municipal market guide - ubs...4 november 2016 municipal market guide a confluence of factors we...

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30 November 2016

Municipal Market GuideCIO Wealth Management Research

Transportation wins at the ballot box

Tax reform prospects increase

Munis lose ground as fund flows reverse

Weathering the storm

This report has been prepared by UBS Financial Services Inc. (UBS FS). Analyst certification and required disclosures begin on pg. 33.

02 At a glance

03 Market view

06 Outlook

11 In the news

17 Follow-up on ballot initiatives

27 Chartbook

30 State ratings

32 Endnotes

35 Disclaimer

Contents

AuthorsThomas [email protected]

Kathleen McNamara, CFA, [email protected]

Kristin [email protected]

Sangeeta [email protected]

Sara [email protected]

David [email protected]

DESKTOP PUBLISHINGGeorge StilabowerCognizant Group – Basavaraj Gudihal, Srinivas Addugula, Pavan Mekala, and Virender Negi

Cover photo: Getty Images

At a glance

Total return by sector

Source: BofAML, Bloomberg, UBS, as of 25 November 2016

In %

Treasuries

Taxable FI Agg

Munis

Build America Bonds

Emerging Markets

Preferreds

High Yield

Investment Grade

Agencies

TIPs

S&P 500

2016 YTD TR

2015 TR

0 15105–10 –5 20

Congress last succeeded in crafting a tax reform package just over 30 years ago. The election of Donald Trump as the next US president has altered the political dynamics in Washington and increased the probability that a com-prehensive tax reform package will be introduced and passed next year. According to our colleagues in the US Office of Public Policy, the odds of passage are the highest since the last major tax reform legislation was signed into law in 1986. Still, there will be many hurdles along the way, and we believe the odds of enactment to be around 50-50 right now.

Every tax incentive has its own corps of supporters eager to defend its importance and value to the US econ-omy. Tax exempt bonds are no dif-ferent. For the past four years, public interest groups have made a con-certed effort to convince members of Congress that the municipal tax exemption reduces the cost of capi-tal for states and cities, and thereby

encourages investment in America’s infrastructure. But, to reduce mar-ginal rates substantially and simplify the tax code, numerous tax deduc-tions (tax expenditures in the parlance of Washington) must be curtailed or eliminated. We expect that any seri-ous effort to reduce personal income tax rates will contribute to market vol-atility as the merits of preserving tax exemption are actively debated.

Municipals will face other challenges as well. After more than a year of con-sistent inflows, mutual funds have been obliged to accommodate sig-nificant withdrawals as interest rates spiked. Two weeks does not consti-tute a trend, but it is reasonable to expect that demand for tax exempt bonds will exhibit greater volatility in 2017. The muni market has been char-acterized by long periods of tranquility punctuated by brief episodes of tur-moil. We are inclined to believe that tax exempts are in for a challenging few months ahead.

Tax reform is a once-in-a-generation opportunity.Max Baucus, US Ambassador to China and former US Senator

Note to our readers: The next edition of the MMG will be published in January.

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Municipal Market Guide NOVEMBER 2016 3

Market view

Municipals lose groundIn last month’s edition of the Municipal Market Guide, we fore-casted increased volatility in the tax-exempt market due to declining technical strength and diminishing inflows to muni mutual funds. Had rates risen at a moderate pace in November, we would have been inclined to attribute the move to the afore-mentioned trends, and moved on. What we experienced was hardly a moderate reaction to diminishing technical strength. Donald Trump’s come-from-behind victory was complemented by a GOP sweep of Congress, with Republicans retaining major-ity control of the Senate. The election results increased the probability that a broader fiscal stimulus package will be imple-mented next year. Treasuries sold off as investors anticipated bigger federal deficits and more inflationary pressure. Municipal bond prices declined in sympathy with Treasury securities, but also were rocked by the increasing likelihood that a comprehen-sive tax-reform package would be debated in 2017.

From 7 through 18 November, the tax-exempt asset class lost ground, ceding 1.8% in total return. This price decline reduced the sector’s year-to-date performance, which was only margin-ally positive at 0.3% through 18 November.1 Subdued demand for municipals after the Thanksgiving holiday drove year-to-date returns into negative territory as of 29 November. Mean-while, high yield munis exhibited even larger losses (-4.0%) in the wake of the election. That said, given the stronger perfor-mance of the high yield sector earlier this year, the year-to-date performance was still positive.2

The US tax exempt market remains highly vulnerable to changes in investor sentiment. External factors, such as a fear of rising rates, can drive individual investors out of the market, as we saw in 2013. Broker dealers have less inventory capacity to cushion the impact of abrupt reductions in retail demand. Municipals are still a “long-only” market, so prices can be whipsawed when demand evaporates.

Fund flows reverseFollowing 13 straight months of net cash inflows into munici-pal mutual funds, the tax-exempt sector was subject to the inevitable reversal of fortune. For the week ending 17 Novem-ber, municipal mutual funds lost approximately USD 3.1bn of assets as investors redeployed funds into cash or the equity market. The outflows continued last week in front of the Thanksgiving holiday; municipal mutual funds lost an addi-tional USD 2.2bn of assets for the week ending 23 November. While not surprising, the sheer volume of withdrawals added impetus to falling prices as portfolio managers accommodated withdrawal demands by selling fund assets. There is an inverse relationship between the direction of yields and muni fund flows, a correlation that we have described in prior editions of the Municipal Market Guide. The pattern repeated itself again, as shown in Fig. 1. Market participants will recall that mid-2013 (taper tantrum) was a particularly volatile time for the muni market. At that time, net cash outflows eclipsed the sig-nificant outflows seen in late 2010/early 2011, another period of rising muni yields.

Note: November flows are MTD as of 16 November 2016 Source: Investment Company Institute (ICI), MMD, UBS as of 23 November 2016

Monthly Net New Cash Flow

AAA GO 30yr Monthly Yields

0

5,000

–15,000

–20,000

–5,000

–10,000

0

10,000

4

3

2

1

5

6

Nov-13May-13Nov-12May-12Nov-11May-11Nov-10May-10 May-16Nov-15May-15Nov-14May-14 Nov-16

Fig. 1: Municipal mutual fund flows and long term yields

Le hand side in millions, right hand side yields in %

Historically low yieldsMeridith Whitney

“60 minutes”interview

Rate volatility

4 NOVEMBER 2016 Municipal Market Guide

A confluence of factors We attribute the abrupt decline in the value of municipal bonds to a confluence of factors. First and foremost, there was a sharp increase in US Treasury yields immediately following the election. This prompted a corresponding sell-off in munis, although as usual tax-exempts were slower to react. Second, the prospects of increased federal spending and a rising defi-cit represent new headwinds for the market. Third, after an exceptionally long period of muni mutual fund inflows, the market was more vulnerable to a shift in investor sentiment. As the late economist Herbert Stein was quoted as saying, “If something cannot go on forever, it will stop.” And finally, in addition to the probability that a Republican Congress will enact broad-based tax cuts, comprehensive tax reform is back on the table again and will be the subject of negotiation in the next Congress. What’s next?For the balance of 2016, we believe that munis will continue to face challenges. First, mutual fund outflows are likely to persist, based on the shift in investor sentiment now under-way. Second, we also expect that net new issue supply will weigh on the market through the middle of December. A number of transactions were postponed in the past two weeks, and many of those issuers will seek market access before year-end. Bonds out for the bid increased by another 4% on Tuesday heading into the Thanksgiving holiday, bring-ing the aggregate secondary market supply to its highest level in five years, according to Bloomberg.

Market view

Fig. 3: AAA muni-to-Treasury yield ratios YTD

Source: MMD, UBS, as of 22 November 2016

In %

100

95

90

85

80

105

110

10 yr

30 yr

Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16

Source: Bloomberg, UBS, as of 22 November 2016

0

–20

–40

–60

40

60

Nov-16Sep-16Jul-16May-16Jan-16 Mar-16

20

Issued

Matured/Maturing

Announced Calls Net Issuance

Visible Supply

Fig. 2: Municipal bond market monthly profile

In USD billions

With municipal yields having incurred a substantial market move in the wake of the election, we do not expect another pullback in yields of the same magnitude from this point. The 10-year US Treasury benchmark note appears to have stabi-lized, hovering at around the 2.35% level. Market participants will be focused on the final outcome of the next Federal Open Market Committee meeting (13-14 December).

The market has already priced in a 25 basis point rate increase. Here’s why. First, inflation expectations have increased mark-edly in recent weeks. Second, economic data has been gener-ally supportive, with few surprises to the downside. And most importantly, Fed Chair Janet Yellen’s testimony before the Joint Economic Committee on 17 November reaffirmed that the Fed is ready to hike rates in December. In prepared remarks, she noted that a rate increase “could well become appropriate relatively soon.” That’s about as clear an indication as you will ever get from a central bank official. In our view, the combina-tion of good economic data and gradual rate hikes should not trigger another municipal market sell-off similar in magnitude to what we just experienced.

Year-end portfolio strategies Consider tax-loss harvesting The recent pullback in tax-exempt yields may have presented some tax-loss harvesting opportunities within municipal bond portfolios. By realizing (harvesting) a capital loss to offset tax-able capital gains, reported investment gains and tax liabili-ties decrease. Thus, Internal Revenue Service regulations may


Fig. 4: AAA muni yields


In %

2.5

2.0

1.5

1.0

0.5

3.0

3.5

AAA GO 5 yr

AAA GO 10 yr

AAA GO 30 yr

May-15 Aug-15 Nov-15 Feb-16 May-16 Aug-16 Nov-16

Market view

have the effect of granting losses of noteworthy value to an investor. While wash sale rules exist, tax-loss strategies are often used in conjunction with other portfolio improve-ments, such as duration adjustments and credit-quality management. See our Education note: Loss-harvesting to save taxes, 7 October 2016.

Manage duration and coupon income We maintain our preference for high-coupon bonds ver-sus low-coupons to help minimize future market discount risk. We also prefer floating-rate securities and bonds with a shorter duration. Floating rate securities are better insu-lated from interest rate changes because the income distri-butions are reset periodically based on a particular reference rate. For fixed-rate securities, we recommend bonds with maturities in the 6- to 10-year portion of the curve rather than longer-duration bonds (see Municipal Brief: Post-elec-tion and guidance, 9 November 2016). They are better posi-tioned in an environment with rising interest rates and with the ambiguity accompanying the tax treatment of munici-pal securities. Although this maturity area witnessed some underperformance over the past two weeks, reflecting a steeper curve, we maintain our preference. Bear in mind that this portion of the curve can provide attractive roll-down opportunities for investors.

Focus on higher-rated creditsWe continue to favor higher-rated investment grade munis over high yield tax-exempt paper (Municipal Market Guide, 14 July 2016). Based on our expectations for higher volatility in the months ahead, we believe that higher-rated muni credits will prove more resilient. The municipal high yield market has been a principal beneficiary of positive fund flows earlier this year. As the flows reverse, investors will be obliged to scruti-nize underlying credit quality more closely.


Fig. 1: Credit quality spreads


In bps

200

150

100

50

0

250

350

300

400

BAA GO 10 yr – AAA GO 10 yr

A GO 10 yr – AAA GO 10 yr

AA GO 10 yr – AAA GO 10 yr

Nov-06 Nov-07 Nov-08 Nov-09 Nov-10 Nov-15Nov-14Nov-13Nov-12Nov-11 Nov-16

Outlook

Source: BofAML, UBS, as of 22 November 2016

–5

10

5

0

15

20

2006

5.03.0 2.3

11.2

7.3

–2.9

9.8

0.2

2007 20122011201020092008 201520142013 2016

Fig. 2: Historical municipal total returns, 2006–2016 YTD

In %

–4.0

3.6

14.5

Each year, in lieu of a more traditional Spotlight article, we devote some space in the November edition of the MMG to the publication of a few forecasts regarding the future performance of the municipal market. Predictions are, by their very nature, fraught with risk. But the exercise is often useful as a means to take a step back and examine recent events in a more objective light.

Portfolio strategyTax reform discussions in Washington, DC will contrib-ute to municipal market volatility. Comprehensive tax reform is back on the table. The Trump Administration and a GOP Congress will make the first serious attempt at com-prehensive tax reform in 30 years. The ambiguity around the willingness of Congress to preserve municipal tax exemption will lead to some disorder in market pricing. Municipals are in better position now than they were in 2012 when President Obama and former House Speaker John Boehner reached a budget deal that would have curtailed the exemption. Even so, public interest groups will remain on guard for any proposal to reduce the value of the tax exemption, leading to some mar-ket volatility in the absence of any certainty that municipals will be left unaffected.

To the extent that Congress preserves tax exemption, or oth-erwise protects outstanding bonds from taxation, munis will outperform other fixed income instruments. Conversely, to the extent that Congress limits municipal tax exemption, or taxes

interest retroactively on bonds already issued, we expect that prices will suffer. The binary outcome is impossible to price effectively, which we believe will contrib-ute to illiquidity as Congress deliberates, as well as volatility as different outcomes are weighed by investors.

