China's Downward Pressure on Yields
Our update this week takes us around the globe, from China to Chicago. We spoke a few weeks back about a huge flight to quality movement in US fixed income as Chinese equities were facing additional losses. In a nutshell, as investors face potential losses in Asian markets, the desire for principal preservation and “riskless” investments will drive them towards the safe haven of US Treasuries and in some instances municipal bonds. The buying pressure will drive prices up as demand increases and, in turn, have an opposite effect on the yields of those bonds. Investors awoke on Monday morning to news that the Shanghai Composite Index for the Chinese markets fell almost 8.48% overnight. The magnitude of overnight selling has led some pundits to surmise that there is still a huge effect of margin accounts in the Chinese equity markets and that there may be further short-term downside. Margin, in essence, is the ability to magnify the gains in your investment account via leverage, or borrowed funds. In a bull market, this strategy can pay off for savvy investors, however, in a sell-off situation, large amounts of leverage can also magnify losses and create a self-perpetuating downward spiral of sorts. The direct effect on municipal bonds will be downward pressure on yields as dollars move to the US. The markets are already seeing this develop, but on the long end of the yield curve.
Chicago's Unconstitutional Pension Overhauls
Another topic that we are revisiting this week is that of Chicago and its continual pension battles. The latest developments out of the Windy City bring news that Cook County courts declared the previous pension overhauls as unconstitutional. Initial changes to the pension plans included some benefit cuts as well as increasing employer and employee contributions. Judge Rita Novak’s decision sided with pension fund members who felt that the City pension reform was in violation of the state constitution’s pension clause. Obviously, the City is going to appeal this decision because this can dramatically increase the near and moderate term pension contributions that Chicago would have to make to its plans. Because this decision on Friday is not the final word on whether the pensions can be modified, rating agencies are taking a tempered wait-and-see approach before lowering the City general obligation ratings any further and by proxy increasing Chicago’s borrowing costs as investors would demand more of a yield penalty to lend the City money. This is still a fluid situation that we will monitor closely, but should not have an immediate effect of the liquidity of Chicago debt in the market place. To a large degree, this lower court decision was almost priced into current yields and does not dramatically change the credit landscape for the City in the shorter duration of bond purchases.
The new primary market municipal issuance for this week is still substantial, but less than last week, at $7.5 billion versus $10 billion. The three largest deals this week are a $990 million bond sale for the Michigan State Building Authority, a $650 million bond sale for the City of New York and lastly a $379 million bond sale for the City of San Antonio, Texas. The Michigan Building Authority debt is rated Aa2, which is one notch below the Aa1 rating for State of Michigan general obligation bonds. The one notch differential is due to the appropriation from the State legislature needed for payment each year. Both the New York and San Antonio bond sales are supported by a general obligation tax backed pledge by each entity, leaving bondholders with a secured form of payment on the bonds that are purchased.
The Bottom Line
While there are plenty of new issuance deals to purchase for those looking to add to municipal exposure in their portfolios, sometimes better values can be found in the secondary markets. For instance, Chicago bonds are trading at a premium due to the pension uncertainty and last week’s court decision. However, the general obligation debt for the City is still backed by the full faith and power of the legislature to levy taxes on all property and historical GO defaults are statistically quite low. One way to add value in a portfolio would be to limit duration on purchases such as these and add yield to your portfolio.