Municipal Bonds: Finding Value Through Credit Analysis. Presented by:

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1 Municipal Bonds: Presented by: Drew Simmons, Vice President

2 Relative Value - Sector Spreads: Today Muni MBS AGY

3 Municipal Market Review

4 Municipal Market Review (continued)

5 Muni vs. Treasury When Rates Rise 64% 32% 51% 42% 41% 36% Average Muni Sensitivity to TSY 44% 10Yr Treasury 10Yr AAA BQ Muni

6 Muni vs. Treasury Regression A regression analysis of 10yr Treasury yields and 10yr Municipal yields shows Municipal yields rise only a fraction of Treasury yields. The top left chart shows that during the time period, when Treasury yields move 100bp, Municipal yields move just 61bp. It also shows that this was a relatively tight relationship. The bottom chart at left shows that since 2007, that relationship has been inconsistent and less reliable, but still shows Municipal yields moving much less than Treasury yields.

7 Municipal Defaults The Next Crisis? You could see fifty to a hundred sizable defaults, more. This will amount to hundreds of billions of dollars worth of defaults [within 12 months]. Meredith Whitney 60 Minutes December 19 th, 2010

8 Municipal Default Update Volume Defaults spiked in Q4 11 while nominal defaults were muted Most of the Defaults in 2011 were nontraditional municipalities (e.g. American Airlines BK, Tobacco Corps)

9 Municipal Defaults Are Rare Special Assessment 16% Defaults By Type Other 5% G.O. 1% Defaults By Tax Status BQ 2% Taxable 5% AMT 9% Revenue 78% NBQ 84%

10 State GO Ratings and Pension Status

11 Municipal Bankruptcy Of the 300+ BK filings over the past 40yrs, bond investors were repaid in full, sometimes late, but made whole. Source: Chicago FED, Tempestuous municipal debt markets: Oxymoron or new reality? Oct. 2011

12 Municipal Tax Collections Source: Moody s U.S. Municipal Bond Defaults and Recoveries, March

13 City Revenue Changes in 2011

14 City Spending Changes in 2011

15 Municipal Transparency Very Weak 5yrs 19% Delinquent Filings 19% of issuers have NEVER filed 4yrs 9% Current 43% 3yrs 6% 2yrs 8% 1yr 15% 56% of issuers are 1 or more years delinquent In 2009, 72% of all financials were more than 2 year old % of Issues 3+ Years Delinquent by ST Average filing time is 228 days after fiscal year-end Source: DPC DATA Inc., Recent Trends in Municipal Continuing Disclosure Activities, February 3 rd, % 80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% WY VT ME MT ID SD UT NE AK IA OK DE VA ND LA MS AZ

16 The Credit Analysis Process Implement a Robust Credit Risk Assessment System Pre-Purchase & Post-Purchase Analysis Ability to Repay, Demographics, Financial Condition Specific Attention to Non-Rated, Non-Insured bonds Pre- Purchase Analysis Purchase Decision Post- Purchase Analysis Justify Position Defaults mostly coming from smaller issuers Defaults mostly coming from non-rated (NR) securities

17 Regulatory Focus: Municipal Bonds if a bank has a high concentration of municipal bonds relative to their capital, they better dazzle me with credit analysis FDIC Capital Markets Examiner Understand Your Municipal Concentration Munis as a % of Capital There is no specific threshold Special focus: less than A-Rated, Non-Rated, Revenue Bonds Perform Thorough Pre/Post Purchase Credit Analysis Understand What You Own & Know Your Credits Access & Review Financial Statements Develop Specific Credit Criteria & Monitor Regularly Municipal Credit Reports Credit Profile Sheets

18 Regulatory Changes: Dodd-Frank OCC NPRM, November 2011: The definition of investment grade in 12 CFR Part 1 to no longer include reference to credit ratings Consideration of internal analyses, third party research, and analytics including external credit ratings, internal risk ratings, default statistics, and other sources of information Having a Robust Risk Management Framework "Risk measurement should be obtained from sources independent of sellers or counterparties and should be periodically reviewed The key word here is Risk Measurement, meaning the internal procedure, NOT the data itself.

