2013 Credit Outlook
The next 12 months are uncertain ones for the municipal bond market. Many municipal issuers remain fiscally stressed, and federal deficit reduction efforts may further pressure state and local budgets. Even the tax exemption for municipal interest may be at risk.
In our view, heightened credit and tax risk suggests that investors should emphasize credit research and remain biased toward higher quality bonds. Bonds with sturdy credit fundamentals are typically more resilient when a credit or tax event leads to selling pressure.
In this Special Commentary, we outline the stable – but imperfect – financial outlook for state and local issuers in 2013, and discuss the credit risks associated with federal budget austerity. We begin with a discussion of municipal credit quality, including some comments regarding the recent downgrade of Puerto Rico. We then discuss the impact of federal austerity on municipal issuers.
In a future Special Commentary, we plan to address how federal austerity may threaten the 100 year-old tax-exemption for municipal bonds.
Municipal Credit Quality: Stable Now; Risks Remain
The municipal market exhibits mostly stable credit fundamentals heading into 2013.
Low default rates. Through November 2012, municipal default rates remained lower than in 2011. New defaults comprised 0.06% of the $3.7 trillion municipal market.1
Falling debt levels and good liquidity. Low default rates partly reflect falling debt levels and improved cash management. State and local debt has declined for eleven consecutive quarters as a percentage of GDP.2 State and local fund balances are up compared to prior recessions.3
Uptick in home prices. Stabilizing real estate prices are also contributing to the market’s resilience. Home prices began to increase in 2012 in many areas of the country (see graph below). An improved housing market is likely to benefit municipal governments, down-the-road. Property tax collections generally lag real estate valuations by two years or more.4
Willingness to finance public initiatives. “Softer” factors also seem to be supporting the market, including a growing public willingness to raise taxes to finance public services deemed essential. In November, California voters approved $6 billion in new taxes to support public schools and public safety, and two dozen California cities and counties supported their own local tax hikes for specific purposes.5
A change in attitudes toward state and local taxes has percolated to the federal level, as well. A growing number of Congressional leaders support empowering states to tax currently exempt internet transactions, a change that could add $23 billion annually to state coffers.6
Despite improvements, municipal issuers continue to face an array of long-term challenges.
Legacy costs. State and local governments have made significant headway addressing their long-term pension and retiree healthcare liabilities over the past three years.7 In fact, some experts predict that overall pension-funding ratios will begin to increase in 2013 (see chart below).
However, additional reforms are likely needed. New Government Accounting Standards Board (GASB) rules will compel higher pension contributions for many governments beginning in July 2013,8 and reforms designed to ease public pension costs may be delayed (or forestalled) in the courts.9 Moreover, aggregate funding ratios mask wide variation in the funding ratios of individual issuers. For example, Illinois’ several pension funds remain only 40% funded and are unlikely to recover any time soon.10
Lackluster revenues. Tepid state and local revenue growth remains a challenge. Since 2009, state and local government taxes have grown at an annualized rate of 3.3%. This is too slow to support the cost structure of existing state and local programs. During the 30 years prior to 2009, state and local taxes grew by 6.5%, annually.11
Deteriorating labor relations. Public sector labor relations are likely to sour further in the coming year. In 2012, issuers ably managed several public sector strikes, including September’s high-profile Chicago teachers’ strike.12 To date, most labor disputes have broken slowly in favor of issuers.13 We expect this pattern to continue, but we also anticipate that poor labor relations will grab headlines.
Ageing infrastructure. The need to replenish ageing infrastructure is becoming more apparent in state and local financial disclosures. Since 2006, the average age of state, county, and municipal infrastructure has increased from 12.9 years to 14.4 years (see chart below). Nationwide, roughly one of every eight bridges is “structurally deficient,” and by some estimates, the country is trillions of dollars behind in infrastructure maintenance.14 Pressure to maintain infrastructure spending at today’s levels will likely to squeeze other budget priorities.
