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Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision.
For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report.
M O R G A N S T A N L E Y R E S E A R C H
North America
December 7, 2010
Municipal Strategy
Muni Outlook 2011 Risk Redefined
Strategy for a Market Coping with Unfamiliar Risks: Despite an improved macroeconomic backdrop, we anticipate the muni market will be punctuated by bouts of technical volatility due to still-elevated credit risks, an impulsive path higher for interest rates, and the potential for spillover from the European debt crisis. We recommend a low-volatility strategy that facilitates opportunistic risk-taking.
State and Local Government Credit Risks Remain Elevated But Revenue Bonds Will Show Stability: Despite expected cyclical revenue increases, substantial structural challenges to fiscal health will remain. It is our base case that austerity measures are forthcoming, but not of the scale necessary to offset this risk in the near-term. Most revenue bond sector fundamentals should fare better.
Technical Event Risk Greater Than Credit Event Risk: Outright defaults will likely remain low and idiosyncratic even as systemic risks continue to build. However, rising rates and curve volatility risk bouts of lower demand for the asset class, offsetting a key 2010 market strength.
What Happens in Europe Won’t Stay in Europe: US states don’t share near-term risks of European sovereignties in scale, but do share it in character. In our view, investors are unlikely to differentiate between the two, which will link muni performance, the European story, and success of states’ austerity measures.
Observations on the Role of CDS in 2011: We expect the muni CDS market to progress toward standardization, increase in size, and converge in price toward cash spreads, thus increasing the relevance to traditional cash investors as a pricing gauge.
Morgan Stanley & Co. Incorporated
Michael Zezas, CFA [email protected]
+1 212 761 8609
Ashley Musfeldt [email protected]
+1 212 761 1727
State Budget Solutions Gap
13% 15%
31%
4%
50%
81%
0
20
40
60
80
100
120
140
160
2011 2012
Projected Cyclical Revenue Growth Projected ARRA Aid Other Solutions
Source: Morgan Stanley Research, Center on Budget and Policy Priorities
Rate Volatility Impact on Munis
114
115
116
117
118
119
120
121
10/8/2010
90
95
100
105
110
115
SP Muni Index (LHS) USD 1Y10Y (RHS)
Munis Sell Off
Rate Volatility Spikes
Source: Bloomberg, Morgan Stanley Research
M O R G A N S T A N L E Y R E S E A R C H
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December 7, 2010 Muni Outlook 2011
Muni Outlook 2011: Risk Redefined
Michael Zezas, CFA (212) 761-8609
Strategy for a Market Coping With Unfamiliar Risks
We expect the macroeconomic backdrop for munis to improve markedly in 2011. However, persistent structural fundamental issues, an impulsive trajectory for interest rates, the coincident potential for negative returns, and the potential for spillover of European sovereign concerns are more likely to yield a market defined by technical volatility than one buoyed by growth-driven stability.
Accordingly, we recommend beginning 2011 with the following strategies:
Technical Stress Indicators Use sharp, upward moves in rates and/or equities as leading
indicators of a reversal in positive tax-exempt muni demand.
Exhibit 1
Demand Driven by High Muni Real Rate Advantage
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
6/30
/81
6/30
/83
6/30
/85
6/30
/87
6/30
/89
6/30
/91
6/30
/93
6/30
/95
6/30
/97
6/30
/99
6/30
/01
6/30
/03
6/30
/05
6/30
/07
6/30
/09
10Y RR to UST -1 stdev Mean +1 stdev Source: Morgan Stanley Research, Bloomberg, Municipal Market Data
Curve Positioning to Begin 2011 Neutral to short duration vs. intermediate tax-exempt
benchmarks to take advantage of 2s10s steepness with the Fed likely still on hold (see US Economics: US Economic and Interest Rate Forecast, Richard Berner et al., December 3, 2010).
Short duration vs. aggregate and long benchmarks due to projected bear steepening of the UST curve (see 2011 Global Interest Rate Outlook, Jim Caron et al., December 3, 2010) and high volatility in the long end of the muni curve due to an uncertain future for BABs beyond 2011.
Exhibit 2
MMD 2s10s Show Historical Steepness
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Dec-05 Oct-06 Aug-07 Jun-08 Apr-09 Feb-10 Dec-10
Source: Municipal Market Data, Morgan Stanley Research
Exhibit 3
Projected YE2011 UST Curve
0
1
2
3
4
5
6
YE11 2-Dec
3010520.50.25
Source: Morgan Stanley Research, Bloomberg
Credit Allocation Overweight revenue-supported credit vs. GOs on stable
fundamentals and political risk remoteness (see Water Rising: The Political Risk Alternative, August 2, 2010).
Overweight BABs vs. Corporates against taxable benchmarks on program extension and market growth diminishing the orphan and liquidity discount in spreads (see BABs for the Long Run, September 29, 2010)
In the near term, be a tactical buyer of GO BABs when credit tensions in Europe rise: credit correlation in the price of muni and European sovereign credit risk may increase, but 2011 muni default probability is low.
