- Topline municipal credit fundamentals are strong, with the municipal default rate at its lowest level in nearly a decade; however, in some ways today’s credit profiles are built on shaky foundations.
- The mix of structural and fundamental risks suggests limited value in bonds rated A- or BBB, and a smaller municipal market.
- Crossover opportunities could make sense for high-grade bond investors more than in the past.
- We continue to closely analyze relative value and perform in-depth, bottom-up fundamental credit research.
An ounce of prevention is worth… probably more than the market thinks.
As the municipal market advances into the second month of 2018, investment grade credit fundamentals are stable and there are few obvious catalysts to spur near-term deterioration. However, we believe caution is warranted given the maturity of the economic recovery, a Federal Reserve positioning for interest rate hikes and a variety of structural challenges that make pockets of the municipal market less resilient to recession. We are retaining an up-in-quality bias in 2018, noting the following challenges:
- A meaningful portion of today’s credit health has been purchased with tomorrow’s dollars. Inadequate pension funding, delayed infrastructure maintenance and deferred hiring for essential services portend higher costs in the future.
- Willingness (or political) risk remains elevated and security pledges appear less reliable.
- State governments are struggling to convert economic growth into predictable revenues.
- The federal government has become a risk, as opposed to a stabilizing force, for municipal credit.
- Risks related to climate change are growing.
Against this backdrop, tight credit spreads appear to offer limited value and the market seems likely to shrink, which could pressure municipal ratios. Investors should expect new money issuance to remain tepid for quite some time, as fiscally constrained governments issue debt less frequently. Low supply coupled with the recent tax reform may cause municipal ratios to settle into a “new normal” lower range, suggesting that crossover opportunities will make sense for high grade fixed income buyers more often than in the past.
Municipal Market Strengths
Steady U.S. Economy. There is little question the economy is on firmer footing heading into 2018. Real GDP has grown by over 3 percent for two consecutive quarters. The U.S. unemployment rate has fallen to 4.1 percent, down from 4.7 percent at the beginning of 2017. Retail sales growth is accelerating, and home prices continue to grow at an annualized pace of 6 percent.1 The U.S. stock market finished 2017 with its second straight year of double-digit gains, and the recently passed Tax Cuts and Jobs Act (TCJA) should provide a near-term economic stimulus, as it reduces federal income tax for roughly 80 percent of taxpayers.2
Strength in Transportation Credits. Better economic performance is likely to support credits that benefit directly from faster growth. These include a variety of transportation-related credits, including airports, ports, toll roads and bonds backed by gas tax revenue, among others. Traffic and trade tends to grow as the economy expands. Notably, in the transportation sectors S&P Global Ratings’ upgrades were 4.8 times higher than downgrades in 2017, while Moody’s Investors Service’s 2018 outlook for airports remained positive for a third consecutive year.3
Strength in Dedicated Tax Bonds. A steady outlook for retail sales growth suggests that coverage on most sales tax bonds should improve or remain stable. Growing e-commerce and the aging U.S. population remain meaningful risks for some dedicated tax bonds, especially those supported by a small sales tax base (see Not Yet in Lockstep: E-Commerce, Sales Tax and Muni Credit). But in the near term, most dedicated tax credits should benefit from the breadth of the current recovery.
The outcome of a Supreme Court case may also be a positive for dedicated tax credits in 2018. A ruling in favor of South Dakota in South Dakota v. Wayfair Inc. would clear the way for 45 states to impose sales tax collection requirements on e-commerce sellers.4 This change could generate $11 billion annually nationwide, and it would absolve Congress from taking action on the issue.5
The market’s liquidity profile suggests that a broad swath of issuers are reasonably well-prepared for an economic downturn.
Solid Issuer Liquidity. Issuer liquidity is generally strong across municipal sectors. Figure 1 underscores that municipal issuers are more liquid today than they were in the fiscal years immediately after the recession. Strong liquidity is a major factor behind Moody’s stable outlooks on water-sewer utilities and on local governments for 2018.6 These two sectors account for roughly 25 percent of the Bloomberg Barclays Municipal Bond Index.7 The market’s liquidity profile suggests that a broad swath of issuers are reasonably well-prepared for an economic downturn.
Municipal Debt Levels. State and local debt levels continue to fall as a percentage of the economy. Deleveraging is generally a credit positive for bond investors. State and local government debt has declined from 20 percent of U.S. GDP in 2009 to 15 percent in Q317.8 As Figure 2 illustrates, personal income grew faster than debt in all but five states between 2009 and 2015. And in 13 states, aggregate state and local debt actually declined in absolute terms.
Lower Default Rates. An improving economy, a rise in liquidity and a decrease in state and local debt burdens have contributed to low default rates (see Figure 3). The municipal default rate in 2017 was the lowest since 2009, and it has declined each year since the end of the recession.
