municipal bond outlook - december 2013

INVESTMENT PROFESSIONALS

B. SCOTT MINERD

Global Chief Investment Offi cer

ANNE B. WALSH, CFA

Assistant Chief Investment Offi cer, Fixed Income

JAMES PASS

Senior Managing Director, Portfolio Manager

ALLEN LI

Director, Portfolio Manager

CHRIS RANDALL

Vice President, Trader

DAVID A. STONE

Analyst, Credit Research

KELECHI C. OGBUNAMIRI

Vice President, Investment Research

DECEMBER 2013

Municipal Market Outlook

The structural issues that have plagued the municipal sector for decades have received widespread media coverage over the past three years. The severity of pension shortfalls, the sector’s worst kept secret, fi nally came to light and individual investors responded by withdrawing $50 billion from municipal bond funds in 2013. Despite the signifi cant obstacles facing specifi c issuers, such as Illinois, Puerto Rico, and Detroit, these isolated instances are not representative of the highly diverse $3.7 trillion municipal market.

Current sentiment is reminiscent of December 2010, when dire forecasts of widespread defaults resulted in $16 billion of municipal bond fund outfl ows over a two-month period. At the time, we stated that the “blanket misperception of credit deterioration across the asset class has led to wider spreads for even the most creditworthy municipal debt issuers.” (See "Opportunities in Municipal Finance" Q4 2010) Actual default activity paled in comparison to the magnitude predicted, and market hysteria subsequently abated. The sector produced 11 percent annualized returns in 2011, outpacing both equity and corporate bond markets. We believe current headline risk has created a similarly attractive opportunity for fundamentally driven investors.

REPORT HIGHLIGHTS:

• With $50 billion in capital withdrawn from municipal bond funds this year, individual investors are clearly operating under a “sell fi rst, ask questions later” mentality, similar to what occurred following Meredith Whitney’s now infamous prediction of fi nancial Armageddon in the municipal market in late 2010.

• The fi nancial media’s fi xation on troubled issuers has created the perception that fi scal conditions are deteriorating across the United States. In reality, the overall fi scal picture is improving as U.S. state and local tax revenues in the second quarter of 2013 rose 8.9 percent, the 14th consecutive quarter of growth.

• We see attractive opportunities in areas of the market recently vacated en masse by investors, such as intermediate to longer-duration bonds, and select revenue bonds of distressed cities. For investors with the ability to decipher the complex municipal market, we believe current market dislocations off er the opportunity for attractive returns.

INSTITUTIONAL INVESTOR COMMENTARY MUNI • HY • ABS • CMBS • RMBS

http://guggenheimpartners.com/GP/media/pdf/QuarterlyInvestmentFocus4Q2010.pdf

MUNICIPAL MARKET OUTLOOK | Q1 2014

SOURCE: THOMSON REUTERS. SPREADS RELATIVE TO TREASURIES FOR TAXABLE MUNICIPALS, AND LIBOR FOR TAX-EXEMPT MUNICIPALS. DATA AS OF DECEMBER 06, 2013.

Municipal Market ScorecardAS OF MONTH END

TAXABLE MUNICIPALS

Dec-12 Oct-13 Nov-13 Dec-13

Spread Yield Spread Yield Spread Yield Spread Yield

10-year AAA GO 57 2.30% 75 3.29% 75 3.49% 75 3.63%

10-year A GO 157 3.30% 148 4.02% 148 4.22% 148 4.36%

30-year AAA GO 77 3.69% 94 4.57% 88 4.70% 84 4.75%

30-year A GO 152 4.44% 148 5.11% 133 5.15% 129 5.20%

TAX-EXEMPT MUNICIPALS

Dec-12 Oct-13 Nov-13 Dec-13

Spread Yield Spread Yield Spread Yield Spread Yield

10-year AAA GO (7) 1.72% (25) 2.44% (18) 2.65% (18) 2.76%

10-year A GO 65 2.44% 50 3.19% 61 3.44% 63 3.57%

30-year AAA GO 8 2.83% 45 4.04% 35 4.10% 37 4.20%

30-year A GO 75 3.50% 117 4.76% 113 4.88% 116 4.99%

BARCLAYS MUNICIPAL BOND INDEX RETURNS BY TYPE BARCLAYS MUNICIPAL BOND INDEX RETURNS BY RATINGS

SOURCE: BARCLAYS. DATA AS OF DECEMBER 06, 2013.

