for the investor to understand what this security is in order to determine if it is a suitable investment for him/her. A weekly Auction Rate security has a rate that resets weekly. This rate is determined by an “auction” process. The stated maturity is shown to be 6/1/2034. This security is not deemed to be Money Market Fund eligible because a money fund can normally only invest in maturities out to a little over 1 year. It is possible, but highly unlikely, in the event of a failed auction that the investor would end up owning a security with a maturity in 2034, instead of a money market alternative. The underlying credit quality of APS is BBB-. This is shown in the Bloomberg screen shot below. While it is normally unlikely for an auction to fail, the current stress on the guarantors (in this case AMBAC) and the weak underlying credit quality of APS increase the possibility of this unlikely event occurring.

We have avoided these securities and invest in Variable Rate Demand Notes instead. These securities are money market eligible because the liquidity to put them back to the dealer on 7 days notice is guaranteed.

Conclusion
We would caution investors to be aware of the risk of a failed auction on a weak underlying security that is guaranteed by an insurance company that cannot maintain their AAA rating.

Variable Rate vs. Auction Rate

2007-12-12T09:01:00.001-08:00

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

2007-11-13T10:36:00.000-08:00

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

2007-11-01T11:16:00.000-07:00

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

2007-09-20T09:47:00.000-07:00

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

2007-09-19T11:29:00.000-07:00

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

2007-08-27T09:45:00.000-07:00

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?

2007-08-16T11:38:00.000-07:00

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

2007-07-26T16:36:00.000-07:00

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

2007-06-18T09:11:00.000-07:00

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

2007-06-11T10:54:00.000-07:00

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?

2007-06-11T07:00:00.000-07:00

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

2007-05-22T14:42:00.000-07:00

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

2007-05-22T07:05:00.000-07:00

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

2007-05-09T11:17:00.000-07:00

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

2007-04-30T10:38:00.000-07:00

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.

How do you explain to your clients about using a SAM?

2007-04-20T10:34:00.000-07:00

We frequently hear this question from advisors: How do I explain to my clients that they should use a bond manager when we've been managing the bonds?

A portfolio of individual securities can be a tax-efficient and customized alternative to a mutual fund. In the past, advisors were able to add value because the cost of using a separate account manager was too high. With a decline in the cost of using a separate account manager, they have become an option for advisors to use for their clients instead of doing it themselves. The firm Evensky & Katz came to this conclusion in 2003 (see Harold Evensky's May 6th, 2003 article entitled, Why Hire a Manager to Pick Your Bonds? This article can be found here. Currently, this article can only be downloaded with Internet Explorer; We are sorry for the inconvenience). Below, we discuss the fees, specialization, value added, and validity of separately managed accounts.

Fees

Just as mutual funds charge fees, so do separate account managers. The separate account manager directly states the fees charged, while mutual funds disclose their fees in the prospectus. Mutual funds deduct their fees before they report performance and the client does not see the exact amount. If the investor is using a separately managed account, the investor pays fees to the manager and they are more transparent. Separately managed account fees were relatively high in the past (in the neighborhood of 1.5-2.0+%), but now they are very competitive (.25-.50+%) in comparison with mutual funds.

Specialization

Bond portfolio managers have lower transaction costs than the typical advisor. They also have access to other beneficial tools such as Bloomberg not usually utilized by an advisor. There is a great deal of specialized knowledge and detailed work that goes into managing bond portfolios. A professional money manager is able to do things that even a good advisor doesn't do.

Value Added

The cost/benefit analysis for using a separate account manager is much more favorable today than it was in the past. Customization and tax-efficiency are the main reasons to use Separately Managed Accounts. These benefits are difficult to achieve using a mutual fund. Value-adds from a SAM can compensate for the cost of professional management. In the past, separately managed accounts were marketed as customized when they were really 'expensive closet mutual funds' according to Evensky. The competition has increased over time with SMA's and money managers are discovering more ways to add value to a client's portfolio. Harold Evensky places the value of active bond management in a SMA at .10-.30% net of fees. Tax management may provide additional value to the client's portfolio as seen in the chart below.

Validity

Harold Evensky, a nationally renowned financial planner with Evensky & Katz Wealth Management in Coral Gables, FL, had this to say about altering his bond strategy: "(C)hanges in the economy led us to believe in spite of our expertise, our strategy of individual bond selection was no longer in our clients' best interests." The cost effective strategy of a bond separate account manager became available and Harold made the switch.

Conclusion

While the advisor may have done a good job in the past managing the client's bond portfolio, declining fees of separate account managers have created the opportunity to increase after-tax performance for the client. This allows the advisor to focus on managing the relationship with the client and free up time to work on other tasks.

Bonds: Harvesting Losses

2007-04-19T20:18:00.000-07:00

There are times when it can be beneficial to realize a loss for tax purposes. Losses can be used to help offset up to $3,000 of current income a year, and capital gains from other investments. They can also be "banked" or carried forward to another year if they can't be used in an existing tax year.

The value of these losses depends upon the taxpayer's marginal tax rate and the capital gains tax rate. The first $3,000 of losses may be used to offset ordinary income. Let's say the investor is in the 35% tax bracket. The value to him/her of this loss is: $3,000*.35%=$1,050. If the size of the loss is greater than $3,000, then the remaining loss can be used to offset capital gains. For example: if the loss is $8,000, there is $5,000 of losses remaining after using the first $3,000 against ordinary income . The value of using these losses to offset capital gains is $5,000*.15= $750. We use .15% as the capital gains tax rate. This rate is scheduled to expire in 2010 and return to the .25% previous rate. The total losses harvested in this example is $1,800 ($1,050 + $750). The higher the tax rate, the more value there is in the loss.

When realizing losses for tax purposes, it is important to remember the Wash Sale Rule. This rule states that when you take a loss on a security, you may not re-purchase the same security for 30 days in order to use the loss on your return. This rule is meant to discourage investors from selling a security and immediately buying it back. If you own stock in Microsoft and realize a loss, you can't buy back MSFT for 30 days and use the loss. What works best in tax loss selling is finding a security that is a good substitute for the security you are selling. Muni bonds are the ideal securities for tax swapping. For example, if you own City of Chandler, AZ 5% coupons due 1/1/2013, you could swap these for City of Scottsdale, AZ 5% coupons due 1/1/2013 in a legalized way around the wash sale rule.

The challenge in doing these types of trades is having low transaction costs. The typical retail client is locked into a buy and hold strategy because their transaction costs are too high. For example, it would not make sense to do the swap above if your cost of doing the trade is greater than the tax savings you generate. The typical bid/ask spread for a retail client is over 2%. If the investor has a $5,000 loss, it is worth $750 to him. If it costs him $2,000 to do the trade, then his position will be impaired $1,250 by doing the trade ($750 - $2,000). Thus, he is locked into a buy and hold strategy. If, however, your transaction costs are $0, then you can save $750 in taxes by doing the trade.

