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Assessing Short-Term Risk on the Municipal Bond Market NFMA Advanced Seminar

Assessing Short-Term Risk on the Municipal Bond Market NFMA Advanced Seminar. Robert Donahue Deutsche Asset Management Boston, MA. Revision of Belief. Consider a turkey that is fed every day.

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Assessing Short-Term Risk on the Municipal Bond Market NFMA Advanced Seminar

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  1. Assessing Short-Term Riskon the Municipal Bond MarketNFMA Advanced Seminar Robert Donahue Deutsche Asset Management Boston, MA

  2. Revision of Belief Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race looking out ‘for its best interests’, as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.” The Black Swan by Nassim Nicholas Taleb

  3. Municipal Revisions of Belief Headline Risk Low Risk Willing and Able Increasing Reluctance Respect of Contracts Anything Goes Credit Enhancement Credit Diminution Municipal Scale Global Scale Money Funds Safest Systemic Risk

  4. ….and more gray hair

  5. Why Focus on the Short Term? • Been There, Done That • New York City, NY • Orange County, CA • Jefferson County, AL • Reserve Fund Breaks the Buck • Growth of swaps and variable rate debt • Uncertain banking environment • Current rate environment Barron's MFQ  | SATURDAY, OCTOBER 9, 2010 Low Yields Are Just One of Money Markets' Woes

  6. Liquidity Time Bombs • Note Roll-over Risk • Cash Flow Notes • TRANs, TAN’s, RAN’s • Bond Anticipation Notes (BAN’s) • Tax-Exempt Commercial Paper • Variable Rate Roll-over Risk • Bank-supported LOC & SBPA’s • Other Risks • Self-Liquidity/Market Access Products • FRN’s, Windows • Interest Rate Shocks

  7. Risk #1: Short Term DebtIllinois vs. Greece?

  8. Illinois is Clearly not Greece Illinois

  9. But It Is all about Expectations… 7/12/2010 $5.9B

  10. Highly Liquid…. …or Insolvent…

  11. 10/6/2010 • …$6.4B of FY2010 unpaid invoices (23% of budget) with $3.5B more racked up in FY2011… • … unsatisfied payees could seek judicial remedies to obtain payments in amounts unprecedented in the state’s history. • “There is a very real possibility…the state's ability to maintain services will be severely jeopardized...creating chaotic fiscal conditions as the situation snowballs."

  12. Tools for Analyzing Note Risk • Appreciate “Trickle Down” Risk • Full and timely payment (not “money good”) • New York School District TANs • Discount speculative assumptions • Discount “borrowables” • Beware Rolling Notes • Recognize relationship between ratings and market access • Using the “Other” line item • Factor vendor payables as short–term debt • Assess issuers’ priority payment structure (IOUs). • Track the outcome of pending legislation or court cases. • Distinguish between rhetoric and reality

  13. Risk #2: Variable Rate Debt • VDRN Rollover Risk • Bank Bond “Term Outs” • Uncertain Fees • Swap Collateral posting and termination liability • Self-Liquidity/Market Access • EMCP, FRN’s, Windows • Structural risk • Onerous bank remedies for technical covenant defaults • Market technicals • Supply/Demand imbalance • Interest rates

  14. IL: Variable Rate Debt and Swaps • In October 2003, the State issued $600 million of Variable Rate General Obligation Bonds, Series 2003B maturing in years 2020 through 2033…secured by a liquidity facility from DEPFA Bank, PLC. 10/1/10: Moody’s downgraded Depfa short-term rating by two notches to Prime-3 from Prime-1 • The State simultaneously entered into five interest rate exchange agreements. • A Counterparty may terminate its related Agreement if the State’s rating falls below “BBB” from S&P, “Baa” from Moody’s and “BBB” from Fitch. • If the Agreements are terminated, the bonds would bear interest at a variable rate, and the State could be liable for a termination payment if the Agreements have a negative market value. Swap mark-to-market is negative. Illinois rating remains negative from all three rating agencies (A+/Aa3/A)

  15. VRDN’s: What Does the Future Hold? All Money Fund Assets Municipal Money Fund Assets Supply Demand

  16. Tools for Analyzing VRDN Risk • Analyze short-term debt exposures • % of floating rate debt with swaps • Run interest rate sensitivity analysis • Review swaps • Negative mark-to-market; trapped issuer • Understand counterparty termination rights, collateral posting requirements • Assess counterparty financial strength • Money center, foreign and US regional banks • Track LOC/SBPA expirations • Discuss plans for fixing out, replacing or extending • Calculate impact of bank bond term out on issuer liquidity • Assess bank terms and conditions • Particularly important for weaker underlying borrowers • Request reimbursement agreement and analyze covenants

  17. Coming Attractions • “Lost Decade”? • Politicians must be careful what they wish for.. • Here we go again… • California Revenue Anticipation Notes (RANs) • Auction Rate, Part Deux? • Liquidity Expirations • Drop Dead! • Federal deficits • What did you expect? • Muni High Yield (e.g. Florida CDD’s) • Se habla Espanol? • Deuda mucho, poco dinero

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