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We have worked to find areas that have proven to be worthwhile and serve as excellent experience for the storm ahead.

Another Milestone Crossed

July 13th, 2012 by Kurt L. Smith
  • Summer is in full swing and things are heating up. Oil prices, any way you measure them, are down thirty percent from their highs in March. The last time oil fell thirty percent, the S&P promptly lost fifty percent of its market value in less than eight months. The narrative is not important. Keeping your assets safe and intact amidst the growing storm is our goal.

    I cannot stress the importance of my call to Cash and short-term municipals that will turn to Cash in the coming months. Selling Stocks, long-term bonds and other non-Cash assets is now advisable and also possible. The professionals are mostly fully invested but they can still accommodate us. Most professionals, or close to all, did not sell in 2008 so why would they sell now? Now is the time, and by my way of thinking the last time for a long time as we want to own Cash and investments that will turn into Cash over the coming months. One does not want to be asking about what assets to sell as this global asset plunge roars forward.

    In turbulent, stormy times investing for yield ignores the greater danger. Stocks can and do go down fifty percent; dividend paying stocks can fall just as hard. Junk bonds can and do go down fifty percent as well. This idea to add yield by buying corporates, high yield corporates (junk), long-term municipals, master limited partnerships, etc. as a strategy probably forgot to tell you it might just be a short-term strategy as prices of these assets can move down dramatically. It is not the return on your investment that is important in turbulent times; it is the return of your investment.

    We own municipal bonds and municipal bonds will not escape the carnage. I have talked extensively about the municipal bond distribution scheme — we want to use this to our advantage, not be at its mercy. I have talked extensively about the rotting of municipal credit quality and again we want to use this to our advantage and not be at its mercy.

    Since the onset of the financial crisis in the summer of 2007 we have practiced and performed using municipal bonds fully prepared for the storm, whether in the eye or deep in the turmoil. This is why we avoided the strategy of others: continue to buy long-term and go to the beach. Municipal credit quality is declining and the spreads on municipal bonds are widening as the market is taking notice. Meredith Whitney has said it before and she reiterated her concern that the problems in the municipal market are not over but instead “that’s the very beginning of it.”

    Municipal bonds and municipalities will be at greater risk in the coming months. Again, this is nothing new for us. Stockton California laid out a bankruptcy plan last week that linked concessions from workers (pensions and healthcare) with the payment of bond debt. We expected such linkages especially when one steps back and discovers increased debt (credit expansion) allowed excessive perks to be considered in the first place.

    Stockton did not propose reneging on all of its debt payments. Stockton proposed reneging on two 2007 issues. Again, no surprise here. As credit expansion reached its height in 2006-2007, bond indentures became weaker and weaker. Such gutting of bond indentures was the end of a decades-long trend as bond investors were more anxious to buy bonds than be concerned with the lowest bond default rate in recorded history. Unfortunately trends change. Expect the default rate on bonds to soar from here.

    Another early casualty of default is the city of Monrovia California. Monrovia unfortunately followed the advice of its municipal financial advisors and issued five year redevelopment bonds back in, you guessed it, 2007. Rather than issue serial bonds that can be retired annually with the cash flow from the redevelopment district, Monrovia and its advisors decided to issue more debt and do so on a five year balloon maturity. Monrovia, its advisors and its bond investors assumed the issue could be refinanced prior to its June 1st, 2012 maturity date. This is called refinancing risk and even the (former) greatness of GE Capital fell victim to its circumstances in 2007-2008.

    Refinancing risk is huge in the bond markets despite the benefit of hindsight. Some corporations got the message and have worked diligently to spread out their maturities long-term and over many years. But others, like Monrovia, have sat idly by as their window of opportunity was in the process of being slammed shut. Monrovia has defaulted and yes it will attempt to make its bondholders whole, but it only takes one misstep as a debtor and bankruptcy may arrive. This is an issue I believe where we will see more and more municipalities make the news.