Municipal distress. As we have discussed in several prior Special Commentaries, there remains a wide and growing divergence in credit quality among the Nation’s handful of severely distressed local governments and what might be termed a “typical” issuer. Increasingly, it may make policy sense for some of these issuers to restructure bond contracts. Unfortunately, only a few states have taken steps to clarify how they will treat bondholders when unwinding overburdened local governments. Uncertainty pervades the following subject areas:
- Pensions. The bankruptcies of San Bernardino and Stockton, California raise several issues, including whether state laws regarding public pension plans must be honored in municipal bankruptcy filings. As we noted in our November 2, 2012 podcast, CalPERS’ Challenges with Distressed Municipalities, the outcome of the San Bernardino and Stockton bankruptcy cases could prove beneficial or harmful for municipal bondholders.
State control of local governments. States have the legal authority to control their local governments, but the very slow financial rehabilitation of Detroit and Harrisburg illustrate that, in practice, state governments have limited ability to swiftly restructure struggling municipalities. Detroit and Harrisburg’s distaste for state authority may foreshadow greater use of Chapter 9 bankruptcy to restructure local governments. If state officials are unable to advance negotiated solutions between creditors and local politicians, a bankruptcy judge may be the only option.
Extending credit to struggling municipalities. Some struggling municipalities have tapped the private placement and bank credit markets when shut out of the broader bond market (e.g., Detroit). However, recent deals suggest the cost of this capital is very high. Scranton, PA officials secured an $11 million private placement in October at an interest rate of 8.9%. The City seeks an additional $21 million (at a 10% rate) to meet payroll at the end of December.15 It is unclear how long issuers like Scranton can continue to finance operating costs with expensive debt.
- Willingness to pay. In 2011 and 2012, several local governments defaulted on weakly secured obligations issued to finance non-essential assets (e.g., Wenatchee, WA, Vadnais Heights, MN, San Bernardino, CA and Stockton, CA). Severely distressed issuers are likely to continue to default on these kinds of obligations. In most of these situations, bonds are insured or guaranteed, the debt has been issued to finance a speculative, non-essential project (e.g., something other than a school, police station, or water utility), and/or the underlying security is weak. We wrote extensively about eroding “willingness to pay” in our June 2012 Special Commentary.16
Puerto Rico. In December, Moody’s downgraded Puerto Rico’s general obligation bond rating to Baa3 from Baa1.17 This is an unwelcome development for municipal investors.
The downgrade impacted $46 billion in debt and dropped $5 billion of the Commonwealth’s bonds to “junk status.” The Commonwealth’s appropriation-backed bonds now carry a Ba1 rating, and the outlook remains “negative.”18 In the week following the downgrade, the interest rate on long-maturity Puerto Rico GO bonds rose by 84 basis points compared to only 31 basis points for the market, as a whole.19
As we explained in our March 2012 Special Commentary, “Puerto Rico’s Challenge,” a default by the Commonwealth would reverberate throughout the municipal market. It would likely invite speculation that creditworthy states like California and Illinois “are next” and induce mutual fund redemptions by skittish retail investors. This would be problematic, as Puerto Rico’s bonds are widely held by state specific municipal bond mutual funds. A spate of redemptions by retail investors could cause market interest rates to rise and liquidity to suffer.
The downgrade has certainly created some selling pressure, but in our view, a default remains a low probability event in the near term.
First, the Commonwealth seems likely to retain its market access. Its sales tax secured COFINA bonds retained their Aa3 rating, and officials are likely to refinance any maturing bonds through the COFINA structure.
Second, selling pressure in the market appears to be driven by fund managers, not retail investors. Many funds have credit guidelines that limit their exposure to low- or below- investment grade bonds, and some of these funds have begun selling their Puerto Rico positions.20
Third, fund sales will probably abate in the near term, even if the Commonwealth suffers additional downgrades from Fitch or S&P. Support for Puerto Rico bonds may dissipate a bit, but fund managers have little incentive to sell so long as the island’s market access remains intact.
One caveat to this analysis is the impact of a change to the tax exemption for municipal bonds. Investors often purchase Puerto Rico’s debt for its “triple tax-free” yields. If the tax status of Puerto Rico’s debt is altered, the Commonwealth’s borrowing costs could rise just as its credit rating is downgraded and mutual funds feel greater pressure to sell Puerto Rico’s bonds.
