MUNICIPAL BOND MARKET UPDATE

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1 BLX Group LLC 75 Arlington Street, Suite 500 Boston, MA ph: WISCONSIN HEALTH AND EDUCATIONAL FACILITIES AUTHORITY Annual Workshop MUNICIPAL BOND MARKET UPDATE 2013 Recap and What is Ahead for 2014 March 17, 2014

2 PRESENTATION TOPICS p Recap a) Municipal Market Forces b) Federal Reserve Taper c) Credit Issues: Detroit & Puerto Rico d) Bond Fund Redemptions 2. What is Ahead in 2014? a) Municipal Market Forces: Supply & Demand b) Federal Reserve & Improving Economy c) International Tensions 3. New Regulatory Environment a) Tax Code Overhaul b) Basel III c) Proposed High Liquidity Asset Rule d) SEC Disclosure Requirements e) Municipal Advisor Rule

3 2013 RECAP p. 3 Macro Forces Economic Conditions: 2013 began to see signs of improving economy, unemployment rate declined - a key focus of the Fed Federal Reserve: when will the Fed accommodation be withdrawn? Bond Buying Taper: Chairman Bernanke's comments in June about tapering monthly treasury and mortgage bond purchases roiled market Credit Issues Detroit: bankruptcy filing July 18 th has raised doubts about general obligation pledge Puerto Rico: deficit borrowing, high debt burdens & underfunded pensions spooked investors, debt has been widely held by bond funds and retail investors because of exemption from state, local, and federal taxes Concern about potential contagion risk and panic selling

4 2013 RECAP p. 4 Municipal Bond Rates Rise in rates in market triggered by Federal Reserve taper anxieties, municipal credit concerns, and municipal bond fund redemptions AAA GO 1/2/2013 AAA GO 6/28/2013 AAA GO 12/31/ Data Thomson Reuters, Municipal Market Data

5 2013 RECAP p. 5 Tax-Exempt Bond Fund Flows Negative Funds saw redemptions accelerate beginning in May Spike in rates and credit concerns initiated redemptions Net fund outflows second half of the year Resulted in limited liquidity in secondary & primary markets: dealers were not taking on bonds for their trading inventory and new issue deals were postponed as funds were net sellers Liquidity began to return to the market towards the end of the year

6 2013 RECAP p. 6 Flow of Funds (B Billions $) Tax-Exempt Bond Fund Flows Date (Bi-Weekly) source: Lipper

7 2013 RECAP p. 7 Emergence of New Buyers Non-Traditional Muni Buyers: hedge funds, crossover buyers, taxable high yield funds Opportunistic Buyers: buying bonds at attractive spreads to alternative fixed income investment choices such as treasuries or corporate bonds Hedge Funds: muni holdings today are in the billions where 5 years ago they held almost none Strategy: 1. buy bonds at attractive spreads, high yields and cheap prices and sell when spread relationship compresses and prices are higher 2. buy credit when weak or low rated and sell when credit improves and is upgraded to higher rating

8 WHAT IS AHEAD FOR 2014? p. 8 New Issue Supply & Demand First two month of this year low new issue supply & issuers received strong reception from muni investors Demand has outweighed supply so far this year Day New Issue Municipal Supply 14.0 Supply (Billions $) Date (Monthly) Source: Thomson Reuters

9 WHAT IS AHEAD FOR 2014? p. 9 New Issue Supply & Demand Mutual fund flows: have stabilized & turned slightly positive in some reporting weeks this year Tax-Exempt Bond Fund Flows 3.0 Flow of Funds (Billions $) source: Lipper Date (Bi-Weekly)

10 WHAT IS AHEAD FOR 2014? p. 10 New Issue Supply & Demand Most refunding opportunities have been completed during last 3 years when rates were lower, don t anticipate many refundings this year due to higher interest rates Long term new issue volume estimate is $296 billion for 2014 versus $335 billion last year (projections reflective of lack of refunding volume this year) February issuance $14.7 billion -40.4% from last February and lowest February volume since 2000 Borrower attitudes & concerns- debt adverse?, spirit of austerity High earners facing higher tax rates: top marginal rate now up to 39.6% up from 35% in top tax bracket has not been this high since increasing demand for muni bonds- makes the exemption even more valuable to investors $3.5 billion Puerto Rico new issue last week- well received by investors orders totaling $16 billion- maturing in 2035 at yield of 8.727%

