You are on page 1of 4

T RIDENT

MUNICIPAL RESEARCH
Municipal Market Weekly Thursday, February 6, 2014

MUNIVERSES

verse one surveying the horizon

Don’t Blame the Weather
Twitter reported its first quarterly results as a public company this week. The results were disappointing in terms of user growth, sending the stock price down nearly 25%. We immediately saw comments from many wags saying “they should blame it on the weather.” Can the municipal market’s big news of the week also be blamed on the weather? Sadly, no. Puerto Rico officially joined the ranks of non-investment grade credits when Standard & Poor’s downgraded the Commonwealth’s GO and GDB ratings to BB+ on Tuesday. Last week TMR discussed the rock and a hard place between which the island has found itself vis-à-vis the rating agencies. However, Puerto Rico’s woes do not change our view that broader municipal market offers a respite from the stormy weather plaguing global markets. Liquidity could still be a concern for municipals, but the other major risks that confront municipals; tax policy, general credit, and interest rates seem to be favorable to neutral. Weakness in commodities markets such as copper and gold are bellwethers showing that deflationary and inflationary risks are somewhat balanced. Without inflationary pressures, interest rates are likely to remain contained in recent ranges. We’ve discussed the favorable environment for credit and tax policy in recent MuniVerses. That leaves liquidity. Part of the sell off in municipals during 2013 was triggered by portfolio managers selling higher quality municipals in response to outflows of funds. When the need to sell arises, portfolio managers tend to sell the most liquid positions, rather than the the most problematic credits such as Puerto Rico or Illinois. If the latest storm clouds trigger additional selling, we would expect it not to be isolated to Puerto Rico. However, as in 2013, the resulting sell-off would be a significant opportunity. In a positive sign, and a sign that markets may have already begun to discount Puerto Rico’s problems, there was no evidence of the announcement causing the kind of knee-jerk flight from municipal credit that we saw during the second half of 2013 as Puerto Rico fears began to gain wide circulation. Broad based municipal yields were relatively stable and investors continued to contribute net inflows to municipal base bond funds. In short, while Puerto Rico remains the municipal market’s entry in the looming Emergency Markets turmoil, it’s woes are isolated from the broader market. With the equity markets also inflicting the equivalent of a polar vortex driven winter storm on investor portfolios, many sectors of the municipal market offer a sunny vacation spot.
TRIDENT MUNICIPAL RESEARCH, LLC A JOINT VENTURE OF ARBOR RESEARCH & TRADING, LLC & ALPRION CAPITAL MANAGEMENT LP

The theme of this week's MuniVerses is bad weather.

In the absence of inflationary pressures, we expect rates to remain below 3.0% for 10Y US Treasuries.

No Contagion Here:
zzPuerto Rico's woes did not dampen investor appetite for Il linois' $1B borrowing this week. zzShorter maturities were over 10x subscribed.