There is significant benefit for investors in knowing what their transaction costs are, and in finding ways to reduce them. The lower the transaction costs, the more beneficial tax loss harvesting becomes. This will result in higher portfolio returns both before and after tax.

Muni Bonds: The Retail Model

2007-04-12T16:20:00.000-07:00

The Problem: Retail Pricing Model

The retail broker/dealer for munis is primarily concerned with how to pay the salesperson to sell or market muni product and how the retail trader can maximize his/her trading profits. This is an incentive-based system for retail firms. Most retail brokers are paid on commission, only the commissions are buried in the offering price of the securities. A retail trader will determine what type of securities his/her sales force can sell. He/she will make an assessment that includes maturity, quality, coupon, and absolute yield levels. A retail trader also knows what type of incentive or mark-up is needed to offer to get his/her sales force to sell the firm's offerings. He/she then looks for bonds with desired characteristics and positions them in inventory for the sales force to sell. His/her ability to find the right merchandise with the right mark-up will determine how successful a retail trader is. Studies have shown these mark-ups can be significant and will be influenced by such factors as maturity, quality, and block size.

Transaction Costs For Retail

In 2004, there were two independent studies published which addressed the typical bid/ask spreads for retail muni investors. These studies are shown in the table below. The typical spread was between 2-2.50%. Most retail investors have an account with only one firm. This gives the broker dealer a captive situation, because the client is not able to get competitive offerings or bids from other dealers. This can lead to a conflict of interest on the part of the dealer and poor trade execution for the client.

Problems For Individual Investors

There are additional problems for the retail buyer of munis. These difficulties pertain to valuation of securities.

The typical retail buyer has difficulty within this model in the following areas:

1. Callable Securities- It is best to value callable securities with appropriate bond software, which can be expensive and require specialized expertise. Very few retail investors know how to use OAS (Option Adjusted Spread) to value callable bonds. Instead, they may tend to underestimate the value of calls and buy callable bonds that look attractive on a yield to maturity basis, but are very unlikely to be outstanding to maturity. If they get called, they may turn out to be unattractive instead. It is not difficult to make this valuation analysis, but it requires tools and knowledge that is out of reach of most retail accounts.

2. Credit Spreads- There are over 50,000 different issuers of municipal securities. In order to have a clear understanding of how they should trade relative to one another, the investor requires specialized knowledge and a system for valuing these securities. A retail investor may easily underestimate how wide a credit spread should be for a lower quality credit in comparison to higher quality securities. This would enable a dealer to make a larger mark-up at the expense of the unknowing retail investor. Most retail investors are “flying blind” and have no solid basis for price relationships based on credit spreads.

3. Coupon Spreads- Retail investors tend to have a preference toward purchasing par bonds (bonds priced near 100.) This makes these bonds overpriced in the market relative to other coupons available. Our studies have shown that premium bonds are less risky (they have lower duration), return principal faster (which allows us to take advantage of higher reinvestment rates in a rising rate environment), and avoid the market discount rule. We are generally able to buy these coupons at wider spreads than par bonds. This is especially true when buying in block sizes of 100,000 or less.

4. AMT- About 5% of the muni market consists of bonds that are subject to the Alternative Minimum Tax calculation. These bonds are issued with a public purpose, but there is a benefit to a private party. Stadium bonds, airports, and single family housing bonds can all be examples of AMT bonds. The trend is for more and more individuals to be subject to AMT status. We believe the spread vs. non-amt bonds could widen in the future as a result of this trend. Retail accounts may have difficulty knowing what an appropriate spread for AMT bonds should be. They may look at their own situation and if they are not in AMT status, they may undervalue the spread for AMT bonds and pay too much.

5. Maturity Spreads- Muni bonds are issued serially out to about 30 years. The yield curve is generally upward-sloping. This gives an investor an incentive to extend to pick up extra yield. It may be difficult for a retail investor to know how to value the amount of risk he/she is taking by extending for any given amount of yield. This could lead the retail account to extend too much for too little benefit.

The Solution

A professional bond manager has the necessary institutional bond tools to value the above-mentioned securities properly. These tools include Bloomberg software and The Bond Buyer, a specialized daily bond news publication. Institutional money managers have also built up an institutional network of dealer coverage that allows them to narrow the bid/ask spreads of individual securities significantly. This combination of low transaction costs, (like a mutual fund) and establishing a tax-basis on each individual security (like a retail investor) is a powerful solution to the Muni problem. The portfolio can then be tax-managed cost-effectively by doing tax-swaps when it is advantageous, and by building state preference portfolios.

Muni Bonds: Moody's Maps Muni Ratings To Corporate Bond Ratings

2007-04-09T16:10:00.000-07:00

Moody’s Default Report

Last month, Moody’s issued a report entitled: “The U.S. Municipal Bond Rating Scale: Mapping to the Global Rating Scale and Assigning Global Scale Ratings to Municipal Obligations.” The purpose of the report is to map muni ratings to the corporate rating system.

We have felt that one of the in-efficiencies in the taxable bond market is taxable muni bonds trade too cheaply for their quality. Recent experience shows that a Aaa-rated taxable muni trades at about the same spread to U.S. Treasuries as an A-rated corporate bond. This makes no sense, because the munis are less likely to default and are not subject to the same event risk as a corporate bond. This report confirms our position on taxable munis. Moody’s shows default rates for the last 36 years on all bonds they rate. During this time period, there were a total of 41 defaults by municipal issuers considered to be investment grade (Baa or higher). Of these, only 1 default was backed by either a General Obligation pledge or Water & Sewer Revenues. These types of bonds have a very low risk of default. The chart below shows that an investment grade corporate bond has a 2.1% chance of defaulting during the next 10 years, while an investment grade muni has only a .1% chance of default, according to the study.

Moody’s separates munis into different categories and then maps them to corporate ratings.

Here are some of their conclusions:
1. An A-1 rated state GO is equivalent to a Aaa-rated Corporate Bond.
2. A Baa-2 rated local GO is equivalent to a Aa-3 rated Corporate Bond.
3. A Aaa-rated Corporate Bond is 5 times more likely to default during the next 10 years as an investment grade muni bond.
4. The risk of default by a State GO, local GO, or Water & Sewer revenue bond is much lower than other categories of muni bonds.
5. Local lease obligations and special tax, electric & gas for transmission, mass transit, public higher education, general airport revenues, and existing toll roads have all shown superior risk profiles.