The federal government’s deficit reduction efforts will affect state and local bond issuers in FY 13 and beyond. Federal austerity is likely to impact municipal credit quality in one of three ways:
Negatively through failed debt limit, sequester, or FY 13 budget negotiations,21
Positively through a deficit stabilization plan with negative impacts for specific issuers, or
- Negatively over the long-term.
We examine each scenario below:
Failed Debt Limit, Sequester, and Budget Negotiations. Federal lawmakers have until early March 2013 to increase the Nation’s borrowing limit and address “sequester” cuts to defense and discretionary programs.22 By March 27th, lawmakers must pass an appropriations bill to fund the government for the remaining six months of FY 13 or risk a government shutdown.23
Failure to adequately deal with any of these items for a prolonged time period would have several negative consequences for municipal bonds.
Failure to increase the federal government’s borrowing limit would likely induce immediate and significant budget cuts, negatively impacting municipal credit quality throughout the country. This would endanger the economic recovery and interrupt state and local cash flows from federal grants. In an extreme scenario, failure to raise the debt limit might trigger a run on Treasuries or a U.S. government bond default. We view these possibilities as very unlikely. Policymakers likely want to avoid a repeat of the unpleasant debt limit experience in the summer of 2011.
The sequester is a more real threat to municipal credit quality. On March 1st, $85 billion in immediate cuts to discretionary and defense spending will take effect unless Congress acts.24 Issuers that rely on specific grant funding might be hit particularly hard. The sequester requires an across-the-board 7%-8% reduction in funding for many federal programs that funnel money to states and local governments.25 When across-the-board cuts are enacted, the effects are typically apportioned differently among programs. Some grant programs may be cut only 2%, others 30%.26 The higher education and hospital sectors seem particularly vulnerable.27 (Notably, Medicaid is unaffected by the sequester.)
The sequester would also dampen GDP growth in 2013 and might pressure state and local finances significantly in certain areas of the country. States and local governments with economies heavily dependent on the defense industry or federal research and development grants would likely suffer most.28
Finally, the sequester may negatively affect certain Build America Bonds (BABs) and GARVEE bonds. Some taxable Build America Bonds were sold with “extraordinary call” provisions that empower issuers to call their bonds if the federal subsidies that support them are reduced. The sequester reduces these subsidies. Likewise, states often rely on vulnerable federal transfers to secure “GARVEE” bonds (Grant Anticipation Revenue Vehicle bonds).29 Earlier this year, Breckinridge sold BABs and GARVEEs that were overly exposed to these cuts.
Failure to enact an appropriations bill for the remainder of 2013 would also have a negative impact on municipal credit quality. A delayed appropriations bill might lead to a government shutdown, sharp cuts in spending, and reduced growth in 2013. Certain areas of the country would be impacted significantly. For example, the FY 96 government shutdown led to the furlough of 800,000 federal employees and impacted roughly 20% of federal contractors in Washington, D.C.30
However, a prolonged government shutdown seems unlikely. The longest shutdown in U.S. history was only 21 days.31
We believe lawmakers will reach a compromise on the sequester cuts, extending the debt limit, and providing for appropriations for the duration of FY 13. The downside risks associated with failure are too great. Nonetheless, the process is likely to be messy.
Deficit Stabilization Plan. If Congress and the President manage to reach a longer-term deficit stabilization agreement, it will have a positive near-term effect on most issuers’ credit quality. Deficit stabilization is expected to increase real GDP growth to 4% annually.32
However, even under a longer term agreement, some issuers will feel negative impacts. Deficit stabilization requires an additional $1.4 - $2.4 trillion in tax hikes or spending cuts,33 and it is unclear precisely how federal budget pain might be distributed.
For example, if federal lawmakers eliminate the state income tax deduction as part of a budget deal, it would impact states like California and Hawaii more than others.34 The table below illustrates the variation. It shows the 10 states with the highest marginal income tax rates and the difference between today’s effective top rate and the rate if the state income tax deduction is eliminated. Taxpayers in states that are highly dependent on income tax revenue, like California and Hawaii, would experience a hike in taxes. This might lead to slower growth or reduced revenues.
