The following is an edited transcript of an Aug. 21 webcast, “Muni Markets: Maneuvering Through the Minefield,” moderated by InvestmentNews senior reporter Jeff Benjamin.
Mr. Benjamin: Let's give everyone a chance for a brief introduction. Ronald Bernardi, do you want to begin?
Mr. Bernardi: We are a vertically integrated municipal bond specialty firm based in Chicago. I've worked for 32 years, exclusively in the municipal bond business, so I think I've been at it long enough that I can provide all of you with a different and helpful perspective.
In our business, we assist high-net-worth individuals, managing the portion of their portfolios in the municipal bond market. We also help state and local governments plan and raise capital for their essential-service public-purpose projects — schools, city halls, jails, water and sewer facilities.
Mr. Benjamin: Tom Dalpiaz, how about you?
Mr. Dalpiaz: I head up the buy-side fee-based municipal bond portfolio management group at Advisors Asset Management. I have been in the municipal bond business for over 30 years. I was a municipal bond credit analyst before I was a municipal bond portfolio manager and I managed individual bond portfolios for high-net-worth individuals.
Mr. Benjamin: And Stephen Winterstein.
Mr. Winterstein: I'm chief municipal strategist at Wilmington Trust. We are a buy-side shop. We run about $4 billion in the ultra-affluent space — tax-exempt municipal fixed income. In my role, I set strategy for client portfolios, overseeing portfolio management, credit and trading, and the entire investment process.
Mr. Benjamin: Let's start with the general state of the muni market today and how it is different from where it was in December 2010, when Meredith Whitney made her prediction of a wave of defaults and bankruptcies. Stephen, can you give us some perspective on that?
Mr. Winterstein: If we take December of 2010 forward, I think it tells a good story. But if we take a step back in time, I think the story becomes even a little more robust. So from my perspective, I think everything in the municipal market changed Oct. 29, 2007. That was the date the ratings agencies announced they were going to take a second look at capital adequacy of the monoline insurers.
So from that date forward, we saw a devolution, if you will, of the monoline insurance industry.
What happened in the early 2000s was that municipal bond insurers [known as monoline because they historically insured only one kind of credit: municipal bonds] started to branch out and insure other kinds of credit transactions: structured finance, derivatives, [collateralized debt obligation]-squared, all the alphabet soup that got us into trouble in 2008.
Ultimately, that was what deteriorated their capital and ability to insure all these transactions. Eventually, the bond insurers became meaningless in terms of a credit safety net in the marketplace. So by the time we got to Meredith Whitney, we had already started to see some of those credit trends unfolding.
She made some pronouncements that scared a lot of individual investors. But what happened in the ensuing months created a lot of opportunity for those who do their own original bottom-up credit research. So while the municipal market is still, in my judgment, very high in quality, it is extraordinarily fragmented — 55,000 issuers, 22 sectors, 50 states and five territories. And it's very difficult to generalize about whether it's a good market, a bad market, a safe market, a risky market. It remains fragmented. What's changed is that we went from a very homogenous market, where the majority of municipal bonds were AAA-insured, to a very stratified and fragmented market.
Mr. Benjamin: Tom, how is the muni market different today than it was in 2010?
Mr. Dalpiaz: I think a couple of simple things are different from December 2010. Rates are much lower than they were then. That's a function of all sorts of things. The Treasury market is certainly one of those reasons. But I think the other thing that's fairly different is that the demand for municipal paper has been very strong. Right after the end of 2010, when very disastrous predictions were laid out, there was a drop in demand and some people tried to move out.
People who did their research, really looked at the underlying credit and had an understanding of the municipal market through longstanding experience, stayed with their knitting. Demand slowly came back, and that that's one very big difference. That very strong demand has helped to push municipal yields lower.
FEEDING DEMAND
The one thing that's the same is that credit quality is being challenged. There are real issues out there. It is nowhere near the case that it's a deluge of defaults, and I still don't hold that point of view and didn't hold it back then.
In fact, I think some of the demand has come from the recognition of a very resilient asset class, one that has staying power, one where the vast majority of issuers are making the tough choices. We've seen a couple of obvious, highlighted stories, but when you think about just how large the market is — that thousands and thousands of issuers are honoring their obligations — the demand still is strong.