M O R G A N S T A N L E Y R E S E A R C H
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December 7, 2010 Muni Outlook 2011
Underweight local governments with above-average exposure to state revenues
States Still Stressed; Locals at Increased Risk
Despite projections of stronger economic growth in 2011 and indications that revenues have stabilized, the states’ budgets and cash flow will likely remain stressed. While the recent swing toward political support for austerity at the state level may facilitate important first steps toward credit repair in some areas, it is our view that solutions will lack sufficient scope and scale to offset these risks over the next year. Accordingly, political risk may increase while headline risk remains. While we maintain that, in 2011, the possibility of state defaults remains low and local defaults/bankruptcies should be idiosyncratic in nature, ongoing fundamental weakness erodes confidence in the asset class as a safe haven.
Exhibit 4
State Spending Outpaces GDP Ahead of Recession
30%
33%
36%
39%
42%
45%
48%
2001-2008
State Spending Nominal GDP
Source: US Census Bureau, Bloomberg
States continue to face their most significant fiscal challenges in at least a generation. Following a period of sustained increases in public expenditures that outpaced economic growth, states have suffered substantial revenue degradation in the most recent recession given peak-to-trough GDP declines that outpaced the previous two recessions. The result was budget gaps across states that were more structural (attributable to an imbalance in long-term expenditure vs. revenue growth) than cyclical (attributable to a temporary decline in economic activity). This problem was larger in scale than the previous two recessions due to comparatively higher budget gaps and unemployment levels.
Exhibit 5
Factors Impacting Revenues After Recessions
91-92 01-02 08-09
Peak-to-Trough GDP Decline -1.36% -0.27% -3.66%Cumulative State Gap For Following Fiscal Year ($B) $6 $75 $200 Last Recession Quarter 0.91% 0.30% -3.12%YOY Tax Rev % Change 1 Quarter Out 2.00% -0.12% -1.57% 2 Quarters Out 1.30% -0.60% 0.22% Last Recession Quarter 6.60% 4.83% 9.27%Unemployment Rate 1 Quarter Out 6.83% 5.50% 9.63% 2 Quarters Out 6.87% 5.70% 10.03%
Source: Bloomberg, Bureau of Labor Statistics, Center on Budget and Policy Priorities, San Francisco Federal Reserve, Morgan Stanley Research
We expect the structural gaps that have persisted since FY09 will continue in FY11 and FY12, but without the benefit of enhanced federal aid that was critical to balancing state budgets in FY09 and FY10 due to the spending sensitivities of the Republican majority in the US House of Representatives. While we recognize that many of the major revenue sources for states have stabilized, ongoing growth in those sources is unlikely to provide meaningful relief. Given the historical relationship between nominal GDP growth and the growth of state income, corporate, and sales tax revenues, we model an estimated cyclical growth of $21 billion for calendar 2011. This extra income only closes about 15% of the projected 50-state budget gap for FY12.
Exhibit 6
State Solutions Gap
13% 15%
31%
4%
50%
81%
0
20
40
60
80
100
120
140
160
2011 2012
Projected Cyclical Revenue Growth Projected ARRA Aid Other Solutions
Source: Center on Budget and Policy Priorities, Morgan Stanley Research
Accordingly, we expect mid-year FY11 budget revisions and FY12 budget negotiations will have to account for the remainder of the fiscal solutions, which will keep investor focus on political and execution risk.
M O R G A N S T A N L E Y R E S E A R C H
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December 7, 2010 Muni Outlook 2011
Execution Risk and the Politics of Austerity
While states have a considerable amount of options in addressing both the projected gap and their potentially unsustainable long-term liabilities, the political feasibility of exercising many of those options will remain low throughout 2011, in our view. Accordingly, the most likely set of adopted solutions will do little to mitigate these important credit risks in the near term.
Given that state budget gaps are largely structural rather than cyclical in nature, they represent stresses that will persist beyond the current economic cycle. Accordingly, gaps that are not addressed properly not only contribute to short-term liquidity risk but also decrease the long-term capacity of a municipal government to effectively cope with the burden of long-term liabilities, such as debt, pensions and other post-employment benefit (OPEB) liabilities. We argue that the latter stresses are the most relevant to bondholders: if they remain unaddressed, they could introduce political risk (or risk of willingness-to-pay) to the market. For example, the Pew Center on the States estimates that unfunded pension and OPEB liabilities of the 50 states are roughly $1 trillion. This equates to about nearly 150% of current annual state revenue. Accordingly, it is unlikely this liability can be fixed through revenue growth and/or enhancements alone. Furthermore, state-driven solutions that include more rapid amortization of pension and OPEB liabilities would substantially crowd out other policy expenditures.
Exhibit 7
Crowding-Out Effect of Pension Funding
0%
5%
10%
15%
20%
25%
30%
CA FL GA MA IL NJ
Interest Principal Pension OPEB Extra Pension
Crowding Out of Policy Spending
Source: Center for Retirement Research at Boston College; State CAFRs; Pew Center on the States Note: Extra pension reflects full ARC based on 5% return assumption; OPEB is if states paid full ARC today.
Thus, any solution to the long-term liability issue hinges on the choices that balance near-term operating needs with honoring long-term commitments. While states have
consistently demonstrated a dedication to honoring long-term liabilities, meaningful risk reduction would have to come in the form of policies that address paying for those commitments.
