Chicago Junk Bonds

Hard to believe it's come to this, but municipal bonds issued by the Second City are now considered junk bonds. Moody's lowered the rating on Chicago's bonds this week to "Ba1", below investment grade. The rating change was prompted by the rating agency's continuing concern with the city's public employee pension liabilities. The unfunded portion of the city's ten public pension funds now totals a daunting $37 billion. Standard & Poor's and Fitch continue to rate the city in the "A" category, however, showing a considerable divergence in views with Moody's on the depth of the city's woes.

The rating change for the city comes on the heels of a recent ruling of the Illinois State Supreme Court, which just last week struck down a pension reform measure championed by Governor Pat Quinn and passed by the Illinois State Legislature in 2013. That ruling, potentially disastrous for the state facing its own massive unfunded pension debt, also has negative implications for Chicago.

The rating change affects over $8 billion of bonds outstanding, with investors holding those bonds seeing their price degrade day by day. General obligation bonds issued by the City of Chicago in 2012 and due in 2033 yielded just 3.75%, or a spread of roughly 100 basis points to high quality municipal bonds. By 2014, however, with concerns already beginning to emerge about the city's pension problems, bonds of the city of equivalent maturity were sold at a yield of 4.87%. The yield represented a spread of 170 basis points to the high quality index.

As of today, those same bonds issued just last year at 4.87% are now trading at a yield of 5.51% or at a spread of 2.81% to the index.  With price moving inversely to yield, this represents a loss of $5.45 per $100 of value (or 5.45%) to investors who purchased the bonds at the offering just last year. If the bond ratings are similarly dropped by S&P and Fitch, the bonds will unquestionably fall much further in value.

Far higher interest rates on new borrowings of the City and the losses suffered by investors in the city's outstanding bonds may be the least of it, however, with interest rate swaps entered into by the city from years earlier posing a vexing problem for the troubled city. The downgrades may permit banks that had entered into interest rates swaps and other derivative products with the city to now demand payment on upwards of $2.2 billion of those agreements. Similar downgrade provisions helped force Jefferson County, Alabama into bankruptcy a few years earlier.

The past few years have seen some of the largest, and most frequent bankruptcy filings of local government in US history. Jefferson County, Alabama, the cities of Vallejo, Stockton, San Bernardino, Central Falls, Harrisburg and Detroit have all filed, largely due to excessive debts and pension liabilities. The Commonwealth of Puerto Rico, with a staggering $73 billion of US municipal debt outstanding now teeters. Chicago, now in junk status, is on deck.

April Employment Report

The April employment report of the Labor Department showed a 223,000 change in non-farm payrolls with the unemployment rate dropping to 5.4%, in line with forecasts. Less noticed perhaps in the report were the significant downward revisions to the March employment report, with jobs being revised down by 40,000 to 85,000 for the month. The bond market has taken the news hard, as if April employment exceeded forecasts and March was revised higher, rather than lower. Go figure.

The fascination, though, with the employment report in both equity and debt markets is slightly puzzling. The theory, of course, is that job creation creates income and spending power to drive consumption and GDP. It would also signal improved confidence of businesses, seeking greater employment. But there's a disconnect between theory and practice, with Q1 GDP significantly below the economy's tepid 2% annual pace and forecasts for Q2, equally as grim.

Nevertheless, it's the unemployment rate, that soundbite of 5.4% that seems to catch the attention of bond traders around the globe. This fascination sustains, despite great controversy surrounding the number itself, and the impact of a stubbornly low labor participation rate upon the calculation. If we are trying to measure the propensity of consumers to, well, consume, perhaps the unemployment rate is not the best measure.

In addition to the unemployment rate, the Bureau of Labor Statistics also publishes a ratio of employment to population. This, to our thinking, might be a better representation of the portion of the population that is both generating income and consuming, versus the portion of the population, like children and the elderly, that primarily consume. The latter two groups, in effect, access financial resources to support their spending from parents, savings and governmental spending, rather than through income generation.

