Commentaries

July Market Commentary

By: admin / July 17th, 2012

The Supreme Court’s landmark, split decision on the Obama Administration’s healthcare legislation seemed to represent more of the same confusing direction emanating from Washington in the past few years. Observers “observed” that the Chief Justice’s opinion appeared to have reversed course from ruling the legislation un-constitutional to ratifying the most controversial aspect – mandatory purchase of health insurance – a “tax” and thus within purview of Congress. Yet the ruling’s impact appears very muted as divisions in governments from the Middle East to the Euro Zone to the U.S. pushed the Court’s headlines quickly from the front pages. Financial markets seemed far more concerned with the global economic slowdown and the lack of clear direction from World leaders.

In a recent report the International Monetary Fund (IMF) stated that global growth is at its lowest level in a decade, matched only by the lowest levels seen in 2009 following the near collapse of the global financial system in 2008. As reported in the Wall Street Journal, the IMF’s Chief Economist said “fears among consumers and businesses of a deeper downturn are creating uncertainty that is difficult to pinpoint…. It’s a world they cannot quite think about…” You think?

With such uncertainty in global markets it is no surprise that the benchmark 10-year Treasury yield hit new lows again this week after touching a record low of 1.43% in June. Until the global ship regains a firm hand on the rudder, markets are likely to remain adrift. And with apologies for the extended metaphor, with “rudderless leadership” worldwide it’s no surprise that the financial markets view this as a “world they cannot quite think about.”   

 

• The U.S. Supreme Court’s decision to uphold the Patient Protection and Affordable Care Act (PPACA) could benefit nonprofit health care providers, but has had little impact on the bond markets and could potentially result in an increase in bond issuance for this sector in the next few years.
• From a credit sector perspective, APA believes that PPACA should benefit not-for-profit hospitals and has had little impact on the municipal market with regard to spreads.  
• Although Stockton, California is the largest U.S. city to seek bankruptcy court protections from creditors, APA believes this filing along with two other California cities (Mammoth Lakes and San Bernardino) are not reflective of the municipal market as a whole and has had little impact overall on the trading and pricing of municipal bonds.
• While far from over, recent news in the Jefferson County, Alabama bankruptcy proceedings reinforced bondholder protection in how an issuers’ payments should be distributed.
• The G20 summit, which followed a few weeks after the G-8 summit, ended with attending nations focusing their attention on a framework for addressing the Euro Zone crisis, but with little concrete proposals to stem the crisis is confidence among market participants. As a result, flight to quality continues in world financial markets.

 

Supreme Court Upholds Bulk of the Patient Protection and Affordable Care Act (PPACA)

The U.S. Supreme Court’s decision to uphold the Patient Protection and Affordable Care Act (PPACA) could benefit nonprofit health care providers, but has had little impact on the bond markets. However, it could result in an increase in bond issuance for the healthcare sector in the next few years.  With the United States spending nearly 18.5% of GDP on healthcare, the legislation will have an impact on many Americans and the U.S. economy.

On June 28^th, 2012, the U.S. Supreme Court ruled in a split 5-4 decision that the bulk of the Patient Protection and Affordable Care Act (PPACA) was constitutional. Key provisions of the PPACA upheld include the requirement that all citizens carry insurance or pay a fine based on their income.  It prevents insurance companies from refusing insurance to anyone with a pre-existing medical condition, allows children to remain on their parents’ insurance coverage until the age of 26, increases the Medicaid eligibility to 133% of poverty level, and requires businesses with 50 or more employees to offer insurance or pay a fine to the government.   In its decision the court stated that Congress has the authority to impose a mandatory insurance requirement under its power to levy taxes. Justice Roberts, writing for the court, stated that while the federal government may not require people to purchase health insurance, the Federal Government can “…impose a tax on those without insurance.” The law, in the courts view, “…is therefore constitutional because it can be read as a tax.”  The court did limit the law’s extension of the Medicaid program for low income citizens by stating that the Federal Government does not have the right to threaten existing funding for non-participation by the states. This ruling will allow states to opt in or out of the Medicaid expansion requirements after 2014. Some states, such as Florida, Texas, and Ohio, have already indicated that they may opt out of the Medicaid expansion.  

From a credit sector perspective, APA believes that PPACA could benefit not-for-profit hospitals and has had little effect on muni market spreads. The ruling has provided some clarity for hospitals and other providers who have spent more than two years preparing for the new law.  APA recognizes that new reimbursement models, new payment penalties for hospitals with high readmission rates and reductions in overall Medicare reimbursement payments will pose a financial challenge for many hospitals. However, extending coverage to the previously uninsured may reduce charity care cases as well as improve efficiencies in the utilization of space like emergency rooms.   Credit and pricing spreads have remained mostly unchanged in the market since the ruling. Issuance in the healthcare sector is up, with Wells Fargo showing hospital bond volume of $12.2 billion through the middle of June which was 23% higher than 2011 volume. The reason for the increase may be tied to demand as investors search for yield, issuers pushing up supply ahead of the Supreme Court ruling and hospitals taking advantage of lower borrowing costs.