However, we view the potential for adoption of such policies in 2011 to be minimal for the following reasons:
Budget gaps remain large and the political capital expended in their closure will leave little desire to address longer-term issues
De facto deficit borrowing by paying less than the actuarially required contribution (ARC) to one’s pension fund should continue to be a popular gap-closing tool that also deepens the long-term liability problem
The most likely set of austerity measures to be widely employed are expenditure cuts given the current political climate. The success of the Republican Party in the midterm elections in regaining control of the US House of Representatives and increasing their share of state governorships suggests that the American people currently support spending cuts over tax increases, the argument for which was a major plank of the party platform. This also increases the incentive for states to continue to be creative in their gap-closing policies to avoid tax increases. Some strategies are more constructive than others, such as using a low rate environment to refinance outstanding debt in order to backload the term structure of maturities. However, such policies have consequences and risk simply compounding an already daunting long-term liability burden.
Exhibit 8
Likely 2011 Austerity Solutions Fall Short of Addressing Structural Issues
Wide-
spread Idiosyncratic Minimal
Positive Credit Policy
Options in 2011 OPEB Reductions – Current Employees X OPEB Reductions – Future Employees X Pension Reductions – Current Employees X Pension Reductions – Future Employees X Ongoing Expenditure Cuts X Ongoing Revenue Enhancements X
Weak Credit Policy
Options in 2011 Deferral of ARC X Delay of Payments X Temporary Expenditure Cuts X Temporary Revenue Enhancements X Debt Refinancing Restructuring X Debt Financing of Deficits X
Source: Morgan Stanley Research
M O R G A N S T A N L E Y R E S E A R C H
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December 7, 2010 Muni Outlook 2011
Thus, while the options enable states to remain default risk-remote in the short term (we elaborate on this later in the report), we see little improvement in the long-term credit conditions for states throughout the coming year.
Local Governments May Ultimately Bear the Brunt of State Weakness
Local governments are perhaps more at risk than their state counterparts of a meaningful deterioration in credit fundamentals in 2011. This is due to the negative impact on their fiscal burdens of the likely gap-closing solutions adopted by states. In particular, since our view is that state austerity in 2011 is most likely to include widespread operating expenditure cuts above other options, we believe that large, discretionary spending items are most at risk. Chief among these spending items is aid to local entities, including cities, towns and school districts.
Cuts in these expenditures can be particularly perilous to local governments that rely heavily on state aid. As an example, we stress test a generic, Aa-rated California school district and conclude that a 15% cut in state aid since fiscal 2009 (the latest year from which data is available) results in a budget deficit large enough to consume the district’s entire unreserved fund balance (roughly the equivalent of a tangible equity cushion in the private sector).
Exhibit 9
Stress Test of Local Issuer to State Aid—Common Size Income Statement Based on Moody's Medians (Aa)
2009 -15%
State Aid 61% 52%Unreserved Fund Balance % of Revs 9.40% 0%
Source: Education Data Partnership, Moody's, California Department of Finance
This is particularly troublesome given that California’s budget for FY11 calls for spending about 20% less on education than FY09. In theory, local governments’ ability to tax allows them to supplement their reserve/equity position and boost long-term solvency. In reality, there are severe limitations given the weak macro economy and the popularity of cost-cutting politics. Furthermore, the primary means of monetizing local taxing capacity is through property tax revenues, which we view as increasingly “tapped out” given that it has already absorbed the shortfall burden created by decreases in sales, income, and corporate tax revenue, and property taxes have rapidly increased when scaled against the size of the US economy.
Exhibit 10
Property Taxes Increased As Other Revenues Dropped
0
100,000
200,000
300,000
400,000
500,000
600,000
Dec-8
8
Jul-9
0
Mar
-92
Nov-9
3
Jul-9
5
Mar
-97
Nov-9
8
Jun-
00
Feb-0
2
Oct-03
Jun-
05
Feb-0
7
Oct-08
Jun-
10
PIT CIT Property Sales
Source: US Census Bureau
Exhibit 11
Collapsing GDP/Property Tax Implies a Substantially Higher Burden on Property Owners
3,000
3,200
3,400
3,600
3,800
4,000
4,200
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
0
100
200
300
400
500
600
Millions
GDP/Property Tax Revenues State Aid
Source: US Census Bureau, Bloomberg, Morgan Stanley Research
Local governments that rely heavily on state aid will therefore lack the options available to their state counterparts and face meaningful credit deterioration.
Credit Event Risk Should Remain Low Next Year
Despite the substantial challenges to state and local governments, we still view the risk that a meaningful credit event will drive the market in 2011 to be low as outright defaults and/or bankruptcies are likely to remain idiosyncratic in nature. We cite the following in support of our view:
States’ capacity to service their long-term liabilities remains strong
M O R G A N S T A N L E Y R E S E A R C H
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December 7, 2010 Muni Outlook 2011
While local governments are more at risk, mid- and large-size investment grade issuers retain meaningful options to keep them financially viable in 2011
Muni pricing tends to act independently of isolated, small scale defaults
An important truth, in our view, is that reliance on capital markets for funding is minimal for US states. Because states, like most muni market participants, have historically issued debt in serial rather than bullet form, they pay a portion of their outstanding debt principal down annually along with interest payments. This makes for a smooth term structure of debt maturities that allows states to use a manageable portion of their revenues annually to service debt, diminishing the need for capital market access to honor long-term liabilities.
