It has been the same old song for munis, but we think the beat is about to get a bit “louder”. In August, supply was up 40% over 2015 levels, yet muni cash continued to absorb it. The market is just beginning to enter into a historically weak seasonal time of year and the estimate on new supply is not slowing up. Could we finally see some good investment opportunities in munis?
It is that time of year to look back and see where the municipal market stands versus where we thought we were heading. There were two themes at the start of the year that we thought would be influential in 2016: the money market fund reforms and the need to reform the General Obligation pledge. Over the summer months, both of these issues have had some interesting developments. We will update these developments in this month’s credit review.
Short-term municipals are adjusting to the new money market reforms. Year-to-date, the Funds have lost roughly one-third of their assets, which has caused the rate to spike to 63 bps as of the end of August, while taxable rates have remained unchanged (52 bps). This 7-day rate is now higher than a one year muni rate, which is yielding 60 bps. This outflow illustrates the amount of institutional money that is leaving the tax-exempt money market as institutional TEMMF’s will no longer be able to guarantee a $1.00 NAV and could have liquidity fees and/or “redemption gates”. This recent spike in rates demonstrates the amount of investment from “institutional clients”. For more information on the pending money market reforms starting October 14, 2016, please see this month’s credit review. We do feel that this recent spike is a bit overdone, and that levels should drift back down to the low 50 bps in the next 45 to 60 days.
Infrastructure spending is finally here! Low borrowing rates and improved political will power has finally generated new borrowing by municipalities for infrastructure projects. The last two months have put the issuance of municipal bonds on a record pace that may now top the 2010 record level of $432 billion.
We have seen a mixed message for the credit direction of the Commonwealth of Pennsylvania. Credit ratings were upgraded to a stable outlook at AA-/Aa3, which seemed like good news. Yet, in late August, Pennsylvania once again (second time in two years) borrowed money from a line of credit to help meet short-term cash needs. This is negative news and shows the state is still suffering from a structural budget deficit. We tend to believe actions speak louder than words, and feel the stable outlook could be reversed in time.
We started 2016 asking investors where their cash was. Additionally, we suggested they pay attention to the credit details and not the ratings when evaluating General Obligation bonds. We are now over half way through 2016 and, once again, we can ask these same questions with the benefit of market information to help answer them.
Reforming the GO Pledge:
The National Federation of Municipal Analysts (NFMA) is an organization with over 1,300 members whose job is to provide research and analysis used to assess municipal securities risks. The NFMA released a white paper in July, discussing their concern with the “sanctity of the General Obligation pledge” given the recent treatment of these bonds in various Chapter 9 and state court receivership cases. This white paper is focused on providing guidance and recommendations on the best way to clarify and protect the GO pledge.
NFMA recommends that a statutory lien on all general obligation bonds be demanded by investors. This lien will enhance the treatment of the revenue backing the bonds in a Chapter 9 case. This lien essentially makes the GO pledge like a revenue bond, where the bonds receive a priority on repayment and continued debt payment from the revenues during the Chapter 9 process. The NFMA currently feels there is difficulty in identifying whether a statutory lien actually exists on most GO deals. They are requesting issuers do a better job of explaining if a statutory lien does exist, and are requesting that all issuers provide a legal opinion stating the lien does exist.
We, at MainLine West, have been concerned with the loss of the “gold standard” on GO bonds for a couple of years. We are happy to see that the NFMA has finally addressed the situation and we strongly agree with their proposed solutions. We agree that investors must demand a statuary lien on revenues backing their bonds, whether they are GO or revenue bonds. Investors need all the protection they can get from Chapter 9 judges, politicians, and special interest groups, when it comes to protecting their principal. For old time muni investors, it must seem unnatural to think that the only way to secure the “gold standard” GO pledge is to treat it like a revenue bond! Welcome to the new muni world.
Reforming Money Market Funds:
My guess is, due to reforms being enacted on October 14, 2016, many of you are getting notices from your bank regarding the changes they are going to be making to your cash sweep investment. We first discussed this change last fall, and made recommendations at that time. We will refresh those changes below, and add in some of the new twists we have seen since then.
- Your account will be treated as a retail account or an institutional account, depending on whether or not it is registered under your social security number. Those using their SSN will have their account categorized as a retail account and, therefore, eligible for money market funds that guarantee a $1.00 NAV and have no liquidity restrictions or fees.
- Investors classified as “institutional clients” will have to invest in US Treasury Funds to get a stable $1.00 NAV and no liquidity restrictions or fees. There are no other options if you want the old money fund guarantee.
- Custodian banks appear to be moving institutional accounts into either US Treasury Funds, or an overnight bank deposit.
- The US Treasury Funds continue to guarantee the $1 NAV, no restrictions on withdraws, and of course still earn close to nothing (0 to 1 bps).
- The overnight bank deposit is backed by SIPC up to $250,000 in cash. In some cases, the bank has obtained additional insurance to protect balances above this amount.
- We feel, given that both investment options are paying 1 bps, that the US Treasury Fund is a better option for the following reasons:
- The bank sweeps will earn an overnight rate that is set by the bank. Right now, it is 1 basis point, which is the same as the US Treasury Money Market Funds. However, going forward, we do not know what this rate will be. There is no market based formula being used to set it.
- You will not know what bank your money will be invested in each night. This means you may not know your exposure. It is possible the deposit is made in a bank you where already have a CD or another account. If the bank goes out of business, you may get an awkward surprise regarding how much money you had parked there.
- These bank deposits, in some cases, are products of the banks and, therefore, it is quite convenient for them to move your money into it.
We recommend investors more clearly define “cash”. Cash for today, cash for next month, cash for next year. Depending on this “cash roadmap”, a series of different liquidity investments should be made to provide both income and liquidity. Allowing all of your cash to be swept into a bank deposit or a US Treasury Fund is a real loss of income, without much of a gain in principal security.
If you have any questions, or would like us to review what your bank is proposing as your sweep option, please feel free to contact us.
This material has been prepared for informational purposes only and is not an offer to buy or sell, or a solicitation to buy or sell. The information herein was obtained from sources which Mainline West Municipal Securities LLC, a member of FINRA and SIPC, and its suppliers believe reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed herein constitutes a solicitation of the purchase or sale of any securities. Any prior investment results presented herein are provided for illustrative purposes only and have not been verified by a third party. Furthermore, any hypothetical or simulated performance results contained herein have inherent limitation and do not represent an actual performance record. Actual factual performance will likely vary and may vary sharply from such hypothetical or simulated performance results. An investor should consider the investment objectives, risks, and charges and expenses associated with municipal bond securities before investing. More information about municipal bond securities is available in the issuer’s official statement or can be found at http://emma.msrb.org.