I think people have also kept up demand for munis because, generally speaking, if you stay in that investment-grade intermediate space, it tends not to be quite as volatile as a number of other classes have been. I think that if you're a conservative investor and you do the math, municipals still provide very nice after-tax yield.
All those things have combined to create very strong demand for municipals.
Mr. Benjamin: Ronald, can you give us your perspective on the muni market?
Mr. Bernardi: The bottom line is that over the last several years, the municipal bond market has performed very well for investors. And, Meredith Whitney's commentary aside, what she predicted has not occurred. It just hasn't.
Most of the bankruptcies over recent decades have been in the nonessential-service, nonpublic-purpose type of issuance. And short of a cataclysmic national financial event, there won't be massive defaults for school projects and county jails and water and sewer plants. Most of the defaults in recent years are not in those sectors.
We have a saying that municipal finance is mostly a local phenomenon. What we mean is that you've got to look under the hood. A rating metric is useful and an insurance policy is useful, but you really have to look at the balance sheet of that municipality. Then, depending on how strong or weak the credit is, it needs to be [analyzed] periodically because that credit quality will change.
We manage portfolios. When we underwrite issues, the credit either makes our approval list or it doesn't. We've got an in-house credit research staff that spends hours upon hours examining those types of credits.COMMITTED TO PROCESS
Both Steve and Tom made an excellent point that the collapse of the monoline insurance business has fragmented the market. That is absolutely the case, and in our view, it's one of the real strengths of this market. You've got to roll up your sleeves and do the work to understand that that credit is good and that such diversity and fragmentation create some wonderful investment opportunities. I won't lie to the audience: In "08 and "09 — that six-month period — we were net buyers. And many times, as we were making investments for our clients, we were scared buyers, scared investors.
But as it turned out, those proved to be some of the best investments we've made for our clients in many, many years, because that water system in Central Illinois that was a good, solid moneymaking enterprise in August 2008 was the same good, solid moneymaking enterprise in November "08, irrespective of Lehman [Brothers Holdings Inc.]'s and General Motors [Corp.'s] collapse.
If you're going to be in this sector as an investor, as a professional, you need to commit to that credit research process.
Mr. Benjamin: Ronald, could you put a little context into how municipalities are different from a publicly traded company in terms of debt issuance and explain the strong dependency that municipalities have on debt issuance?
Mr. Bernardi: Picture the town you live in. The town, short of a local disaster, isn't going anywhere. People count on the services that that municipality provides, that school districts provide. That's presumably why people live there.
So the municipality issues bonds to finance its operations. Part of what we look as a credit-analysis process is how much debt they're issuing, and what they're issuing it for.
Take the state of California. It has run deficits for a handful of years. And how does it finance that? It does so by essentially rolling over debt. It just issued some notes recently, borrowing at what I think is a very attractive rate from their perspective.
We didn't invest in any of them. It was overpriced. Those notes are secured by what? The hope [or] expectation that a year from now, the state will be able to issue as many notes — probably more — because they'll have a larger deficit and there will be buyers for them.
At the micro level, the credit-review-process level, that's not a credit I want to own.
Mr. Winterstein: I think Ron made a great point about credit being the focus. And I touched on the monoline insurance. I think this is a point well worth taking away from this conversation. There is something that has fundamentally changed individual investors' portfolios. And this is critical to understand if you're an adviser.
Up until 2008, the mantra for individual investors, whether they purchased bonds through a brokerage firm or had a trust company manage their money, was that the bonds had to be AAA-insured. And that went away.
What we're left with in today's market are portfolios that look nothing like what individual investors thought they owned four years ago. Now, instead of that AAA insurance applying to their portfolio in terms of credit quality, what we have are stratified portfolios. Tom and Ron can affirm this. When we do portfolio analyses today, investors who entered into a portfolio of municipal bonds they thought were AAA-insured often find themselves owning a fair amount of BBB securities. The insurance no longer applies, and the ratings go to the underlying rating of that issuer.