Exhibit 12
Comparative Rollover Risk
0%
10%
20%
30%
40%
50%
60%
CA FLGA
MA NY NJ
OH PA TXW
A IL
Greec
e
Portu
gal
Irelan
d
Spain
Italy
Interest Principal Source: State CAFRs, Morgan Stanley Research
Therefore, states do not face the same deadline-driven funding needs of their European counterparts. Anticipation of these deadlines was often the driving force behind negative market sentiment toward troubled sovereigns. We do not expect any meaningful change in states’ revenue bases and/or the term structure of their debt maturities, and accordingly do not see meaningful credit event risks for states over the next calendar year.
Local governments also enter the year with relatively strong credit fundamentals.
Exhibit 13
Local Medians
US Cities
Unreserved General Fund Balance as % of
Revenues
Overall Net Debt Per
Capita ($)
Adjusted Debt Burden as % of
Full Value Quick Ratio
2009 14.7 2,781 2.7 3.5
2008 14.6 2,708 2.7 3.62007 17.0 2,690 2.9 3.32006 16.3 2,491 2.9 3.12005 15.3 2,334 3.1 3.12004 13.9 2,300 3.0 2.62003 13.6 2,056 3.0 2.0
2002 13.1 2,000 2.9 4.3
Note: Cities with more than 100,000 population and $100M in outstanding debt. Source: Moody's
US School Districts
Unreserved General Fund Balance as % of
Revenues
Overall Net Debt Per
Capita ($)
Adjusted Debt Burden as % of
Full Value Quick Ratio
2009 8.6 2781 1.7 3.1
2008 8.2 2708 2.3 3.62007 7.8 2690 2.4 3.52006 7.5 2491 2.3 3.32005 7.5 2334 1.9 3.62004 7.0 2300 1.8 3.2
2003 6.7 2056 1.3 2.52002 7.0 2000 1.9 0.7
Note: School Districts with more than 100,000 population and $100M in outstanding debt. Source: Moody's
Though we see an elevated risk for these fundamentals, we do not believe there will be any meaningful credit events as a result in 2011. This is because most state-aid reliant local governments are, in our estimation, only on step two of a pre-default path. Their fiscal cushion and taxing capacity is increasingly at risk, but they maintain several short-term time-buying strategies that can carry them through 2011 even under more adverse economic conditions.
Exhibit 14
Pre-default Path of Aid-Reliant Local Governments
Step 1: Initial State Spending CutsReactionary Policy Step-back Options - Can be considered temporary - Economic rebound - Trim non-essential spending - Build immediate structural balance on - Use of reserves as needed assumption of lower baseline of state aid - Cut capital expenditures
Step 2: Multiyear State Spending CutsReactionary Policy Step-back Options - Possible Reserve Depletion - Above-trend economic growth - Core operating/personnel cuts - Gain concessions in long-term contracts - Tax/fee increases - Build immediate structural balance on assumption - Creative accouting of lower baseline of state aid
- Use non-essential asset sales to fund long-term budget restructuring
Step 3: Sustained State Spending CutsReactionary Policy Step-back Options - Substantial tax increases - Renegotiation of labor and other long-term, - Substantial operating/personnel cuts non-bondholder contracts- Deficit financing - Sale of core assets- Emergency external assistance
Bankruptcy
Healthy
Source: Morgan Stanley Research
M O R G A N S T A N L E Y R E S E A R C H
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December 7, 2010 Muni Outlook 2011
Thus, market triggers based purely on credit events, such as default or bankruptcy, remain a lower risk compared to technical factors in 2011.
Revenue-supported Debt Shows Greater Credit Stability
Bonds secured by dedicated revenue streams, particularly those of essential service public enterprise systems, should continue to demonstrate credit stability vs. state and local governments in 2011. Operating margins, debt service coverage ratios, and debt burdens have remained stable at healthy levels throughout the economic downturn.
Exhibit 15
Stable Debt Service Coverage
0x
1x
2x
3x
2003 2004 2005 2006 2007 2008 2009
Total Senior DS Coverage (x) Total DS Coverage (x) MADS Coverage(x)
Source: Moody’s, Morgan Stanley Research
Exhibit 16
Stable Margins and Reserves
0%
20%
40%
60%
80%
100%
2003 2004 2005 2006 2007 2008 2009
Net Take-Down (%) DS Safety Margin (%)
Debt Ratio (%) Unrestricted Res as % of O&M Source: Moody’s, Morgan Stanley Research, Company Reports
More cyclical securities, such as port and sales tax bonds, should also see more stability than GOs in 2011 given projections for meaningful global economic growth that drives
trade and retail activity (US Economics: US Economic and Interest Rate Forecast, Richard Berner et al., December 3, 2010). Airport bonds stand out from the group as potentially weaker if inflation comes in the form of cost-push rather than demand-pull, driving fuel costs and ticket prices higher than passenger demand warrants and creating a slowdown in air traffic (see The Great Transmission: From DM QE to EM Inflation, Greg Peters et al., October 15, 2010). On the whole, though, overall fundamental stability for enterprise-driven munis warrants overweighting revenue-supported credit versus state and local credit in 2011.
Technical Event Risk Greater than Credit Event Risk
Technical risks to the tax-exempt market remain high, in our view, and are more likely to force a re-pricing reflecting higher credit risk than an actual credit event, the potential for which, as previously discussed, we deem to still be low over the next 12 months despite ongoing deterioration of fundamentals. In particular, we view technical risks in 2011 to be attributable to:
An expectation of a volatile path higher for US Treasury rates, which may increase the frequency of tactical changes in portfolio duration for muni investors
The same expectation drives the potential for periods of sharp negative returns, which undermines what had been overwhelming demand for munis over the past two years
Increased volatility in the shape of the tax-exempt yield curve, which reduces investor conviction and increases defensive portfolio positioning
The failure to ease fundamental stresses in state and local governments in 2011 will compound this volatility effect by diminishing general confidence in the asset class, thereby elevating the discount needed to attract marginal buyers.