The Court’s ruling aside, APA has always stressed underlying credit fundamentals when assessing any credit sector, including hospital credits. Our credit analysis focuses on those hospitals that have leading market share in their given service area, high days cash on hand relative to rating, positive profit and operating margins, above average debt service coverage for rating category and below average debt levels.

Issuers Seeking Bankruptcy Protection the Exception, Not the Rule.

With the recent headlines of Harrisburg (PA), Jefferson County (AL) and most recently the California cities of Stockton, Mammoth Lakes and San Bernardino all entering bankruptcy protection, investors may be led to believe that there has been an increasing threat of municipal bankruptcies. Although Stockton is the largest U.S. city to seek bankruptcy court protection from creditors and was broadcast to investors long ago, we believe these and other filings are not reflective of the municipal market as a whole and have had little impact on the trading of municipal bonds.    

On June 27th, 2012, the City Council of Stockton voted 6-1 to adopt a spending plan for operating under bankruptcy protection. As a result, the city of nearly 300,000 residents with over $700 million total in debt outstanding, sought bankruptcy protection under Chapter 9. Mammoth Lakes followed six days later seeking bankruptcy protection on July 3^rd. The Town Council there voted to seek Chapter 9 Protection after Mammoth Lakes Land Acquisition, the town’s largest creditor, which won a court order requiring the town to pay a $43 million judgment. The City of San Bernardino is expected to file later this month after the City Council voted 4 to 2 to file for Chapter 9. San Bernardino is facing insolvency due to accounting errors, deficit spending, pension and debt costs, and limited revenue growth.

Data examined by APA shows that the number of issuers seeking bankruptcy protection appears low relative to the municipal market as a whole and confined to localities with small populations and bonds issued by “special land districts”, not cities, towns or counties.  According to data from Bloomberg, from 2000 to July 2012, there were a total of 95 actual bankruptcy filings by various municipalities. With over 60,000 issuers in the municipal markets, the percentage of bankruptcies was .016% of total issues. In general, the majority of filings prior to the great recession have been in places with small populations yet we have seen entities with larger populations more likely to seek protection in the last few years. However, one trend does seem to be evident: Since 2007, those entities seeking bankruptcy protection are larger population centers than those prior to 2007. The average population of issuers among the top 5 issuers by population that filed prior to December 2007 was approximately 10,328. Of the top 5 municipalities that filed after December 2007, the average population was approximately 229,019. Additional data from Bloomberg also shows that since 1981, there have been 220 Chapter 9 (municipal) bankruptcies filed in the U.S. This pales in comparison to the 20,000 companies that sought protection under Chapter 11 bankruptcy during that same time period. In addition, only 20%, or 43 of the total Chapter 9 cases filed in the U.S. during that time period were from towns, cities or counties.

Top 5 Chapter 9 Bankruptcy Filings by Population Size, 2007 to July 5th, 2012
Month and Year	Municipality	Population
November-11	Jefferson County (AL)	658,466
June-12	Stockton (CA)	291,707
May-08	Vallejo (CA)	116,760
Oct-11	Harrisburg (PA)	49,528
Oct-09	Prichard (AL)	28,633
Average		229,019
Source: Bloomberg Brief, page 4, July 5th, 2012
Top 5 Chapter 9 Bankruptcy Filings by Population Size, 2000 to 2007
Month and Year	Municipality	Population
December-01	Desert Hot Springs (CA)	16,582
June-02	Rio Bravo (TX)	5,553
May-04	Washington Park (IL)	5,345
April-05	Muldrow (OK)	3,104
Jan-05	Alorton (IL)	2,749
Oct-09	Prichard (AL)	28,633
Average		10,328
Source: Bloomberg Brief, page 4, July 5th, 2012

Good News Out of Jefferson County (AL)

While far from over, recent news in the Jefferson County bankruptcy proceedings reinforced bondholder protection regarding revenue bond issuers’ fund flows.  The judge reaffirmed the generally accepted interpretation of the bond indenture, which contained various definitions for what constituted operating expenses. The county had been attempting to include other items such as legal fees related to chapter 9 proceedings and the creation of a reserve to fund future capital expenditures in their interpretation of operating expenses. This could have hurt bondholders, who are paid after all expenses are accounted for under the indenture. The judge’s ruling ratified bondholders understanding of how revenue bonds’ funds should flow and what is defined as an expense. The ruling has broad market implications should other issuers filing for chapter 9 attempt to redefine what constitutes operating expenses and the resulting cash available for debt service.