■ 2012 ■ 2013 YTD ■ 2012 ■ 2013 YTD

-6%

-8%

-4%

-2%

2%

0%

8%

6%

4%

14%

12%

10%

General Obligation Revenue Build America Bonds(BABs)

5.6%

-5.6%

-2.5%

7.8%

12.1%

-3.1%

6%

4%

-6%

-8%

10%

8%

-2%

-4%

2%

0%

14%

12%

AAA AA A BBB

4.5%

-1.8%

6.2%

-2.3% -2.8%

8.2%

9.8%

-6.5%


Seeing the Forest From the TreesVOLATILITY INDUCED BY HEADLINE EVENTS HAS CREATED ATTRACTIVE MARKET OPPORTUNITIES

The fi nancial media’s fi xation on troubled issuers has created the perception that fi scal

conditions are deteriorating across the United States. In reality, the overall fi scal picture is

improving as U.S. state and local tax revenues in the second quarter of 2013 rose 8.9 percent,

the 14th consecutive quarter of growth. However, the pace of recovery has been uneven,

underscoring the need for security-level analysis. Rather than conducting the requisite

analysis needed to bifurcate the truly at-risk issuers from the healthy ones, it appears that

many investors have chosen instead to fl ee the municipal market. With $50 billion in capital

withdrawn from municipal bond funds this year, individual investors are clearly operating under

a “sell fi rst, ask questions later” mentality, similar to what occurred following Meredith Whitney’s

now infamous prediction of fi nancial Armageddon in the municipal market in late 2010.

Historically, the performance of the market has largely been driven by expectations on tax

policy and interest rates, with credit risk a distant, tertiary concern. Actual municipal bond

defaults since 2011 total $16.4 billion, representing just 0.4 percent of the $3.7 trillion market –

contrary to the prediction of “sizable defaults totaling hundreds of billions of dollars.”

While defaults still remain low on an absolute basis, and relative to investment-grade

corporate bonds, increased credit risk, nonetheless, represents a signifi cant paradigm shift

in the psyche of the municipal investor. The recent spate of municipal bankruptcies (Jeff erson

County, Alabama in November 2011, Stockton, California in July 2012, and Detroit, Michigan

in July 2013) represents unfamiliar territory for an investor base not accustomed to dealing

with signifi cant credit risk.

“The municipal market fi nds itself at a critical infl ection point. From tapering fears to municipal bankruptcies, the resolve of investors has been tested. In response, mutual funds have experienced massive outfl ows, similar to 2010, when dire default forecasts shook investor psyche. We believe the market’s strong aversion to risk during this time of interest-rate uncertainty has created attractive investment opportunities, particularly in the long end of the curve.”

– Scott Minerd, Global CIO

RECENT FUND FLOW BEHAVIOR REMINISCENT OF WHITNEY EFFECT

SOURCE: LIPPER. DATA AS OF SEPTEMBER 30, 2013.

2008 2009 2010 2011 2012 2013

$8.0Bn

$6.0Bn

$4.0Bn

$2.0Bn

$0.0Bn

($2.0Bn)

($4.0Bn)

($6.0Bn)

($8.0Bn)

The Whitney Effect

Negative headlines have led to $50 billion in year-to-date municipal bond fund outfl ows, similar to what occurred in 2011 following Meredith Whitney’s infamous prediction of widespread defaults in the municipal market. Following two consecutive quarters of negative returns, the municipal sector is down nearly 3 percent year-to-date in 2013.


In 2005, 57 percent of municipal bonds were ‘wrapped,’ or insured by monolines, guaranteeing

interest and principal payments to investors. Given this additional layer of security, 79 percent of

bonds in the Barclays Municipal Bond Index were rated ‘AAA’ that year. Such pristine ratings gave

investors a false sense of security, masking the inherent risks and complexity of the sector.

Amid solvency concerns of the leading monoline insurers following the 2008 fi nancial crisis,

municipal insurance quickly become a relic of the past: today only 5 percent of bonds are insured.

Diminutive Size Belies Its ComplexityFRAGMENTED NATURE OF ISSUER AND INVESTOR BASES CREATES MARKET DISLOCATIONS

Although less than half the size of the corporate bond market, the municipal market has

roughly six times as many issuers and approximately 1.5 million securities compared to 40,000

for the corporate bond market. Municipal bond issuance is diversifi ed regionally, by sector,

and repayment source, with issuance generally taking one of three forms.

General obligation (GO) bonds are secured by the pledge of the municipality’s full faith,

credit, and taxing power. The primary source of repayment for GO bonds is property taxes

at the local level and a combination of income tax and sales tax at the state level.