T RIDENT
MUNICIPAL RESEARCH

MUNIVERSES

Municipal Market Weekly Thursday, February 6, 2014

verse two following the currents

California Drought Overview
As we sit in our New York office, we look out upon a sea of grey, composed of dirty snow, dirty slush and puddles as large as the Great Lakes. Water would appear to be the least of of our concerns. New York’s reservoir (located upstate) levels are currently in excess of 90% capacity. Unfortunately, this abundance of H20 cannot be transferred to California, which is suffering its worst drought in decades. The potential of a water crisis to stunt the State’s economic resurgence, in particular the agricultural sector, should not be discounted as a credit concern. The California Department of Water Resources (DWR) recently took an unprecedented action to conserve the existing water supply by imposing strict restrictions on water use. Beyond limits on watering lawns, washing cars or serving water in a restaurant unless requested, the DWR has dropped the State Water Project (SWP) allocation to zero in order to preserve remaining supplies. Enough water will flow to maintain public health and safety and to maintain reservoir levels to keep salt water from seeping into the Sacramento-San Joaquin River Delta and damaging the water supply. The State Water project was created in 1960 via a voter approved $1.75 billion bond issue to improve the retention and distribution of water. While serving households and businesses, the system irrigates crops in the San Joaquin Valley, the world’s most productive agricultural region. Over 80% of the SWP water supply is used for agricultural purposes. Water short farmers are expected to fallow thousands of acres creating additional economic pressure on many farming communities. The current drought creates potential environmental issues as well. Farmers will pump increasing amounts of groundwater, further depleting overtapped aquifers. Several proposals have been made by the state administration and legislature. The Senate President is preparing a $644 million emergency drought relief bill that would fast track water supply projects and expanded use of recycled water and other conservation measures. In the long term, Gov. Brown is proposing a $15 billion plan to build two massive water tunnels to ship water from Northern California to the more water-use intensive areas in the Southern part of the state. In the meantime, local water agencies will face the decision whether to push for rate increases to offset decreased revenues due to reduced water usage. Higher rates are always politically unpopular, but a prolonged period of drought could make rate hikes necessary. Water agencies have been enjoying an improved credit profile along with the rest of the Golden State, for example Moody's recently reported that the median Debt Service Coverage for local agencies has rebounded to 2.7x in 2013 from 2.0x in 2010. The drought could challenge that continued recovery.
TRIDENT MUNICIPAL RESEARCH, LLC A JOINT VENTURE OF ARBOR RESEARCH & TRADING, LLC & ALPRION CAPITAL MANAGEMENT LP

California State Water Project
zz34 reservoirs, lakes and storage facilities zz20 pumping stations zz5 hydroelectric power plants zz700 miles of aqueducts and pipes

S&P comment:
zzMost local water district debt have adequate cash reserves to cover a period of reduced revenues from water sales. zzDebt service coverage above 1x provides some cushion for fluctuations.

T RIDENT
MUNICIPAL RESEARCH

MUNIVERSES

Municipal Market Weekly Thursday, February 6, 2014

verse three charting the course

Curve Allocations
As we briefly mentioned in Verse One, we don’t see any indications of risks for inflationary pressures that would drive rates significantly higher. On the other hand, the stability of the continued moderate US economic recovery means the scope for further decreases in interest rates is also somewhat limited. When the fundamentals don’t give a clear picture of what the trend in interest rates should be, it is often useful to turn to technical analysis to get a sense of the potential resistance and support levels that could contain the market until fundamentals begin to give a clearer picture. Our friends at Arbor Quantitative Analytics (AQA) provide a support and resistance zones for various time frames. The current monthly resistance levels of 2.51-2.56% on the 10Y US Treasury have held during the recent rally, suggesting to us at TMR that further weakening in the underlying fundamentals would be needed to drive rates lower. The chart below shows the curve rolldown potential of various points of the municipal curve, adjusted for yield volatility. What this means is, assuming that the shape and level of the yield curve doesn’t change, what total return would be generated by, for example, holding a 10Y bond for one year until it becomes a 9Y bond. The total return would be the interest earned during a year and the price appreciation of “rolling down” a steep yield curve. The current yield curve spread for 10Y to 9Y bonds is approximately 14bp right now. This total return is then adjusted for the fact that shorter maturities tend show more yield volatility than longer maturities. As the chart shows, the 10Y sector actually offers less incremental risk adjusted return than shorter maturities and the increased return potential for maturities longer than 20Y is marginal.
5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0%
5Y 10Y 15Y 20Y 25Y 30Y

Thesis: TMR would favor moving in the yield curve and avoiding both the 10Y sector and the 25Y+ end of the curve. A barbelled maturity exposure in 7Y and 20Y offers the best value. Confidence: Medium Concerns: If interest rates resume their decline, investors could shift more assets to longer maturities and cause 25Y+ maturities to outperform.