11 WHAT IS AHEAD FOR 2014? p. 11 Federal Reserve Markets will continue to closely monitor Fed actions Leadership transition to Yellen- 1st policy meeting as Chairwoman this month Pace of taper- decline by $10 billion a month- planned to end in the fall- will it keep on pace? March 7 th jobs report better-than-expected ensuring another $10 billion taper this week at FOMC meeting Fed unlikely to tighten and raise short term rates especially given lack of inflationary pressures-inflation under Fed s 2% target- first hike in short term rates 2 nd half of 2015 Improving Economy Should see continued improvement in 2014 Recent setback: Fed estimates winter cold & snow has cut a.5% to 1% off economy s annualized growth rate in 1 st quarter March 7th unemployment release: unemployment rises to 6.7% from 6.6% but reflective of more people encouraged to look for work and entering the pool of those looking for jobs

12 WHAT IS AHEAD FOR 2014? p. 12 Improving Economy Fed exploring focusing on a broader array of economic indicators to gauge strength of economy- not just a sole focus/target on 6.5% unemployment rate to trigger rise in short term rates Recalibrate, or de-emphasize the threshold (6.5%) for unemployment to initiate Fed s actions International Tensions & Considerations Headline Risk- Market Movers Ukraine Russia China

13 WHAT IS AHEAD FOR 2014? p. 13 Current Municipal Bond Rates Borrowing rates have improved since beginning of year AAA GO 1/2/2013 AAA GO 6/28/2013 AAA GO 12/31/2013 AAA GO 3/7/ Data Thomson Reuters, Municipal Market Data

14 NEW REGULATORY ENVIRONMENT p. 14 Many issues to be aware of going forward... Tax Code Overhaul- unlikely in but important to monitor debate- will be continuing issue in next few years- will hang over the market- constant long term threat Municipals caught in the cross hairs Some proposals floated: limit or eliminate 501(c)(3) tax-exempt financing, 28% cap on interest exemption (resulting in higher interest expense for nonprofit organizations) Obama s 2015 budget: 28% cap, America Fast Forward Bonds AFF taxable direct pay bonds (25% federal subsidy, BABs were 35%) (eligibility includes eligible private activity bonds PABs and nonprofits) Recent release of tax reform discussion draft proposal by House Ways & Means Chairman Camp: may be the starting point for changes- would eliminate taxexemption for PABs after institute a new surtax on municipal bond interest for taxpayers who earn more than $400,000 or estimated to be as many as 40% of bondholders

15 NEW REGULATORY ENVIRONMENT p. 15 Tax Code Overhaul- unlikely in but important to monitor debate- will be continuing issue in next few years- will hang over the market- constant long term threat Political paralysis for far reaching legislation like tax reform Congressional mid-term elections this year, partisan gridlock Senate Finance Committee leadership change- Senator Wyden (D. Oregon) takes over as Chairman

16 NEW REGULATORY ENVIRONMENT p. 16 Basel III Regulatory standard for bank capital adequacy, stress testing, and market liquidity risk Implications for pricing and terms of bank letter of credits and bank direct purchases Proposed High Liquidity Asset Rule (HQLA) Imposes new liquidity requirement standards on banks Municipal bonds would be at lower tier of liquidity- Federal Reserve demotes municipal bonds into less liquid category declaring munis not easy to trade/sell especially in a volatile market Could discourage banks from holding municipal bonds Would have negative impact for municipal bond market resulting in higher interest rates for borrowers

17 NEW REGULATORY ENVIRONMENT p. 17 SEC Disclosure Requirements Borrowers responsibility to provide up-to-date and accurate disclosure or face financial penalty Precedent setting cases: last year penalties imposed on Harrisburg, PA and Wenatchee, WA for lack of compliance Municipal Advisor Rule municipal advisor and underwriter roles more clearly defined at early stage of dent issuance transaction IRMA - Independent Registered Municipal Advisor: fiduciary responsibility standard Positive implications for borrowers More transparent and informed transaction

18 CONTACT INFORMATION p. 18 MARK E. PERRY MANAGING DIRECTOR BLX GROUP

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