Lower marginal tax rates would reduce the appeal of munici-pal bonds. Even if Congress fails to enact a comprehensive tax reform package, opting instead for a more limited reduc-tion in marginal tax rates, municipal bond interest would be less attractive to individual investors. Lower marginal tax rates would reduce the value of the tax shelter provided by the fed-eral tax exemption on municipal bond interest, thereby plac-ing some downward pressure on prices (see Municipal Brief: Examining the value of tax-exemption: what’s next?, 15 November 2016).

New issue volume will soften. Following a period of robust municipal bond issuance in 2016, we expect the number of new bond issues to subside in the year ahead. New issue vol-ume in 2016 is now on track to establish a record high (USD 414.5bn, as of 25 November 2016). We expect total issuance to reach USD 440bn in 2016, up from USD 397.7bn one year earlier. This record issuance was driven in large part by current and advance refundings (61%) rather than by new money proj-ects (39%). Bear in mind that tax-exempt bond yields hit his-torical lows in mid-2016, allowing muni issuers another chance to refinance their higher cost debt.


Outlook

Advance refundings are apt to decrease based on a higher rate environment. The universe of bonds eligible for current refundings in 2017 will be lower than in 2016. We do expect the par amount of new issues to move higher, but not enough to fully offset the likely decline of refunding trans-actions. The November 2016 election has provided local gov-ernments with approval to issue at least USD 60.2bn of bonds for infrastructure projects.1 We forecast overall supply to total about USD 375bn for calendar year 2017.

Expect modest returns. Investors should be prepared for an environment where returns are relatively modest. Putting aside the risk associated with tax reform negotiations in Washing-ton, the monthly outflow of assets from municipal bond funds is apt to continue for some time. Municipals are likely to post flat returns for calendar year 2016, and we expect only incre-mental improvement in the year ahead.

Exchange-traded fundsMunicipal ETF assets will grow by USD 10bn in 2017. We believe municipal ETF growth will accelerate as investors are likely to prefer an investment option that may offer bet-ter liquidity in a politically volatile environment. Positive flows into municipal ETFs through the end of October were just over USD 5bn, already the most in any full calendar year. While the prospect of higher muni yields could lead to some hesitation among investors to invest in municipal ETFs, the ability to sell positions quickly makes it an alternative for investors wary of holding municipal bonds in an environment where compre-hensive tax reform is under discussion.

There will be a new entrant in both the active and pas-sive municipal ETF market. We were frankly surprised by the fact that another new entrant did not appear in the municipal ETF market during 2016. We expect to see a new entrant in both the actively managed and passively managed municipal ETF market next year. The more challenging environment for municipal bonds may provide opportunities for active manage-ment to add value. The active municipal ETF market consists of just six ETFs from four discrete issuers, so the hurdle for new issuers to compete is not as high as in other areas of the ETF market. With respect to a new entrant for a passively managed ETF, four of the 10 largest ETF issuers do not have a munici-pal ETF. Each of these four issuers has fixed income ETFs. We are obliged to note that this forecast is dependent on the tax treatment of municipal bond interest remaining unchanged.

The first smart beta ETF focusing on municipal bonds will be issued. The smart beta classification refers to ETFs that track an index, where the index attempts to improve upon the returns of a traditional benchmark by relying on criteria other

than market cap to select and/or weight securities. At the end of 3Q16, roughly 94% of smart beta ETF assets tracked equity indi-ces. There were only 24 smart beta ETFs tracking fixed income indices, none of which focus on municipal bonds. We think fixed income smart beta issuance will pick up next year and that the first municipal bond smart beta ETF will be issued.

Municipal closed-end fundsWe expect to see further pressure on market prices and net asset values (NAVs) of closed-end funds. Municipal closed-end funds sold off across the board in the wake of the election, wiping out the gains recorded earlier in the year. In just the last four weeks, national leveraged muni closed-end funds are down 7% in terms of market price and 5% in terms of NAV. And, in just the last two weeks, we have seen USD 5.3bn of outflows from open-end muni mutual funds.

We expect to see some temporary support for the CEF market after tax-loss selling, but this is likely to be short-lived. Leverage costs for most funds are based on short-term rates, and are pegged to the SIFMA Index. After reaching a recent high of 87bps, the SIFMA Index has moved down to 55bps. The move reduces the cost of leverage, but the rate is still higher than it was a year ago, and it will con-tinue to exert pressure on fund earnings. Distribution cuts dominated calendar year 2016, and we believe this trend will continue into 2017. Closed-end fund tax-free distributions ranging from 5.5-6% are still attractive for investors in higher tax brackets, in our view, but the ambiguity surrounding tax reform discussions is likely to restrain CEF performance. In contrast to July of this year, when funds were up by double digits in terms of market price and NAV, closed-end funds are now trading at cheap levels versus their one- and two-year average discounts.

Investors should be prepared for an environment where returns are relatively modest.


Municipal creditPension liabilities will preoccupy credit analysts and receive even more scrutiny from the mainstream media. The American Legislative Exchange Council calculated the aggregate unfunded liability for state public pension plans at USD 5.6 trillion. Moody’s Investors Service expects that these unfunded liabilities, as reported by governments, will grow by another 10% based on insufficient employer and employee contributions, and relatively poor returns on invested assets. We believe that institutional investors and rating agencies will place even greater weight on a municipality’s unfunded pen-sion liability in assessing creditworthiness in the year ahead. Investors can sidestep pension risk by swapping out of state and local government credits that are struggling with ris-ing pension costs in favor of essential service credits located in the same area. Some examples include the New Jersey Turnpike Authority, the Philadelphia Water and Sewer enter-prise, Chicago-area airports, and Detroit Metropolitan Wayne County airport.

Insured bonds from solvent insurers will provide a safe harbor for clients concerned about pension liabilities. The bond insurance industry’s share of the municipal mar-ket has diminished in the past decade. We believe two legacy insurers, Assured Guaranty and National Public Finance Guar-antee, are likely to sustain losses on their exposure to Puerto Rico. However, we also expect both firms to survive the shake-out on the island. A third bond insurer, Build America Mutual (BAM), focuses on smaller municipal borrowers and has no exposure to Puerto Rico. We believe the market will ascribe incrementally higher value to policies from these three com-panies over time on scarcity value. Investors should still review the underlying credit of insured bonds and focus only on those with investment grade ratings.

Favor enterprise sectors better insulated from fixed costs. Our preferred issuers are airport authorities, water and sewer utilities, public power enterprises, and established sur-face transportation agencies. Select higher education institu-tions2 and state housing finance agencies also fit the bill. We are less constructive on local government leases and other credits where repayment is subject to discretionary appro-priations. Many local governments were struggling with ris-ing fixed costs prior to the election, and could now be fur-ther pressured by proposals to convert Medicaid into a block grant program and to repeal the Affordable Care Act (ACA). For the same reason, we maintain a more cautious stance on

non-profit healthcare, where we believe that election-related uncertainty may cause the sector to underperform in the near term. We expect higher-rated healthcare systems to be better equipped to manage any potential volatility.

It’s preferable to be a secured creditor. In the rare instance of a Chapter 9 filing, GO bondholders that benefit from the presence of a statutory lien on taxes levied for the payment of debt service have better prospects for a full recovery, all else being equal. Investors should keep in mind, however, that being a secured creditor does not eliminate the risk of default, nor does it guarantee full recovery after a missed pay-ment. Understanding an issuer’s underlying financial condi-tion remains an important consideration as a result. We view a state’s willingness to offer investors secured status on local gov-ernment debt as a positive attribute; California did so last year.

If nothing else, it signals a state’s support of a legal framework protective of bondholders. More states have demonstrated their willingness to do so over the past several years, and we expect this trend to continue. Some of the broadest and most explicit applications of a statutory lien on ad valorem revenues pledged to local government debt can now be found in Califor-nia, Idaho, Louisiana, Minnesota, Oregon, Rhode Island, Ten-nessee, Texas, and Utah.

Downward movement of state ratings will continue. While upgrades are on pace to outpace downgrades across US public finance for 2016 by each of the three major rating agencies, some pockets of weakness are evident. Through the third quarter, S&P had downgraded more state ratings than it upgraded for the year, and the local government sector led the rating agency’s multi-notch rating downgrades. As another example, Fitch downgraded more non-profit healthcare credits in the third quarter than it upgraded. While US public finance is likely to continue to experience overall rating stability in 2017, we believe that further rating pressure in the state and local government sectors, as well as in non-profit healthcare

We maintain a more cautious stance on non-profit healthcare, where we believe that election-related uncertainty may cause the sector to underperform in the near term.

Outlook


is possible. States experiencing an above-average level of pen-sion-related (IL, NJ, CT, MA, PA, KY, LA) or energy sector risk (AK, LA, OK, WV, ND, NM, WY) are vulnerable, in our view. Kansas also is likely to experience higher borrowing costs due to persistent revenue misses and recurring budget challenges. And, if history is a guide, fiscally strained states can be quick to downstream some of their own budgetary difficulties to local governments or other public institutions reliant on their aid, such as public universities and school districts. We are obliged to note that Moody’s and Fitch unveiled new rating methodol-ogy in 2016 that distorted overall results to the positive.

Medicaid begins to capture more attention as a credit issue. Medicaid is the largest area of federal grants to state and local governments. S&P estimates that the category rep-resented USD 369.6bn, or 61%, of total federal outlays to the state and local sector in FY16.3 According to the National Association of State Budget Officers (NASBO), over 55% of state spending growth since FY12 can be attributed to the Medicaid program, averaging 9.4% over the past four years, in comparison to 2.4% growth in all other categories.4 As a per-centage of total state spending, NASBO found that Medicaid consumed 29% of all dollars in FY16 in comparison to 20.5% in FY08, and handily represents the largest spending area. We believe that any meaningful reductions in federal Medicaid aid would quickly complicate fiscal matters for the state and local government sector.

Puerto Rico investors holding uninsured bonds incur losses. We do not expect the Commonwealth to execute a comprehensive debt restructuring agreement in 2017, but the outlines of such an agreement should begin to take shape. After rejecting a ten-year fiscal plan provided by Governor García Padilla’s Administration in October, the Financial Over-sight and Management Board for Puerto Rico, created under the Puerto Rico Oversight, Management, and Economic Stabil-ity Act (PROMESA), has now requested that a revised plan be submitted by 15 December 2016. The plan must also include a debt restructuring proposal and a debt sustainability analysis. The Oversight Board’s goal is to be in a position to certify a fis-cal plan no later than 31 January 2017.

We readily concede that Puerto Rico has been incapable of reaching any agreement with creditors during the Gar-cía Administration. Governor García’s successor, Ricardo Ros-selló, was elected earlier this month. He appears more attuned to the capital markets and appears genuinely interested in restarting negotiations with creditors on a more amicable

basis. Even so, the island’s economy is contracting, and the federal government is less likely to provide increased financial assistance under the Trump Administration, in our view. We expect contentious litigation, a subsequent deferral of princi-pal, and eventual concessions from creditors in return for fun-damental financial reforms by the government.

New Jersey credit spreads will widen. The recent trans-portation funding agreement between the Christie Adminis-tration and the Democratic legislature did little to resolve the state’s recurring budget challenges. We expect more rating downgrades and recognition among investors that the prob-lems besetting the Garden State are as difficult as those facing Illinois, and the yields demanded by investors should be similar. While Illinois GO bonds are trading at notably wider spreads than New Jersey GOs, the majority of the Garden State’s debt is subject to appropriation, and thus is a better point of com-parison.5 Based on our analysis of select securities, Illinois GOs are still modestly cheaper than New Jersey appropriated debt across the curve, as shown in Fig. 3, but we expect this gap to narrow in 2017.

Connecticut will reach the tipping point. We have been highlighting Connecticut’s inability to forecast its own rev-enues accurately for some time now. The state also exhibits an appallingly low pension funding ratio and remains reliant

Outlook

Fig. 3: Spread between Illinois GO and NJ appropriation bonds

Note: A positive spread indicates that Illinois GO bonds are trading cheaper thanNJ appropriation bonds. 7yr spread calculated using Illinois GO 5s of 2023 (452152VS)and NJ Economic Development Authority 5s of 2023 (645918U9). 15yr spreadcalculated using Illinois GO 5¼s of 2031 (452152VH) and NJ Economic DevelopmentAuthority 5¼s of 2031 (64577BJV). 23/24yr spread calculated using Illinois GO 5s of2039 (452152VM) and NJ Economic Development Authority 5¼s of 2040 (64577BKA).Source: Bloomberg, UBS, as of 29 November 2016.

In bps

20

0

–20

–40

–60

80

60

40

100

7yr spread 23/24yr spread

15yr spread

Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16


on less than a dozen townships to generate a disproportion-ate share of state revenue. Taxes have been raised, making the Nutmeg State less appealing for business. We believe the depth of the state’s budgetary challenges will become more evident in 2017, causing credit spreads to widen and the last vestiges of the reputation the state once enjoyed as a pre-ferred issuer in the municipal market to be stripped away. Con-necticut local governments with an above-average level of reliance on state aid may also find themselves experiencing a heightened level of fiscal pressure in the year ahead.