Recent muni market moves highlight the technical issue, which pits perceptions of munis as a bullet-proof asset class against the reality of weakened fundamentals and the potential for a smaller real pre-tax yield advantage over Treasuries. That tension threatens the market dynamics that supported the post-2008 rally and spread tightening in tax-exempts, which was largely demand-driven as evidenced by sustained, strong fund flows. In our view, flows were largely attributable to ongoing asset allocation toward fixed income, a high real pre-tax yield advantage toward Treasuries, and perception of the asset class as safe (see Technical Knockout, September 7, 2010). However, when one of those conditions is violated, it has the power to undermine demand and meaningfully move the market. This is essentially what
M O R G A N S T A N L E Y R E S E A R C H
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December 7, 2010 Muni Outlook 2011
occurred, beginning at the end of the week of 11/8/2010, when a sharp move higher in 30-year UST yields eroded the muni yield advantage and introduced quick, negative returns to tax-exempts. The result in the following week was an accelerated sell-off in tax-exempts and coincident fund outflows even as Treasuries began to rally.
Exhibit 17
30-year UST Spike Preceded Recent Sell-Off
114
115
116
117
118
119
120
121
10/8/2010 10/21/2010 11/3/2010 11/16/2010 11/29/2010
3.8
3.9
4
4.1
4.2
4.3
4.4
4.5
SP Muni Index (LHS) US 30 YR (RHS)
Source: Morgan Stanley Research, Bloomberg
Exhibit 18
Fund Flows vs. Munis
-6,000
-5,000
-4,000
-3,000
-2,000
-1,000
0
1,000
10/8/2010 10/21/2010 11/3/2010 11/16/2010 11/29/2010
112
113
114
115
116
117
118
119
120
121
SP Muni Index 5 per. Mov. Avg. (ICI Flow)
Source: Morgan Stanley Research, Bloomberg, ICI
Thus, sharp oscillations in the interest rate environment put the tax-exempt market at increased risk for these types of accelerated sell-offs. We expect this type of movement to be prevalent in 2011 given the dueling pressures of Fed Treasury purchases and a rebound in economic growth.
Exhibit 19
UST Volatility Impact on Munis
114
115
116
117
118
119
120
121
10/8/2010
90
95
100
105
110
115
SP Muni Index (LHS) USD 1Y10Y (RHS)
Munis Sell Off
Rate Volatility Spikes
Source: Bloomberg, Morgan Stanley Research
The tax-exempt curve may deal with the additional pressure of BAB market extension uncertainty. While at the time of this publication, the Build America Bond program has not been reauthorized for 2011, comments from key lawmakers suggest the program is likely to be extended at a lower subsidy rate for one more year as part of a negotiated extension for the existing income tax structure. Assuming this extension, we expect the long end of the muni market will be susceptible to elevated volatility based on speculation about the certainty of the program beyond 2011. The following exhibit shows how the steepness of the curve beyond 10 years has reacted during prior periods of BABs market consideration.
Exhibit 20
Munis 10s30s Shows BAB-related Volatility
0.7
0.9
1.1
1.3
1.5
1.7
1.9
2.1
Aug-08 Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10
Post-Lehman Liquidity Crisis
ARRA Passes
BAB Renewal Fears
Source: Morgan Stanley Research, Municipal Market Data
M O R G A N S T A N L E Y R E S E A R C H
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December 7, 2010 Muni Outlook 2011
Finally, while we forecast supply to be lower for 2011, the decline is not likely to be substantial enough to provide a technical tailwind by offsetting potential drop-off in demand. (Please see Appendix A for more information on our supply forecast.)
Exhibit 21
Projected Supply
0
50
100
150
200
250
300
350
400
450
500
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 est.
2011 Forecast
Taxable
Tax-exempt
Bln.
Source: Morgan Stanley Research, The Bond Buyer
Despite Important Differences, Market May Focus on Similarities between US and Europe
It is our view that credit-oriented investors, particularly BAB investors, are likely to focus on the common drivers of elevated US state and European sovereign credit stress in spite of the relatively small scale of US state difficulties relative to those of Europe. We cite the following in support of this view:
Elevated interest rate volatility and allocation to fixed income among the retail investor base suggests ongoing risk aversion
Likely continuation of volatility in the long end of the tax-exempt curve coupled with opacity of financial reporting will leave investors grasping for explanations in an informationally inefficient market
States share similar, easily identifiable macro-level risks with their European sovereign counterparts, which are of increased focus among institutional investors
Given Morgan Stanley’s view that the European sovereign crisis will continue to intensify (see The Global Monetary Analyst, On the Question of QECB, Joachim Fels et al., December 1, 2010), the linking of states with conditions in Europe, and the resulting correlation, increases the downside to munis in 2011.
