Sell-off Creates Opportunity in Selected Munis

A number of our clients have expressed concern about recent media reporting on municipalities – their budget gaps, revenue shortfalls, unfunded liabilities for pensions and retiree health care, and, occasionally, their preliminary speculation about bankruptcy. These expressions of concern come as SNW Asset Management is in the midst of our re-review of every municipal credit owned by our clients – a total of more than 2,200 items. So far our most recent reviews confirm what we have previously thought, which is that while there are definitely states and local governments with real problems, state revenues (though not expenditures) seem to have bottomed out during fiscal year 2009 and are now showing signs of modest recovery . While there are reasons to fear that states have cut and will continue to cut revenues which they share with local governments into fiscal years 2010 and 2011, we are also finding a great number of credits which, as we had previously thought to be the case, through a combination of planning and foresight and tough decision-making are doing quite well. The trick lies in knowing which credits are vulnerable and which are well-positioned, and we believe that our experience in this market enables us to do this.

Municipal bond prices have been under pressure for more than a month now. There are a number of reasons for this – among others those alarming reports from the media, California’s massive financing, which required relatively higher yields/lower prices to market successfully, and proposals in Congress to reduce the federal subsidy for Build America Bonds or to end the program entirely, which has led to a high volume of quick sales of these bonds with consequent depression of market prices. Many municipal bonds now yield more than comparably-maturing U.S. Treasury securities, even before the effect of their attractive tax treatment is factored in. Given the still-impressive overall credit quality of municipal bonds, the current structure of market pricing represents the best relative buying opportunity in nearly two years.

Near-term, it is certainly possible that the factors which have been depressing municipal bond prices will continue to be at work. It is also certainly possible that depressed prices will continue to spill over from truly weak credits to include even the stronger names which we have acquired (and will continue to acquire) for our clients, but we think that indiscriminate panic pricing of most municipal bonds will prove to be a temporary phenomenon. We are happy to be buyers of municipals at times like this.

In conclusion, recent events in the US fixed income market have caused investors to pay attention and to ask hard questions. SNW Asset Management’s response is that the municipal market, while experiencing some challenges, continues to be an attractive and relatively safe market for investors. We continue to find great value in selected municipals.

Thoughts on California Revisited

California General Obligation Debt

Overview

• As a new fiscal year approaches, California is about to re-enter its highly politicized and publicized budgetary process.
• The state’s budget picture has continued to deteriorate over the past 6 months.  Personal income tax receipts (roughly half of general fund resources) dropped 20% during fiscal year 2008-2009. Estimated total general fund receipts have been revised downward again in 2009-2010. The latest total revenue estimates are 12% lower than initially estimated for 2008-09.  Sales tax estimates are flat.
• The state is projecting FY 2009-10 expenditures for education to be down by 15% from initial FY 2008-09 estimates, and for health/human services expenditures to be down by nearly 20%.  Are these reductions likely to be realized, and, even if so, are they sustainable?
• At the latest estimate, education expenditures would still consume 51% of general fund resources, health/human services 28%.
• General obligation debt is now above $68 billion.  Lease purchase debt, which is subject to legislative appropriation, adds another $8 billion.
• General obligation debt service payments are roughly $4 billion annually, or less than 5% of estimated general fund resources, but they rank behind expenditures for education ($45 billion at latest estimate) in terms of priority.
• More than $8 billion in economic recovery bonds are secured primarily by sales tax revenues.  Ultimately, they become an obligation of the general fund if sales tax revenues falter.
• The $2 billion in Cal Vet home loan debt appears sound and self-supporting.

Summary: Although G.O. debt service amounts to only about 5% of total general fund and general government expenditures, California’s massive, embedded educational expenses lie ahead of it in their claim on incoming revenues.  Debt that is supposedly “self-supporting” is also vulnerable.

Fiscal Practices

• This basic structural credit flaw is aggravated by the state’s on-going fiscal practices.
• The 2007-08 statement of revenues and expenditures showed expenditures at 111% of revenues, a difference of about $20 billion. 
• The state plugged the gap by borrowing $14 billion during the year and drawing fund balances down for the remainder. 
• New York City used to do the same thing before defaulting in the mid-1970s. 
• The general fund has a substantial negative unrestricted fund balance (minus $69 million as of June 30, 2008).
• The state is running out of cash.
• Newer financial reports should become available soon, but the present financial outlook is not encouraging.

Conclusion

We do not like what we see and we have responded by selling credits as opportunities permitted.  Over the past several months, we have substantially reduced or eliminated our exposure to the following credits: Unrefunded California GOs, Cal Economic Recovery bonds, and select Cal Lease Revenue bonds. We have also conducted an extensive review of other credits and their reliance on the state for funding.