Revenue bonds are secured by claims on non-tax revenues derived from tolls or fees

associated with the project or facility being fi nanced by the bond issue. Projects fi nanced

by revenue bonds generally include water/sewer facilities, public power/utilities, airports,

and toll roads.

Appropriation-backed bonds are secured by a “promise to pay” backed by legislatively

approved appropriations. Typically, appropriation bonds carry a rating one notch lower

than an issuer’s GO bonds since the sources of interest and principle payment can be

directly, and possibly, adversely, impacted by legislation.

The composition of the investor base has evolved considerably over the past 30 years. In 1980,

banks’ share of the municipal market totaled 40 percent. By the end of 1990, their share had

fallen to 12 percent, largely due to new regulations. For example, a provision of the Tax

Reform Act of 1986 limited banks’ deduction of interest expense on borrowed capital used to

purchase municipal bonds. Banks now represent 11 percent of the market. Individual investors

(through either direct investment or through mutual funds) currently comprise 73 percent of

the municipal bond market, compared to 15 percent ownership of investment-grade corporate

bonds. High net-worth individuals are particularly attracted to municipal bonds due to the

sector’s high credit quality and tax-exempt status. Municipal bond interest income is exempt

from federal taxes and, in some cases, also from state and local taxes.

1

2

3


Individuals Banking Institutions Mutual Funds Insurance Companies Other

40%

10%

0%

50%

20%

30%

60%

1980 1982 1984 1986 1990 1992 1996 1998 2000 2002 2004 2006 2008 20101988 1994 2012

Banking Institutions

Individuals

The Barclays Municipal Bond Index contains bonds from all 50 states, in addition to the District

of Columbia, Guam, and Puerto Rico. Given the inherent challenges in analyzing such a diverse

array of investments, each subject to its own unique set of risk considerations, an investor

base dominated by individual investors seems incongruous. Historically, exceptionally strong

credit quality has helped overcome this investment hurdle. Since 1970, the average 10-year

cumulative default rate is 12 basis points, compared to 278 basis points for investment-grade

corporate bonds. However, with credit concerns rising, the importance of individual security

selection is magnifi ed and made more diffi cult by structural challenges such as unfunded

pension liabilities, population trends, and other post employment benefi ts (OPEB).

Structural Headwinds PENSION CONCERNS CAST A LONG SHADOW ON U.S. FISCAL HEALTH

While the revenue side of the U.S. fi scal ledger exhibits gradual but steady improvement, it is

the liability side that investors must be wary of. Long overlooked by municipal credit analysts

and government offi cials, pensions quickly rose to prominence following the 2008 fi nancial

crisis as unfunded obligations ballooned. Estimates on the magnitude of pension funding

shortfalls vary dramatically, primarily due to diff erences in asset return assumptions. A recent

study by Northwestern University puts the total unfunded pension liability for U.S. cities and

counties at $574 billion, adding to the $3 trillion in estimated U.S. state unfunded pension

liabilities. Illinois, one of the biggest agitators for pension reform, has a funding ratio of 40

percent, the lowest of any U.S. state.

PUBLIC POLICY HAS PLAYED AN INTEGRAL ROLE IN SHAPING INVESTOR BASE

SOURCE: FEDERAL RESERVE. DATA AS OF JUNE 30, 2013.

Regulatory changes and public policy decisions have contributed to waning demand for municipal bonds from commercial banks. Over the past 30 years, banks’ market share has fallen to 11 percent from 40 percent, as individual investors have become the biggest holders of municipal debt.


The intense scrutiny placed on pension obligations has obscured investors’ attention from

OPEB burdens, which we believe pose as signifi cant a risk. A November 2013 report by Pew

Charitable Trusts showed that the 30 most populous metropolitan U.S. cities faced $225

billion in aggregate unpaid commitments – $121 billion for pensions and $104 billion for OPEB.

OPEB are retiree benefi ts covering healthcare costs. Relative to pension liabilities, the lack of

transparency regarding OPEB has led to decreased attention from rating agencies, investors,

and politicians.

U.S. STATE PENSION FUNDING LEVELS

SOURCE: U.S. CENSUS BUREAU. DATA AS OF SEPTEMBER 30, 2013.

Long overlooked by municipal credit analysts and government offi cials, pensions quickly rose to prominence following the 2008 fi nancial crisis. Illinois, one of the biggest proponents for pension reform, currently has a funding ratio of 40%, the lowest of any U.S. state.