Important perceived commonalities between European and US state credit difficulties include:
Structural budget imbalances driven by an escalating fixed-cost base
Opacity of financial reporting relative to the private sector
Questionable capacity to meet large, long-term liability commitments
Perceived lack of political will to undertake meaningful austerity measures in response
Lack of control over the supply of currency in which their debt is denominated means that both entities are unable to mandate their debts away
Given our view that closing state budget gaps will be politically difficult and that meaningful risk-mitigating austerity measures are not forthcoming, we expect the investors’ linking of US states and Europe to be reinforced by headline and fundamental developments in 2011. The following exhibit demonstrates this relationship by showing the trend toward increasing excess correlation between BAB spreads and European sovereign CDS vs. investment grade corporate CDS.
Exhibit 22
Excess Correlation of BABs to SovX vs. IGCDX
Source: Morgan Stanley Research, Bloomberg
Accordingly, BAB investors are more directly exposed to this risk than their tax-exempt counterparts, but we caution that sustained, negative linking of BAB spreads to European sovereign spreads should, over time, induce similar behavior in tax-exempts.
This may outweigh a key truth, in our view, that European reliance on the capital markets for funding dwarfs that of US
-0.8
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
Nov-09Feb-10
May-10Aug-10
S M S l R h Bl b
Excess Correlation w/ SovX (IGCDX)
M O R G A N S T A N L E Y R E S E A R C H
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December 7, 2010 Muni Outlook 2011
states. As we argued earlier, states typically maintain a smooth term structure of debt maturities that allows states to use a manageable portion of their revenues annually to service debt, diminishing the need for capital market access to honor long-term liabilities. Conversely, sovereigns face substantial near-term maturities that from a practical standpoint require capital markets financing, making rollover risk and capital market access issues of great credit importance. The exhibit below, which we also highlight earlier in the report, visually demonstrates this condition.
Exhibit 23
Rollover Risk Lower for States than Europe
0%
10%
20%
30%
40%
50%
60%
CA FLGA
MA NY NJ
OH PA TXW
A IL
Greec
e
Portu
gal
Irelan
d
Spain
Italy
Interest Principal Source Morgan Stanley Research, State CAFRs
Therefore, we reiterate that states do not face the same deadline-driven funding needs of their European counterparts, the anticipation of which often drove negative market sentiment toward troubled sovereigns. Nevertheless, while the market apprehension about munis may not match the severity of concerns about Europe, we still think investors will latch onto the easily identifiable similarities.
Economic Impact of State and Local Weakness
The ongoing impact of state and local austerity measures and correlation of muni pricing to conditions in Europe is likely to be expressed in particular segments of the US economy. We anticipate the push toward a lower expenditure base will result in a smaller piece of the capex pie going to services that support government workforces. For example:
Office technology support, including computers, servers and long-term service contracts
School and office building construction
Heavy equipment
Exhibit 24
State and Local Investment Tracks Employment
1,0731,147 1,154
1,096
243
254 250254
800.0
930.0
1,060.0
1,190.0
1,320.0
1,450.0
2007 2008 2009 2010 Est.
19200
19300
19400
19500
19600
19700
19800
19900
Structures Equipment and software Employees
Source: US Census Bureau
However, the impact on infrastructure spending related to roads, utilities, and the like is less certain. Increased Republican control of governorships suggests the possibility that large scale, debt-financed projects may be tabled, as was the case in New Jersey with Governor Christie’s decision to cancel construction on a multibillion dollar transit tunnel to New York City. However, remaining dedicated funds from the American Reinvestment and Recovery Act (ARRA) may boost infrastructure spending elsewhere as an offset. Thus, we are not willing to concede that this type of spending will experience meaningful declines in 2011.
The private sector may also experience enhanced exposure to European sovereign difficulties through munis. High correlation of the perception of state and local government credit risks with those of peripheral Europe will likely expose sectors to the Europe story if they are holders of muni credit risk. These industries potentially include:
Life Insurance
Property & Casualty Insurance
Financial Services
Nevertheless, the real drag on economic growth for 2011 should be minimal given our view that there is only modest risk of a major credit event in the near term. (See State & Local Fiscal Problems: How Big a Headwind?, June 25, 2010.)
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Observations on the Role of Muni CDS in 2011
In 2011 we expect to see further developments in the municipal CDS market. First, we expect the market to undergo some sort of standardization, similar to what occurred in the corporate CDS market in 2009, known as the “Big Bang” or SNAC protocol. The coupons on trades were standardized, auction settlement – whereby every CDS and index contract gets settled at the same recovery rate if a credit event occurs – became the standard setting, and other contract changes occurred, making the market more fungible. We see many benefits to the municipal CDS market if this sort of standardization were to occur.
Additionally, we expect to see an increase in volumes in both the single-name and index markets, as more non-traditional investors enter the market. Given the attention the municipal market is getting and that the taxable nature of the BABs product allows new investors to look at the municipal market in ways that were not profitable before, we expect to see the investor base of the municipal market as a whole to continue to develop, and with it, the municipal CDS market.
For those investors who are already involved, this additional standardization and liquidity should only bolster market depth and help cash and CDS spreads converge further. We highlight that while there is still a basis between CDS and cash bonds, it is converging and CDS is becoming a better barometer as time goes on. For those investors who are not planning to use this market for hedging or expressing long views, we highlight that this corner of the municipal market can still be useful, if only to provide another source of pricing information and thus something to watch closely this year.
Why Are Investors Interested?
The development of the taxable market has coincided with a global rise in credit risk premiums and an increase in liquidity in non-corporate credit derivatives, particularly sovereign European debt. Thus while the muni CDS market has been around for several years, it is in the last 18 months or so that we have seen increased interest in this market from a broader base of market participants.