Chicago will remain a persistent irritant in the municipal market. The Windy City has been the subject of many critical reviews in recent years. Having privatized many physical assets and then misallocated the proceeds to non-recurring budget-ary solutions, the city is close to hitting the proverbial wall. The Emanuel Administration has raised taxes and taken other posi-tive steps, but we believe these will prove to be insufficient in the long run. The city’s ratings have stabilized for the time being, in our view, but investors should remain attuned to its myriad long-term challenges. These include high fixed costs, continued pension-related risk, rising out-year budget gaps, practical limitations to further raising revenue, and a largely non-discretionary spending profile. With this in mind, we con-tinue to recommend that investors consider any price improve-ment as an opportunity to diversify holdings.

CBOE is a greater risk. Arguably, Chicago’s most immediate challenge is arriving at a solution that stabilizes the distressed Chicago Public Schools. The Chicago Board of Education (CBOE), which issues debt on behalf of the school district, has seen its credit ratings fall deeply into the non-investment grade category. A dangerously narrow liquidity position, reliance on uncertain budget assumptions, its need for market access, and nominal reserves are a combination that makes the credit an inappropriate investment for the traditional muni investor, in our view.

Philadelphia, Dallas, and Houston to see more scrutiny. Like Chicago, Philadelphia is also challenged by a relatively nar-row reserve position, large unfunded pension liabilities, and a high debt burden. The rating agencies began to acknowledge the extent of the city’s debt and pension-related challenges with rating actions in 2016. We expect there may be more to come. And, despite carrying higher credit ratings than Philadel-phia, pension risk has become a growing area of credit pres-sure for Dallas. We expect that its near-term rating stability will hinge on its ability to achieve proposed Police and Fire Pen-

sion Fund benefit reductions.6 Turning to Houston (Aa3/AA/AA), the city recently identified a series of reforms to reduce its large unfunded pension liabilities.7 The proposal, which we view as a positive step, still carries some risks, including a large

USD 1bn pension obligation bond issuance to bolster plan assets. Longer term, Houston’s and Dallas’ outsized pension liabilities are disadvantages relative to other city governments with more manageable pension costs, in our view. Investors unwilling, or unable, to closely monitor pension developments in these two Texas cities should consider divesting themselves of their positions ahead of potential rating changes. We are obliged to add that we do not anticipate a default, but do expect closer rating agency scrutiny.

The State of California will remain financially stable, but exposed to revenue volatility. Golden State voters extended the “temporary” income tax surcharge through 2030. The vote is no doubt a disappointment for many high-income residents, but bondholders will welcome the additional cushion the income tax revenue provides. With that said, the next recession will bring an abrupt decline in revenue, as the amount of income generated by capital gains is reduced. We do not expect that recession in 2017, but its inevitable arrival in some subsequent year will result in another budget crisis. We still favor the state’s bonds, though, because of the size of the California economy and the evident willingness of voters to tax their more affluent neighbors.

Outlook

The problems besetting the Garden State are as difficult as those facing Illinois.


Alaska

Last month, Alaska shelved a USD 2.3bn pension obligation bond (POB) deal just days before it was expected to price. As we mentioned in October’s Municipal Market Guide, S&P placed the state’s GO bond rating on CreditWatch with neg-ative implications on concern that the POB financing would weaken the state’s credit profile. The decision to table the deal was preceded by the state Senate Finance Committee sending a letter to Governor Bill Walker on 19 October urging him to reconsider the issuance given limitations which it, and the likely S&P downgrade, would place upon the state’s future financial flexibility. The letter further admonished the state’s current pen-sion cost assumptions as overly optimistic, especially the 8% assumed rate of return. On 27 October, S&P removed Alaska’s AA+ GO rating from Credit Watch negative on the deal’s sus-pension; however, the rating is still accompanied by a negative outlook. The next determinant of the rating trajectory is likely to be the state’s ability to make progress toward structural bal-ance, with FY18 budget negotiations beginning next month.

California

California Controller Betty Yee announced on 10 November that state revenues for the month of October missed projec-tions by 5%, bringing FY17 collections 1.1% below estimates on a year-to-date basis. Lower personal income tax receipts were cited as the cause of October’s miss. Year-to-date, weak-ness in both corporate and sales/use taxes are the primary drivers. These revenue trends will likely influence the make-up of the state’s FY18 budget, the first draft of which will be released by Governor Jerry Brown in January.

Colorado

Colorado-based Catholic Health Initiatives (CHI) and San Francisco, CA-based Dignity Health announced that they had signed a non-binding letter of intent to explore aligning their organizations on 24 October. A merger would create one of the nation’s largest not-for-profit healthcare systems, with operations spanning 25 states. CHI currently operat-ing more than 100 hospitals in 18 states. As we mentioned in the May 2016 Municipal Market Guide, CHI’s expansion activity has strained operating performance and increased its leverage. Weakening financial results drove Fitch to down-

grade the system’s revenue bonds to BBB+ from A- on 12 July 2016. A negative rating outlook accompanies Fitch’s, as well as Moody’s A3 rating of the system. As we go to press, S&P placed its A- rating of CHI under review for possible down-grade on 29 November as preliminary FY16 financials results indicate ongoing operational strain. The rating agency plans to incorporate the potential effects of the CHI and Dignity merger as part of its review. Dignity’s revenue bonds are meanwhile rated A3 by Moody’s, A- by S&P, and A by Fitch, with S&P having recently downgraded its rating based on sim-ilar operational strain attributed to Dignity’s expansion activ-ity. That rating is also accompanied by a negative outlook. While a merger would not immediately alleviate CHI’s and Dignity’s existing operational challenges, Moody’s cited the possible alignment as a credit positive based on the opportu-nity for expanded market access and other synergies. The rat-ing agency estimates that the earliest any deal could close is mid-2017, as the merger could face regulatory scrutiny even through the two system’s existing acute care facilities do not overlap geographically. We expect that future rating activity will be driven by merger-related developments.

Connecticut

Moody’s downgraded Hartford County Metropolitan Dis-trict’s (MDC) GO bonds to Aa2 from Aa1 and assigned a neg-ative outlook on 19 October. MDC provides water and sewer service to eight communities in, and around, the Hartford area. The downgrade was attributed to weakness in the credit profile of the District’s largest member, the city of Hartford (see last month’s Municipal Market Guide for additional back-ground). Hartford accounts for 26% of MDC’s tax revenue, or about USD 11mn of annual assessments. The nature of the ser-vices provided gives the city a strong incentive to make those assessment payments. However, in addition to the city’s ele-vated property tax burden, its narrow liquidity position could become a strain for MDC. District management is consider-ing establishing a reserve fund to protect against any poten-tial missed payments by the city. The reserve would be funded with new warrants levied against other member municipali-ties, which does not require their approval. MDC would simply establish the fund during its next annual budget process. While we believe that the diverse service area and rate-setting auton-omy provide sufficient support to MDC’s credit profile, this example serves as a reminder of the risk posed by exposure to weaker underlying local governments.

In the news From 13 October 2016 – 28 November 2016


Fitch revised the outlook on Bridgeport’s GO bonds (currently rated A) to stable from negative on 15 November. The revision was attributed to recent efforts by a new city management team to stabilize the FY16 budget, and the potential for an improved reserve position. A combination of debt refunding, asset sales, and other one-time measures were used to close a USD 20mn mid-year budget gap, equal to 7.3% of FY16 bud-geted expenditures. Although Bridgeport anticipates reduc-ing cash flow borrowing by 20% in FY17 compared to FY16, reserves are expected to remain weak at just 2-3% of general fund expenditures. The city’s weak financial position compels us to reiterate our previously stated concerns. In our report America’s cities (9 February 2016), we assigned a negative out-look to Bridgeport based on its large unfunded pension liabili-ties, weak budgetary flexibility, and poor economic profile. Its reliance on state aid for almost half of all revenue is also problematic, in our view. Although the city is projecting a nar-row surplus for FY17, it plans to achieve this by deferring USD 4.8mn of required contributions to a state-sponsored pen-sion plan, and is permitted to defer a portion of the contribu-tion in FY18 as well. In our view, there has been little structural improvement in Bridgeport’s credit profile. We expect further rating pressure over the intermediate term.

Georgia

Fitch upgraded Hartsfield-Jackson Atlanta International Airport ‘s (ATL) senior general airport revenue bonds (GARBs) to AA- from A+ on 3 November. The rating action was attrib-uted to a new airline use and lease agreement (AUL) signed in April with its largest carrier, Delta, which will allow the airport to efficiently manage its 20-year, USD 6.2bn capital improve-ment plan. The new AUL’s rate structure permits healthy cover-age on anticipated bonded debt, but also ensures that the air-port retains its comparative cost advantage. A provision which keeps Delta’s corporate headquarters in the city for the next 20 years is another positive, as connecting traffic (much of which is contingent on the airport’s hub status for Delta) accounts for about two-thirds of all enplanements. ATL’s other credit strengths include its scale as one of the busiest airports in the world, and strong enplanement growth trends of 3.7% and 5.6% in FYs 15 and 16, respectively. Nevertheless, carrier con-centration is likely to remain a constraint on ATL’s bond rat-ings. Delta accounted for 82% of all passenger traffic in FY15. Moody’s and S&P currently rate the airport’s senior GARBs Aa3 and AA-, respectively.

Illinois

S&P downgraded the Illinois Sports Facilities Authority (ISFA) by four notches to BBB- from A on 3 November. S&P’s prior rating was based largely on strong debt service cover-age provided by pledged tax revenue. The rating agency now views Illinois’ protracted budget impasses as a significant risk to ISFA debt repayment, which is subject to appropria-tion by the state legislature. S&P had previously warned that if the state’s GO bond rating fell to BBB (which it did on 30 September 2016), it would test the degree of insulation from the state’s fiscal troubles. By contrast, Moody’s has histori-cally rated the authority’s bonds one notch below the state’s GO rating, an approach with which we have long agreed (see Municipal Market Guide, “Ranking risk in Illinois,”19 May 2016). While Illinois’ latest stop-gap budget appropriated tax revenue sufficient to cover FY17 ISFA debt service, there is no such assurance for FY18. The Authority can rely on a 2% hotel tax for payment of debt service in the event of non-appropri-ation, as it did in FY16; however, that revenue is not legally pledged to bond repayment. We believe that Illinois will make good on its pledge to appropriate payment to state authorities for debt service in the coming fiscal year, but are less optimistic that lawmakers in Springfield will be able to do so in a timely or orderly manner.

Speaking of the state capital, Moody’s lowered Springfield’s GO bond rating to A3 from A1 on 27 October. The city’s ele-vated retirement liabilities have long presented a challenge, and were the primary driver behind Moody’s two notch down-grade last month. In our America’s Cities report (9 Febru-ary 2016), we assigned Springfield a negative outlook largely for that reason. In this instance, the notoriously underfunded state-sponsored pension plans are not the culprit. Springfield contributes to one multi-employer pension plan, the Illinois Municipal Retirement Fund, which is relatively well-funded. The city’s pension issue, by contrast, lies in its historical under-funding of two city-sponsored pension plans for police and firefighters. Combined, those plans were just 39% funded at the end of FY16. In addition, Springfield is inherently exposed to Illinois’ own fiscal challenges, with state government accounting for 29% of city employment. Springfield’s bud-get director recently announced that general fund revenues were tracking 3% below budget for FY17 on weaker sales and income tax collections. Continued revenue weakness would present a concern, in our view, given rising fixed costs related to pensions and retiree healthcare. We find that the AA rating

In the news


assigned to Springfield’s GO bonds by S&P does not accurately incorporate these risks, and may therefore be susceptible to downgrade at the time of the rating agency’s next review.

The merger between Advocate Health Care and North-Shore University Health System recently hit another road block. The US 7th Circuit Court of Appeals overturned a lower court’s decision to deny the Federal Trade Commission’s (FTC) injunction request on 31 October. As mentioned in the Jan-uary 2016 Municipal Market Guide, the FTC filed a claim in December 2015 stating that the merger would be anti-com-petitive and harmful to consumers in Chicago’s North Shore area. Two of Advocate’s 11 acute care hospitals are located in Chicago’s northern suburbs, as are all four of NorthShore’s. In June 2016, the trial court challenged several of the FTC’s assumptions and denied an injunction request filed jointly by the FTC and the Illinois Attorney General. The state and fed-eral government requested the injunction to block the merger pending the conclusion of the FTC’s administrative trial. The case is now back in the hands of that lower court. Both Advo-cate and NorthShore indicated on 16 November that they intend to continue to pursue the merger in court. This stands in contrast to the October 2016 decision made by Pinnacle Health and Penn State’s Hershey Medical Center to end their proposed merger upon facing a similarly strong FTC chal-lenge (see Municipal Market Guide, 13 October 2016). The proposed Advocate/NorthShore deal will likely have a signifi-cant impact on future mergers and acquisitions in the non-for-profit healthcare sector.

