Perspective of a Portfolio Manager

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GIC Economic OutlookFirst Thoughts on the Coming Decade -Session III State of the States Fiscal Challenges “ Perspective of a Portfolio Manager”

John R. Mousseau, CFA President, Chief Executive Officer & Director of Fixed Income john.mousseau@cumber.com

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Tax Reform Overview of Munis • Tax Cut and Jobs Act Highlights – – – – – – –

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Corporate tax rate reduced to 21% from 35% Lower individual tax rate of 37% Lack of State and Local Tax (SALT) deduction ($10,000 limit) Capped deductible mortgage interest for new homes at $750,000 Doubling of the individual standard deduction Reduced Amount of taxpayers subject to the AMT Municipalities no longer able to do advanced refundings on a tax exempt basis

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Tax Reform Overview of Munis •

Market Technicals – Supply and Demand Dynamics – Demand way outstrips supply: – The TCJA reduced supply of municipal bonds. In 2017 the potential loss of the tax exempt status of Advanced Refunding Bonds and Private Activity Bonds (PABs) caused a rush of issuance in the municipal market in December 2017 lowering supply in 2018. Subsequently Advanced Refundings were not allowed in the new tax law although PABs were.

– Nonetheless the supply estimates for 2019 are similar to 2018 averaging $340 billion.

Uncertainty regarding and Infrastructure Plan, affordability, pensions and taxpayer resistance contribute to lower supply .

– Strong retail demand, especially for long dated mutual funds, caused municipals to outperform Treasuries. The ratio of municipal yields declined to 90% from a high 130% of Treasury yields • Individual tax rate highest bracket at 37% is still high.

• Limit on SALT to $10,000 • Rhetoric from Governors taxing the wealthy at higher rates

– Property and Casualty insurance companies and banks have reduced holdings of municipal bonds – Corporations and foreign buyers are increasing investment in municipal bonds • Low correlation with other markets, good risk adjusted returns, predictable cash flows

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Tax Reform Overview of Munis •

Credit Quality of Municipal Bonds – Improving economy and changes to the tax law continue to bolster state coffers. The ability of states to tax internet sales has also helped.

– Large under budget state tax collections reported earlier in the year have reversed because tax payers were postponing sending in their taxes. Collections are back on track - meeting or exceeding budget estimates.

– Home price growth in high tax states have slowed or declined in part due to lack of SALT deductions and capped deduction of home mortgage interest expense.

– Lack of deductions increases homeowners expense and could put pressure on municipalities’ ability to raise property taxes – Good economic growth and stimulus from tax law changes result in improved revenues for most municipalities – States increased funding of education will help local municipalities – Many local municipalities, like states, are bolstering their rainy day funds – to be prepared in the event of a recession

¹From Governing.com 11-16-18 article, referencing National Association of State Budget Officers’ State Expenditure Report ©

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General Fund Revenue Compared to Budget Projections

Source: The National Association of State Budget Officers(NASBO) Fall 2018 Fiscal Survey of States Summary: https://www.nasbo.org/reports-data/fiscal-survey-of-states Š

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Average State Rainy Day Fund

Source: The National Association of State Budget Officers(NASBO) Fall 2018 Fiscal Survey of States Summary: https://www.nasbo.org/reports-data/fiscal-survey-of-states Š

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Total State Net Tax-Supported Debt

Source: Moody’s Sector Profile June 3, 2019: “Medians - Flat debt total signals cautious borrowing, despite infrastructure needs.” https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBM_1172874 ©

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Aggregate State Debt Levels (Medians)

Debt Metrics Net tax-supported debt service as a % of governmental expenditures Net tax-supported debt per capita ($) Net tax-supported debt as a % of personal income Net tax-supported debt as a % of GSP

Fiscal year 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 3.7

3.8

3.8

3.9

3.7

4

3.5

3.6

3.6

3.5

1,010 945 955 1,018 957 999 1,036 1,010 932 870 2.1

2.1

2.2

2.5

2.4

2.5

2.5

2.5

2.5

2.4

1.8

1.7

2.3

2.4

2

2.2

2.2

2.1

2.2

2

Source: S&P CapitalIQ June 11, 2019 Commentary: https://www.capitaliq.com/CIQDotNet/CreditResearch/SPResearch.aspx?articleId=&ArtObjectId=11017708&ArtRevId=5&sid=&sind=A& Š

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Unfunded Other Post-Employment Benefits

Source: Moody’s Sector In-Depth October 17, 2018: “New OPEB accounting sheds light on credit impact of retiree healthcare liabilities” https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBM_1140516 ©

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Source: NFMA presentation: “Tax Reform and the Muni Market”, May 2019, https://nfma.memberclicks.net/assets/documents/education/ac19/ac19taxreform.pdf ©

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Muni Visible Supply

Source: Bloomberg Š

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200

338.93

448.61

444.80

397.71

$132.15 Billion

339.05

250

$131.96 Billion

334.07

287.72

409.69

389.63

429.89

408.28

359.75

300

383.34

350

358.40

400

388.84

450

379.61

Municipal Bond Issuance

433.27

May 2019 YTD Issuance: Compared to May 2018 YTD Issuance: A 0.14% decrease

131.96

150 100 50 0 2002 YEAR

2003 JAN

21.77 27.10 20.71 22.12 18.78 31.21 19.78 23.15 32.66 12.44 17.45 27.04 19.60 29.32 25.72 36.05 21.51 24.67 Source: The Bond Buyer 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

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2004

2005

2006

2007 2008 2009 2010 2011 2012 2013 2014 Selected Categories 2000 - 2017 Year-to-Date ($ Billions)