Conclusions

There is less credit risk in certain types of muni bonds than the ratings imply because of their superior risk profiles. Moody's recognizes in this report that State and local GO's may be under-rated by their existing rating system compared to their Global Ratings for Corporate Bonds. Some Muni investors may wish to buy lower rated investment grade GO's and Water & Sewer bonds if they are over-compensated for the additional credit risk taken. Moody's estimates that about 50% of the Muni bonds they currently rate as Baa will be upgraded to A-rated in the near future. This may create opportunities for "spread tightening" trades. Unfortunately, credit spreads in the Muni market are currently relatively tight by historical standards. So, it may be difficult to take advantage of these potential upgrades by Moody's. The better opportunity for spread tightening may be in the Taxable Muni market where quality spreads still have plenty of room to compress.

Bonds: Probit Models Predict Probability Of Recession

2007-03-29T16:36:00.000-07:00

There was much ado over Greenspan's recent comments that there is a 33% chance the U.S. economy will enter into a recession later this year. The Fed seemed to be caught off guard by these comments, and Bernanke testified before Congress that The Fed was still concerned about inflation and the economy is in good shape. Why would Greenspan make such remarks?

We believe it is highly likely that Greenspan's forecast is based on probit models designed by The Fed. For those of you who aren't familiar with a probit model, we will look at the following definitions of probit. Wikipedia's definition is: "In statistics, a probit model is a popular specification of a generalized linear model, using the probit link function. Probit models were introduced by Chester Ittner Bliss. Because the response is a series of binomial results, the likelihood is often assumed to follow the binomial distribution." About Economics defines probit as: "An econometric model in which the dependent variable yi can be only one or zero, and the continuous independent variable xi are estimated in:

Pr(yi=1)=F(xi'b)

Here b is a parameter to be estimated, and F is the normal cdf. The logit model is the same but with a different cdf for F."

For those who still don't know what a probit model is, let's just say it is an econometric forecasting model. Probit models have been used by The Fed to forecast recessions. These models are based on the slope of the yield curve and have been very reliable in forecasting periods of economic weakness. When the 90 day T-Bill yields more than the 10 Year treasury bond, the model views this as a negative development for the economy. The chart below shows the history of the 10 Yr vs. the 90 Day T-Bill for the last 20 years.

Jonathan Wright from the Federal Reserve Board's Division of Monetary Affairs developed a probit model that measures the spread between the 3 month T-Bill yield and the 10 Year Treasury yield. It also looks at the general level of Fed Funds. He has written a working paper entitled "The Yield Curve and Predicting Recessions" which compares 4 different versions of the model. He concludes that measuring the spread between the 3 month T-Bill and the 10 Year Treasury as well as including the level of Fed Funds is the best of the 4 approaches for predicting recessions. The results of the model are shown below. The number at the right is the probability of a recession and the red areas show periods of economic weakness. As you can see, this model has had a very close correlation when predicting periods of economic weakness in the past without giving false signals.

Griffin Kubik, a securities firm in Chicago, replicated this model. The model is currently saying there is a better than 50% chance of a recession in the next 4 Quarters. We have seen other models projecting as high as a 95% chance of recession. Some of these other models are based on the spread between the 1 Year T-Bill and the 10 Year, without factoring in the general level of interest rates. Wright enhanced these earlier models by including Fed Funds as a proxy for interest rates. It seems likely that Greenspan is using some variation of one of these types of probit models. Perhaps he has enhanced Wright's model with some other variable. Although each of these models project different probabilities for a recession, they all agree that the longer The Fed keeps the yield curve inverted, the greater the probability our economy will enter a recession by the end of the year. The chart below shows the current estimation of the probability of a recession using Wright's model. Remember the probability was only at 20% when the chart above was created.

Taxes: The Battle Over AMT

2007-03-27T07:09:00.000-07:00

It is estimated that the Alternative Minimum Tax, if left unchanged, will raise about $50 billion this year for the Federal Government. This is a tax implemented by Congress several years ago to make sure wealthy individuals pay their "fair share" of taxes. This tax was not indexed to inflation and is now affecting many members of the not-so-wealthy middle class. There is considerable ongoing debate about what to do about the AMT in Congress, because it is not fair to leave it as it is. The Republicans would like to either repeal the tax or mend it for another year. The Democrats would like to change the tax so that more of the tax is paid by the wealthy and eliminate the Republican tax cuts from 2001 and 2003,which are set to expire in 2010, as a way to pay for the AMT fix.

Congress has consistently over-estimated it's ability to implement a "fair" tax code, and under-estimated the impact on the American people and our economy of constantly changing the code. The Alternative Minimum Tax is a good example of why it is time for a change in how Congress views taxes. We believe the Government has proven it's inability to create a fair tax system. Instead, they should simplify the code and beef up the enforcement division of the IRS. A simpler tax code would help to narrow the tax gap and the AMT could be eliminated without having to fret over the $50 billion in lost revenues it generates this year.

The Wall Street Journal on March 21,2007 had an article discussing the current Tax Gap because of under-reporting of taxes due. This amount is estimated to be $345 billion. The table/chart below shows the composition of the tax gap and the decline in the number of IRS enforcement agents over the last 10 years.

We believe much of this under-reported income is caused by the complexity of the existing tax code. The first step for Congress should be to simplify the code. The current system of graduated brackets, deductions, and exceptions creates incentives for taxpayers to find ways around paying taxes. The more complicated we make our tax system, the more money falls through the cracks. For example, a flat tax with no deductions would be simple and easy to implement and enforce. Some may say that a flat tax would be unfair. Our answer to that is: "How fair is it that we are paying taxes and there are $345 billion of taxes owed that others aren't paying?"

Bonds: How Strong Is The Economy?

2007-03-26T07:41:00.000-07:00

The Index of Leading Economic Indicators is showing potential economic weakness in the months ahead. The chart below shows the LEI for the last 15 years. The LEI peaked out in January 2006 at 139.1. The levels for February, which were just released, show a reading of 137.3. This index is a good indicator of economic strength over the next 4-6 months. The weakness in this indicator would suggest slower growth or weakness for the balance of 2007.

The LEI is composed of 10 different components. The different components are listed below with both their weighting in the index and their contribution to the last reading of LEI. The Conference Board releases this data about 3 weeks after the end of the previous month.

The largest contributors to the LEI are the Money Supply and the Factory Workweek. These 2 components account for about 60% of the value of the LEI. Recently, there has been much talk in the press about the housing market and whether the weakness in housing will drag down the rest of the economy. This sector of the economy is measured by Building Permits which accounts for only 2.7% of the LEI. However, most of the focus of economists and the press has been on housing. Now, their attention is moving to high defaults in sub-prime mortgages, and possible tightening of credit conditions for new home buyers.

Let's look at the LEI and some of the other components of the index. Last month, 5 of the 10 measures showed weakness in the economy. These measures were: the yield curve, vendor performance, initial jobless claims, consumer expectations, and building permits.

There is value in following the LEI and all of these components. The weakness in the index is not coming from only 1 sector of the economy (housing), but is shown in several of the individual measures of future economic growth. There are several economists calling for the economy to pick up later in the year. (These economists are obviously not paying attention to the LEI). We feel this is unlikely, and expect the economy to continue to slow. This should provide a favorable backdrop for bonds.