In the latest of a series of blows, S&P downgraded the debt issued by the Chicago Board of Education (BOE) to B from B+ on 9 November and maintained a negative outlook at the lower rating level. The district’s heavy reliance on cash flow borrowing and increased expenditures resulting from a new teacher contract were cited for the most recent rating action. The BOE had planned to price a USD 426mn bond offering this month. However, the combination of market movements and the fresh downgrade caused district officials to postpone the sale. Chicago BOE is likely to remain an extremely distressed credit for quite some time, in our view, and is not appropriate for most individual investors.

Moody’s downgraded the village of Rosemont’s GO bonds to Baa1 from A3 on 16 November. The rating outlook is negative. Located near Chicago O’Hare airport, Rosemont benefits from strong connectivity and its proximity to the greater Chicago metro area. However, Moody’s found that the village’s ongo-

ing support of several non-essential business enterprises has elevated debt levels, strained reserves, and exposed the village to operational risk. Rosemont currently owns and operates a conference center, theater, numerous other commercial prop-erties, and a new minor league baseball stadium. S&P, which affirmed its A rating on the same obligations on 17 November, has a more positive assessment. While acknowledging the vil-lage’s elevated debt burden, S&P argues that Rosemont does not operate as a traditional municipal entity. For our part, we have observed that the support of a large amount of non-essential enterprises can often lead to significant fiscal strain for local governments, especially in the event of an economic downturn. Thus, we are inclined to agree with Moody’s more cautious assessment.

Kansas

On 10 November, Kansas’ Consensus Revenue Estimating Group released its latest estimates for the current FY17, as well as the first official estimates for FYs 18 and 19. FY17 rev-enue is now projected to be 5.5% (or USD 345.9mn) below the previous estimate from April, and 1.5% lower than FY16. Declines are anticipated in all of the state’s largest revenue streams, including personal income, corporate, and retail sales taxes. This weakness is projected to continue into FY18 when revenue is expected to be 7.4% (USD 443.7mn) below the FY17 level. Despite a forecast for marginally positive organic revenue growth in FY18, the overall decline is principally due to planned transfers out of the state general fund to repay deferred pension contributions and loans from various special fund reserves made in FY16. As we mentioned in the August 2016 edition of the Municipal Market Guide, we expect Kan-sas’ rising pension costs, narrow reserves, and prior expen-diture cuts to limit its ability to achieve structural balance in FY18. Kansas is also awaiting a state Supreme Court decision on a long-running case over the adequacy of state funding to schools. An adverse ruling could further pressure the FY18 budget. Absent significant structural revenue enhancements or expense reductions, we foresee negative rating pressure and widening credit spreads.

Louisiana

Based on concerns surrounding structural budget deficits and mounting pension liabilities, we assigned a negative outlook to the city of Shreveport in our report America’s cities (9 Febru-

In the news


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ary 2016). Since that time, Moody’s downgraded its rating of the city’s GO bonds to A2 from A. Despite contributing just 41% of the actuarially required amount to city pension plans, Shreveport ended FY15 with a general fund deficit equal to 1.5% of revenue, as sales tax collections fell by 2%. The city’s largest pension plan, the Employee’s Retirement System, was only 46% funded at the end of FY15. Although FY14 pen-sion reforms mandated that city contributions as a percentage of payroll increase beginning in FY15, the actuarially required contribution in that year would have been over 41% of pay-roll, in comparison to a phased-in contribution increase under the reforms that would reach 29% by FY18. While Shreve-port now anticipates a budgetary surplus for FY16, continued pension underfunding and stagnant growth are significant concerns, in our view. The FY17 budget assumes that sales tax collections will be 2% lower than budgeted in FY16, and anticipates reserves narrowing to a level equal to just 4.4% of revenue, below the city’s target of 7%. These projections incorporate the imposition of a new garbage collection fee, which is expected to bring in USD 9.5mn, or 5% of FY15 rev-enue. We expect Shreveport’s credit rating to exhibit a down-ward trend as sustainable pension funding will likely be diffi-cult to obtain. Economic growth is uncertain in the near-term, given the region’s exposure to the natural gas sector.

Michigan

Fitch assigned a positive outlook to revenue bonds issued by the Wayne County Airport Authority for Detroit Metro-politan Airport (DTW), currently rated A-, on 2 November. The rating agency attributed the improved outlook to stron-ger operating performance trends, including growth in non-airline revenue and enplanements. Preliminary FY16 results indicate 4% growth in enplanements, bringing traffic to lev-els not seen since FY08. The greatest increase was registered by low cost carriers, such as Spirit, but Delta (which repre-sents 74% of all DTW traffic) also saw enplanement growth of 2%. Airline revenue improved by a marginal 0.6%, while non-airline revenue jumped by 6.7% on strong parking rev-enue. Although much of the non-airline revenue growth was offset by similarly higher operational expenses, Fitch expects the overall cost per enplanement to steadily decline over the next few years given DTW’s moderate capital plan. DTW’s strengthening credit profile is in contrast to the persis-tent credit challenges faced by the City of Detroit and Wayne County. Although some of DTW’s traffic is exposed to the underlying economic strength of its service area, this is miti-

gated by a strong base of connecting traffic and the proxim-ity of Ann Arbor and the University of Michigan. We recog-nize DTW’s reliance on Delta traffic as a credit constraint, but believe incremental rating improvement is possible. The A2/A ratings assigned by Moody’s and S&P, respectively, are mod-estly higher than Fitch’s, and neither has reviewed the credit in over a year.

New Jersey

S&P downgraded New Jersey’s GO bond rating to A- from A on 14 November on renewed concerns about the state’s inten-sifying budgetary pressures. A negative outlook was main-tained at the lower rating. According to S&P’s calculations, New Jersey will contribute only 40% of the actuarially required amount to its pension plans in FY17. As we mentioned in last month’s Municipal Market Guide, the tax cuts which accompa-nied the state’s recently enacted gas tax hike are likely to exac-erbate general fund budgetary pressure going forward. S&P’s rating now stands one notch below the A2/A ratings assigned by Moody’s and Fitch, respectively. We believe further rating pressure and spread widening are likely.

The New Jersey Department of Community Affairs (DCA) rejected Atlantic City’s five-year fiscal plan on 1 November, deeming it unlikely to stabilize the embattled gaming hub. The DCA challenged several financial metrics used in the plan, pos-iting that debt service was underestimated and that tax rev-enue projections were optimistic. It also highlighted several operational and qualitative concerns, including an insufficient reduction in the city’s workforce, uncertainty regarding the sale of the city’s defunct airport to Atlantic City’s Munici-pal Utilities Authority, and the failure to increase taxes. On 3 November, the city submitted a supplement to that fis-cal plan, hoping to address many of DCA’s concerns. It, too, was rejected on 7 November. Two days later, the DCA’s Local Finance Board unanimously approved a five-year state takeover of the city, which gives it authorization to alter outstanding debt, change existing contracts, and sell city assets. The DCA appointed former US Senator Jeffrey Chiesa as the Director’s Designee on 14 November to oversee all Atlantic City financial matters during the control period. Mr. Chiesa formerly served as New Jersey Attorney General, and in various roles in Gover-nor Chris Christie’s administration. For bondholders, the devel-opments are not altogether bad. Initial priorities are expected to include the payment of debt service and finalization of the FY17 budget. Moody’s had previously expressed concern over


the city’s ability to make USD 7mn of debt service payments due in December, but now believes that state intervention eliminates the threat of immediate default. While we expect that state intervention will stabilize the city’s credit profile for now, the level of coordination between local and state officials is uncertain.

Moody’s upgraded Jersey City’s GO bonds to Aa3 from A1 on 31 October. In our Americas’ cities report (9 Febru-ary 2015), we mentioned that the city’s financial position had steadily improved despite elevated pension costs. Moody’s upgrade is largely attributed to strong economic growth, which it expects to continue given the city’s proximity to New York. S&P, which recently affirmed its AA- rating on the city’s GO bonds on 8 November, expressed similar optimism. The city contributes to two state-sponsored pension plans, the Public Employee’s and Police & Firemen’s Retirement Systems. In total, those plans were 43% and 59% funded, respectively, as of 30 June 2014. The city also sponsors a defined benefit plan for its employees which was just 48% funded as of 30 June 2015, and assumes an exceptionally optimistic 8.25% assumed rate of return on plan assets. While pensions certainly present a large challenge, a strengthening tax base helps insu-late Jersey City from some of the fiscal pressures facing other local governments in the state.

New York

According to a new report released by State Comptroller Thomas DiNapoli on 3 November, state revenues were down 3.5% (USD 1.3bn) in the first half of FY17 compared to the same period in FY16. This amount is USD 919mn lower than projected in the FY17 enacted budget. DiNapoli attributed the decline to weakness in personal income tax receipts, the state’s largest revenue source. While New York has ample time and flexibility to address this shortfall, we continue to moni-tor revenue trends for the Empire State as Governor Andrew Cuomo and Albany lawmakers begin to finalize a budget pro-posal for FY18, which begins on 1 April 2017.

Fitch upgraded the city of Buffalo’s GO bonds to AA- from A+ on 14 November. That places Fitch’s ratings one notch higher than the A1/A+ ratings assigned by Moody’s and S&P, respectively. Fitch’s rating action is principally based on the application of its new ratings criteria for US tax-supported debt. Even so, the rating agency expects the city to see mod-

est revenue growth stemming from the state’s ‘Buffalo Bil-lion’ economic development initiative. As we mentioned in the March 2016 Municipal Market Guide, Buffalo’s credit pro-file has stabilized in part as a result of this renewed investment across the upstate portion of the state. Concerns regarding the lack of high-wage job growth stemming from these projects, including at a new solar panel facility, and a federal investiga-tion into the state contracting process, surfaced more recently. It is our understanding that the state remains committed to its development plan. For its part, Moody’s Economy.com believes that Buffalo’s economy is expanding and observed that the region is still seeing solid inflows of young workers. We are hopeful that this trend will keep Buffalo’s credit profile stable for now, but tend to agree with the lower rating assess-ments provided by Moody’s and S&P.

Nevada

Governor Brian Sandoval signed legislation on 17 October authorizing the use of up to USD 750mn to finance a new USD 1.9bn professional football stadium which will be built in Las Vegas. Proceeds from a 0.88% hotel tax increase would be pledged to repay at least a portion of the debt service associ-ated with bonds used to finance the project. The new 65,000-seat, domed facility is expected to be the home of the National Football League’s Raiders (currently located in Oakland, CA) and the University of Nevada, Las Vegas’ (UNLV) football team. Many aspects of the deal still need to be finalized, but the largest hurdle is approval from three-quarters of the National Football League’s owners. That vote is expected to occur as soon as January.

Pennsylvania

As we highlighted in the September 2016 edition of the Municipal Market Guide, Philadelphia’s pension liabilities and recent operating performance have exposed its credit to renewed scrutiny. S&P cited operating strain presented by rising retirement costs as the reason behind its assign-ment of a negative outlook on the city’s A+ GO bond rating on 7 November. Further rating pressure is likely, in our view. We have regularly advised investors to consider the revenue bonds of enterprise credits as a strategy to sidestep local gov-ernment pension risk. Philadelphia’s Water and Wastewa-ter revenue bonds present one such example. S&P upgraded

In the news


its rating of the securities to A+ from A on 7 October, citing positive financial performance trends. The utility system is also geographically diversified, serving the city and several subur-ban communities. Moody’s revised the outlook on the Pennsylvania State Sys-tem of Higher Education (PASSHE) to negative on 28 Octo-ber. The agency assigns a rating of Aa3 on the majority of the system’s outstanding revenue bonds. The outlook revision reflects the potential for expenses to materially increase as a result of new tentative collective bargaining agreements and rising pension costs. From 19-21 October, faculty at PASSHE’s institutions went on strike regarding salary and benefit nego-tiations. Although Moody’s referred to the strike as “unprec-edented,” we are obliged to note that 85% of the system’s workforce is unionized. We believe future labor unrest is pos-sible. With 14 public universities across the state, PASSHE has seen steady enrollment declines over the past several years in line with declining high school graduation rates in Pennsylva-nia. To counteract enrollment loss, PASSHE has successfully used tuition increases to grow net tuition revenue by 26% over the last 5 years. Unfortunately, expense growth has outpaced revenue growth, a trend which is apt to continue.

Rhode Island

After downgrading Providence’s GO bonds by one notch in 2016, Fitch upgraded the same obligations by three notches to A- from BBB- on 3 November. It also assigned an issuer default rating (IDR) of BBB. The decision to maintain a two notch dif-ferential between the IDR and GO rating is reflective of the statutory lien attached to GO bonds issued in Rhode Island. Fitch’s rating action comes on revised rating criteria, but the agency also cites the city’s progress in reducing a negative general fund balance and stabilizing its budget. As we men-tioned in the June 2016 Municipal Market Guide, Providence closed FY15 with an unexpected operating deficit. However, FY16 ended with a surplus of USD 1.1mn (or about 1% of rev-enues), according to Fitch, almost all of which will go toward eliminating a USD 13.5mn accumulated general fund defi-cit. The current FY17 budget is supported by a 4% property

tax increase (the maximum allowed under the state’s cap), and includes USD 6.1mn for deficit elimination. Providence is hopeful that the general fund deficit will be fully eliminated between FYs 18 and 21. For our part, we believe there are cer-tain risks to this scenario. Despite significant reforms to pen-sion and retiree healthcare programs in 2013, related costs continue to rise. For example, as of 30 June 2015, the sin-gle-employer pension plan covering most city employees was just 28% funded, and assumed an optimistic 8.25% rate of investment return. Better expenditure control will be neces-sary to address volatile operating performance, and continued growth in Providence’s tax base to restoring structural balance. Moody’s was focused on these concerns when it affirmed a Baa1 rating and negative outlook on the city’s GO bonds on 7 October. Fitch’s rating action strikes us as optimistic and we believe that a cautious approach is warranted.