Above 90%80% to 90%70% to 80%60% to 70%Under 60%

Represents percent of state pension obligations that are currently funded

CA

NV

AZ

UT

IDOR

WA MT

WY

CO

NM

AK

TX

OK

KS

NE

SD

NDMN

IA

MO

AR

LAMS AL

HI

FL

GA

TN

KY

IL

WI MI

IN OH

WV

SC

NC

VA

PA

NYVT

NH

ME

MARI

CTNJ

DEMD

LOW RESERVES WEIGH ON THE FISCAL HEALTH OF U.S. CITIES

SOURCE: WALL STREET JOURNAL. DATA IS BASED ON THE PUBLIC FILINGS OF THE 250 LARGEST U.S. CITIES THAT HAVE REPORTED THEIR 2012 FINANCIAL RESULTS AS OF AUGUST 2013.

With expenditures exceeding total fund balances in select cities, it is important to understand your source of repayment. The risks of low reserves are amplifi ed for holders of appropriation-backed bonds, which rely on general fund balances to service debt.

RANK CITYFUND BALANCE

TO EXPENDITURES RANK CITYFUND BALANCE

TO EXPENDITURES

1. Detroit, Michigan -27.1% 6. Paterson, New Jersey 0.1%

2. Glendale, Arizona -21.2% 7. New York, New York 0.7%

3. Providence, Rhode Island -3.4% 8. New Haven, Connecticut 1.7%

4. New Orleans, Louisiana -1.8% 9. Bridgeport, Connecticut 2.4%

5. Allentown, Pennsylvania -0.9% 10. Philadelphia, Pennsylvania 2.7%

MEDIAN FOR 250 LARGEST CITIES: 26.8%


The widespread coverage of the municipal sector in the fi nancial media has put investors on

alert, seeking to identify the “next Detroit.” However, the next signifi cant credit event in the

municipal market is unlikely to catch investors by surprise, just as Detroit’s travails were fairly

well telegraphed. Unlike credit events in the corporate bond market that can arise suddenly,

the factors contributing to Detroit’s $18 billion bankruptcy (growing debt, large pension liabilities,

the economic deterioration of the auto industry, etc.) were easily observable for decades.

Since 1950, the city of Detroit has experienced a 61 percent drop in population, resulting in large

debt burdens being serviced by an increasingly smaller tax base. Detroit’s direct debt equals 12

percent of the city’s property valuation (rising to 23 percent when including pension obligations).

The experiences of Detroit, Illinois and Puerto Rico serve as catalysts for change, usually in the

form of pension reform or renewed fi scal conservatism. The challenges faced by the municipal

sector have shed light on its complexity, which has long been underappreciated. Current fi scal

headwinds in select municipalities can off er investors, who are able to identify strong, improving

credits, an attractive entry point to the municipal markets.

Detroit, Illinois, and Puerto Rico have long represented the poster children of the municipal market’s problems. Despite the pervasiveness of the issues aff ecting each, it is important to remember that these are isolated instances and far from representative of the aggregate municipal market.

MUNICIPAL PROBLEM CHILDREN

SOURCE: MOODY’S, BLOOMBERG. DATA AS OF SEPTEMBER 30, 2013.

• Population declined 25% since 2010, and 61% since 1950

• Labor force has shrunk by 9.3% over the past 10 years, compared to 5.8% growth of aggregate U.S. labor force

DETROIT, MICHIGAN

• General fund defi cit increased by 32.5% between 2009 and 2012

• $70 billion debt burden, with net tax-supported debt as a percentage of personal income increasing to 89% from 66% in 2008

• Widely held in U.S. municipal bond funds due to its triple tax exemption

PUERTO RICO

• In fi scal year 2011, net pension liability was 241% of revenues

• Lowest rated U.S. state municipal issuer

ILLINOIS

ON AN AGGREGATE BASIS, DETROIT, PUERTO RICO, AND ILLINOIS DEBT REPRESENT JUST 8.2% OF BANK OF AMERICA MUNICIPAL MASTER INDEX.


Investment ImplicationsTURNING CURRENT CHALLENGES INTO FUTURE OPPORTUNITIES

The market’s disproportionate fi xation on select credit issues creates opportunities for

sophisticated investors with the ability and resources to evaluate credits throughout the highly

diverse $3.7 trillion municipal market. Devising an investment strategy to take advantage of

current market dislocations relies both on optimal positioning on the yield curve as well as

identifying credits off ering strong structural protection. Amid the massive wave of bond fund

outfl ows, there has been a reallocation of capital by individual investors. The majority of this

year’s net municipal bond fund withdrawals have come out of longer-maturity funds. This can

be partly attributed to interest-rate concerns, given the higher duration of longer-dated bonds,

but the composition of the investor base has also played a role.