    Florida and its economic rebound has been in the news lately. We were able to focus on Florida bonds for several years, selecting what I believed to be the gems amongst the waves of selling. Florida’s legislature it seemed, would create programs which could be bonded upon only to later take them away and replace them with other bonding opportunities. We as bond buyers had a myriad of bonds and revenue streams from which to choose. From a legislative viewpoint it seemed whenever some bond program expired the legislature would later add something back. This seemed to me to be the give and take method of progress in allowing a state and its municipalities to raise revenue in which to grow with the economy.

    California legislators have experienced no growth in their economy of late and have therefore been stuck in the take, take, take mentality with respect to California municipalities. Whereas municipalities across the nation are having to deal with contracting budgets (revenue) of just a few percent, California municipalities are finding themselves down ten, twenty and thirty percent, largely due to the take, take, take of Sacramento. The biggest impact in California centers upon redevelopment bonds, issued by over 240 municipalities. For us, the bond buyer, redevelopment bonds represent a bonding of an income stream, usually a one percent property tax on increased assessed property values. As property values soared, revenues received by the municipalities soared. The best part for municipalities: they got to keep the excess cash that wasn’t used to pay us bondholders.

    Many municipalities became hooked on the benefits of redevelopment bonds. Some were hooked on the concept of issuing more bonds to bring in more cash. Some were just hooked on the extra cash. When state legislators eyed this extra cash as a way of plugging their own budget issues, the effect was both widespread and dramatic. Regardless of a municipality’s involvement with redevelopment bonds, the fiscal impact on the municipality is often material and it will sometimes be devastating. It doesn’t matter how strong the city, some redevelopment agencies are leveraged beyond their ability to pay debt service and a shrinking economy only makes matters worse.

    For us, this is business as usual albeit with greater opportunities, both in quantity and quality. Not only do we have the advantage of hindsight, we also have the advantage of foresight. Credit Expansion Finished is not just a phrase but rather a guiding principal that reminds us that issuing more debt may not always be an option to solve problems. The world is deleveraging, the economy is shrinking and most of all, asset prices are falling. These are the assumptions that allow us to select gems and avoid Monrovia Redevelopment bonds or the poorly secured bonds of Stockton.

    This is the market environment for which we have prepared. The great news is that we need not sit in zero percent bonds to get here. We have worked to find areas that have proven to be worthwhile and serve as excellent experience for the storm ahead. I believe Meredith Whitney is right. This is just the very beginning. I am expecting many more Stocktons and Monrovias to add to the Jefferson Countys, Detroits and Harrisburgs. Some of these situations were decades in the making; many of the ones to come will spring from seemingly nowhere.

    Invest in municipals for .50%, 1%, 2%, 3% or 4% for the long-term? Fall victim to ignoring the reality that municipalities all across America are facing shrinking, not growing, revenues? Are you kidding me? Watch spreads rise as risk becomes a risk again.  But it will be the selling that makes things interesting. If, and when, this happens asset prices (municipal bonds included) can drop dramatically in price. By keeping our principals and sound practices firm our opportunities should continue to be bright.


    Belton TX Independent School District  – General Obligation Bond
    DUE 2/15 DATED 7/1/12 MATURITY: 2/15/2039
    AAA S&P (AA- Underlying)
    Permanent School Fund Guaranteed
    SALE AMOUNT: $54,900,000
    2 02/14 3.00% 0.520%
    3 02/15 3.00% 0.720%
    4 02/16 4.00% 0.870%
    5 02/17 3.00% 1.150%
    7 02/19 4.00% 1.630%
    8 02/20 4.00% 1.920%
    9 02/21 5.00% 2.170%
    10 02/22 4.00% 2.310%
    11 02/23* 3.00% 2.550%
    12 02/24* 3.00% 2.750%
    13 02/25* 3.00% 2.920%
    14 02/26* 3.00% 3.020%
    15 02/27* 3.00% 3.100%
    20 02/32* 5.00% 3.120%
    27 02/39* 5.00% 3.400%
    27 02/39* 3.625% 3.750%
    * Call Date 2/15/22
    Source: Bloomberg
    This is an example of a new issue priced the week of 6/25/12
    Prices, yields and availability subject to change.


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