Under another scenario, Florida communities could suffer. Florida would be impacted if deficit reduction entails higher Medicare premiums, reduced social security payments, or taxing dividends at ordinary income tax rates. Eight of the 10 metro areas most reliant on income derived from dividends, interest, rent, and government transfers are located in Florida.
These examples underscore that conducting bottom-up credit research makes sense in the current fiscal environment. Issuers with adequate reserves, low debt loads, and balanced economies are more likely to prove resilient in the face of hard-to-predict federal austerity.
Long-term Trends Augur for More Federal Austerity. Even if federal lawmakers can reach a broad deficit reduction agreement in the next few months, long-term budget trends strongly suggest that federal austerity will continue to weigh on municipal issuers for the coming years and decades.
No current deficit reduction proposal sufficiently keeps the Nation’s long-term debt in check.
As the graph above illustrates, deficits and debt merely stabilize for several years under proposals currently being discussed. (The graph shows the President’s original FY 2013 budget plan, which is consistent with most plans under consideration. It includes a real GDP growth assumption of 3.6% annually, from FY 13 to FY 18.35)
After 2022, deficits and debt grow, mostly the result of rising Medicare costs associated with ageing baby boomers. The graph below, from the CBO, shows just how much long-term deficit reduction remains.
Persistent, elevated federal debt levels portend additional cuts to state and local governments for at least two reasons.
First, states and local governments have the ability to raise taxes and cut spending to offset declines in federal aid. This differentiates them from other constituencies that are less able to withstand government cutbacks, including individuals who rely on social security checks, Medicare beneficiaries, or even defense contractors.
Second, the lobbying clout of state and local governments has diminished over the years. There are few formal lines of communication between federal lawmakers and their state and local counterparts. In prior decades, the Advisory Commission on Intergovernmental Relations (ACIR) facilitated fiscal cooperation between the states and the federal government. However, that body disbanded in 1996, and today, few federal policymakers have a strong understanding of the interplay between federal policy and its impact on states and local governments.36
Credit quality is largely stable heading into 2013, but significant challenges remain for municipal issuers. In particular, federal budget austerity may drain economic and financial resources from states and localities. Even the tax exemption for municipal interest payments may be at risk. (a topic we plan to address in more detail in a future Special Commentary).
Depending on how lawmakers choose to balance the federal budget, municipal credit quality, and bond prices, could rise or fall.
In such an environment, we believe a bottom-up approach to credit analysis is imperative. Borrowers that exhibit sound credit fundamentals are more likely to retain their value if credit or tax risks put pressure on prices.
DISCLAIMER: The material in this document is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Nothing in this document should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. Factual material is believed to be accurate, taken directly from sources believed to be reliable, including but not limited to, Federal and various state & local government documents, official financial reports, academic articles, and other public materials. However, none of the information should be relied on without independent verification.
1. See: Bank of America / Merrill Lynch Muni Commentary, November 30, 2012. Default count includes monetary defaults, only.
2. It is down from 19.4% of GDP in December 2009 to 17.8% today. See Federal Reserve Flow of Funds report, December 6, 2012.
3. See National Association of Budget Officers’, Fall 2012 report (p. 52-54), and National League of Cities “City Fiscal Conditions in 2012” survey.
4. See “The Lag Between Economic & City Fiscal Conditions,” National League of Cities (NLC). Available at: http://www.nlc.org/find-city-solutions/center-for-research-and-innovation/finance/city-fiscal-conditions-in-2012/the-lag-between-economic-and-city-fiscal-conditions. The NLC notes that the “lag is anywhere from 18 months to several years, and it is related in large part to the timing of property tax collections.