2015

FEB

MAR

APR

MAY

JUN

JUL

AUG

SEP

OCT

20.98 30.23 26.85 31.20 23.87 32.03 21.40 23.40 27.05 16.54 27.03 24.58 16.54 33.16 31.66 23.39 17.90 26.24

25.42 28.14 38.69 45.01 27.07 44.35 43.83 38.83 44.69 18.91 34.79 32.75 28.56 45.60 42.49 32.89 26.08 27.08

25.86 36.31 31.09 31.31 29.35 33.54 51.72 36.84 27.50 15.76 34.85 38.29 26.76 41.00 35.37 30.71 31.52 26.51

34.00 35.70 37.61 35.94 35.04 42.92 43.75 30.41 38.32 21.39 37.89 30.30 27.91 36.74 42.32 38.71 35.15 27.46

38.46 48.25 35.07 44.25 45.33 47.18 50.79 43.86 34.68 31.97 43.45 26.11 35.85 40.19 47.96 39.30 33.39 0.00

28.02 33.20 25.30 34.49 27.86 31.86 37.09 26.11 29.15 24.91 28.64 30.21 27.86 35.30 28.83 24.97 27.74 0.00

31.58 25.86 27.94 34.02 31.59 29.21 32.50 36.36 29.71 23.83 33.50 22.83 24.73 32.38 46.66 37.54 34.04 0.00

27.57 26.26 25.20 31.67 28.03 32.82 20.19 29.95 35.65 27.46 26.36 21.38 25.16 23.57 39.79 29.70 25.22 0.00

42.41 34.87 32.22 27.31 31.57 45.18 21.93 46.37 45.73 32.86 35.13 28.94 37.32 33.95 53.45 40.10 36.59 0.00

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2017 2017 2018 2019 2017 A Record NOV A Record DEC TOTAL 2016

35.60 26.27 25.77 39.42 42.77 30.12 25.73 38.29 46.07 37.29 33.78 24.61 29.56 24.30 31.66 45.43 27.85 0.00

26.73 31.15 33.30 31.56 47.58 29.47 20.91 36.11 42.05 24.37 26.76 27.04 39.20 22.20 18.88 69.83 21.96 0.00

358.40 383.34 359.75 408.28 388.84 429.89 389.63 409.69 433.27 287.72 379.61 334.07 339.05 397.71 444.80 448.61 338.93 131.96

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Muni Squeeze, 12-01-17

US General Obligation A Muni Curve – 12/01/17 California Muni Curve – 12/01/17 New York Muni Curve – 12/01/17

Source: Bloomberg ©

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Muni Squeeze Spread, 12-01-17

3m

1y

2y

3y

5y

10y

15y

30y

National

1.435

1.527

1.742

1.847

2.069

2.585

2.972

3.267

California

1.304

1.4

1.598

1.655

1.786

2.249

2.66

3.002

National California Spread

0.131

0.127

0.144

0.192

0.283

0.336

0.312

0.265

New York

1.243

1.353

1.549

1.58

1.65

2.079

2.523

2.981

National New York Spread

0.192

0.174

0.193

0.267

0.419

0.506

0.449

0.286

Source: Bloomberg Š

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Muni Squeeze, 06-17-19

US General Obligation A Muni Curve – 06/17/19 California Muni Curve – 06/17/19 New York Muni Curve – 06/17/19

Source: Bloomberg ©

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Muni Squeeze Spreads, 06-17-19

3m

1y

2y

3y

5y

10y

15y

30y

National

1.509

1.548

1.577

1.609

1.701

2.05

2.458

2.793

California

1.123

1.165

1.201

1.244

1.345

1.619

2.108

2.642

National California Spread

0.386

0.383

0.376

0.365

0.356

0.431

0.350

0.151

New York

1.154

1.177

1.177

1.187

1.237

1.532

1.946

2.366

National New York Spread

0.355

0.371

0.4

0.422

0.464

0.518

0.512

0.427

Source: Bloomberg Š

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5-year CDS: State of California

Last Price: 26.970 High on 07/06/17: 77.350 Average: 45.645 Low on 03/12/19: 22.435

2017 Tax 2017 Bill Tax Bill

Source: Bloomberg Š

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5-year CDS: State of New York

Last Price: 26 High on 06/27/16: 58 Average: 32 Low on 01/10/18: 23

2017 Tax 2017 Bill Tax Bill

Source: Bloomberg ©

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5-year CDS: State of New Jersey

Last Price: 61 High on 11/22/16: 195 Average: 120 Low on 02/28/19: 60

2017 Tax 2017 Bill Tax Bill

Source: Bloomberg ©

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5-year CDS: State of Florida

Last Price: 27 High on 08/23/17: 48 Average: 34 Low on 01/30/19: 25

2017 Tax 2017 Bill Tax Bill

Source: Bloomberg Š

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5-year CDS: State of Texas

Last Price: 31 High on 07/19/16: 65 Average: 39 Low on 09/10/18: 25

2017 Tax 2017 Bill Tax Bill

Source: Bloomberg ©

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5-year CDS: State of Washington

Last Price: 26 High on 11/14/16: 47 Average: 34 Low on 09/07/16: 24

2017 Tax 2017 Bill Tax Bill

Source: Bloomberg Š

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Disclosure All material presented is compiled from sources believed to be reliable. However, accuracy cannot be guaranteed. Past performance is no guarantee of future results. All investments involve risk including loss of principal. Fixed income investments are subject to interest rate and credit risk.

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