Mechanics of Finance: Municipal Finance

MILKEN INSTITUTE CENTER FOR FINANCIAL MARKETS N AT I O N A L P R E S S F O U N D AT I O N T U E S D AY, N O V E M B E R 1 2 , 2 0 1 3

Historical Interest Rate Yield: 2008-2013

5
4.5 4
Nov 2010 July 2009
QE1 expanded

Mar 2010
QE1 ends

10 Year UST

10 Year AAA

Jul 2011
QE2 ends QE2 announced

3.5 3
Sep 2008
Lehman Bros. Bankruptcy Fannie Mae and Freddie Mac conservatorship Treasury guarantees money market mutual fund

Apr 2012
Italian and Spanish bond yields spike

Yield (%)

2.5 2 1.5

Feb 2009
Financial Stability Plan announced Recovery ACT signed

Jul 2010
Dodd-Frank ACT signed into law TARP investment authority reduced and limited to existing programs

Sep 2011
Operation Twist announced

1
0.5 0

May 2013
Bernanke discusses tapering

Data Source: Bloomberg

Muni Bonds: Where we are now

Source: Morgan Stanley - Municipal Bond Monthly Oct 2013

Muni Bonds Holders

Households are the largest holders of municipal bonds Households include farm households, domestic hedge funds, private equity funds, and personal trusts (pension account) Excludes bonds owned indirectly, such as through mutual funds, which hold about $528 billion
Foreign Holdings 2% Closed-end Funds 2%
Mutual Funds 17% Money Market Funds 8% Insurance Companies 12% Brokers and Dealers Other 1% 3%

Households 44%

Total Outstanding Debt Held ($ Billions)

2000 1800 1600 1400 1200 1000 800 600 400 200 0 2008 2009 2010 2011 2012

Commercial Banks 11%

The trend is gradually changing Mutual funds and commercial banks are increasing their presence in this market

Households
Money Market Funds

Commercial Banks
Mutual Funds

Insurance Companies

Data Source: Q2 2013 Flow of Funds, Fidelity Capital Markets

Muni Bond Issuance

500 450 400 350 300 250 200 150 100 50 0
Revenue bonds as a percentage of total issuance

80% 70%

60%
50% 40% 30% 20%

in $bn

10%
0%

2011

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2012

GO

Revenue

Private Placement

Municipal bond issuance is far below the 2010 levels Majority of municipal market is composed of revenue bonds

2013 YTD
Data Source: SIFMA

New-Issue Supply
500 433 429 450 410 408 390 387 383 379 400 360 358 350 295 288 287 300 251.1 228 221 250 201 185 200 150 100 50 0 70%
60%

50%
40% 30% 20% 10%

in $bn

0%

2011

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2012

Total Municipal Issuance

Refunding as % of Total Issuance

New dollar issuance New Issue supply in 2013 YTD ($251.1 bn) is at nearly 60% of what it was during its peak in 2010 which reflects ongoing austerity measures at both the state and local levels Overall, refunding and maturities continue to marginally outweigh the new money supply in 2013, creating a slightly net negative supply environment

2013 YTD

Data Source: SIFMA

Current State: Muni Finance

Source: Blackrock - Municipal Market Myths and Realities Aug 2013

Funded Ratios of State Public Pension Plans

Source: taxfoundations.org/maps

Credit Profile
Most U.S. State credit profiles are strong, but there has been select deterioration States are keeping their debt levels relatively flat

Municipals exhibit high credit quality versus corporates bonds

Source: Blackrock Municipal Market Myths and Realities

Source: Janney Fixed Income Strategy State Fiscal Health Update Oct 2013

Tax Treatment

As discount increases, the gap between YTM and After Tax Yield grows With the recent uptick in the interest rates, tax considerations have become more important than ever Increase in yields is leading to a fall in after tax yields for muni bonds

Source: Janney Fixed Income Strategy Muni Tax Considerations Aug 2013

Challenges: State
State Funding Status According to reports by Center on Budget and Policy Priorities, states have been forced to close $593bn in budget gaps from FY 2009 to FY2013 Largest gaps were closed by huge tax hikes in CA, CT, IL and MA netting $23.9bn in FY 2010 Unprecedented spending decline of 3.8% and 6.3% in FY 2009 and FY2010

Removal of Muni Bond Interest affects Municipalities Repeal in tax credit could affect creditworthiness of at risk municipalities

Source: Standard &Poors

Challenges: Detroit

Source: Detroit Free Press

Challenges: Puerto Rico

Trade volume of Puerto Rican bonds increased to $20bn from an average of $3bn-$5bn since September 75 percent of muni bond funds own Puerto Rico bonds (Morningstar funds)

70 60

50

($ billion)

40 30

103% of GNI

20
10 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 GNI, Atlas method (current US$) Public Debt

Commonwealth of Puerto Rico has not balanced its budget in twelve years Annual deficit financing has caused the islands debt-to-GNI ratio to rise. In 2010, it was 109%, compared to 64.8% in 2000

Data Source: World Bank and Government Development Bank of Puerto Rico; Moodys Analytics