So we've seen a tectonic shift in the AAA segment of the market. Back in 2007, you had about a 50% penetration of bond insurers in the market — meaning that about 45% of the outstanding market was AAA-insured. About 50% of new issuance was AAA-insured.
With the bonds still outstanding four years later, that insurance no longer applies, and the underlying ratings of those municipalities now represent the credit quality of those portfolios.
I think what you're seeing is a shift from then, when perhaps 100% of the portfolio was AAA, to perhaps 10% being in the BBB category. Some of those securities are nonrated. And we've seen a big shift down into the single-A category.
The point that I'm making is that there's been a tectonic shift in credit. The financial pressures notwithstanding, because that insurance is no longer effective, the average credit quality of portfolios is lower.
Mr. Benjamin: Can we step into specifics on some of the Chapter 9 filings? And maybe somebody can jump in and break down how a Chapter 9 filing differs from Chapter 7 or Chapter 11?
Mr. Dalpiaz: Chapter 9 [municipal bankruptcy filings] are still very rare. Municipal entities that get involved in Chapter 9, even those that mention it as a possibility, get headlines precisely because it still is such a rare event. If you talk to attorneys that even specialize in bankruptcy law for municipalities, they will tell you that there is not a lot of case law on this.
That's one thing to keep in mind. Even though you have been hearing a few names and a few [have happened] in succession, keep in mind that there are roughly 55,000 issuers — a very large market.
Keep in mind that the vast majority of entities want to avoid bankruptcy. It is in their self-interest to avoid it, and they are self-correcting. They have tools to fix their problems. These are things that people can overlook.
If you talk to any mayor, any governor, they have wonderful tools called municipal bonds that help them finance large projects. They don't want to lose that tool; it's very effective for them. It helps them with important needs they must fill for their community. They want to keep that market access.
That's one of the reasons you'll see the vast majority of entities make tough decisions to maintain that market access, to keep that wonderful tool called municipal bonds. There are some exceptions that have hit the news where people have kind of thrown up their hands, but, again, the vast majority have that self-interest. They see it as important.
The other reason is self-correcting tools. There is a whole pocketful that municipalities can use to straighten out their budgets. Some of them are not terribly pleasant for citizens, but bondholders should take a certain kind of comfort that there are so many tools that they can use.
The entity can always raise taxes. It can cut expenses. It can cut its employment payroll a bit. Perhaps it can reform its pensions. It can sell government assets if it has to, or even borrow from funds to tide it over. The entity can use miniday funds. It can refund its debt. The list goes on and on. Those are just some things to consider about the nature of an [insular] market and why thousands of entities are honoring their obligations and making the tough choices to stay out of Chapter 9.ABILITY VS. WILLINGNESS
Mr. Benjamin: Ron, is California somehow unique in this situation?
Mr. Bernardi: There certainly is a stigma for municipalities, a local government, to file. States cannot file. In the last couple of years, we've paid particular attention to which states allow local governments to file because there is, as Tom said, a multitude of tools available for municipalities to work through their financial problems. There is a distinction in our view — and we're seeing it in certain places — between the ability to pay and the willingness to pay.
To that extent, I'll pick on California, just because there have been several instances of Chapter 9 filings. No. 1, only the municipality can initiate a Chapter 9 filing. And once it gets into the [bankruptcy] court, unlike a corporate filing, there is not much the court can do to satisfy bondholders' demands. It has to work its way through.
So once you go down that route, it is long and painful and as Vallejo, Calif., found out — it filed in "07 and just recently came out of bankruptcy protection — very costly. And I think if you were to poll a lot of people in positions of authority in Vallejo, they would probably not speak positively about what they accomplished for the city by going through Chapter 9.
But I look at the state of California's hands-off policy regarding the filings by Stockton, Mammoth Lake and San Bernardino. I contrast that with how Michigan is pushing — both from the governor's office and legislatively.
The state of Rhode Island is pushing to make it very difficult for its municipalities to file Chapter 9, because from a credit perspective, it tells us something. We pay attention to that. We pay attention to the fact that Montgomery County, Ala., and the state of Alabama have essentially washed their collective hands of what's going on in Jefferson County.