This ratio has been stuck, stubbornly, at 59%, give or take a couple of basis points, since 2009. After falling considerably from its levels in the years preceding the financial crisis, the ratio has failed to recover during the economic recovery that began in 2009. There can be many explanations for this, including the advancing of the Baby Boomers into retirement, a process that itself has been linked to the sluggish recovery, rather than the other way around. It can also be linked to the explosion of student loan borrowing, elevating college and post-college attendance. And lastly, it can be attributed to the soaring rates of disability claims, following the Great Recession.

Whatever the explanation, America needs to find a way to employ a greater share of its population and raise the median wage of that employment if the intent is to once again rely upon the consumer to fuel economic growth. The latter will be a subject of a future post.

Rising Yields on Treasury Bonds

We've seen a startling and unexpected move to higher yields on the UST 10-year over the past two weeks, with yields rising from 1.87% on April 17 to 2.24% on May 6. Market professionals are scratching their heads to understand the backup in rates amidst weak Q1 GDP, durable goods, factory orders and most recently, ADP private payrolls. 

Much of the latest tantrum followed a prescient call by Bill Gross on shorting German BUNDs, for which those investors following his advice would have profited considerably. Soon to follow were prognostications by a variety of equity guys, including Warren Buffet, who while a demonstrated equity maven, might not be the best source of advice on bonds. Warren's a bit like your family doctor, who skilled in medicine seeks to give advice on a range of subjects beyond his expertise.

For his part, Warren is an old school cronie, not unlike John D. Rockefeller or J. P. Morgan, who built fortunes on the intersect of politics and business. But a bond trader, not so much. Equity guys fail to understand how bonds trade or the simple fact that bonds, unlike stocks, have terminal value.  

For those who make their living in the sector, bonds trade on price, not yield. The price reflects the ownership of a stream of future cash flows. As robust economic activity and the prospect of inflation discount the value of those cash flows, bonds diminish in value. Conversely, weak economic growth creates value. In the deflationary world that Bernanke so feared, bonds would scream.

All of which is to say, the weak level of recently reported economic fundamentals argues that the current tantrum may not have legs and, at least in this one instance, an investor might profit by taking the other side of Warren's trade.

Early Social Security Benefits and the Labor Participation Rate

Marketwatch reported today on the percentage of Social Security recipients taking "early" benefits from Social Security. A surprisingly high 73% of recipients or nearly three out of four, now elect to take benefits prior to full retirement age, thereby significantly reducing the benefits that they will receive in retirement.  

Full retirement age for those born between the years 1943-1954 is defined as age 66, with the date gradually increasing.  For those born 1960 or later, 67 becomes the new full retirement age. Social security benefits are available to those retiring earlier than these ages, but at a reduction of 13% for those electing benefits at 65, the age most commonly associated with retirement (reduced benefits are actually available as early as age 62, but at a 30% reduction). For those waiting until age 70 to take social security, benefits increase each year by 8% relative to the full retirement age, up until age 70 when they are capped. The benefit claimed at any of these ages, is then fixed for the duration of the person's retirement.

These changes were put in place as part of the Social Security Amendments of 1983 (HR 1900) when the Trustees of the Social Security Trust Fund first became concerned about the solvency of the Trust relative to future benefit payments. Interestingly, this act also expanded Social Security benefits to members of Congress and the White House and instituted the taxing of benefit payments to recipients. What Congress giveth with one hand, they taketh away with the other.

Most retirement planners advise people to wait as long as possible to claim benefits. But the point of this article is not to advise people on their selection, but rather to examine the social and economic issues that drive behavior. There are several reasons why people might take early, reduced benefits including illness, or because they believe they can invest the funds at a higher rate of return. The most common reason, though, is that they simply need the money. But there is another reason to consider: Social Security benefits are not guaranteed. The Trustees of the Fund can change the level of benefits going forward at any time.

Of these reasons, the fact that people need the money is both the most likely explanation and the most telling of the limp recovery following the financial crisis.  Along with the significant rise in disability claims over the past six years (and the vast expansion of the student loan program) early social security benefits likely explains the last piece of the puzzle in the pronounced and lengthy decline in the labor participation rate.