In many ways, the emergence of the BABs market and the simultaneous growth in the CDS market could be interpreted as the municipal markets’ transition from a largely rates-based product to one that is more credit premium driven. The credit risk premium priced into municipals has widened alongside the overall credit market, and in line with deterioration in risk assets as a whole over the last several years. However we
caution that while spreads have widened in this market, actual defaults are still rare, and much of the default and recovery assumptions necessary to price many credit derivatives remain largely theoretical for municipals.
What Is a Credit Default Swap?
Earlier this year, we published an extensive primer on the credit default swap market in general (The CDS Lifecycle – A Market Primer, May 2010), with a focus on the corporate CDS market. Municipal CDS is much the same mechanically: it is an OTC contract between the seller and buyer of protection against the risk of default on a set of debt obligations issued by a specified reference entity. A municipal CDS is triggered if, during the term of protection, an event that materially affects the cash flows of the reference debt obligation takes place. Exhibit 25 summarizes credit events across assets.
The MCDX index comprises 50 individual municipal credit swaps, with the intent of serving as both an investment vehicle and a barometer of market activity. By buying protection on the index, an investor makes quarterly premium payments, and in return, if any of the credits in the portfolio were to experience a credit event, the investor would receive par – recovery for that reference entity. The underlying portfolio is static and does not change. It does, however, roll to a new series every six months, at which point the new index may contain new reference entities. Unique among credit indices, thus far each series has had the same list of constituents as the one before it, and the only change is that the maturity of the index is rolled out six months. Additionally, as the liquid single-name municipal CDS market only includes a handful of names at this point, not all of the constituents of the index are liquid.
Exhibit 25
Sample Credit Event Triggers Across Assets
Source: Morgan Stanley Research
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Sizing Up the Municipal CDS Market
This market began trading in limited size around five years ago, and has grown considerably since then. Net notional risk outstanding peaked earlier this year, at which point the largest reference entities in the market had an outstanding net notional of around $3.5 billion. While this may seem like a large number for a young market, consider that the municipal market as a whole is approximately $2.8 trillion in size. Even just examining G.O. debt vs. CDS risk in Texas for example, we see that CDS net notionals outstanding are around $130 million today, peaking late last year at just over $450 million. According to the Texas Bond Review Board, as of the end of 2009, the State has G.O. debt outstanding to the tune of $34 billion. Compare this to the corporate market, where, in many instances the net notional of CDS protection far exceeds the corporate cash bonds outstanding.
The MCDX index has also been part of the growth in the muni CDS market. Net notionals outstanding are around $4 billion across series, up from under a billion two years ago, and we expect activity in the index to increase. MCDX notionals are most comparable to SovX, which has around $11 billion net notional across series. Both are naturally dwarfed in size by the corporate CDS index market – the CDX IG index has over $50 billion net notional outstanding in just the most recent series alone, which has been trading for only 2 months.
Exhibit 26
Net Notional CDS Outstanding by Reference State
0
500
1,000
1,500
2,000
2,500
3,000
3,500
Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10
New York City
Texas St
California St
Florida St
Illinois St
New Jersey St
New York St
Source: DTCC, Morgan Stanley Research
Municipal CDS Pricing
In a market with so few historical defaults, we get a number of questions regarding what, exactly, the contract represents. While the contract does, in fact, pay out a par minus recovery
amount to the buyer of protection in the event of default, in our experience most investors are using this more as an instrument to take a view on the asset class by synthetically replicating the cash market. In the corporate IG space, the rolling 10-year cumulative average default rate is around 2.8% (according to Moody’s), which, while much higher than the G.O. municipal market, is still very low, and yet investors routinely buy protection there as well. They do this for a number of reasons; some want to hedge some exposure they have in their portfolio, others have a directional view on credit spreads, while others may want to make some sort of relative value play on one credit vs. another. Thus the emergence of investors who buy protection on municipal CDS does not necessarily indicate an increase in investors who believe that defaults in the market are imminent, but rather that they have a view that the credit spread component of the municipal bond yield will increase. This is particularly pronounced in the municipal market as there is no other way to express a short view on the underlying assets.
A better way to think of CDS spreads is that they should, in theory, simply represent the spread of the underlying municipal cash bond over and above the appropriate risk-free metric. So for BABs, this would be the difference between BABs and Treasuries; for tax-exempts this would be the spread over MMD. CDS spreads are elevated in today’s market partly because there is a perceived increase in municipal risk given budget constraints, and also partly due to an increase in risk premium across all risky assets.
The Municipal Basis
One thing to look at when considering the pricing of municipal CDS is where it trades relative to cash bonds. In theory, an investor should be indifferent between buying a cash bond and selling protection on CDS and funding it with a Treasury- or LIBOR-based instrument. If the basis is negative, or CDS is trading tighter than cash, then an investor could buy a bond and then buy protection, and thus earn a spread while being effectively “credit risk neutral.” As illustrated in Exhibit 27, the municipal CDS-cash basis is currently positive for most names, indicating that muni CDS in general is trading wider than the cash bonds for the GO debt of those states.