G20 Summit: Little Progress in EuroZone Issues; Flight to Investment Grade Muni’s Continues

The G20 Summit of industrialized nations, which followed a few weeks after the G-8 summit of the largest developed economies, ended with little progress in resolving the Euro Zone’s debt woes.  As a result, inflows into Investment Grade Bond Funds continued for the 31st straight week. According to reports, the International Monetary Fund (IMF) has agreed to increase its lending resources to $456 billion or 360 billion euros to troubled Euro Zone countries but with little clarity on how the funds might be deployed. Euro Zone countries, in return, promised to take certain necessary steps to maintain stability in the Zone and keep financial and capital markets flowing. The Summit appeared to support and reaffirm the concept of a common Euro currency. Although tepid, the actions taken by the nations in attendance seemed to underscore the magnitude of the debate in that any progress to aid in the crisis could lead to further Euro consolidation.   A key comprise to emerge from the summit was German Chancellor Angela Merkel’s changing position to allow Euro Zone funds to directly aid Spanish and Italian banks. France’s new president Francois Hollande had championed the direct infusion of ECB funds.

 

APA’s Strategic Direction

APA’s Investment Committee believes the best strategy currently is a “modified barbell strategy”, which consists of high quality bonds, 50% of which we would recommend with a 1 to 5 year maturity and 50% in the 8 to 12 year area. APA’s overall duration target is 4 to 4.5 years. In order to enhance our clients’ portfolio yield, APA will invest up to 20% of the total portfolio within the A-rated category.  More specifically:

1. For investors with a lower risk tolerance, APA recommends a Short-Term Strategy. With a lower duration and high credit quality, this strategy offers clients a defensive position against rising interest rates. We recommend this strategy to investors seeking protection of principal in a rising rate environment while looking for generally higher returns compared to traditional money market funds. APA will tailor this portfolio for each client based on their individual liquidity and tax needs. 
2. For new portfolios, or for investors seeking slightly higher yields at lower risk than longer duration bonds, APA recommends an Intermediate Strategy. With a slightly longer duration than APA’s Short-Term Strategy, we recommend bonds selected utilizing a modified “ladder” investment approach targeting bonds with 1 to 10 year maturities. We are also increasing our A rated bond holdings from 10% to 20% in this strategy.   

Because APA does not see any significant near-term threat from inflation, the Investment Committee believes that current muted improvements in the economy will benefit investors buying along this curve. As stated, our overall duration target is now in the 4 to 4.5 year range. The top five Municipal Bond sectors in our composite Intermediate Strategy portfolio includes Local General Obligation Bonds (GOs), Higher Education, “Other Revenue”, State GOs, and Utility Bonds.

1. For investors with a higher risk tolerance seeking higher yields and attractive after tax returns, APA recommends our High Income Strategy. This strategy provides investors with higher current income while maintaining exemption from federal income taxes. The bonds purchased in these portfolios have a slightly longer duration, lower credit ratings and longer maturities.  The top five bonds in these portfolios typically are in the following sectors: hospitals, life care, other revenues, higher education, and local GOs.
2. For all of the strategies detailed above, APA recommends investors allocate a portion of their portfolios to out-of-state bonds, even in high-tax states, in order to increase geographical diversification and help mitigate concentration risk. Currently, investors may take advantage of a comparatively flatter, but still overall steep municipal yield curve, to lessen the tax effect on out-of-state bonds by extending maturities a year or two out.
3. Further, we believe that APA is well positioned to capture additional yield by investing in market sectors where credit spreads remain wider than historical averages. For example, we emphasize purchases of single A-rated issues, water & sewer bonds, highly rated hospital bonds, public power authorities and public school district debt in states offering an “intercept” program which can strategically bolster diversification and price stability.

Disclosures:

Past performance is not indicative of future results.  This material is not financial advice or an offer to sell any product.  The actual characteristics with respect to any particular client account will vary based on a number of factors including but not limited to: (i) the size of the account; (ii) investment restrictions applicable to the account, if any; and (iii) market exigencies at the time of investment. Asset Preservation Advisors, Inc. reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time you receive this report or that securities sold have not been repurchased. The securities discussed may not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings.  It should not be assumed that any of the securities transactions, holdings or sectors discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein.

APA is a registered investment advisor. More information about the advisor including its investment strategies and objectives can be obtained by visiting www.assetpreservationadvisors.com.   A copy of APA’s disclosure statement (Part 2 of Form ADV) is available without charge upon request. Our Form ADV contains information regarding our Firm’s business practices and the backgrounds of our key personnel.  Please contact APA at 404-261-1333 if you would like to receive this information.  APA-12-146