Tennessee

Fitch upgraded Vanderbilt University’s (VU) GO bonds to AAA from AA+ on 14 October. The upgrade was attrib-uted to the university’s separation from Vanderbilt University Medical Center (VUMC) in April 2016. Although the univer-sity and VUMC remain strategically aligned, the transaction decreases VU’s leverage and reduces its exposure to more vol-atile healthcare revenues. Fitch estimates that payments from VUMC will now account for around 25% of university oper-ating revenue, down from as much as 66% before. Vander-bilt University will retain all medical academic programs, while VUMC will continue to benefit from its prestigious brand rec-ognition and access to a strong pool of physicians. This type of structure has become more common among highly rated private universities. The separation also served as the rationale behind positive rating outlook assignments by Moody’s and S&P on their Aa1 and AA+ ratings of the University on 13 and 20 October, respectively.

In the news


Follow-up on ballot initiatives

In last month’s edition of the Municipal Market Guide, we included a representative sampling of state and local ballot measures that were up for consideration on 8 November. The tables that follow summarize the outcomes of those elections and a few additional initiatives. Below, we discuss some of the common themes and key decisions.

California voters act. We view the passage of Propositions 51, 52, and 55 as credit positive for the state, its schools, and not-for-profit hospitals. Beginning with Proposition 55, vot-ers decided to extend by another 12 years the temporary per-sonal income tax increases enacted in 2012. The related reve-nue is primarily allocated to K-12 schools, community colleges, increasing reserves, and paying down debt. The state Legis-lative Analyst’s Office estimates that the measure will gen-erate USD 4-9bn annually. The passage of Proposition 51 is another positive for school and community college districts statewide, particularly for those seeking state matching funds under the state’s depleted School Facility Program, as it autho-rizes the issuance of up to USD 9bn of bonds for construction projects. Reverting to Proposition 52, California hospitals with high Medicaid exposure stand to benefit from the extension of a program originally introduced in 2009 that increases their reimbursement, saving the state general fund dollars that oth-erwise would need to be allocated for this purpose. The pro-gram had previously been subject to renewals and delays.

More constraints for New Jersey and Illinois. With the passage of Amendment 1 in Illinois and Question 2 on the New Jersey ballot, transportation-related tax revenue may only be spent on transportation projects. Both states will find themselves with less financial flexibility, as transportation rev-enue may no longer be diverted for general fund purposes. In the wake of the election, Moody’s characterized the related constitutional amendments as credit negative for each state. S&P lowered New Jersey’s general obligation (GO) bond rat-ing to A- from A on 14 November based on its view that state budget pressures are likely to intensify in future years.

Mass transit wins. Transportation and infrastructure-related measures saw solid support in the voting booths this Novem-ber. We review some examples. Los Angeles County Metro-politan Transportation Authority stands to benefit from an aggregate increase in the combined county sales tax rate dedi-cated for transportation projects to 2%, with the focus of the new incremental funding being on mass transit. In San Fran-cisco, the approval of Measure RR authorizes the Bay Area Rapid Transit District to issue up to USD 3.5bn in GO bonds to

finance system upgrades to address a large backlog of infra-structure needs. Meanwhile, a new half-cent sales tax was approved for the Metropolitan Atlanta Rapid Transit Authority to expand and enhance the system.

Moving on, voters in Washington approved Proposition 1 to fund a USD 54bn transit improvement program for the Central Puget Sound Regional Transit Authority. In addition, the com-bined government of Marion County and Indianapolis, Indiana,

approved an income tax increase whereby the proceeds will expand bus service throughout the city. And in Wake County, North Carolina, voters increased the sales tax rate for the ben-efit of its transit plan, which is expected to include a startup commuter rail system.

Positioning for the future. The passage of Amendment 5 in Louisiana establishes a revenue stabilization trust fund to hold excess mineral and corporate tax revenue. Although depressed energy prices suggest a slow ramp-up for the fund, its creation as an additional source of financial reserves is a longer-term positive for the state and could help to mitigate its exposure to the energy sector in the future. Unlike Louisiana, which saw its GO bond rating downgraded by Moody’s and Fitch this spring, Hawaii was upgraded by Moody’s and S&P in September. A more recent positive, the passage of Amendment 2 sets the stage for the state to use excess general fund revenue to pre-pay debt and retirement liabilities. Hawaii has an above-aver-age level of these liabilities in comparison to many states, so we consider the constitutional amendment a prudent step.

Taxing tobacco remains viable. California voters passed Proposition 56 by a wide 63% to 37% margin. The measure involves a USD 2.00 per pack increase in the state cigarette tax. The taxation of tobacco products at the state level remains a constant risk to cigarette consumption and is a negative for the municipal tobacco settlement revenue bond sector. Please refer to our Intellectual Capital blog, California voters approve Proposition 56 – tobacco tax increase (10 November 2016) for more information.

Transportation and infrasturcture-related measures saw solid support in the voting booths this November.


Follow-up on ballot initiatives

More states are legalizing and taxing the use of mari-juana. Five additional states – California, Alaska, Massachu-setts, Maine, and Nevada – approved the use of marijuana for recreational purposes this month. Colorado, Washington, and Oregon had already approved marijuana’s recreational use and sale. Meanwhile, Arkansas, Florida, Montana, and North Dakota voters approved the use of marijuana for medical pur-poses. As the legalized use of marijuana becomes more prev-alent throughout the country, we believe that more states will consider the product as a viable future source of tax rev-enue. And, while marijuana-related tax collections have yet to meaningfully drive revenue in states where its use has been approved, its taxation may nonetheless present an attractive option, particularly for states that are already struggling with a more challenging budget outlook.

The taxation of sugary beverages is also proliferating. In the wake of decisions in Berkeley, California, and Philadel-phia to tax the sale of sugary drinks, November ballot results suggest that momentum is increasing in this area. Major cit-ies, such as San Francisco, Oakland, Albany, and Boulder, all approved a variation of a tax on sugar-sweetened beverages this month.

Gaming fades. The major gaming initiatives on the November ballot failed. New Jersey voters opted against expanding gam-ing to two additional counties outside of Atlantic City, while Massachusetts voters chose not to allow the state gaming commission to issue additional slot parlor licenses. We believe that the increasing saturation of the casino gaming market has made these types of initiatives less attractive as a potential rev-enue-raising solution.


Proposition 51: Funding for K-12 School and Community College Facilities Passed Yes 54% No 46%

Overview Impact

The measure allows the state to issue USD 9bn of bonds for school and community college construction projects through the state’s School Facility Program (SFP). SFP was founded in 1998 but depleted its prior bonding authorization in 2013. USD 6bn will go toward K-12 school con-struction and modernization, USD 2bn to community colleges, and USD 500mn for both charter school and career/technical education projects.

We believe this proposition’s passage is a positive for schools, as without the funding authorized under this act, the districts would have had to rely on local funding. This particularly benefits districts with weak tax bases. Currently there are 69 districts who have received funding ap-proval through the SFP but have still not received funds. There are also USD 1.6bn in funding applications currently awaiting approval.

Proposition 52: Medi-Cal Hospital Fee Program Passed Yes 70% No 30%

Overview Impact

A constitutional amendment that extends indefinitely an existing statute that imposes fees on hospitals to fund Medi-Cal services (the state’s sub-sidized healthcare program for low-income families), care for uninsured patients, and children’s health coverage. If it had not passed, the existing charge would have ended on 1 January 2018. During FY16, California hospitals are estimated to have paid USD 4.6bn into the hospital fee program. The California Association of Hospitals and Health Systems, the main supporter of the proposition, estimates that the program also generates over USD 3bn a year in federal matching funds.

Proposition 52 will be a positive for non-for profit hospitals, in our view, as it solidifies a program which improves reimbursement for patients cov-ered by Medi-Cal. Moody’s notes that city and county owned hospitals typically see less of these payments than private 501(c)(3) hospitals. It is also a credit positive for the state as it saves approx. USD 1bn in annual general fund spending. The program has been in place since 2009 but has often been subject to periodic delays around renewals which placed strain on some hospitals’ liquidity. This measure improves the predict-ability of the payments. Large beneficiaries under the program are Dignity Health, Sutter Health, Children’s Hospital of Los Angeles, Valley Children’s Hospital, and Community Hospitals of Central California.

Proposition 53: Revenue Bonds. Statewide Voter Approval Failed Yes 49% No 51%

Overview Impact

The amendment would have required two-thirds voter approval before the state could issue more than USD 2bn in revenue bonds. It would have also applied to any projects that are financed, owned, operated or managed by the state, or by a joint agency formed between the state, a federal government agency, or another local government.

Given the high threshold, the limitation would have likely only affected a select few projects - the most notable being the USD 17.1bn “California Water Fix” project to build water tunnels in the San Joaquin River Delta. Although the proposition’s defeat allows for that plan to move forward, the project remains controversial, and faces other significant hurdles.

Proposition 55: Tax Extension to Fund Education and Healthcare Passed Yes 62% No 38%

Overview Impact

A constitutional amendment that extends by twelve years the temporary personal income tax increases enacted in 2012 on personal earnings over USD 250,000. The revenues are allocated to K-12 school funding, com-munity colleges, and healthcare. Currently, the tax increase will expire on 1 January 2019, but an extension makes the tax effective through 31 December 2030. The state estimates that the tax increase would bring in between USD 4-9bn annually throughout the life of the extension.

Passage of Proposition 55 is a credit positive for California K-12 school districts, community colleges, and the state, in our opinion. About half of all new taxes raised go to K-12 and community college funding. Moody’s estimates that Prop 55 funds represents 9% of the state’s educational funding. The state is expected to use the remainder of these funds to increase reserves and pay for escalating Medi-Cal costs. However, this does increase the state’s dependence on personal income taxes, which represented approximately two-thirds of FY17 general fund revenue, and can be volatile. As a point of comparison, in 2006, the state relied on personal income taxes for just 54% of general fund revenue.

California


California - City of San Francisco - Proposition K Failed Yes 35% No 65%

Details Impact

The measure would have instituted a 0.75% increase in the city’s sales tax rate for the next 25 years, with proceeds deposited into the city’s general fund. The city estimated that the tax would raise USD 155mn in additional revenue in FY18, the first full fiscal year of implementation.

The measure’s failure is a negative for the city, in our view, as it does not have funding for the social programs called for under Proposition J, which did pass. However, if San Francisco chooses to not pursue those programs, the impact will likely be minimal.

Colorado - Amendment 69 Failed Yes 21% No 79%

Details Impact

The measure would have established a statewide program to provide universal healthcare coverage for Colorado residents, to be known as Colorado Care. It was intended to largely replace private, employer-pro-vided insurance, and the state’s current Medicaid program. The system would have been funded by a 10% payroll tax as well as a 10% tax on all other non-payroll income.

It was estimated that once fully implemented, the measure would have brought in USD 25bn in new tax revenue - making it one of the largest ballot initiatives this year. Passage would have been a negative for the state, in our view, while its defeat is credit neutral.

Hawaii - Amendment 2 Failed Yes 58% No 42%

Details Impact

A constitutional amendment which allows the legislature to use excess general fund revenues to prepay debt service, pension contributions, or retiree healthcare (OPEB) costs.

Passage is a credit positive for the state, in our opinion, as it increases Hawaii’s financial flexibility. In the past, if the state’s General Fund bal-ance exceed 5% of revenues for 2 consecutive years, it was required to provide a tax refund or put the excess funds into a Budget Reserve or Hurricane Relief Fund.

Louisiana - Amendment 3 Failed Yes 44% No 56%

Details Impact

The measure would have eliminated the corporate deduction for federal income taxes on state taxes. It would have also replaced the staggered 4-8% corporate tax rate with a flat corporate tax rate of 6.5%.

As one of only three states which allows businesses to make this kind of deduction, Louisiana also has one of the highest marginal corporate tax rates in the south. The revenue impact of the measure was uncer-tain given volatility in corporate tax collections. However, it would have simplified the corporate tax code and delinked the state’s revenues from federal corporate tax policy, in our view.

Louisiana - Amendment 5 Passed Yes 54% No 46%

Details Impact

A constitutional amendment which creates a new Revenue Stabilization Trust Fund which will be funded with annual corporate income and fran-chise tax revenue above USD 600mn, and all annual mineral revenues above USD 660mn and up to USD 950mn. Interest earnings can be appropriated for capital projects, and once the fund reaches USD 5bn, up to 10% of the balance can be appropriated each year. Incremetal mineral revenues can also be applied toward the state’s unfunded pen-sion liabilities.