All data shown above is from the Conference Board which releases the Index of Leading Economic Indicators.

Taxes: Tax Freedom Day

2007-03-21T10:24:00.000-07:00

This is the time of year to be thinking about taxes. We believe that each investor has a unique tax situation, and we are concerned about their marginal tax rates in the selection process of individual securities for their fixed income portfolios. We believe the last elections were a watershed event for tax rates, and that marginal tax rates are likely to rise in the future. This will probably make tax-free securities more attractive compared to taxable securities for some investors in the future.

The Tax Foundation publishes some interesting data about taxes and their impact on our daily lives. As a way to show how much of our income we pay in taxes, they created Tax Freedom Day. If we assume that we pay our taxes before we can use the rest of our earnings, this would be the day that we are "free" of paying taxes and the rest of our earnings go to us. The later in the year we reach Tax Freedom Day, the more time we are working for the government and the less time we are working for ourselves. This is a valuable way of measuring the bite that taxes are taking from our paychecks, and allows for comparisons over time. The chart below shows Tax Freedom Day for the last 27 years. The axis on the left shows the number of days it takes to get to Tax Freedom Day and the graph shows the results over time. We reached a high of about 123 days in 2000 and now are working about 116 days for the government.

How much do you pay in Federal taxes and how much do you pay in State & Local taxes? The chart below begins in 1900 and shows the number of days over time you work for each of these.

If you are wondering how many days you work to pay for your taxes compared to how many days you work to pay for housing, the chart below gives you the answer. We work 77 days to pay Federal taxes, 39 days to pay State & Local taxes, and 62 days to pay for housing and household operation. Federal taxes is the largest category.

You may also be wondering how the different taxes break down by type of tax. Below is a chart that shows the types of taxes. For example, out of the 77 days you work to pay for Federal taxes, 30 days go to pay for social programs such as Social Security and Medicare.

The amount of time you spend working for the government depends upon where you live. The chart below shows you will be working harder for the government if you live in New York than if you live in Montana. The states in dark blue mean that Tax Freedom Day occurs later in the year than the light blue and white states. We would encourage you to visit the website for the Tax Foundation for further information. We have provided a link to their website on our blog for your convenience.

Muni Bonds: Why Buy Premium Coupons?

2007-03-20T15:09:00.000-07:00

Premium Coupon Bonds Are Less Risky

Bonds purchased at par (a dollar price of 100) are considerably more risky than premium coupon bonds for three different reasons. First, the duration is greater for a par bond. Second, the reinvestment of interest earned has less of an impact on total return. Finally, in a rising rate environment, par bonds become subject to the Market Discount Rule more quickly.

Most investors purchase bonds as a way to dampen the volatility of their whole portfolio and to create a stream of income. Since the bond portfolio is used to reduce overall risk, it makes sense to reduce the risk taken in this conservative part of the portfolio whenever possible. The purchase of premium coupon bonds is a natural way for the fixed-income portfolio manager to reduce the risk for his investors.

An Example of Bond Cash Flows

There was a Michigan Trunk muni bond issue that came the week of August 16, 2004 consisting of par bonds and premium bonds in the same maturities. The original pricing was the same for both coupon structures (3.77% yield). The par bonds were 3.75% due to mature on 9/1/14 and the premium bonds are 5.0% maturing on the same date. The following is a comparison of these two different coupon structures. Assume that about the same amount of money is invested in each bond. Both structures will provide about the same amount of total income or cash flows, if held to maturity.

The par bonds will consist of a greater par value of bonds ($1,000,000 vs. $906,000), but will have lower coupon payments than the premium bond ($375,000 vs. $453,000). The coupon payments are assumed to be reinvested at the purchase yield of 3.77%. The par bond will earn less reinvestment income than the premium bond ($73,395 vs. $91,078). Note: This illustration allows us to purchase a $906,000 block of bonds. Munis come in $5,000 denominations, but this example more accurately shows how the cash flows work.

Duration

The table shows the duration for the par bond is 8.248 at the time of issue. The duration for the 5.0% coupon is 7.927. Since the 5.0% coupon has the lower duration, it is the less risky of the two structures. Duration is a measure of market or interest rate risk. The greater the duration, the more market risk the investor is taking. Duration is similar to beta for stocks, where beta is the amount of risk the investor is taking compared to the risk of the market. One way to think of duration is as a measure of how much the price of an individual bond would change with a 1% change in interest rates. A bond with a duration of 4.0 would have a price change of about 4.0%. In our example, the par bond would change .321% more than the premium bond because of market risk (8.248-7.927).

Reinvestment of Interest Earned

The premium bond receives more cash flows from coupon payments ($453,000 vs. $375,000). The reinvestment of these cash flows creates additional interest earned for the investor. Since the cash flows received from coupon payments are greater for the premium bond, the amount of interest earned from reinvestment is also greater. In this example, we assume the reinvestment rate rises 1.0% to 4.77. This creates $4,479 in additional income for the investor in the premium bonds. This is a favorable characteristic in a rising rate environment. The investor is receiving his money back more quickly which allows him to reinvest it at higher rates (if rates rise).

Market Discount Rule

Avoiding the Market Discount Rule is the most important reason to invest in premium coupon bonds. The Market Discount Rule assigns a price (yield) for each security when it is purchased. If yields rise above that pre-assigned yield, the market would penalize the investor's security if the investor needed to sell the bond because the difference between the purchase price for the new investor and the price he receives at maturity would be taxed as ordinary income. This has a very negative impact on an individual security’s value. Most investors purchase muni bonds because they want tax-free income. Discount bonds cheaper than the market cut-off price will need to appeal to an investor willing to earn taxable ordinary income which is (in the case of the high net worth individual) most likely taxed at the maximum tax rate. Our example shows that the par bond has a market cut-off or QTAX of 4.05. If market yields were to rise to 4.77% for this maturity, the par bond would likely have to trade at a yield of 5.34% in order to entice investors to purchase the bonds. This extra yield is necessary because the difference between the purchase price of $88.751 and the price received at maturity (par or 100) is taxed at the taxpayers ordinary income tax-rate.

The premium bond would avoid this Market Discount Rule problem and would decline in value by (3.12%) vs. the decline in value of the par bond by (7.43%).

As you can see, the Market Discount Rule can have a very significant impact on total returns in a rising rate environment.

Who Buys Par Bonds?

The primary purchasers of par bonds are bank trust departments and individuals. Bank trust departments buy par bonds because of the nature of the trust relationship. In every trust, there is an income beneficiary and a remainder man. It is the trustee’s responsibility to make sure both parties are treated fairly. Tradition has argued that the best way to ensure fairness is to purchase par bonds. Remember that a bond consists of a series of cash flows. If a premium coupon bond is purchased and all of the income received is paid out, the remainder is less than what the remainder man would ordinarily be entitled to (part of the income is really amortized premium or principal). One has to question this logic, however. Is the remainder man of the trust being treated fairly if the market value of his holdings declines because of the market discount rule? One could argue that the trust department could still buy premium bonds and only pay out that portion to which the income beneficiary is entitled. This approach requires more work for the trust department, but is a lower risk strategy for the trust as a whole.