5. See Alison Vekshin, “California Voters Add Local Taxes on Top of New Levies,” Bloomberg, November 8, 2012. See also, the full text of California Proposition #30, which states that the “chief purpose of this measure is to protect schools and local public safety…”
6. Under current law, states can impose sales taxes only on transactions with sufficient “nexus” to the state. (“Nexus” has historically meant “physical presence.”) When a state resident makes an on-line purchase from an out-of-state vendor (a vendor with no brick-and-mortar store in that state, no employees or sales associates, e.g., no “nexus”), the vendor cannot be compelled to collect state sales taxes. Ideally, the buyer reports the purchase and pays “use” tax, but this seldom happens. Congress can change this framework to empower states to collect sales taxes on internet transactions without a traditional “nexus.” The change may result in up to $23 billion in new revenue for states, annually. See: Monica Langley, “Tax Break Nears End for Online Shoppers,” Wall Street Journal, July 16, 2012. See also: Quill v. North Dakota, 504 U.S. 298, (1992).
7. See National Conference of State Legislatures’ “Enacted State Pension Legislation,” 2012, 2011, and 2010 reports. Available at: http://www.ncsl.org/issues-research.aspx?tabs=951,69,140#140.
8. See GASB rules 67 and 68. The new rules apply to fiscal years 2014 and 2015. Governments are encouraged to implement GASB rule 68 (which requires a more conservative measurement of liabilities) earlier than the required start-date, which is for fiscal years beginning after June 15, 2014.
9. See: Kristen De Pena, October Pension Litigation Update, October 3, 2012 (State Budget Solutions). Available at: http://www.statebudgetsolutions.org/publications/detail/october-pension-litigation-update.
10. See: Tim Jones, “ Illinois Pension Failure Costs Rise $17 Million Daily,” Bloomberg.com, January 9, 2013. Available at: http://www.bloomberg.com/news/2013-01-09/illinois-lawmakers-fail-to-act-on-fixing-pension-deficits.html.
11. See U.S. Census of Governments, Quarterly Summary of State and Local Tax Revenue.
12. See “Perspective on the Chicago Public School Teachers’ Strike, Municipal Labor Relations & Implications for Investors,” Breckinridge Capital Advisors, September 2012 white paper.
13. This has been the pattern in Wisconsin and Michigan, among other states. For example, in Wisconsin, lawmakers curtailed collective bargaining rights in 2011 only to suffer a backlash in 2012. However, the collective bargaining law remains intact, and the Governor, who was threatened with a recall, remains in office. Likewise, in Michigan, voters rejected the state’s emergency financial manager law at the ballot box (the emergency financial manager law was unfriendly to labor interests), but rejected another ballot amendment designed to enshrine collective bargaining rights in the state constitution. In December 2012, the legislature enacted a law to make Michigan a right-to-work state, which has implications for public sector workers (except police and firefighters). Going forward, public sector unions are likely to collect fewer dues in Michigan. See Public Act 348 of 2012.
14. See: Donal F. Kettl, “The Looming Infrastructure Crisis,” Governing.com, April 2010. The author cites data from the American Society of Civil Engineers (ASCE).
15. See Jim Lockwood, “Scranton Closing in on $21 million Loan,” The Times Tribune, December 5, 2012. Available at: http://thetimes-tribune.com/news/scranton-closing-in-on-21m-loan-1.1412281. Both Scranton deals were private placements through Janney Capital markets. See Bloomberg. CUSIP #810759PC.
16. See “Assessing Willingness-to-Pay” in the Post-Great Recession Muni Market,” June 2012. Available at: http://www.breckinridge.com/insights/whitepapers.html
17. See “Puerto Rico Downgrade,” Janney Fixed Income Strategy, December 18, 2012.
18. See Moody’s December 13, 2012 ratings downgrade of Puerto Rico. The “market-wide” rate is the MMD rate.
19. Citi Municipal Securities, Daily Market Summary, December 18, 2012.
20. Note that if Fitch or S&P downgrades Puerto Rico’s debt, it may lead to slightly more selling pressure by funds. Often, fund guidelines require at least two rating agencies to downgrade an issuer before credit guidelines take effect.
21. See David Malpass, “Nothing is Certain Except More Debt and Taxes,” Wall Street Journal, January 1, 2013. The sequester takes effect on March 1, sometime around that date, the Nation will reach its debt limit, and by the end of March, FY 13 budget authority expires. Also, lawmakers agreed to enact some modest additional cuts to offset their failure to implement honor the “sequester” the first time around.