19 OCC: Risk Management Framework

20 Municipal Bond Concentration if a bank has a high concentration of municipal bonds relative to their capital, they better dazzle me with credit analysis FDIC Capital Markets Examiner Buying a municipal bond should be viewed in the same manner as making a loan. Pre- and postpurchase credit analysis is just as important. Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Municipals / Tier 1 Capital

21 Municipal Credit Checklist Understand Your Exposure Municipal Holdings as a % of Capital There is no specific threshold Geographic Concentration Tax Status, Issue Type, Revenue Source, etc. Implement Credit Metric Benchmarks Develop credit criteria as part of you investment policy and/or strategy Justify metrics that are out of benchmark when appropriate Document areas of concern Proof of an Established Credit Analysis Process Pre-Purchase Documentation: Credit Profile Sheets, Financial Statements, OS Evidence of a meaningful Post Purchase Review Process

22 Understand Your Exposure

23 Municipal Credit Metrics

24 GO Credit Analysis Criteria Metric Principal GO Debt as a percentage of the Issuer s Assessed Valuation Debt Limit, if applicable Principal GO Debt Per Capita Property Tax Collections as a % of the Levy GO Debt Service relative to Property Tax Collections The Increase in the Issuer s debt burden as a result of Overlapping Debt Benchmark No more than 2.00x the Average Debt to Assessed Ratio in the residing state No less than 10% debt capacity remaining Less than $3,500 At least a 90% collection rate Property Tax Collections should be at least equal to the GO Debt Service requirements, excluding double barrel bonds No more than a 3x increase in Overlapping Debt when per capita debt exceeds $2,000

25 Revenue Credit Analysis Criteria Metric Essential Purpose Pledged Revenues (Utility Revs) above the Principal and Interest Requirements in a fiscal year. Sales and Income Tax Pledged Revenues above the Principal and Interest Requirements in a fiscal year. Lease and/or Mortgage Lien Structures. Benchmark Coverage above the applicable rate covenant and at least 1.25x Coverage above the rate covenant and at least 1.50x Debt Coverage is not applicable, but lease structures may not be subject to annual appropriation without a secured interest of the facilities through a 1 st Lien Mortgage

26 Additional Points of Interest Metric Change in Net Assets School District s Intergovernmental State Aid Dependence City and County Intergovernmental State Aid Dependence Flag Declining Net Assets will be flagged to determine if the cause is attributed to operating deficits For school districts, State Sourced Funds not pledged to service bonded debt should not exceed 65% of all Governmental Funds For all other governments, State Sourced Funds not pledged to service bonded debt should not exceed 45% of all Governmental Funds

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28 Pre-Purchase Analysis 1. Hyperlinks to the Official Statement and recent financials 2. Revenue that Supports the debt service payments 3. Debt Coverage, and Rate Covenant 4. Compares the district s debt to assessed ratio to the state s average 5. Gross and Net GO Direct Debt (net = gross less self supporting debt) 6. Tax Assessed vs Market Value 7. Tax collections to tax levy and GO debt service 8. Any applicable GO debt limit as a percentage of the Assessed Value 9. Overlapping Debt Metrics & Per Capita 10. Dependence on State Aid 11. Change in Net Assets 12. Unemployment rates

29 Post Purchase Monitoring - Credit Report Hyperlinks to the most recent financials and the bond s official statement County Unemployment Rate and Source of Payment (Security) Type, Credit Enhancement and Ratings Change in Net Assets Credit Metrics: GO - Debt to Assessed, Per Capita Debt REV - Debt Coverage, Rate Covenant Overlapping Debt Metrics: GO - Debt to Assessed, Per Capita Debt

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31 Municipal Credit Process