California Municipal Investors

Overview
SNW Asset Management would like its clients to understand that we are following the economic and fiscal situation closely in the state of California.  Significant portions of the assets that we manage are for California residents and institutions whose investment objectives are being met with municipal securities.  We respect the concern investors have for the impact the state’s challenges may have on municipalities and their ability to meet outstanding as well as future obligations.  However, we also feel it is important to take a step back and understand that many California municipalities are well managed and have strong balance sheets.  We see no reason to avoid these well-managed and soundly financed credits.In the universe of California municipal bonds the communities, security structures and credit quality varies widely as does the risk/reward of owning those securities.

SNW Asset Management’s Core strategy

• Maturities between 1 and 10 years
• Due diligence on the underlying credit
• Diversification by sector, issuer and geographic region
• Continuously monitor the fundamentals of each credit

What We Are Buying

• Average duration between 2 to 4 years
• Healthy credits with balance sheet flexibility
• Pre-refunded bonds
• Select general obligation bonds
• Select revenue bonds

Examples:

• Select Community College and School District General obligation bonds that receive a stated percentage of the annual California state budget because of the issuer’s preferential position in the state’s constitution.
• Issuers who have pricing power as the low cost provider of a service and can raise fees and issuers who provide essential services in communities that will weather the recession such as select water, sewer, and irrigation districts.
• Issuers who are not dependent on the state for revenue, such as select port authorities and healthcare providers.
• Issuers whose revenue sources are diversified and who are not excessively leveraged

Thoughts on California

California General Obligation Debt

Overview

• The general obligation debt of the state now totals more than $60 billion
• In FY 2007-08, general obligation debt services was just over $5 billion
• Education expenditures were more than 10 times greater at $65 billion
• (Health and human services accounted for nearly 30% of general fund expenditures. The nearly $2 billion in Cal Veterans’ home loan program debt appears sound and self-supporting.
• However more than $8 billion in outstanding economic recovery bonds is secured primarily by dedicated sales tax revenues. Ultimately this becomes an obligation of the general fund if sales tax revenues falter.
• The state has lease revenue obligations of more than $7 billion which are payable from subject-to-appropriation moneys in the general fund.
• General obligation debt service payments are run through the general fund, where they rank behind expenditures for education in terms of priority.

Sumamry: Although G.O. debt service amounts to only about 5% of total general fund and general government expenditures, California’s massive embedded educational expenses lie ahead of it in their claim on incoming revenues.  Debt which is supposedly “self-supporting” is also vulnerable.

Fiscal Practices

• This basic structural credit flaw is aggravated by the state’s on-going fiscal practices
• The 2007-08 statement of revenues and expenditures shows expenditures at 111% of revenues, a difference of about $20 billion
• The state plugged the gap by borrowing $14 billion during the year and drawing fund balances down for the remainder
• New York City used to do the same thing before defaulting in the mid-1970s
• The general fund has a substantial negative unrestricted fund balance (minus $69 million as of June 30, 2008)
• The state is running out of cash

Conclusion
For years the state has dealt with its cash shortage through an intricate system of inter-fund borrowing.  That cannot last too much longer, because all fund groups are now starting to run out of cash.  SNW Asset Management believes the state must resolve not just the current budget impasse but also its unsound financing practices and systemic imbalance between expenditures and real revenues.  Although the governor and the legislature have announced agreement on an updated budget, important details have apparently not been finalized, and no comprehensive text has yet been published.  We believe that to this point the state has not carried its burden of proof that it is committed to sustainable and sound budgetary discipline and that it will follow better budgetary and financial practices in the future.  We therefore see no reason to alter our view of the state’s financial outlook, nor to discontinue either our systematic sale of the state’s general obligation bonds or our continuing caution with respect to new purchases of bonds issued by the state’s hard-pressed municipalities.

Fiscal Practices

• Maturities between 1 and 10 years
• Due diligence on the underlying credit
• Diversification by sector, issuer and geographic region
• Continuously monitor the fundamentals of each credit

What We Are Buying

• Average duration between 2 to 4 years
• Healthy credits with balance sheet flexibility
• Pre-refunded bonds
• Select general obligation bonds
• Select revenue bonds

Examples:

• Select Community College and School District General obligation bonds that receive a stated percentage of the annual California state budget because of the issuer’s preferential position in the state’s constitution
• Issuers who have pricing power as the low cost provider of a service and can raise fees and issuers who provide essential services in communities that will weather the recession such as select water, sewer, and irrigation districts
• Issuers whose revenue sources are diversified and who are not excessively leveraged