22. As part of the “fiscal cliff” deal enacted on January 1, 2013 (formally known as the American Taxpayer Relief Act of 2012), lawmakers agreed to delay scheduled, automatic, across-the-board spending cuts until March 1, 2013. These cuts amount to $109 billion annually and $1.2 trillion over 10 years. They fall equally on non-defense discretionary spending and defense spending. See Richard Kogan, “How the Potential 2013 Across-the-Board Cuts in the Debt-Limit Deal Would Occur,” Center on Budget and Policy Priorities, November 2011.
23. See H.J. Res. 117 – Continuing Appropriations Resolution, 2013.
24. Originally, the sequester was for $109 billion, but the American Taxpayers Relief Act of 2012 offset some of these cuts with the new revenue generated from higher tax rates on the wealthy. See: Ryan Holeywell, “Fiscal Cliff Deal a Mixed Bag for State, Local Leaders and Richard Kogan, “How the Potential 2013 Across-the-Board Cuts in the Debt-Limit Deal Would Occur,” Center on Budget and Policy Priorities, November 2011. See also: “The Impact of the Fiscal Cliff on the States,” pp. 18 – 22 (November 2012).
25. See Federal Funds Information for States. Available at: http://www.ffis.org/.
27. See Moody’s Special Comment, “The Fiscal Cliff and Sequestration: Myriad Risks for Public Finance Credits,” December 20, 2012, p. 4.
28. See Moody’s Special Comment, “The Fiscal Cliff and Sequestration: Myriad Risks for Public Finance Credits,” December 20, 2012.
29. These transfers are backed by highway trust fund taxes and general fund transfers to the highway trust fund. Only the highway trust fund transfers are impacted by the sequester. See: Fitch Ratings’ 2013 Outlook: U.S. Transportation Infrastructure, p. 12. December 13, 2012.
30. See: Clinton T. Bass, Shutdown of the Federal Government: Causes, Processes, and Effects, Congressional Research Service, February 18, 2011.
31. This was the 1996 government shutdown. See: Shutdown of the Federal Government: Causes, Processes, and Effects, Congressional Research Service, February 18, 2011
32. See See Office of Management and Budget, President’s Budget, Table S-14. Available at: http://www.whitehouse.gov/omb/budget/Overview. See also, written Testimony of Mark Zandi, Chief Economist and Cofounder, Moody’s Analytics, December 6, 2012. Zandi believes growth will exceed 4% in 2014 and 2015 if a deficit reduction deal is reached.
33. Despite the gridlock displayed during the recent “fiscal cliff” negotiations, Congress has made halting progress towards reducing the Nation’s annual deficits. In 2010 and 2011, lawmakers reduced the federal government’s discretionary spending baseline by $1.7 trillion over 10 years. The recently enacted American Taxpayer Relief Act of 2012 (the “fiscal cliff” deal) added another $737 billion to deficit reduction in the form of tax hikes and interest savings. As a result, lawmakers must find only an additional $1.4 - $2.4 trillion to reach the near-term goal of deficit stabilization. The $1.4 - $2.4 trillion range is dependent on economic growth assumptions. See: written Testimony of Mark Zandi, Chief Economist and Co-founder, Moody’s Analytics, December 6, 2012 and See Richard Kogan, “$2 Trillion in Deficit Savings Would Achieve Key Goal: Stabilizing the Debt over the Next Decade,” Center for Budget and Policy Priorities, November 1, 2012.
34. For a colorful editorial on the disparate effects of the state income tax deduction, see “Of Liberals and Loopholes,” Wall Street Journal, December 16, 2012. Though we do not subscribe to the editorial’s broad conclusions, we do believe that the credit impact of eliminating the state income tax deduction would vary significantly from state-to-state.
35. See Office of Management and Budget, President’s Budget, Table S-14. Available at: http://www.whitehouse.gov/omb/budget/Overview..
36. See Report of the State Budget Crisis Task Force, Paul Volcker and Richard Ravitch, Chairman, July 2012. Available at: http://www.statebudgetcrisis.org/wpcms/.
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