Potentially Favorable Labor Reform. Management-labor relations may tilt in favor of issuers in 2018. This spring, the Supreme Court will be poised to outlaw state-mandated agency fees in Janus v. American Federation of State, County, and Municipal Employees (AFSMCE), Council 31.9 Such a ruling would likely weaken the bargaining power of public sector unions in certain parts of the country. The number of union dues-paying members is likely to drop if the agency fees are no longer mandated.10
A weaker labor presence should benefit some issuers. Rating agencies take a dim view of restrictive collective bargaining agreements, and eliminating the requirement to pay union agency fees is likely to reduce the number of such agreements.11 Over the long-term, heavily unionized states that are actively seeking ways to slow employee-benefit growth, such as California, Connecticut, Illinois, New York and New Jersey, may also benefit.
Municipal Market Challenges
Today’s credit repair has been purchased with tomorrow’s dollars.
Deferred Costs. Today’s credit repair has been purchased with tomorrow’s dollars. Across the market, credit benchmarks, like improved liquidity and lower debt levels, have been financed, in part, by pushing costs into the future. This is evidenced by three key indicators:
- Deferred maintenance. Figure 4 illustrates that between 2008 and 2016, public infrastructure aged for water-sewer systems, school districts, counties and cities by two to three years. We estimate the cost of this delay at $168 billion based on issuers’ reported depreciation expense. However, actual costs are likely higher, as the cost to replace aging facilities accelerates over time (see Infrastructure Accounting: A Blind Spot Facing Investors). The nation faces a $2 trillion funding gap between estimated needs and funding sources across all major infrastructure sectors through 2025, per The American Society of Civil Engineers.12
- Insufficient Pension Contributions. Issuers continue to contribute too little to their pension plans. In 2016, contributions by 34 of the largest 50 local governments rated by Moody’s were deemed insufficient to slow liability growth, per Moody’s analysis.13 And although public pension plans are revising their return assumptions downward, the pace of these revisions is very gradual. The median return assumption for a public pension plan in 2016 was 7.5 percent. This compares to a 2.6 percent rate on 30-year Treasuries in the same year. Actuaries favor return assumptions closer to 6 percent given a roughly 70 percent/30 percent split between stocks and bonds.14 One consequence of underfunding is the near certainty of higher costs in the future. When combined with retiree healthcare costs, pension contributions now make up over 10 percent of expenses in 132 U.S. cities. This is up from only 66 cities in 2010.15
Figure 5 illustrates the challenge. State and local governments are taking more risk in their pension plans and contributing more to them, but unfunded liabilities continue to grow. However, to be clear, while the long-term trend remains negative, we continue to expect most issuers to meet their pension funding challenges, even over the long term. Pension stress and funding discipline varies widely by state and issuer, and annual pension costs remain manageable for most. In addition, the legal environment for pension benefits continues to change, with most courts concluding that pension rights are less robust than previously believed (notwithstanding more stringent rulings in Illinois and Arizona).
- Failure to Re-Staff. Issuers’ credit repair is also a function of their refusal to rehire since the recession. State and local governments are notoriously overstaffed, but state and local government workers are experiencing the weakest post-recession recovery on record.17 U.S. state and local employment is down 6 percent on a per capita basis compared to its 2009 level (Figure 6). State and local governments’ failure to staff a baseline number of police officers, firefighters and teachers indicates that some issuers’ willingness and ability to fund essential services remains degraded-a full 104 months into the current economic expansion.
Elevated Willingness Risk. Despite a strong economy and a low municipal default rate, bondholders remain an unloved group of creditors. In 2017, Luke Bronin, the mayor of Hartford, Connecticut threatened bondholders with losses after the state enacted a rescue package for the struggling city.18 Illinois Gov. Bruce Rauner implored voters not to “listen to Wall Street” when faced with the threat of junk ratings from the major rating agencies19 and Sen. Elizabeth Warren of Massachusetts advocated for the complete discharge of Puerto Rico’s debt, including that of its political subdivisions.20
These remarks reflect more than just ordinary political posturing, in our view. They also suggest, on the margin, more mainstreaming of creditor-unfriendly, “populist” thinking in the policymaking community. Just a few years ago, public officials with similar ambition, financial savvy and stature would likely have avoided this kind of rhetoric.21 As we noted in Thoughts on Populism and the Muni Market, populist sentiments percolating in the electorate likely amplify willingness risk in the municipal market.
Less Reliable Security Pledges. A growing swath of market participants, including rating agencies, are growing skeptical of security pledges-even those specifically designed to insulate investors from general fund credit stress.22 We note that in Puerto Rico this year, the judge overseeing the commonwealth’s restructuring allowed the diversion of pledged toll revenue away from Highway and Transit Authority bondholders despite the toll money’s likely status as “special revenues,” which are supposed to honor payments to bondholders during a bankruptcy.23 The ruling ran counter to the precedent established in the 2011 Chapter 9 filing by Jefferson County, Alabama, and it further muddies investor confidence in municipal security pledges.24 The reduced confidence of market participants in security structures is likely to contribute to more costly market access in the next downturn for issuers that need it. It may also inform issuer behavior and future court decisions. In the next downturn, more distressed issuers are likely to claim “you knew the risks.” Their claims will have more justification given the bending of security pledges in recent insolvencies such as those in Detroit and Puerto Rico.
