While the market continued to debate the timing of the Fed’s first rate hike and its pace of tightening, the 10-year treasury yield bounced between 2.15 percent and 2.30 percent, ending the month at the low end of that range.
Modern Populism & the Muni Market
Hello, this is Natalie Wright, Product Manager at Breckinridge, and welcome to the Breckinridge podcast. Today, I am joined by Adam Stern, Breckinridge's Director of Municipal Research, and we will be discussing Adam's most recent white paper: Thoughts on Modern Populism in the Municipal Market. So Adam, we've seen populist rhetoric expand in the past year looking, for example, at the U.S. with the presidential candidates Bernie Sanders and Donald Trump, as well as in a number of European countries such as the Brexit referendum in the U.K. recently. Does this populism concern you at all in terms of the muni market?
Well, the short answer is yeah, it does, at least a little bit. You know, populism is really a form of political risk and as the financial markets reacted to the Brexit vote, it can definitely have an impact for investors. I think the impact in municipals is generally a little bit less but I do think it's material in some cases. Where it connects is really in willingness risk. So when a credit analyst, and folks here at Breckinridge, look at municipal bonds, they're always looking at ability to pay and willingness to pay. And as we mentioned a few years ago in a white paper on willingness to pay in the muni market, willingness to pay is very tied together with legal covenants that an issuer gives you as a bondholder as well as the purpose of the proceeds, what the bonds are financing. So if you have, you know, a general obligation pledge to finance a school or a really well-secured, dedicated tax pledge to finance roads or bridges, that's generally going to hold up better when populism rises or other political risks are on the rise relative to a weaker secured credit, maybe a lease appropriation bond for, say, a convention center or a general fund pledge for a hockey rink. We actually saw, speaking of a hockey rink, we actually saw defaults in Vadnais Heights, Minnesota a few years ago on precisely that. Lease appropriation bonds were issued to finance a sports complex and a hockey arena and there was a similar default in Wenatchee, Washington, and there was a spate of other defaults on these nonessential, weakly secured bonds in the year, two or three after the Great Recession and that's where you would be most concerned with populist rhetoric and risk.
Well, does the new populist sentiment suggest to you that there will be more bankruptcies or defaults going forward?
Well, in the immediate term, probably not, but in the next recession, I think the popular sentiment that we're seeing now, especially with the rise of Donald Trump's candidacy and Bernie Sanders' run, which has now ended to be the Democratic nominee for President, that does suggest that there is less willingness out there to honor certain commitments, that the system is a bit strained and that certain obligations are going to have to be rethought. I think in the case of bonds in the vast majority of cases, the bonds are going to do fine. But we should sort of recognize that when we're seeing leaders be willing to throw caution to the wind to upend the status quo, whether it means trade agreements or radical changes in tax policy, that is of a kind with leaders asking for a fresh start for their communities. And I think that Chapter 9's gate-keeping function, you have to prove that you're insolvent to get in, is a good bulwark against willy-nilly bankruptcy filings, but we should be aware that in some cases where there is maybe a question as to whether an issuer is solvent or not, especially in a downturn and especially in a place that has not had a lot of job growth for maybe decades that we should see an uptick in defaults and a downtick in voters and taxpayers' willingness to honor debts. Again, I think this is in a handful of cases in the most distressed situations, but that is something that I anticipate, you know, over the medium-term.
Well, that's looking at the local government level. Are we seeing any of these issues at the state level?