Retail investors or individuals typically purchase par bonds because they don’t understand how bonds work and they may not have the tools necessary to analyze bond cash flows properly. Bond risks are difficult to measure and not readily understood by many retail investors.

Conclusion

Risk management is a major component of managing a municipal bond portfolio. This example shows that premium coupon bonds are less risky than par bonds because they have less market risk, reinvestment risk is lower in a rising rate environment, and the risk associated with bonds becoming subject to the Market Discount Rule is greater for par bonds.

These are the reasons that most institutions and other savvy investors have been attracted to investing in premium coupon municipal bonds.

Bonds: Tax-Free, Taxable, Or Both?

2007-03-19T09:36:00.000-07:00

The Problem
Perhaps one of the most confusing decisions facing an investment advisor today is whether some clients with taxable accounts should purchase taxable or tax exempt bonds for their high quality bond portfolios. This decision is straightforward for clients that earn large amounts of taxable income (over $326,450) which puts them into the maximum tax bracket of 35%. Municipal bonds are clearly the most appropriate investment for them. However, this decision is much more difficult when the client has invest able funds of $1-$3 million and very little (if any) taxable income coming from other sources. In these cases, the investment chosen “drives” the amount of taxable income that the client earns as well as their marginal tax bracket. For example, assume the client has an investment portfolio of $3.5 million and taxable income of $100,000. The portion the advisor allocates to the high quality bond portfolio is $800,000. Most advisors struggle with the appropriate mix of bonds for these clients. “Should I buy taxable bonds, tax exempt bonds, or perhaps a mix of both?” What is the proper way to make this investment decision?

Interest rates are constantly changing and so is the relationship between taxable and tax exempt securities along the yield curve. The changes in both interest rates and the inter-market relationships are important factors in the decision making process. The combination of changing rate levels as well as changing income levels makes this decision appear to be challenging.

Marginal Tax Rates
Tax-managing bond portfolios begins with a careful examination of the client’s marginal tax rate. This rate will determine the suitability of different fixed income securities for each client. This rate is dependent on the type of filing of the taxpayer and the level of income the client earns after all deductions are subtracted.

Filing Status
A single person has a higher marginal tax rate for the same level of income than a married person filing a joint return.

Income
We are referring to taxable income after all allowable deductions have been taken. This is the number from line 43 of the 1040 return. This income number can be used to determine the client’s marginal tax rate. Securities available in the tax-exempt and taxable markets can then be compared on an after-tax basis. These after-tax rates are then compared by maturity to determine what works best for each client. These rates and relationships are changing on a daily basis. Frequently, the portfolio is optimized by using a combination of longer maturity munis and shorter maturity agencies.

More emphasis needs to be placed on determining each client’s marginal tax rate. This may be difficult because of the many variables involved which causes this rate to be a “moving target.” Superior bond portfolio performance depends on improving this process.

Ratio of Munis to Agencies
The muni yield curve can be compared to the taxable yield curve to determine the percentage that each of the maturities trade compared to taxables. Munis traditionally trade at lower ratios in the shorter maturities and higher ratios in the longer maturities. The chart below shows the historical ratio of a 10 year muni compared to a 10 year U.S. Treasury bond. The average for the last 3 years is 86%. Recently, this ratio has fallen to 82.4%. This has an impact on after-tax yields and means that an investor needs to be in a higher tax bracket (86%-82.4%=3.6%) for munis to be attractive. This change is about equal to the amount of state tax a married person filing jointly would pay in the state of Arizona.

One way of looking at the current value of a muni compared to a taxable security is to take the ratio (munis/taxable's) and subtract it from 1. We can do this for all maturities along the curve and we get a chart like the one titled Muni/Agency Ratio which shows tax efficiency below. If we compare this graph to the client’s marginal tax rate (the blue line), we can see that munis will be attractive to the investor whenever this ratio is lower than the marginal tax rate. Munis are only attractive to this investor when he begins to look at maturities in the 5 year part of the curve. Munis would be attractive to all investors in the 35% bracket or higher. The advantage of this approach is that the tax-free/taxable ratio is constantly changing. We can monitor the ratios up and down the yield curve and compare them to the client’s marginal tax rate to determine which fixed income security is best suited for his/her needs.
Conclusion

Each individual investor has a unique tax situation. Returns may be optimized when more attention is paid to the marginal tax rate of each client. This requires familiarity with the client's tax return, and an understanding of the client's tax situation.

So You Think You Want To Be A Credit Analyst: Unfunded Pension Liabilities

2007-03-17T12:15:00.000-07:00

Recently, S&P released a report entitled "Improved U.S. State Pension Funding Levels Could Be On The Horizon." This report is based on 2005 year-end data, which is the most recent data available for all states. S&P made the case that most state pension funds use 5 Yr smoothed returns, and the returns from 2001-2002 have been acting as a drag on the actuarial value of fund assets. If the equity market behaves itself, the 5 Yr smoothed value of these assets will increase as the returns from 2001-2002 fall off the 5 Yr averages. This increase in asset values will increase the funding of these state pension systems, which will help alleviate the current levels of underfunding. We are in agreement with this conclusion; however, there are some states that are grossly underfunded. Let's take a look at these state retirement plans and see how municipal credits are analyzed.

The chart below shows the 10 states with the largest Unfunded Actuarial Accrued Liabilities (UAAL). California, at $47 billion, has the largest unfunded liability, Illinois is next with $31 billion, and Ohio is right behind with $30 billion. The rest of the top 10 are all under $15 billion.

While it is interesting to know the magnitude of the funding gap, it is beneficial to look at the percentage that is funded to determine the progress the state has made in providing money for these obligations. The chart below is based on data from the same S&P report as above. This chart ranks states by the percentage of the funding. West Virginia has the lowest value at only 47% funded, next is Oklahoma at 57%, and Connecticut at 58%.

