David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).
Moody’s, Munis & Cousin BABs
August 16 2009
In their August 13 “Special Comment” Moody’s outlined the current condition of the state budgets and of the various revenue sectors like airports, toll roads, higher education facilities, and hospitals. Nearly two years into a recession, the report is not pleasant reading.
Expenditure budgets are being cut. Tax receipts continue to arrive below projections, which necessitates further budget cuts. A downward spiral seems to be underway. The Muni sector appears to be in a depression.
In part, the damage to state and local budgets has been blunted by huge federal stimulus. This is viewed as temporary by government finance officers, since they must attempt to balance their budgets and may only count on federal assistance that is funded. The term “funded” means that they have the money in hand or will definitely receive it so that they can pay the bills. Thus unfunded items do not count even though they may be anticipated.
Forward-looking projections for municipal bond issuers are truly bleak. They show reduced revenues based on the most current projections of economic weakness. Tax receipts are forecast at extreme recession levels. These budgets do not include any unfunded federal help. Projections are based on all federal programs expiring as determined by present law. Credit ratings by Moody’s and other agencies are based on these worst case scenarios, which is why so many issuers are on credit watch or have been downgraded.
Direct payments are one form of help from the feds to the states and locals. Indirect forms are another. Build America Bonds (BAB) are an example of the indirect form. When certain qualifications are met, the federal government will reimburse the state or local issuer 35% of the interest cost on BABs issued in 2009 and 2010. The current law that authorized BABs expires after 2010. No one knows if Congress will extend it; hence, local government savings from using BABs is not projected after 2010.
In 2009, between $60 billion and $80 billion of BABs will be issued as taxable fixed-income securities; these are substitute issues for what would normally be tax-free Munis. Buyers of these new instruments include tax-deferred accounts like pensions or IRAs in the US and various foreign investors who find the yields on BABs attractive. Neither of these bond-investor groups would be interested in lower-yielding tax-free Munis, since they are not paying taxes to the US government. But they are seizing the opportunity to own BABs.
A secondary effect of BABs is to put downward pressure on tax-free yields in the seasoned bond market as well as in the new-issue Muni markets. Tax-free Munis have to compete against BABs. Issuers make the choice between the two based on the net cost to them. Since the BABs subsidy is 35% of the interest cost, the downward pressure of this “tax arbitrage” has pushed tax-free Muni yields substantially lower than what they were only 6 months ago.
In the shorter-term maturities, tax-free Muni yields are now about 65% of the taxable reference. In other words, this section of the Muni market has been fully corrected. The tax arbitrage is 100% returned. There has been a full compression of the extraordinary spreads that were reached at the pinnacle of the financial crisis.
Readers may remember the collapse period of municipal finance when the weekly floating-rate resetting instrument issued by the Port of NY and NJ had a failed auction, which spiked the yield to 20%. That’s right 20%, tax-free federally and in NJ and NY. That probably marked the absolute extreme of tax-free Muni market dysfunction. Today, similar paper yields a fraction of 1%.
While very short-term Munis are back to normal at about 65% of Treasury yields, intermediate-term Munis are rapidly restoring their more traditional spreads that are based on the tax arbitrage. They are down to the 70% to 80% of Treasury yields depending on the state and maturity.
At the longer end of the Muni curve (30 years) the tax arbitrage is still not restored, although it has been correcting from the extremes reached last year. Many very high-grade Muni issues are available at yields above 100% of the referenced US Treasury security. It the pinnacle these Munis were yielding as much as 150% of Treasury reference yields.
In the case of some issues this unusually high yield is due to the questions about creditworthiness. But credit quality is not the only reason for this mispricing. Hence, opportunity exists in the good credits which are also mispriced for other than credit worthiness reasons.
We can make this statement and back it up because we are still seeing federally backed housing agency tax-free bonds trading at tax-free yields above their Treasury yield reference. In this Muni sub-sector case we are comparing a taxable US Treasury bond with a tax-free state housing agency bond that has federal backing. The credit support is the same government of the United States and is dependent on the US government’s ability to pay. Since the US has unlimited capacity to pay US dollars because it can finance them with the assistance of the Federal Reserve, the markets deem US obligations as riskless when it comes to default.