Curve Rolldown Total Return
3.925% 2.746%

2.311%

TRIDENT MUNICIPAL RESEARCH, LLC A JOINT VENTURE OF ARBOR RESEARCH & TRADING, LLC & ALPRION CAPITAL MANAGEMENT LP

T RIDENT
MUNICIPAL RESEARCH

MUNIVERSES

Municipal Market Weekly Thursday, February 6, 2014

verse three charting the course

About TMR
Trident Municipal Research, LLC ("TMR") is a joint venture of Arbor Research & Trading, Inc and Alprion Capital Management LP focused on providing high-quality, independent research for the municipal bond market. Arbor Research & Trading, LLC (“Arbor”) is an institutional research and brokerage firm that produces innovative research across a broad range of global fixed-income, equity, currency, and commodity markets. In addition, Arbor's trading desk provides comprehensive issue discovery and high quality execution in the fixed income and currency markets. Unencumbered by the biases of holding positions or underwriting securities, Arbor offers objective viewpoints and intelligent solutions for portfolio managers and traders world-wide through a proprietary menu of independent and innovative research products designed to work in conjunction with clients and their systems. Founded in 1988, Arbor has a long history of delivering innovative, technology-based products to many of the largest and most influential financial institutions world-wide. As the landscape of global financial markets has changed, Arbor has adhered to its mission, providing clients with timely analysis, objective opinion and first- class execution. Alprion Capital Management LP (“Alprion”) is a New York-based investment manager focused on the municipal sector. Alprion was founded in 2010 by a team of fixed income professionals with backgrounds in municipal credit and fundamental credit analysis.

Contributors
Bart Mosley, Co-President Rob Novembre, Co-President Jason Hannon, Capital Markets Team Ken Kollar, Capital Markets Team Steven D Schrager, Credit Consultant We, the Contributors, hereby certify that all of the views expressed in this report accurately reflect our personal views about any and all of the subject sectors, industries, securities, and issuers. No part of our compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

DISCLAIMER
This communication is for informational purposes only. This is not an offer or a solicitation of an offer to buy or sell any instrument or security. This document contains certain forward-looking statements and projections. Such state ments and projections are subject to a number of assumptions, risks and uncertainties which may cause actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by these forward-looking statements and projections. Prospective investors are cautioned not to invest based on these forward-looking statements and projections. Certain information contained herein has been supplied to Arbor and Alprion by third parties. While Arbor and Alprion believe such sources are reliable, it cannot guarantee the accuracy of any such information and does not represent that such information is accurate or complete.

Sales & Inquiries

Max R. Konzelman Vice President Arbor Research & Trading, LLC. max.konzelman@arborresearch.com

THIS DOCUMENT IS NOT AN OFFER TO SELL OR THE SOLICITATION OF AN OFFER TO BUY INTERESTS IN A FUND MANAGED BY ALPRION CAPITAL MANAGEMENT LP OR RELATED ENTITIES. AN OFFERING OF INTERESTS WILL BE MADE ONLY BY MEANS OF A CONFIDENTIAL PRIVATE PLACEMENT MEMORANDUM AND ONLY TO QUALIFIED INVESTORS IN JURISDICTIONS WHERE PERMITTED BY LAW. THIS MATERIAL IS FOR YOUR PRIVATE INFORMATION, AND WE ARE NOT SOLICITING ANY ACTION BASED UPON IT. THIS MATERIAL SHOULD NOT BE REDISTRIBUTED OR REPLICATED IN ANY FORM WITHOUT PRIOR CONSENT OF TRIDENT MUNICIPAL RESEARCH. THE MATERIAL IS BASED UPON INFORMATION THAT WE CONSIDER RELIABLE, BUT WE DO NOT REPRESENT THAT IT IS ACCURATE OR COMPLETE, AND IT SHOULD NOT BE RELIED UPON AS SUCH.

www.tridentmunicipal.com

TRIDENT MUNICIPAL RESEARCH, LLC A JOINT VENTURE OF ARBOR RESEARCH & TRADING, LLC & ALPRION CAPITAL MANAGEMENT LP