Overall, we view the measure as a credit positive for the state as it provides another reserve fund to supplement the state’s existing rainy day fund. However, there likely will be a long ramp up period gievn low energy prices, and dedicated revenues will need to rise significantly from current levels to begin to flow to this fund. Corporate income and franchise taxes have not exceeded USD 600mn since FY09.


Details Impact

A constitutional amendment which would have allowed the state to access select funds which are otherwise constitutionally or statutorily dedicated if official revenue estimates for an upcoming fiscal year fall 1% or more below a previous estimate for that fiscal year. Up to 5% of each fund’s current year allocation and 1% of a fund’s existing balance would have been available.

The state still maintains the ability to tap into 5% of each fund’s current year allocation if official revenue estimates for an upcoming fiscal year fall 1% below current year revenue estimates. While the measure would have given the state increased budgetary flexibility, in our view, it also could have promoted imprudent budgeting practices and allowed the state to put off structural solutions to address annual budget gaps.

Other state and local governments


Missouri - Amendment 4 Passed Yes 57% No 43%

Details Impact

A constitutional amendment which prohibits the state, or any of its local governments, from enacting sales and use taxes on any service or activ-ity not subject to a tax on 1 January 2015.

We expect the impact to be limited in the short term, but over the long-term view this as a negative factor that restricts the financial flexibility of the state, as well as its cities and counties.

Nevada - Question 3 Passed Yes 72% No 28%

Details Impact

A constitutional amendment which requires the state to establish an open and competitive retail electric energy market by 1 July 2023. The law prohibits the granting of monopolies and exclusive franchises for the generation of electricity.

Currently, a single utility is generally authorized to provide electric ser-vices to customers in each electric service territory in the state. Utilities are regulated by the Nevada Public Utilities Commission, which has input on the rates charged. The affect on public utilities in the state will vary on the ability of each to adapt to a competitive market, in our view.

North Dakota - Measure 2 Passed Yes 64% No 36%

Details Impact

The measure allows for the state to appropriate from the Founda-tion Aid Stabilization Fund whenever the principal balance of the fund exceeds 15% of the biennium’s aid to school districts. Appropriations of any excess balance can be made for other education-related purposes, including capital projects.

The measure continues the deposit of 10% of oil extraction tax revenue in the Common Schools Trust Fund and 10% of oil extraction tax rev-enue in the Foundation Aid Stabilization Fund. Currently, the Foundation Aid Stabilization Fund can only be tapped to offset reductions in state aid to school districts which were made due to a revenue shortage. The measure is modest positive for the state and its school districts as it improves their financial flexibility, in our view.

Ohio - Cleveland Passed Yes 51% No 49%

Details Impact

The measure raises the city’s income tax from 2 to 2.5%. Current pro-jections suggest that the hike will generate USD 83.5mn in additional annual revenue. City officials have indicated that the additional funds will be used to balance general fund operations, build up reserves, and support capital projects.

As we mentioned in the March 2016 Municipal Market Guide, elevated unfunded pension liabilities are a key fiscal challenge for Cleveland. Addi-tionally, the city is also facing the cost of a Department of Justice consent decree which mandates various public safety reforms. The city’s income taxes already account for roughly half of general fund revenues. Without the tax approval, we believe that Cleveland may have found it difficult to identify sufficient expenditure cuts to meet the aforementioned costs.

Ohio - Lorain County Failed Yes 26% No 74%

Details Impact

The measure would have increased the county sales tax rate by 0.25%, bringing the total tax rate for transactions in the county to 6.75%. County officials estimated that the hike would have brought in over USD 9mn of annual revenue to support the general fund and transit projects.

This marks the third time in the last four years Lorain County voters have struck down a sales tax hike, and another negative for the county. As we mentioned in America’s Counties (15 September 2016) when we assigned a cautious outlook to the county, in our view, the tax increase would have represented a positive step in stabilizing the county’s reserves against a backdrop of rising costs large attributed to an above average pension liability. We accordingly revise our credit outlook from cautious to negative as a result.

Washington - Initiative 732 Failed Yes 41.5% No 58.5%

Details Impact

This measure would have established a new carbon emission tax of USD 15 per metric ton of emissions in July 2017, USD 25 in July 2018, and then raise it by 3.5% plus inflation each year until the tax reached USD 100. It would have also lowered the state sales tax rate from 6.5% to 5.5%, increased the working families tax credit for low income families, and reduced the business and occupation tax rate.

The measure was designed to be relatively revenue neutral for the state. However, if it had been successful, Washington would have been the first state to enact such a tax on carbon emissions - possibly setting a standard for other states.


California - Alameda, Contra Costa, and San Francisco Counties - Measure RR Passed Yes 70% No 30%

Details Impact

The measure authorizes Bay Area Rapid Transit (BART) to issue USD 3.5bn of new GO bonds. BART intends to issue these bonds in ten sepa-rate series, with proceeds used to fund a portion of its long-term capital plan. The bonds will be secured by an increase in BART’s property tax levy of USD 9.98 per USD 100,000 of AV, bringing the total levy to USD 17.49 per USD 100,000 of AV. Combined, these three counties represent one of the largest and most diversified tax bases in the US, according to Moody’s.

We believe the measure to be a positive for BART as it identifies a fund-ing source to address what is currently a large backlog of upgrades. It also allows the system to preserve existing revenue for other expendi-tures. The measure will also improve connectivity in the region, a positive for the counties involved. While the levy increase is material, it is not expected to provide undue strain to the tax base given its affluence.

California - Los Angeles County - Measure M Passed Yes 70% No 30%

Details Impact

The measure permanently extends Measure R (passed in 2008 and set to expire in 2039), which increased the county’s sales tax rate by 0.5%. It also imposes an additional permanent 0.5% sales tax increase which takes effect within 180 days of the election. The county’s combined sales tax rate designated for transportation projects will now be 2%. Most of the additional revenue will fund several large scale public-transit projects, including new rail lines in the San Fernando Valley. The remainder is to be spilt between the county bus system, highway projects, and other local government repairs.

In our view, passage is a positive for the county and the Los Angeles County Metropolitan Transportation Authority (LACMTA), the third-larg-est transit system in the country based on ridership. The capital projects made possible by Measure M will provide more public transportation options in a densely populated area.

California - Sacramento County - Measure B Failed Yes 65% No 35%

Details Impact

The measure would have increased the county’s sales tax rate by 0.5% for the next 30 years. The county estimates that the measure could have brought in USD 100mn of revenue annually, and the additional funds would have been used to fund various transportation projects, including general road repair, new highway construction, and an expansion of the county’s light rail service. County voters previously authorized a separate 0.5% sales tax rate dedicated to transportation in 2004, which went into effect in 2009, and is currently set to expire in 2039.

The failure is a negative for the Sacramento Regional Transit District, in our opinion, as it will now be forced to find alternative funding sources for a variety of capital needs, including light rail expansion and other maintenance projects, or otherwise defer the projects.

California - San Diego County - Measure A Failed Yes 57% No 43%

Details Impact

The measure would have increased the county’s sales tax rate by 0.5% for the next 40 years. Proceeds from the tax increase would have been principally used to fund various transportation and infrastructure proj-ects. County officials estimate that USD 308mn of additional tax revenue would have been brought in annually.

We view the measure’s failure as a credit negative for the county as the tax would have funded various public transportation and freeway expansion projects. Cities in the county would have also had access to the funds to make road and other infrastructure repairs. Although likely a minor nega-tive, those local governments will now have to identify alternative funding or defer the improvements.

Georgia - City of Atlanta Passed Yes 71.5% No 28.5%

Details Impact

The measure institutes a half cent sales tax increase which will be dedi-cated for the Metropolitan Atlanta Rapid Transit Authority (MARTA), the nation’s 9th largest transit service. The increase is on top of an existing 1% sales tax already dedicated to MARTA.

We believe the measure will be a positive for the city of Atlanta and MARTA as it is expected to bring in USD 2.5-3.5bn in additional revenue over the next 40 years. Tax proceeds will be used to fund various rail and bus expansion projects, resulting in better system reliability.

Transportation and infrastructure


Illinois - Amendment 1 Passed Yes 79% No 21%

Details Impact

A constitutional amendment which restricts transportation-related revenues (such as fuel taxes, registration fees, or tolls) to being used to fund highway, mass-transit, and other transportation projects. Moody’s estimates that total transportation revenue subject to the restriction was USD 4.3bn in FY15, or about 6.7% of state revenue.

While a good portion of the state’s transportation revenue was already dedicated for various transportation projects by statute, we believe the measure is a credit negative for the state as it limits its financial flexibility. There are now less revenues available to support general operations, which face mounting fixed costs, most notably pensions. The state has diverted transportation revenues in the past to fill budget gaps, including USD 300mn in FY15.

Indiana - Marion County Passed Yes 58% No 42%

Details Impact

The measure increases the county income tax by 0.25%. It is expected to raise USD 56mn of additional revenue annually. Proceeds will be used to expand bus service throughout the Indianapolis area and finance the Indi-anapolis Public Transportation Corporation (IndyGo) bus rapid transit line.

In our view, the measure is a positive for Marion County and the City of Indianapolis, as the financed projects will improve connectivity for area residents.

Maine - Question 6 Passed Yes 61% No 39%

Details Impact

The measure authorizes up to USD 100mn of bonds to be issued to finance various transportation projects. Approximately 80% of the fund-ing is expected to go toward highway and bridges. The authorization also allows the state to qualify for USD 137mn in federal matching funds.

The measure is a positive for the state, in our opinion, as it allows it to leverage federal funding and pursue previously underfunded mainte-nance projects.

Michigan - Macomb, Oakland, Wayne, and Washtenaw Counties Failed Yes 49.5% No 50.5%

Details Impact

A mass transit proposal for the Regional Transit Authority of Southeast Michigan which would have imposed a 20 year property tax levy. Expect-ed to generate USD 3bn in revenues over the life of the tax, the measure would have funded transit expansion projects, including additional bus lines, a new rail link between Detroit and Ann Arbor, and better direct access to Detroit Metropolitan Airport.

The transit authority is expected to put the measure on the ballot once again in 2018. However, at least in the near-term, we view the measure’s failure as a negative for the four county region.

New Jersey - Question 2 Passed Yes 54% No 46%

Details Impact

A legislatively-referred constitutional amendment which restricts all revenues related to state taxes on motor fuels and other petroleum products to the state’s Transportation Trust Fund (TTF). Previously, 10.5 cents of the per gallon tax on gasoline and diesel fuel was dedicated to the TTF. This amendment does not alter the current tax rate on any petroleum products.

We believe the the measure is a negative for New Jersey as it limits the state’s financial flexibility, especially since a recent 23 cent increase in the gas tax was accompanied by many other tax cuts. This will lead to decreased revenues available to support the state’s general operations, which face large pressure from mounting fixed costs.

North Carolina - Wake County Passed Yes 53% No 47%

Details Impact

The measure increases the county’s sales tax rate by 0.5%. The proceeds will be used to support the county’s 20-year, USD 2.3bn transit plan, which includes a start-up commuter rail system. The first commuter rail line is expected to run 37 miles from Garner to Durham, with stops in Raleigh, Cary, Morrisville, and Research Triangle Park.

As the measure will help alleviaate motorway congestion in the region, we view passage as a credit positive for the county. Potential develop-ment along the new commuter line could also be a positive for cities and towns in the county.

Washington - Portions of Snohomish, King, and Pierce Counties (Puget Sound region) - Proposition 1

Passed Yes 54% No 46%

Details Impact

The measure provides funding for an estimated USD 54bn of transit improvements to be made by the Sound Transit Board over the next 25 years. Additional revenues will be derived from a property tax of 25 cents/USD 1,000 of AV, a half cent sales tax, and a 0.8% motor vehicle value excise tax - all to be collected in the transit authority’s multi-county service area.

We view this measure’s passage as a positive for the counties and cities in the region, most notably Seattle. The projects will help support the region’s existing strong growth, especially through its focus on mass transit projects.


Alabama - Amendment 1 (Auburn University) Passed Yes 73% No 27%

Details Impact

A constitutional amendment which adds two additional members to the Auburn University’s governing board. As opposed to the board’s current 14 members which all must reside in-state, the two new members can reside anywhere in the continental US. The amendment also automati-cally staggers board members terms.

We view the amendment as a positive for Auburn University, as it adds diversity and stability to its governance structure. Currently, up to 9 members of the University’s board are able to transition off during a single year. With this measure, that number will be limited to 3.

California - City of San Francisco - Measure B Passed Yes 80% No 20%

Details Impact

The measure increases a citywide parcel tax for the San Francisco Com-munity College District (SFCCD) by 25% and extends it for 11 years. The tax was originally set to expire in 2021. Proceeds from the parcel tax are expected to provide 10% of the district’s FY17 operating revenue.