As the market share of individual investors has increased to 73 percent from 34 percent in 1980,

this has created a dearth of demand for longer-term municipal bonds. Individual investors

are naturally predisposed to shorter-dated debt to meet their near-term income needs.

Additionally, property & casualty (P&C) insurance companies, another key buyer of municipal

debt, also prefer shorter-term bonds as they seek to maintain a liquid, high-quality portfolio to

meet unexpected liquidity requirements. Devoid of a natural buyer, longer-dated bonds represent

an area of the municipal market we fi nd attractive. The 5s/30s single A-rated slope (the diff erence

in yield between 30-year and 5-year tax exempt municipal bonds) has widened by 120 basis points

since the start of the year, while the corresponding U.S. Treasury slope has remained fl at.

On the following page, we have included our Municipal Market Heatmap detailing the areas we

fi nd attractive. While it has become easier, over the years, to evaluate the fi scal health of U.S.

states, the analysis remains increasingly more diffi cult at the city and county level given the

localized nature of issues. We view this as a potential opportunity as local bonds typically trade

cheap to comparable state issued bonds. While varying from state to state, the yield pickup

between local GOs and state GOs is, on average, 25 basis points. The yield pickup increases

when comparing state GOs to local appropriation-backed bonds.

Another one of our investment themes is our preference for bonds secured by revenue streams

over local appropriation-backed debt. Bonds backed by dedicated revenue streams cannot

be diverted by the city, regardless of the city’s solvency status. The stigma associated with

distressed cities tends to impact essential service bonds, which may be structurally sound.

These situations can provide investment opportunities where capital can be deployed at yields

50 to 75 basis points higher relative to comparable credits without the associated headline risk.

Bonds backed by water and sewer utility systems are good examples as they have proven to be

well-insulated from impairment, even in situations of local government bankruptcies, such as

Detroit or Stockton. Since utilities provide an essential service, delinquencies tend to be muted

even in economically strained areas.


Without understanding the specifi c source of repayment, it is diffi cult to make informed

investment assessments on the risks of a particular municipal bond. Similar to corporate credit,

hierarchy within the capital structure matters. For example, being an unsecured creditor to

the general fund of distressed municipality is materially diff erent than owning a secured claim

backed by a dedicated revenue stream within that same municipality.

Analyzing a complex and fragmented market where many issuers have signifi cant structural

challenges takes a signifi cant amount of resources. Absent these resources, it is diffi cult to

see the trees through the forest, which explains the massive withdrawals from municipal

bond funds. Given the 27 percent year-to-date rally in equities, the municipal sector’s negative

performance has investors questioning its investment merit. However, we believe this is

an inopportune moment to allow headline noise to color one’s fundamental view. We see

attractive opportunities in areas of the market recently vacated en masse by investors,

such as intermediate to longer-duration bonds, and select revenue bonds of distressed cities.

For investors with the ability to decipher the complex municipal market, we believe current

market dislocations off er the opportunity for strong returns.

MUNICIPAL MARKET HEATMAP

SOURCE: GUGGENHEIM INVESTMENTS. DATA AS OF SEPTEMBER 30, 2013.

Given the current condition of state and local fi nances, we are underweight local appropriation-backed bonds which, in some instances amount to unsecured “promise to pay” obligations. We prefer bonds backed by essential services, such as utilities, which represent secured claims backed by dedicated revenue streams.

TAX SUPPORTED

SECTOR VIEW

State LIKEAppropriation, Lease & Pension NEUTRAL

Local LIKEAppropriation, Lease & Pension DISLIKE

Dedicated Tax LIKE

REVENUE

SECTOR VIEW SECTOR VIEW

Transportation HealthcareState POSITIVE Private NEUTRALLocal NEUTRAL Public LIKEToll-way NEUTRAL Tobacco DISLIKEAirport POSITIVE Utility (includes Water, Sewer, Electric) LIKE

Higher Education HousingPrivatete NEUTRAL Singlete LIKEPublic LIKE Multi NEUTRAL

Militarye LIKE

POSITIVE

POSITIVE

POSITIVE

POSITIVE

POSITIVE

POSITIVE

POSITIVE

POSITIVE

POSITIVE

NEGATIVE

NEGATIVEPOSITIVE

CONTACT US

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330 Madison Ave | 10017212 739 0700

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227 W Monroe St | 60606312 827 0100

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LONDON

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municipal bond outlook - december 2013

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