We now have charts that show the magnitude of the shortfall and the progress each state has made in achieving their goal of funding these pension obligations. It is also important to see how well these states can afford to meet these pension obligations. The amount of debt each state has outstanding can be calculated. If we divide this number by the population of the state, we arrive at a number for Debt Per Capita. Let's take the amount of the unfunded liability and divide it by the population to arrive at the Per Capita Unfunded Liability. When these 2 numbers are combined, we have a measure that is a better representation of the total obligation of the state. There are also Per Capita income numbers available for each state. These numbers show the earning power of the average person in the state. The combined Debt Per Capita numbers divided by the Per Capita income number gives us the percent of debt to income for each person. This number helps to show how significant the debt burden is for taxpayers in any given state. The chart below shows these numbers for the 10 states with the highest combined debt burden compared to their earning power. All 10 states have 10% or more ratios, with Alaska over 20%. This may be easier to understand if we use some actual numbers. Let's use Alaska as an example. The Debt Per Capita (PC) is $2,000 and the Unfunded Pension Liability is $6,212 PC. This is a total of $8,212 PC divided by the PC Income of $35,612 to give us a debt ratio of 23%. This is a big number and should cause concern in some investors. This measure gives us a better idea of Alaska's financial health than the $2,000 Debt Per Capita number.

These numbers do not include OPEB liabilities. OPEB is Other Post Employment Benefits and is primarily the actuarial accrued liability for health care costs. States will be coming out with these numbers over the next 3 years as required by GASB 45. This is another huge liability that municipalities have incurred. It should be important to each investor to look at not only traditional numbers such as Debt Per Capita, but also to include unfunded pension liabilites and OPEB obligations in their analysis to determine the creditworthiness of each security. So, do you still think you want to be a credit analyst?

Bonds and the Fed

2007-03-16T05:47:00.000-07:00

We have never had more confidence in the Fed and it's ability to manage the economy. Yet, the Fed has a history of creating excessive credit conditions, and then taking steps to remove these excesses. Tight money tends to cause distress first in the areas that are most overextended. The chart below is from David Rosenberg at Merrill Lynch. His theory is that when the Fed is in a tightening mode, they will continue reigning in credit until something bad happens. Then they will ease to counteract the damage they have just done, and the cycle repeats itself. Some of the most memorable examples from Merrill's chart are, the Tech Wreck, Long Term Capital, S&L Crisis, and Penn Square Bank. Many of these negative events were a result of the excessive credit conditions the Fed created in the first place. When they took steps to get the market to return to normalcy, "bad things happened."

One might ask why this pattern tends to repeat itself? This is largely the result of the Fed trying to manage the economy. Their tool of choice is to control the process of "borrowing short and lending long". In essence, this is how our banking industry works, and it is a great system. When the Fed lowers short-term rates, they make the yield curve steeper. This allows banks to make a larger spread (profitability) and over time increases the amount of liquidity that is available in the credit markets. This increased availability of credit allows borrowers to have the funds that are necessary to make purchases, which in turn stimulates the economy. The reverse is also true when they raise short-term rates which drains liquidity from the system. Isn't it interesting that our system depends upon the borrowers to get it going and to slow it down?

After 9/11 there was a massive reduction in short-term rates which produced large amounts of liquidity and availability of credit. Much of this money went into the housing market. Many of those loans were financed with little or no money down, and many of the borrowers were sub-prime borrowers. It wasn't that long ago that the public and economists were thinking that higher rates wouldn't have that much of an impact on the housing market. Then they were saying that the housing slowdown wouldn't affect the economy and it would continue to grow, and activity would pick up later in the year. Now we are seeing high defaults in sub-prime mortgages by the people who couldn't afford the houses they were buying in the first place. So, will the sub-prime problem spread to the rest of the economy? That is the question being asked now. Shouldn't the question be: Why wouldn't we experience ripples across the credit markets? After all, the Fed has made money tight and we know from experience that they will continue in this mode until something bad happens.

Muni Bonds: Texas Says No To OPEB Rules

2007-03-15T08:25:00.000-07:00

"Whoa!" says Texas to the new reporting guidelines for disclosing OPEB liabilities. The state treasurer, Susan Combs, recently stated that Texas was not planning to comply with the GASB 45 guidelines in disclosing unfunded Health Care liabilities for public workers. These guidelines, which are being phased in over the next 3 years, are designed to increase disclosure of unfunded liabilities so investors have a better understanding of the financial position of a municipality before investing in it's debt obligations.

The State of Texas is taking the following position relative to these disclosure requirements:

1. These are not "hard liabilities" of the State, because the legislature can change the amount it appropriates for the payment of these benefits.
2. It is impossible to know what this stream of benefits may be for the next 30 years.
3. Workers will suffer because municipalities will discontinue offering these benefits to their workers.

This is a very interesting approach to the OPEB disclosure requirements, because what the State is saying in plain English is this: "You can't make us do this because we don't really owe these workers these benefits, it's too much trouble to figure them out even if we did owe it to them, and how dare you jeopardize their future benefits (that we feel we don't owe them anyway)."

This is a unique response and has some serious consequences. First, it is a politically untenable position to take in regard to the employees of the State. After all, if you were an employee of the State of Texas, how secure would you feel your Health Care benefits were after you retired? Second, it is an attempt by the State to thumb it's nose at the GASB and investors. When Texas attempts to fund projects in the municipal bond market, it will receive an adverse determination letter for lack of proper disclosure. What investor will buy Texas' securities under those circumstances?

This position is indefensible and not reasoned properly. Estimates of the State's unfunded OPEB liability are around $50 billion. Can this be what is driving this decision by Susan Combs?

Bonds: The Economy

2007-03-13T09:07:00.000-07:00

The level of interest rates is driven largely by long term inflationary expectations and the growth rate of the economy. We monitor the GDP Core price index as a measure of inflation, and the Index of Leading Economic Indicators (LEI), looking for clues about future economic growth. The LEI consists of 10 different economic indicators.

Let's take a look at inflation. There has been much talk about inflation in the press. We believe we have experienced a cyclical upturn in inflation, but the long term secular trend in inflation is still lower. The response from the Fed during the last 2.5 years has increased our confidence in both their ability and their desire to control inflation. The chart below shows the GDP Personal Consumption Core Price Index from 1992 to 2006. Also graphed on the chart is a 13 quarter moving average, which shows the smoothing of the index over a three year period. Bernanke has said that he would like to see this index under 2% as an upper band. It is currently 1.9%.
Economic growth depends largely upon the availability of credit. A good measure of the tightness of credit is the slope of the yield curve. Our economy has had an inverted yield curve since last June. An inverted curve is like a tourniquet on the economy. The lifeblood of the economy is money, and the Fed is restricting the ability of different sectors to have access to credit. The economy is gradually showing signs of weakness as the restriction of the "blood flow" to the economy affects different "body parts" more quickly than others. The chart below is for the interest rate spread between a 10 year treasury and fed funds. It shows the dramatic change in the yield curve that has taken place since the Fed began tightening in June of 2004. Banks are in the business of borrowing "short" and lending "long". When the yield curve is inverse, the economic incentive for them to loan money is reduced because they can't make money off the trade of borrowing short and lending long. This also helps to restrict the availability of credit, and helps to dampen the economy.
Perhaps the first body part to experience distress was housing. The weakness in housing is illustrated by the rapid decline in building permits which began their decline in the last quarter of 2005.