In our estimation, the measure is a positive for SFCCD as it will help al-leviate the affect of declining enrollment. Improved fiscal stability will be pivotal, as the district is in the final stages of an accreditation review by the Accrediting Commission for Community and Junior Colleges. After first being put on review in July 2014, the final review of the district’s accreditation status is expected to begin in January 2017.

Georgia - Amendment 1 Failed Yes 40% No 60%

Details Impact

A proposed constitutional amendment which would have given the state a mechanism to intervene in chronically underperforming schools. The state would be allowed to transform a school district which received a failing grade for three years in a row into an “Opportunity School Dis-trict.” That status would have allowed varying degrees of state control, from the appointment of administrators, firing teachers, or even turning the school into a charter school.

Overall, we believe the measure’s failure is a net neutral for school districts in the state. While the autonomy of districts and local control is preserved, school districts in Georgia also lack any formal mechanism through which they can receive operational assistance from the state.


Details Impact

A constitutional amendment that would have allowed public universities in the state to retain the authority to set their own tuition levels. Instead, tuition setting authority now reverts back to the state legislature, and any change in tuition rates requires approval by a two thirds majority.

We view this as a negative for public universities in Louisiana, as they will be constrained in their ability to counteract declining state funding. In addition to the often lengthy legislative process, universities will also now face increased political scrutiny of any proposed tuition hikes.

Maine - Question 2 Passed* Yes 50% No 50%

Details Impact

The measure raises the state income tax by 3% on all income over USD 200,000. The marginal tax rate increases from 7.15% to 10.15%. Proceeds will be used to create a Fund to Advance Public Kindergarten to Grade 12 Education. The tax is estimated to raise an additional USD 142mn in annual revenues.

The measure is a positive for Maine cities and school districts, in our view, as the tax proceeds will be distributed based on the state’s existing funding formula, but is limited to funding teachers salaries and other classroom expenses.

Massachusetts - Question 2 Failed Yes 62% No 38%

Details Impact

The measure would have given the state Board of Elementary and Secondary Education the authority to create 12 new charter schools a year or expand enrollment at current charter schools. Priority would have been given to charter schools in districts which were in the bottom quartile of performance.

We consider the measure’s failure to be a positive for school districts in the state, especially in the more socioeconomically challenged regions of Massachusetts.

Education


Michigan - Wayne County Passed Yes 54% No 46%

Details Impact

The measure institutes a county-wide 2 mill property tax levy. The tax is estimated to raise an additional USD 385 per student for the 33 districts in the county.

In our estimation, the measure is a positive for most school districts in the county, especially the newly created Detroit Community School District. Over the next 6 years, it is estimated to generate USD 80mn to help fill gaps in the state funding formula.

Oklahoma - State question 779 Failed Yes 41% No 59%

Details Impact

The measure would have increased the state’s sales tax rate by 1%, with 70% of the additional revenue dedicated to K-12 funding, 19% for higher education, and the remainder going toward other educational programs. It would have also instituted a mandatory increase for most teacher’s salaries.

Overall, we view the measure’s failure as a negative for school districts in Oklahoma. School districts in the state are already facing lower funding levels as state budgetary pressure has been exacerbated by the prolonged period of lower energy prices.

Oregon - Proposition 97 Failed Yes 41% No 59%

Details Impact

The measure would have removed the cap on the corporate gross sales tax, also known as the minimum tax, and established a 2.5% tax on all gross sales that exceeded USD 25mn.

We anticipate that the measure’s failure will be a negative for the state, and its school districts, as it was estimated to have brought in USD 3bn of revenue annually once fully implemented in the 2017 tax year. Those funds would have been used to support some of the general fund’s largest expenditure items, including education and healthcare.

*Measure currently under official state recount.


Arkansas - Issue 5

Struck from the ballot on 13 October 2016 by the Arkansas Supreme Court on the basis that it violated the federal Professional and Amateur Sports Protection Act, which prohibits sports gaming. The measure appeared on the ballot, but the Arkansas Secretary of State was instructed to neither count, nor certify, the result.

Details Impact

A constitutional amendment which would have authorized casino gam-bling in the state. Three casinos would have been allowed to open. One would have been located in Boone County (county seat is Harrison), one in Miller County (county seat is Texarkana), and one in Washington County (county seat is Fayetteville). Each casino would have been required to pay a state tax on net gaming revenues of 18%, a county tax of 0.5% on net gaming revenues, and a city or town tax of 1.5% on net gaming revenues.

The state Supreme Court ruling is a negative the state and for the Arkan-sas local governments in which the casinos were to be built, in our view, as it eliminates a potential new source of revenue.

Massachusetts - Question 1 Failed Yes 61% No 39%

Details Impact

The measure would have allowed the Massachusetts Gaming Commis-sion to issue additional slots-only gaming licenses for existing or pro-posed establishments which are attached to a horse-racing facility. The Plainridge Park Casino currently holds the state’s only slots parlor license. Suffolk Downs had been under consideration for one of these additional slots-only licenses.

In our opinion, the measure’s failure is a negative for the state’s efforts to expand its regional gaming capture; however, the result is a positive for neighboring states and their local governments with existing gaming facilities.

New Jersey - Question 1 Failed Yes 22% No 78%

Details Impact

A legislatively-referred constitutional amendment which would have allowed casino gaming in two additional counties, located in towns which were at least 72 miles away from Atlantic City. Currently, casino gambling in the state is only permitted in Atlantic City, located in Atlantic County. The state’s share of the new tax revenues would have primarily funded aid for Atlantic City and other property tax relief programs.

We believe the measure’s failure is likely positive for Atlantic City. Al-though the city would have benefited from a portion of the tax revenues from the new casinos, further declines in Atlantic City’s gaming activity would likely have followed. Similarily, the result is a positive for neighbor-ing states and their local governments with existing gaming facilities.

Gaming

State Measure Type Status Yes No

Arizona Proposition 205

Recreational Failed 48 52

Arkansas Issue 6 Medical Passed 53 47

California Proposition 64 Recreational Passed 56 44

Florida Amendment 2 Medical Passed 71 29

Maine Question 1 Recreational Passed* 50 50

Massachusetts Question 4 Recreational Passed 54 46

Montana Initiative 182 Medical Passed 57 43

Nevada Question 2 Recreational Passed 54 46

North Dakota Measure 5 Medical Passed 64 36

*Measure currently under official state recount

Sugary beverage tax measures

Name Status Yes No

California - City of Oakland - Measure HH Passed 61 39

California - City of San Francisco - Measure V Passed 62 38

Colorado - City of Boulder - Issue 2H Passed 54 46

New York - City of Albany - Measure O1 Passed 71 29

Marijuana Sugary beverages


Chartbook muni metrics

Source: Bloomberg, MMA, UBS, as of 25 November 2016

30-Day Visible Supply(right hand side)

Treasury 10 yr (le hand side)

AAA GO 10 yr (le hand side)

8,5006,5004,5002,500

3.5

3.0

1.0

2.0

1.5

2.5

4.0

10,500

20,50018,50016,50014,50012,500

24,50022,500

Nov-13 May-14 Nov-14 May-15 May-16Nov-15 Nov-16

Fig. A1: Visible supply and yields

Le hand side in yield %, right hand side in millions


AAA GO 10 yr

AAA GO 5 yr AAA GO 30 yr

4

3

0

1

2

5

May-16Nov-15May-15Nov-14May-14Nov-13 Nov-16

Fig. A3: AAA Muni yields

In %

Fig. A5: Credit quality spreads


In bps

150

100

50

0

200

250

BAA GO 10 yr – AAA GO 10 yr AA GO 10 yr – AAA GO 10 yr

A GO 10 yr – AAA GO 10 yr

Nov-15Nov-14Nov-13Nov-12Nov-11 Nov-16

Note: November flows are MTD, as of 16 November 2016Source: Investment Company Institute, UBS, as of 25 November 2016

10,000

5,000

0

–5,000

–10,000

–15,000

–20,000

15,000

May-13Nov-12 May-14Nov-13 May-16Nov-15May-15Nov-14 Nov-16

Fig. A2: Municipal mutual fund flows

In USD millions

Monthly Net New Cash Flow

Historically low yields

Fed li-off

Rate volatility


10/25/2016

11/25/2016 11/25/2015

3

0

1

2

4

5

0 5 10 15 20 25 30

Fig. A4: AAA yield curve change

In %

Source: Bond Buyer, UBS, as of 23 November 2016

40

30

20

10

0

60

50

FebJan Apr NovOctSepAugJulJunMay DecMar

Fig. A6: Total monthly municipal issuance

In USD billions

Total Issuance 2014 Total Issuance 2016

Total Issuance 2015


Chartbook muni metrics

Fig. A7: One-year horizon total return assuming unchanged AAA yield curve


Total return (TR), in %

3.0

2.0

1.0

0.0

4.0

Favored maturity range AAA GO

1 year horizon TR w/ roll down

292827262524232221201918171615141312111097653210 304 8

Fig. A8: Municipal sector spreads (2010 – present)

Note: The vertical line represents the range of spread from 2010-present, while the square marker shows the average spread over the same time period. The diamond markershows the current spread and the circle marker shows the average spread in 2006. Source: BofAML, UBS, as of 23 November 2016

Option adjusted spreads, in bps

100

50

0

–50

150

200

250

Average OAS Pre-Crisis (2006 avg)

Current OAS

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Fig. A9: AAA muni-to-Treasury yield ratios


In %

100

110

90

80

120

10 yr

30 yr

Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16

Fig. A11: Industrial Corporate and BABs spreads

Source: BofAML, UBS, as of 25 November 2016

Option adjusted spreads, in bps

200

170

140

110

230

260

290

320

U.S Industrial Corp 10+yr OAS

BABS Build America Bond Index OAS

Aug-16May-16Feb-16Nov-15 Nov-16

Fig. A10: A muni GO versus A Industrial Corp. yield ratio

Source: MMD, Bloomberg, UBS, as of 25 November 2016

In %

85

80

75

70

65

60

90

10 year

30 year

Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16

Source: BofAML, UBS, 25 November 2016

70

74

72

78

76

Nov-16

80

Tax-exempt Munis YTM to BABS YTM

Jul-16Mar-16Nov-15Jul-15Mar-15Nov-14

Fig. A12: Tax-exempt to BABs yield ratio

In %

Fig. A13: 10-year GO spreads for select states


State spreads, in bps

150

100

50

0

200

IL PA

NJ CT

CA TX

NY FL

Nov-15Nov-14Nov-13Nov-12Nov-11 Nov-16

Chartbook relative value


State Moody’srating

Outlook Last rating/outlook change³

S&Prating


Fitchrating


Alabama Aa1 Stable 4/16/2010 AA Stable 10/7/2004 AA+ Stable 5/3/2010

Alaska Aa2 Negative 7/25/2016 AA+ Negative 10/27/2016 AA+ Negative 6/14/2016

Arizona Aa22 Stable 5/4/2015 AA2 Stable 5/20/2015

Arkansas Aa1 Stable 4/16/2010 AA Stable 7/24/1991

California Aa3 Stable 6/25/2014 AA- Stable 7/2/2015 AA- Stable 8/12/2016

Colorado Aa12 Stable 4/16/2010 AA2 Stable 7/10/2007

Connecticut Aa3 Negative 3/8/2016 AA- Stable 5/19/2016 AA- Stable 5/19/2016

Delaware Aaa Stable 4/30/2010 AAA Stable 2/22/2000 AAA Stable 4/13/2006

Dist. of Columbia Aa1 Stable 3/12/2015 AA Stable 9/29/2014 AA Stable 9/29/2014

Florida Aa1 Stable 4/16/2010 AAA Stable 7/12/2011 AAA Stable 8/23/2013

Georgia Aaa Stable 4/16/2010 AAA Stable 7/29/1997 AAA Stable 4/13/2006

Hawaii Aa1 Stable 9/14/2016 AA+ Stable 9/12/2016 AA Stable 6/15/2011

Idaho Aa12 Stable 4/16/2010 AA+2 Stable 3/29/2011 AA+2 Stable 4/5/2010

Illinois Baa2 Negative 6/8/2016 BBB Negative 9/30/2016 BBB+ RW Negative 6/9/2016

Indiana Aaa2 Stable 4/16/2010 AAA2 Stable 7/18/2008 AAA2 Stable 10/15/2014

Iowa Aaa2 Stable 4/16/2010 AAA2 Stable 9/11/2008 AAA Stable 4/5/2010

Kansas Aa22 Negative 5/3/2016 AA-2 Stable 7/26/2016

Kentucky Aa22 Stable 6/2/2014 A+2 Stable 9/3/2015 AA-2 Stable 11/8/2012

Louisiana Aa3 Negative 2/25/2016 AA Negative 2/13/2015 AA- Stable 4/5/2016

Maine Aa2 Stable 6/4/2014 AA Stable 5/24/2012 AA Stable 1/22/2013

Maryland Aaa Stable 7/19/2013 AAA Stable 5/7/1992 AAA Stable 4/13/2006

Massachusetts Aa1 Stable 4/16/2010 AA+ Negative 11/23/2015 AA+ Stable 4/5/2010

Michigan Aa1 Stable 7/24/2015 AA- Stable 3/16/2016 AA Stable 4/2/2013

Minnesota Aa1 Stable 7/30/2013 AA+ Positive 8/5/2015 AAA Stable 7/28/2016

Mississippi Aa2 Negative 8/11/2016 AA Stable 11/30/2005 AA Stable 7/15/2016

Missouri Aaa Stable 7/19/2013 AAA Stable 2/16/1994 AAA Stable 4/13/2006

Montana Aa1 Stable 4/16/2010 AA Stable 5/5/2008 AA+ Stable 4/5/2010

Nebraska Aa21 Stable 4/16/2010 AAA2 Stable 5/5/2011

Current state ratings and rating outlooks4 (continued)