We're wary of credits in those kinds of localities. We will continue to see these situations develop, and they need to be played out before you can conclude whether or not you want to avoid California or Alabama bonds completely. I'm not suggesting that at this point, but what I am suggesting is how it's being treated at the state level in those places is quite a bit different from an investor's standpoint and a bondholder's standpoint than in Michigan or Rhode Island.THE AIRLINE EFFECT
Mr. Winterstein: I want to clarify something for our listeners. A lot of people confuse default with bankruptcy. They use them almost synonymously. California is not bankrupt. It's the ninth-largest economy in the world. And besides, even if it weren't, states can't file for Chapter 9 protection under the Bankruptcy Code.
What concerns me is that in the 1980s, we saw airlines start to use Chapter 11 bankruptcy as a reorganization tool. I was in the financial services industry then, and I remember that when the airlines started to do this, it was anathema. It was stigmatized.
Eventually, the markets came to accept that airlines were going to come into and out of Chapter 11 bankruptcy and were going to reorganize. It was simply a financial tool.
I think the same thing happened in 2008 and 2009 in terms of personal bankruptcy. What you saw with the advent of real estate values dropping below balances left on mortgages, people were turning the keys in and walking away. All of a sudden, you saw something that in my grandfather's day was absolutely the last thing you ever wanted to do in your lifetime — file for bankruptcy — become less of a stigma.
Ron, you touch on this, where I have some concern — and it's not rampant, and I don't think it's going to be of epidemic proportions — that Chapter 9 bankruptcy will lose its stigma if municipalities start to make choices based not on the ability to pay but on the willingness to pay. I think we could slide down a rather slippery slope if the [lack of] willingness to pay starts to trump the ability to pay, and that's what we are starting to see."BIG, BAD' WALL STREET
Mr. Bernardi: Well, there's no question. We're already seeing that without the monoline insurance business.
In Jefferson County, Ala., the bulk of that debt in default is insured. They haven't said it, but I believe part of the calculus of decisions made by elected officials down there was, “OK, these bonds are insured. It's not Mr. Smith and Mrs. Jones, individual investors, who are going to be the losers because we're not paying out our debt; it's the big, bad insurers on Wall Street.” Vallejo's debt was all owned by a big California bank.
So in those two specific instances, those entities are clearly using the insurer or the bank that's the investor as their piggy bank to reorganize.
Mr. Dalpiaz: The ratings agencies are actually playing a role here by making a public point of saying: “All this talk about bankruptcy is not helpful. And we are actually going to begin to, in effect, punish people for using it as a tactic, for tossing that word around.”
Municipal market participants can play a role in highlighting those entities that do it well. If you look at actual defaults and bankruptcy filings in the muni world, it's interesting from a regional point of view. The areas with the smallest number are New England, the Middle Atlantic States and the Midwest. Once you get into the Southeast, Florida ruins the numbers there. Texas, a little bit. And then out West, that's where you have more of those numbers.
I don't know what the exact numbers are, but you can check them and the Midwest, and the Middle Atlantic and New England states tend not to have a lot of these things. Part of the reason is the way the larger entities have protective oversight and help municipalities out before they throw up their hands.
Mr. Winterstein: If you also look at default rates by sector, I think it's very telling. In our shop, we use the Standard & Poor's Municipal Bond Index. It contains individual securities and has a market value of $1.3 trillion, almost $1.4 trillion. So the entire market is $3.7 trillion. It's a great sampling representation of the municipal market.
The index has a default rate of about 50 basis points. We've seen a tick up in the last year from, call it 40, to 50 basis points. You mentioned geography, but the thing that's very interesting about the defaults is in what sectors they're occurring. We can look at some of the usual suspects and when I tell you what they are, it's not going to surprise anybody on this call.
One of them is student loans. One of them is multifamily housing in — you guessed it — Florida and California. One of them is nursing homes, continuing-care facilities. So these are the lower-quality sectors.
So when we look at these default statistics, it's very interesting when you look at it geographically. You can also look at it by sector. What you realize is that it brings us full circle back to the original conversation. And that is, it's very difficult to generalize in this market. That's what makes credit research so important, because you ought to know what you're buying.