So why shouldn’t the tax-free rate be substantially lower than the taxable rate? There are several contributing factors to this anomaly. Those factors help explain why this is a great opportunity for investors.
First, only the 20 million or so high-bracket American taxpayers are the typical buyers of tax-free Munis. They have other investment options like stocks, real estate, gold, foreign currencies, etc. Since the financial crisis, many of them have large capital loss carry-forwards; that means they can obtain capital gains on future investments without federal income taxation. Tax-free Munis have a competitor when cap gains are untaxed. At Cumberland we are structuring some specific hedged Muni accounts designed to seize this opportunity that the market is currently providing.
Secondly, many of those same Americans were hurt in the market crash period and are insecure about any investment. That is why the cash hoards are huge by traditional standards.
Thirdly, the tax-free Muni sector was not a direct recipient of any of the special tools that the Federal Reserve used to restore credit-market functionality. The Fed is focused on the banking system. The banks have restrictions when it comes to tax-free Muni holdings, so the Fed’s liquidity injections did not reach to the tax-free Muni world as easily as they have to other sectors like commercial paper or Fannie Mae mortgages.
Lastly, traditional retail Muni conduits like closed-end funds were discredited by the payment problems associated with the adjustable-rate preferreds. Many investors were hurt, and this sector is still in the process of a longer-term workout. Litigation over the disclosures surrounding the preferreds is underway. The result is that buyer support for closed-end Muni funds evaporated during the crisis.
Other forms of tax-free Muni mutual funds have costs associated with them and are not conducive to large, separately managed accounts, in our view. Bond ETFs also have characteristics which we, and other skilled managers, find unattractive. The bottom line is that the major source of funds for the longer-term tax-free Muni market remains the very wealthy or high-tax-bracket American taxpayers who are allocating money to this sector. That is why long-term tax-free Munis are still cheap.
Cumberland has been a total-return Muni manager for decades. John Mousseau, an owner-manager, heads that section of the firm. We also have a long-term history of using taxable municipal bonds. It was established years before BABs existed. Peter Demirali, an owner-manager, leads that taxable Muni effort. Both asset classes are growing rapidly.
The financial crisis, which harmed other sectors of markets, spurred record growth for Cumberland. Our tax-free and taxable separately managed account business has reached all-time records in assets under management, numbers of clients, and institutional consulting portfolios under review. Cumberland’s employment is at a record level. Our firm is expanding.
In sum, market cycles over the last decade featured the tech stock bubble and NASDAQ correction of a few years ago, followed by a bull stock market that peaked in October, 2007. The subsequent collapse of markets and the crash after the Lehman Brothers failure has damaged financial markets and the economy. Years of recovery time will be required to correct them.
During this crisis period, tax-free and taxable municipal bonds suffered terrible damage that had no precedent in the post-World War II period. They reached astronomical yields at the extreme. They are still cheap for reasons outlined above. So we are very active and look forward to more growth. It has been and will continue to be a very busy time.
I thank my friend and client of many years, Michael K, for prodding me to write this commentary.
Let me end this missive with a correction of an error in the “Ricardian equivalence” commentary of August 14, 2009. The sentence in the original email which read, “David Ricardo (1773-1823) is ranked among the classic British economists, along with others like his good friend Adam Smith,” should read: “David Ricardo (1773-1823) is ranked among the classic British economists. He was inspired by Adam Smith’s famous book The Wealth of Nations. Thomas Malthus was among his close friends.”
We apologize for the error and thank those sharp-eyed readers who caught it and emailed us about it. At Cumberland we have several research associates and a copyeditor; they try to help us avoid these things. They are not expected to know every detail of history. So when we publish something at Cumberland the errors belong to the writer whose name is on the piece and not to anyone who assisted them. In this case the error is mine.
David R. Kotok, Chairman and Chief Investment Officer, email: email@example.com