New orders for consumer goods are also showing weakness. This component in the index of leading economic indicators is an inflation adjusted value of manufacturers new orders for consumer goods and materials, and is designed to lead changes in production. This index peaked out in the middle of 2004 when the Fed began tightening credit.
The weakness in housing is now spreading to sub-prime mortgages. There is weakness in risk assets such as domestic and foreign equities, and in commodities like gold and oil. The question being asked now is, "will this weakness spread to other areas of the credit markets?" The answer is clear. The economy will continue to slow until the Fed realizes that it is about to kill the patient, and then they will ease up on rates to try to get things going again. This is a very favorable environment for bonds. We believe that current bond rates are attractive, and investors who are still bearish should rethink their positions.

Muni Bonds: Tax Reporting For Premium Bonds

2007-03-12T08:55:00.000-07:00

How To Determine Reportable Tax-Free Income For The Investor

The amount of reportable tax-free income that an investor receives from their municipal bonds may be dependent on the investor’s cost basis in the individual security and the coupon structure of the bond. Many investors mistakenly believe that the coupon received from a muni bond represents their reportable tax-free income to be filed on line 8b of their 1040 tax form. However, this is only the case for all muni bonds purchased at par.

An individual muni bond may be purchased at par ($100), a premium (greater than $100), or at a discount (less than $100). Each of these coupon structures may be treated differently for tax purposes.

Par Bonds

Par bonds are the simplest for tax reporting. All of the coupon income earned during a tax year is reported as tax-exempt income. No adjustments need to be made. This amount is entered on form 1040 as tax-free income on line 8b.

Premium Bonds

Each individual security has an original cost basis. It is important to identify and remember the original purchase yield for a bond bought at a premium. This yield will be less than the coupon of the bond and needs to be calculated to at least 2 decimal places. The premium paid for the bond is amortized down each year, which reduces the basis for the bond by the amount of the amortization. This amortization is deducted from the coupon income earned and the difference is tax-exempt income earned and is entered on the 1040 line 8b. The new amortized cost basis is also used for determining capital gains and losses if the security is sold.

The logic for amortization of premium bonds:

When a bond is purchased at a premium, the coupon rate must be greater than the yield of the bond. Therefore, only part of the money the investor receives is tax-free income, and the rest is considered to be a return of his principal in the form of a coupon payment.

Amortization Calculation

Most premium bonds are amortized using a constant yield method. There are some exceptions for bonds issued before September 27, 1985. We will not discuss these exceptions in this article.

IRS Publication 550 shows how to calculate the amortization of the bond premium.

The amount of the amortization is subtracted from the coupon income which was received during the tax period. The remainder is the amount of tax-exempt interest that is reported on the Federal 1040 Return line 8b.

Example

Purchase on 1/1/05 $100,000 Salt River Project, AZ 5% coupon bonds that mature on 1/1/09 at a yield of 3.00% for a price of $107.485

Let’s calculate the tax-free interest and amortization for the first 1 year period ending 12/31/05.

The bonds mature at par so the total premium paid is $7,485 ($107,485-$100,000. To determine the bond premium amortization we multiply the acquisition cost times the purchase yield ($107,485)*(.0300) to get $3,225. We then subtract this amount from $5,000 which is the amount of coupon earned for 1 year. The result is $1,775. This is our amortization for the year.

For tax reporting purposes we would take the interest earned for the period less the amortization and report this amount as tax-exempt interest earned on line 8b of our 1040 form. This amount would be $5,000-$1,775=$3,225 for tax-exempt interest earned.
Our new cost basis would be $107,485-$1,775=$105,710.
This process would be repeated every period until the bonds mature at 100 on 1/1/09.

IRS Publication 550 (page 35)

Investment Income and Expenses

Bond Premium Amortization

If the bond yields tax-exempt interest, you must amortize the premium. This amortized amount is not deductible in determining taxable income. However, each year you must reduce your basis in the bond (and tax-exempt interest otherwise reportable on Form 1040, line 8b) by the amortization for the year.

How To Figure Amortization

For bonds issued after September 27,1985, you must amortize bond premium using a constant yield method on the basis of the bond’s yield to maturity, determined by using the bond’s basis and compounding at the close of each accrual period.

Step 1:determine your yield. Your yield is the discount rate that , when used in figuring the present value of all remaining payments to be made on the bond (including payments of qualified stated interest), produces an amount equal to your basis in the bond. Figure the yield as of the date you got the bond. It must be constant over the term of the bond and must be figured to at least two decimal places when expressed as a percentage.
Step 2: determine the accrual periods. You can choose the accrual periods to use. They may be of any length and may vary in length over the term of the bond, but each accrual period can be no longer than 1 year and each scheduled payment of principal or interest must occur either on the first or the final day of an accrual period. The computation is simplest if accrual periods are the same as the intervals between interest payment dates.
Step 3: determine the bond premium for the accrual period. To do this, multiply your adjusted acquisition price at the beginning of the accrual period by your yield. Then subtract the result from the qualified stated interest for the period.
Your adjusted acquisition price at the beginning of the first accrual period is the same as your basis. After that, it is your basis decreased by the amount of bond premium amortized for earlier periods and the amount of any payment previously made on the bond other than a payment of qualified stated interest.

The Problem: Overpaying State Income Tax

Most investors receive a year-end statement from their broker which shows how much interest was earned during the last year. The investor gives this statement to his CPA and the amount is entered on line 8b as tax-exempt interest. This can, under certain circumstances, lead to the overpayment of state income taxes. If the investor owns premium coupon bonds that are not state tax-exempt, and he has not amortized his premium, he will be overpaying his state income tax.

An Example

The investor is an Arizona resident. He owns a municipal bond portfolio that consists primarily of bonds that are premium coupon bonds. Let’s assume that 50% of these bonds are issued by municipalities in the State of Arizona, and that the other 50% are issued by municipalities that are in other states. The interest on the Arizona bonds is exempt from state taxes. The interest on the out of state securities is subject to the state tax in Arizona. Let’s also assume that the investor owns 5% coupons that he/she purchased at an average yield of 3.00%. If the investor does not amortize his coupons he will be paying interest as if he had earned a yield of 5.00%. However, if these premiums are amortized, he will pay tax on 3.00% interest. The table below shows that the investor in this case has reduced his overall yield by .05% by not properly amortizing the premiums of the out-of-state securities.

Calculating Gains/Losses

To continue with our example, let’s assume that at the end of the first year interest rates have risen 1.00% to 4.00%. We decide to take a tax loss and sell the bonds at 4.00%. What is the capital loss that we report on Form 1040 and on Schedule D?

First, we would calculate the dollar price we receive from our sale at 4.00%. The dollar price is $102.80. Thus, we receive $102,800 from our sale. We subtract this amount from our new basis which we calculated above ($105,710)-($102,800) and we get a loss of ($2,910). This is the amount we report on Form 1040 line 13 and on Schedule D.