Mr. Benjamin: One of the audience members brought up the quality or availability of information about the muni market. Isn't it kind of scattered?
Mr. Dalpiaz: It has gotten better in recent years with market participants like the [Government Finance Officers Association]. The National Federation of Municipal Analysts has set standards with the GFOA. And the [Municipal Securities Rulemaking Board] has started to play a role in continuing disclosure. [Information quality and availability] has been an issue — I want to say a problem — looking back in history. It was very difficult to get financial information from some of the smaller and infrequent municipal issuers.
From our perspective, that is a litmus test for us. If we're not getting audited financials, if we're not getting them on a timely basis, if we're not getting these full disclosures, then it raises suspicions for us.
We want to make sure we have timely information on the securities that we're looking at, because that translates into liquidity. It translates into liquidity in the sense of when I want to adjust my portfolio's characteristics and sell a security — and take a profit in it — other practitioners in the marketplace are going to look at those disclosures to tell whether what I have is of value or not.
I think the old adage, “You buy cheap, you sell cheap,” probably applies here. So we use disclosure, and it has gotten a lot better. It's not perfect, but it has gotten better.
I think what you find also is that the market demands disclosure from the large, frequent-to-market issuers. We're not only looking at their financials, but also at management practices, derivatives exposure, unfunded pension liabilities and how they're dealing with those.
We're looking at other post-employment benefits, such as continuing health care for former employees. We're looking at all those expenses. We're looking at how management is handling those things. And what we want to see is continuing disclosure that's clear, that's transparent, that we can digest. And as I said, that's a litmus test for us.
Mr. Benjamin: Ron, can you put the risk of the elimination of the tax exemption on muni bonds into some perspective for us?
Mr. Bernardi: Last fall we published a white paper on the topic and if you go to our website, you can get a full copy of it. But we have spent many, many hours since its release in November having conversations with elected officials at the state and local level and congressmen and senators.
It's important to almost everyone in this country, because radical changes to the present-day municipal market would affect not just the wealthy investors receiving tax-free income — and Bernardi the bond dealer — but all of us, in that costs for projects in your town are going to increase. Fees are going to increase. Taxes are going up. Projects will be scaled back or perhaps not built at all.
Sen. [Ron] Wyden [D-Ore.] has a proposal whereby the tax-exempt market would disappear overnight and be replaced by a tax-credit market. If he gets his way, local control obviously would be sacrificed, compromised, given to the federal government. You [would] have the federal government deciding on whether or not you can build a school, where the school can go, etc.
So it's an important issue. The tax-exempt market has been around since the beginning of the 1900s, and the municipal market began in the late 1800s. Blemishes aside, it is a significant, well-developed and fairly efficient marketplace.
I don't think the tax exemption is going away, but it's going to be challenged once we get through the election.
Once you are dependent on the federal government for some of your financing, you are going to sacrifice local autonomy. If you go back to the genesis of the municipal bond market in the late 1800s, bonds were taxed.
Subsequently, it developed into a tax-free market with the imposition of the income tax in 1917. State and local governments wanted autonomy to finance projects, independent of the federal government.
That is a high-level argument to make, but we've been making it ad nauseam with various senators and congressmen in Washington since the beginning of this year. I think it's important for all of us try to make that point."TOO MANY MOVING PARTS'
Mr. Winterstein: There are multiple ways that taxes and tax policy can affect the tax-exempt municipal bond market. We look back to 1986, when they were [talking about] taking away the tax exemption on municipal bonds, and it would be grandfathered so that bonds issued in the future would be taxable but any bonds outstanding would be tax-exempt.
If that were the case, you would own a asset, and you would presume that — all things being equal — a municipal bond would increase in value because it was an asset.
Another way that they could adversely affect the municipal market with tax policy was [1996 Republican presidential hopeful] Steve Forbes' proposal for a 17% flat tax. There, you didn't actually change the tax status of the municipal bonds. He was proposing to lower taxes on everything, which would have made the relative attractiveness of municipal bonds less so.
I think there are too many moving parts to be able to bet the farm on any one proposal to end the tax exemption on municipal bonds.