There are many reasons for the basis to be positive or negative, and we have seen examples of both in the longer history of the corporate CDS market (see Basis Basics in a Normalized World, March 19, 2010 for more details). The basis can turn negative when investors are wary of using funded instruments, as we saw during the credit crisis in 2008. In the early days of the corporate CDS markets
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however, CDS generally traded wide to cash instruments given the newness of the market and nuances in the contract. We see a number of parallels with the municipal CDS market in this regard today.
Exhibit 27
Municipal Basis
-100
-50
0
50
100
150
200
Feb-10 Apr-10 Jun-10 Aug-10 Oct-10
ConnecticutIllinoisPennsylvaniaOhioFloridaNew York State
Source: Morgan Stanley Research
One issue that is unique to the municipal market is the existence of tax-exempt bonds that could be deliverable into a CDS contract. Thus in theory, a seller of protection could end up holding a tax-exempt bond without getting the tax benefits. While it is difficult to calculate the impact of this, it could be a potential source of additional spread in the CDS market that could keep the basis positive, as the basis here is calculated based on the taxable BABs market.
Finally, the cash spreads and CDS spreads could have a mismatch in the municipal CDS market simply because, as we are still in the relatively early days of this market, there is still very little overlap in the investor base of each. The cash market, particularly the tax-exempt section, is still very much dominated by buy-and-hold investors who are residents of that particular state or city, and their investment objectives and market views may differ from the taxable BABs investors, who in turn may have a different perspective from the CDS investors. Over time, if the investor bases begin to converge and liquidity in BABs and CDS continues to grow, we would expect to see some investors more willing to take advantage of dislocations in one market or the other.
MCDX and Volatility
A recent development this year in the municipal derivatives space is the advent of options on MCDX. Growth in the options markets has been enormous in the last 18 months in the US corporate credit index space, as more and more investors look for cheaper ways to hedge tail scenarios across asset classes. In addition, we have seen a number of investors looking for shorter-dated ways to generate yield. We see the potential for activity in municipal credit options in 2011, particularly if we see a period of market stress or volatility.
Exhibit 28
Realized Price Volatility Across Indices
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
10.00%
Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10
CDX IG
SovX
MCDX
Source: Morgan Stanley Research
The best comparison for the municipal credit derivatives market would be the sovereign index, SovX, which is a European index that consists of Western European sovereigns. During the sovereign stresses this summer, we saw an uptick in SovX realized volatility and with it, an uptick in options trading. While there are meaningful differences between the challenges faced by Western European sovereigns and US municipals, in an overall market environment marked by uncertainty, options markets can proliferate, both with hedgers looking for cheap, short-dated ways to protect themselves in the event of large market moves and those investors who take advantage of dislocations in volatility pricing by entering trades that profit when markets remain range-bound, such as strangles.
See our primer (The Credit Volatility Culture – An Options Primer, May 7, 2010) on the credit options markets for more details on this product.
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Appendix A: 2011 Primary Market Forecast
Following a year in which we expect muni bond supply to have shown modest growth of about 1.5%, our baseline projection for 2011 is for a roughly 5% decline in long-term bond issuance to about $395 billion, with a further downside bias.
Exhibit A-1
2011 Supply Forecast
0
100
200
300
400
500
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 est.
2011 Forecast
Tax-exempt Taxable
Bln.
Source: Morgan Stanley Research, The Bond Buyer]
2010 was characterized by substantial increases in taxable debt, largely due to the Build America Bond program and anticipation of its potential expiry at the end of the year, and revenue-supported debt, with transportation sector bond growth leading the way. We expect that 2011 will mark a break from the former and consistency with the latter, but uncertainty regarding BABs extension and austerity politics at the local level have led us to put forward a baseline, low, and high estimate that skews to the downside.
Exhibit A-2
Baseline, Low, and High Forecast
0
50,000,000
100,000,000
150,000,000
200,000,000
250,000,000
300,000,000
350,000,000
400,000,000
450,000,000
Low Base High
Tax-exempt Taxable
Source Morgan Stanley Research
Baseline Forecast (60% Probability)
The baseline forecast of $395 billion (including $90 billion of BABs) assumes the following
A decrease in new money issuance consistent with expected continued declines in state and local government employment, which is indicative of the austerity mindset of government officials
Extension of the BABs program at a 32% subsidy rate
Exhibit A-3
Positive Spread Benefit in Long End Persists with 28% BAB Subsidy
0
20
40
60
80
100
120
140
20 30
AAA AA A BBB
Source: Morgan Stanley Research
Downward adjustment to BABs supply based on issuers having accelerated debt plans in 4Q10 ahead of a reduced subsidy or
Lower issuance of Build America Bonds due to a likely decline in federal subsidy and the acceleration of issuance prior to 2010 year-end
Expectation of current refunding opportunities for 2001-issued callables
Expectation of refunding demand by sate and local governments to back-load their maturity term structure
Low-end Forecast (30% Probability)
Our low-end forecast of $374 billion deviates from the baseline in its assumption about the trajectory of economic growth and BAB market extension. In particular, it assumes that GDP growth falls short of expectations, driving greater austerity for states and locals, and lower capital spending by enterprise entities. Expiration of the BAB market would also contribute by decreasing the marginal size of long-term offerings within individual issues.
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High-end Forecast (10% Probability)
The high-end forecast of $424 billion assumes upside surprise to moderate GDP growth while the Fed keeps rates on hold at
low levels. This would upsize revenue expectations across all issuing sectors and motivate issuers to accelerate potential refinancing activities while the rate environment remained low.
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