Conclusion

It is important to remember to amortize the premiums on all holdings of municipal bonds in order to report the proper amount of tax-free interest earned, and to be able to have a proper cost-basis to calculate gains/losses on any sales of the securities. Why not then include this information as part of the year-end report for the client by including an Income Report, and Realized Gains/Losses Report that include these calculations? This will be most helpful for the client’s CPA when he does the tax return next year!

Capturing Opportunities Created By An Inefficient Market

2007-03-09T09:48:00.000-08:00

Municipal Bonds

The Municipal Bond Market is an inefficient market. Professional money managers develop strategies to add value for their clients by taking advantage of some of these inefficiencies. Let's take a look at some of the possible ways these firms seek to increase their clients' returns with their approach to managing funds.

Inefficiencies

The Muni Market is inefficient in some of these ways:
· Smaller blocks trade cheaper than larger blocks.
· Premium bonds often trade cheaper than par bonds.
· Transaction costs are exorbitant for individuals when dealing with a brokerage firm. SEC and Journal of Fixed Income studies show the bid/ask spreads to be between 2%-2.5% for smaller pieces of Munis. These costs are significantly lower for institutions.
· Taxable munis are inherently better credits than corporate bonds, but trade cheaper than they should. For example, a AAA-rated taxable muni trades at about the same spread vs. treasuries as an A-rated corporate bond.
· There are different levels of access to new negotiated deals. For example, an institutional client has access to new deals from the manager of the issue, but competing dealers do not have access to these deals.
· Muni bonds are a legalized way around the wash-sale rule which creates a 30 day waiting period before buying back the same security.
· Shorter munis trade at lower ratios to treasuries than do longer maturities.

Strategies For Adding Value In An Inefficient Market

Strategy 1
Most Separate Account Managers consider an account to be properly diversified when they have 8-20 different holdings. A $1 million account would need block size of $50,000-$100,000 to be properly diversified. Since smaller lot size blocks of munis trade cheaper than larger lots, one possible strategy would be to buy smaller lots of bonds that fit the needs of this client. Most fixed income money managers prefer to purchase larger blocks of bonds ($1 million+) and allocate them to different accounts. The money manager that buys the smaller lots is able to generate better returns for the client because the securities are being purchased at cheaper prices.

Strategy 2
Muni bonds are primarily issued to fund long-term projects such as schools, hospitals, water, and sewers. Deals come to market with maturities from 1-30 years to fund these projects. However, there is an enormous demand in short-term munis due to tax-free money market accounts. This creates a supply/demand imbalance in the marketplace. This imbalance leads to a difference in the ratio of muni yields vs treasury yields between short maturities and long maturities. For example, today the ratio in 1 year is about 70% while it is about 89% in 30 years. In addition, the Muni Market almost always has an upward sloping yield curve. One way to take advantage of this imbalance is to "borrow short and invest long" on the yield curve. This strategy is employed by Tender Option Bond Programs (TOB's) and closed-end tax-free funds. These strategies are usually highly leveraged and are done in large size.

Conclusion

Each investor should have a strategy for his/her portfolio. Does your strategy include some way of capturing opportunities that have been created by ineffecient markets?

Finding A Way To Fund Pension Liabilities: Illinois

2007-03-08T14:22:00.000-08:00

The Governor's Plan

Today's Bond Buyer, a trade publication, had an interesting article about the plans the governor of the State of Illinois has to fund it's $41 billion pension liability. This is his creative solution to this problem.

First, the State would sell it's state run Lottery for $10 billion by doing a Public Private Partnership (P3). This would probably be done with a long-term lease arrangement. Last year, the State of Indiana sold the Indiana Toll Road for $3.5 billion to a group of foreign investors using a 99 year lease.

Second, the State would issue $16 billion of taxable Municipal Bonds. These munis would be considered taxable because the proceeds of the bond issue would be invested in equities (a higher returning asset class). This creates an arbitrage situation which does not allow the munis to qualify for tax exemption. Illinois did what is still the largest taxable muni deal in 2003 ($10 billion) at an interest cost of 5.05%, and the pension funds have earned returns of over 14% from 2003 until now. Can they do the same with another $16 billion?

Finally, the State would raise taxes on corporations. This tax increase is expected to generate $6 billion a year beginning in 2009. The State will also enact a payroll fee on businesses that do not provide health care. This is expected to raise $1 billion a year. There are no plans to raise taxes on individuals in the Gov's plan.

Conclusion

The combination of these 3 actions is projected to get the State's pensions up to 83% funded from the current 60% funded level. Of course, this is just a trial balloon that is being floated by the governor of Illinois, Rod Blagojevich. But, in an era of unfunded pension and healthcare liabilities across the nation, it shows the general willingness to sell public assets and issue debt as a way of keeping tax increases down to as low as possible. Welcome to Public Funding 101 in America today.

Separately Managed Accounts

2007-03-07T12:21:00.000-08:00

There are two primary reasons to have a separately managed account: tax-efficiency and customization. Fixed income portfolios for high net worth individuals are ideal candidates for a Separate Account Manager. A good manager can add value for these clients through tax savings, lower transaction costs than a regular account, capturing inefficiencies in the bond market, and monitoring the portfolio against an appropriate benchmark to meet the objectives of the client. It would not be possible for an individual to manage his/her portfolio as tax-efficiently by purchasing individual securities or mutual funds.

Tax-Efficiency

Separately Managed Accounts (SMA’s) for larger taxable accounts can have significant tax benefits for some fixed income clients. Each client has a unique tax situation and an SMA can meet these needs better than a mutual fund or a brokerage account. Portfolios that own securities that are exempt from state taxes can be purchased in an SMA, but low fee mutual funds in states such as Arizona do not exist. During periods of rising rates, losses can be harvested in an SMA. This is not possible in a mutual fund. Can you imagine calling Vanguard and telling them that you want them to harvest $100,000 of losses in their $15 billion intermediate-term muni fund (VWITX)?

Customization

Fixed income money managers are also able to implement different strategies for investors or RIA’s that meet the needs of their clients. This may not be the case for a mutual fund. For example, what if you are concerned that stocks might tank and so you want to have a duration target of 7,8,10.0, etc? It is practically impossible to buy a fund that will fit any duration target that you would like to have. Most fixed income portfolio managers can do this relatively easily. Another example would be an endowment fund that doesn't want money invested in what they deem to be socially offensive industries. This may be difficult by using funds, because mutual fund companies such as Pimco, Fidelity, and Vanguard all invest in tobacco or brewing bonds.

Descriptions of these benefits are shown in the table below:

Some Separate Account Managers are not tax-efficient and do not build customized portfolios for their clients. We would not recommend working with these firms. If a portfolio is not tax-efficent and customized to meet the needs of the client why bother hiring a SAM? Why not invest in a mutual fund instead?