Yeah, in spots. In general, the states are pretty healthy, you know, all but a handful of states continue to have AA level ratings from the agencies or higher, but we are seeing sort of an uptick in willingness risk. I'm not sure it's directly related to populism, but it's plainly willingness risk, really in three areas that I can see. One is just sort of disrespect for state fiscal laws so we're seeing that, for example, in Illinois, a little less so in Pennsylvania where lawmakers have blown through the fiscal year without getting a budget done, Illinois is claiming this appropriation bill that they put together a couple of months ago is a budget, but really it's just authorization to spend money that they haven't balanced with ongoing revenue until after the November elections. In Pennsylvania's case, Pennsylvania lawmakers went almost a full year without a budget, finally got one done and they did do a little better job this year. But this willingness to flout fiscal rules, either outlined in statute or more egregiously outlined in the Constitution does show that again, some of the long-standing norms and practices are breaking down at the sort of established parties and the established political system is not doing quite as good a job at getting to solutions as maybe we would expect, certainly seven, eight years into an economic expansion. Another area we see it is tax aversion so for example, in Kansas, there's been income tax cuts that were enacted in 2012, those continue to be paid for with one-time budget fixes. In Alaska, lawmakers have so far balked at restructuring their tax code which is overly reliant on oil revenue and we all know what's gone on with oil prices, and then, of course, you've got the pension and retiree healthcare funding situation. Many issuers continue to shortchange the full amount that they should be contributing for pensions and that's essentially operating in a structurally imbalanced way. So we are seeing some signs of unwillingness to do the things you'd want states to be doing to maintain credit quality and it’s definitely something to monitor.
In the piece, it discusses how you actually think that populism has more impact on the federal government's ability to get things done than the state. Why is that?
Yeah, well, when you look at the state/federal relationship, what you find is that the states are a little bit in a better sweet spot than the federal government to manage getting things done, at least, than the federal government. So as I just mentioned, you know, most states are in very good fiscal condition at least relative to the federal government. Outside of a few problem issuers, U.S. states all but six are rated AA3 or higher by Moody's, and all but three were AA- or higher by Standard & Poor's as of July. Public trust in government numbers, much, much higher at the state, and the local level for that matter, than with the federal government. If you look at the states, there is only one state where the public basically has less faith in its state government's ability to solve problems and that is Illinois, and the other 49 are in better shape than the federal government. We all know what Congress's approval rating is, it's been in the ditch for a while. When you look at legislative gridlock numbers, state legislatures in 2014, for example, they passed on average about 25% of bills that were proposed, Congress 4%. Now the Congressional gridlock numbers have gotten slightly better since 2014, but if you look at it over a long period of time, you can see sort of the gridlock in action and that the number of bills passed by the U.S. Congress really since the late '40s and '50s has declined fairly steadily.
But the past doesn't always predict the future. So what is it that makes you think this trend will continue?
I think it's commonly believed that the gridlock that we see at the federal level is really part and parcel of Democrats versus Republicans, and political polarization, but there is actually a growing body of research that that shows that the polarization stems from us, from you and I and voters and taxpayers. Americans increasingly self-segregate into homogenous neighborhoods, U.S. counties have become more homogenous as measured by voting patterns, American civic engagement has generally declined across the country, Americans belong to fewer association groups, know their neighbors less, socialize less often than they did in the mid-20th century. You've got growing fragmentation in the media landscape so people tend to self-select their media, whether it's MSNBC, Fox News, or just no news at all, and just watching Sports Center, I guess, more often than watching anything else. And a number of policy thinkers on both sides of the aisle have started arguing that the extent of the political polarization suggests that lower levels of governments like states and local governments may prove better vessels to address modern policy challenges. So this populism that we're seeing is just harder to square at a macro level than a micro level. One example of that might be, folks on the right side of the aisle may see income inequality and lament that there's a lot of rent-seeking behavior because of the tax code, it's highly progressive and there's all these carve-outs and exemptions and connected insiders and lobbyists lobby for these exemptions and they're controlling the establishment in Washington and redirecting capital to where it should not go so therefore we need a flat tax code. And then the other side the aisle sees the same problem and says, well to mitigate the inequality, we need higher marginal income tax rates and so that sounds like maybe there's a compromise there, but it is harder to square in practice than reality and that's really what we've seen for the last 10 or 15 years at the federal level. I also think the federal debt itself plays a role here. The debt is a costly political issue, so no one ever likes to vote to increase the debt limit. We saw this a couple of years ago with the debt ceiling crisis and if it is true that the debt becomes tougher and tougher to authorize, the federal government is going to have a harder time picking and choosing what it wants to finance and so we may see, I think, more of a devolution of at least domestic spending priorities to the states.
Great, well thank you so much, Adam. We hope that you in the field have found this informative and please, for more detail, see Adam's white paper which is currently posted on our website. Thank you, have a great day.
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