State ratings


Nevada Aa2 Stable 3/24/2011 AA Stable 3/10/2011 AA+ Stable 4/5/2010

New Hampshire Aa1 Stable 4/16/2010 AA Stable 12/8/2014 AA+ Stable 4/5/2010

New Jersey A2 Negative 4/16/2015 A- Negative 11/14/2016 A Stable 8/19/2015

New Mexico Aa1 Negative 10/25/2016 AA Negative 11/10/2016

New York Aa1 Stable 6/16/2014 AA Stable 11/10/2016 AA+ Stable 6/20/2014

North Carolina Aaa Stable 1/12/2007 AAA Stable 6/25/1992 AAA Stable 4/13/2006

North Dakota Aa12 Negative 3/28/2016 AA+ Stable 2/18/2016

Ohio Aa1 Stable 3/16/2012 AA+ Stable 7/15/2011 AA+ Stable 4/5/2010

Oklahoma Aa2 Negative 12/23/2015 AA+ Negative 4/6/2016 AA+ Negative 4/1/2016

Oregon Aa1 Stable 4/16/2010 AA+ Stable 3/9/2011 AA+ Stable 4/5/2010

Pennsylvania Aa3 Stable 8/5/2016 AA- Negative 7/19/2016 AA- Stable 9/23/2014

Puerto Rico Caa3 Developing 7/1/2016 D – 7/7/2016 D – 7/5/2016

Rhode Island Aa2 Stable 10/6/2014 AA Stable 6/18/2014 AA Stable 7/18/2011

South Carolina Aaa Stable 12/7/2011 AA+ Stable 7/11/2005 AAA Stable 4/13/2006

South Dakota Aaa2 Stable 7/11/2016 AAA2 Stable 5/4/2015 AAA Stable 6/15/2016

Tennessee Aaa Stable 12/7/2011 AAA Stable 5/26/2016 AAA Stable 4/5/2010

Texas Aaa Stable 4/16/2010 AAA Stable 9/27/2013 AAA Stable 4/5/2010

Utah Aaa Stable 4/16/2010 AAA Stable 6/7/1991 AAA Stable 4/13/2006

Vermont Aaa Stable 4/16/2010 AA+ Stable 11/10/2014 AAA Stable 4/5/2010

Virginia Aaa Stable 7/19/2013 AAA Stable 11/11/1992 AAA Stable 4/13/2006

Washington Aa1 Stable 7/19/2013 AA+ Stable 11/13/2007 AA+ Stable 7/19/2013

West Virginia Aa1 Negative 10/14/2015 AA- Stable 4/21/2016 AA Negative 9/29/2016

Wisconsin Aa2 Positive 11/20/2014 AA Stable 8/15/2008 AA Stable 4/5/2010

Wyoming AAA2 Negative 2/4/2016

Source: Moody’s, S&P, Fitch, UBS, as of 28 November 2016. 1 = Lease rating 2 = Issuer credit rating: a rating equivalent to a General Obligation (GO) rating for states with no GO debt. 3 = Last rating change or outlook revision. Does not reflect an affirmation.4 = Moody’s and Fitch recalibrated ratings on US municipal bond issues and issuers in April 2010.

Current state ratings and rating outlooks4

State Moody’srating


S&Prating


Fitchrating


State ratings


Market view

1 Bloomberg Barclays Municipal Bond Index as of 18 November 2016. 2 Through 18 November.

Outlook

1 Bloomberg, “Municipal Market: Voters OK Infrastructure Bonds, “ 17 November 2016.

2 We favor most state public flagship universities and highly rated private colleges and universities with a strong demand profile, recognized reputation, and solid base of financial resources as select investment opportunities in the higher education sector.

3 S&P, “The Post-Election Landscape for Municipal Bonds,” 14 November 2016.

4 National Association of State Budget Officers, “State Expenditure Report, Examining Fiscal 2014-2016 State Spending,” November 2016.

5 According to MMD, on 28 November 2016, Illinois GOs at the 10-year maturity point stood at 210 bps above the AAA benchmark, while New Jersey GOs rested at 80 bps at the same maturity.

6 Note: Dallas is rated Aa3/AA/AA by Moody’s, S&P, and Fitch, respec-tively, in comparison to Philadelphia’s A2/A+/A-. Dallas’ credit ratings by Moody’s and Fitch are accompanied by a negative rating outlook. Philadelphia’s credit ratings by Moody’s and S&P are accompanied by a negative rating outlook.

7 Houston’s credit ratings by Moody’s and S&P are accompanied by a negative rating outlook.

Endnotes


Required disclosures

Municipal bonds: Although historical default rates are very low, all municipal bonds carry credit risk, with the degree of risk largely follow-ing the particular bond’s sector. Additionally, all municipal bonds feature valuation, return, and liquidity risk. Valuation tends to follow internal and external factors, including the level of interest rates, bond ratings, sup-ply factors, and media reporting. These can be difficult or impossible to project accurately. Also, most municipal bonds are callable and/or subject to earlier than expected redemption, which can reduce an investor’s total return. Because of the large number of municipal issuers and credit struc-tures, not all bonds can be easily or quickly sold on the open market.

Closed-end fundsInvestment Risk: Performance results reflect past performance and is no assurance that a Fund will meet its investment objective. Market Risk: The market value, net asset value (NAV) and distribution rate of a fund’s shares will fluctuate with market conditions. Leverage Risk: Each Fund’s use of leverage (borrowing to increase investments) creates the possibility of higher volatility and greater risk for the Fund’s per share NAV, market price, distributions and returns. Credit Risk: Refers to the possibility that the issuer of the bond will not be able to make principal and interest payments (default).

Statement of risk

Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed

Prepayment Risk: Issuers may exercise their option to prepay principal earlier than scheduled, forcing the Fund to reinvest in lower-yielding secu-rities. Interest Rate Risk: Fixed-income securities will decline in value if market interest rates rise. Reinvestment Risk: If market interest rates decline, income earned from the Fund’s portfolio may be reinvested at rates below that of the original bond that generated the income. Liquidity Risk: This is the risk that the fund may not be able to sell secu-rities in its portfolio at the time or price desired by the Fund. Below Investment Grade Risk: Investments rated below investment grade (typically referred to as “junk”) are generally subject to greater price volatility and illiquidity than higher rated investments. Adjustable Rate Loan Risk: Some of the adjustable rate loans in which the Fund may invest will be unsecured or insufficiently collateral-ized, thereby increasing the risk of loss to the Fund in the event of issuer default. Non-U.S. Securities Risk: Investments in non-U.S. securities involve special risks not typically associated with domestic investments including currency risk and adverse political, social and economic development. These risks often are magnified in emerging markets. Management risk: The risk that investment management decisions may not produce the desired results.

Analyst certification accurately reflect his or her personal views about those securities or issu-ers; and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report.

For a complete set of required disclosures relating to the companies that are the subject of this report, please mail a request to UBS CIO Wealth Man-agement Research Business Management, 1285 Avenue of the Americas, 20th Floor, Avenue of the Americas, New York, NY 10019.

UBS Closed-End Funds Ratings: Definitions

UBS Financial Services Rating Definition and criteria

Buy Higher stability of principal and higher stability of distribution

Hold Potential loss of principal, lower degree of distribution stability

Sell High potential for loss of principal and distribution risk


Agency credit ratings

S&P Moody’s Fitch/IBCA Definitions

Investment grade

AAA Aaa AAA Issuers have exceptionally strong credit quality. AAA is the best credit quality.

AA+ Aa1 AA+AA Aa2 AA Issuers have very strong credit quality.AA- Aa3 AA-

A+ A1 A+A A2 A Issuers have high credit quality.A- A3 A-

BBB+ Baa1 BBB+BBB Baa2 BBB Issuers have adequate credit quality, This is the lowest Investment Grade category.BBB- Baa3 BBB-

Non-investment grade

BB+ Ba1 BB+BB Ba2 BB Issuers have weak credit quality. This is the highest Speculative Grade category.BB- Ba3 BB-

B+ B1 B+B B2 B Issuers have very weak credit quality.B- B3 B-

CCC+ Caa1 CCC+CCC Caa2 CCC Issuers have extremely weak credit quality.CCC- Caa3 CCC-

CC Ca CC+CC Issuers have very high risk of default.CC-

D C DDD Obligor failed to make payment on one or more of its financial commitments. This is the lowest quality of the Speculative Grade category.

Appendix

For purposes of this report, ETFs include index-linked funds regulated under the Investment Company Act of 1940 that trade on US securities exchanges under exemptive relief from the Securities and Exchange Com-mission. The shares of all of the ETF issuers discussed in this Report are listed on U.S. securities exchanges. The ETFs are either open-end, regis-tered investment companies (including UITs) operating under an exemp-tive order from the SEC, or collective investment vehicles, formed as grantor trusts, limited partnerships or similar structures that offer pass-through tax treatment to investors. The different structures provide dif-ferent rights for investors. For example, ETFs registered under the Invest-ment Company Act of 1940 must stand ready at all times to redeem shares (albeit only in creation unit size) whereas those ETFs that are not subject to registration under the Investment Company Act of 1940 may suspend redemptions at any time. We refer to ETFs registered with the SEC under the Investment Company Act of 1940 as “’40 Act ETFs” and to non-registered ETFs as “33 Act ETFs.” All of the ETFs discussed in this Report track an index of financial instruments or provide exposure to a single commodity type.

Exchange Traded Funds (ETFs) Disclosure US-registered, open-ended index-linked funds are redeemable only in Creation Unit size aggregations through an Authorized Participant, and may not be individually redeemed. Many ETFs are redeemable only on an “in-kind” basis. The public trading price of a redeemable lot of ETFs may be different from their net asset value, and ETFs could trade at a pre-mium or discount to the net asset value. UBS AG or its affiliates act as authorized participants for many of the ETFs discussed in this report. In addition, UBS is a regular issuer of traded financial instruments and pri-vately issued financial products that may be linked to the ETFs mentioned in this Report. UBS regularly trades in ETFs. Through these and other activities, UBS may engage in transactions involving ETFs that are incon-sistent with the strategies in this report.

ETFs are subject to the same risks as the underlying securities and commis-sions may be charged on every trade, if applicable. This definition does not imply that ETFs are endorsed by the Securities and Exchange Commission. ETFs are sold by prospectus, which contains details about ETFs, including investment objectives, risks, charges and expenses. Clients should read the prospectus and consider this information carefully before investing. Clients may obtain more information about ETFs, including copies of pro-spectuses or summary, from their UBS FS financial advisor.


DisclaimerIn certain countries UBS AG is referred to as UBS SA. This publication is for our clients’ information only and is not intended as an offer, or a solicita-tion of an offer, to buy or sell any investment or other specific product. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situation and needs of any specific recipient. We recommend that recipients take financial and/or tax advice as to the implications of investing in any of the products mentioned herein. We do not provide tax advice. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially dif-ferent results. Other than disclosures relating to UBS AG, its subsidiaries and affiliates, all information expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness. All information and opinions are current only as of the date of this report, and are subject to change without notice. This publication is not intended to be a complete statement or summary of the securities, markets or devel-opments referred to in the report. Opinions may differ or be contrary to those expressed by other business areas or groups of UBS AG, its subsidiar-ies and affiliates. Chief Investment Office (CIO) Wealth Management (WM) Research is published by UBS Wealth Management and UBS Wealth Management Americas, Business Divisions of UBS AG (UBS) or an affiliate thereof. CIO WM Research reports published outside the US are branded as Chief Investment Office WM. UBS Investment Research is written by UBS Investment Bank. Except for economic forecasts, the research process of CIO WMR is independent of UBS Investment Research. As a con-sequence research methodologies applied and assumptions made by CIO WMR and UBS Investment Research may differ, for example, in terms of investment horizon, model assumptions, and valuation methods. There-fore investment recommendations independently provided by the two UBS research organizations can be different. The analyst(s) responsible for the preparation of this report may interact with trading desk personnel, sales personnel and other constituencies for the purpose of gathering, synthesiz-ing and interpreting market information. The compensation of the analyst(s) who prepared this report is determined exclusively by research management and senior management (not including investment banking). Analyst com-pensation is not based on investment banking, sales and trading or princi-pal trading revenues, however, compensation may relate to the revenues of UBS as a whole, of which investment banking, sales and trading and prin-cipal trading are a part.

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Version as per June 2016.

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