Sluggish State Revenue Growth. State governments are struggling to convert economic growth into predictable revenues. Unexpectedly low revenue forced 22 states to make mid-year budget cuts in 2017, the highest number since 2011 (when states were still recovering from the recession).25 We believe state revenue misses similar to last year’s are likely to occur more often in the future. Greater reliance on progressive income taxes at the state level, coupled with increased volatility in capital gains and wage income, has contributed to larger forecasting errors in recent years.26 In addition, state sales tax bases have shrunk in many parts of the country. A larger portion of consumer spending now goes untaxed in the form of services (e.g., consulting services, healthcare costs, etc.). Finally, the country is aging and consumption and sales tax growth tends to wane as populations grow older. Figure 7 illustrates that consumption declines by about 1.1 percent for every 1 percent change in a state’s median age.
Consumption declines by about 1.1 percent for every 1 percent change in a state’s median age.
Heightened revenue volatility suggests marginally weaker credit fundamentals for states, as well as downstream credits within states like local governments, school districts, public higher education issuers and other entities that benefit from flush state coffers.
SALT Deduction Changes. The recent curtailment of the state and local tax (SALT) deduction is likely to create additional uncertainty for some states. As outlined in Tax Reform: From Risks to Reality, the curtailment of the SALT deduction is likely to weaken the economic competitiveness of high-tax states relative to low-tax jurisdictions. It increases the marginal cost of raising taxes and may lead to greater reliance on more volatile fee- or fine-based revenues in some places. Over time, some states may complicate their tax codes to circumvent the federal change. California is considering a proposal to characterize state income tax payments as charitable deductions, with an offsetting credit for tax paid. New York is exploring the feasibility of replacing personal income taxes with an employer payroll tax.27 We doubt that either of these proposals will become law next year, but the $10,000 deduction cap for state and local taxes is not indexed to inflation. In the future, it is likely to ensnare many more taxpayers, which suggests that more state tax innovation is on the horizon.
Government Policy Risks. The federal government is now as much a risk as a support for municipal credit. The federal government’s fiscal stability and policymaking reliability has been taken for granted by municipal market participants for several decades. However, rising federal debt and entitlement spending is projected to crowd out discretionary funding over the next decade as the baby boom generation retires (Figure 8).
Also, by most measures, political gridlock is at multidecade highs.28 As a result, the federal policymaking pipeline is likely to deliver less aid and more surprises for states, local governments and other issuers of tax-exempt bonds. Notably, in 2017 federal lawmakers came within one vote of hastily revamping the Medicaid program, which now makes up 29 percent of state spending.29 Congress swiftly enacted a tax reform that significantly curtails the SALT deduction, and it delayed financing for the popular Children’s Health Insurance Program (CHIP), threatening the credit quality of children’s hospitals.30
Future U.S. Congresses may have a different partisan flavor and dissimilar policy preferences, but the combination of rising debt and high political friction is unlikely to remedy existing federal dysfunction. A less reliable federal partner suggests that investors need to place greater emphasis on issuers’ own-source revenue in their credit evaluations—especially in preparation for another economic downturn.
Climate Change Risks. Climate change issues are becoming more material to credit risk. More issuers are beginning to plan for climate change-related infrastructure projects. Boston is pondering a $10 billion project to build a floodgate in Boston Harbor. Miami Beach is embarking on a new project, estimated to cost up to $500 million, to adapt to daytime flooding.31 The cost of these projects is significant, which suggests that climate risk is likely to impact credit quality more often in the years to come. Rating agencies have taken notice. In October 2017, Standard & Poor’s and Moody’s both published pieces explaining how climate risks are integrated into the agencies’ municipal ratings.32
Valuation and Market Implications
Breckinridge believes that most issuers will ably manage through the next recession, given municipal issuers’ improved liquidity and reduced debt burdens. However, the market’s structural headwinds suggest that a subset of issuers are likely vulnerable to ratings downgrades and, in extreme cases, default if the economy were to weaken today.
In such an environment, we believe an up-in-quality bias makes sense, especially for investors who intend for municipal bond exposure to balance risk held elsewhere in their personal portfolios.
In such an environment, we believe an up-in-quality bias makes sense, especially for investors who intend for municipal bond exposure to balance risk held elsewhere in their personal portfolios. Figure 9 shows that the spread on BBB-rated municipal bonds maturing in 10 years has declined from over 200 basis points in early 2010 to 84bps in 2018. The 10-year spread on A-rated bonds has declined from over 100bps in early 2011 to around 50bps today. In our view, these spreads poorly compensate investors for the market’s unsettled credit foundations.
Even if credit fundamentals are maintained in 2018 as we expect, current spreads are unlikely to offer much value. The Fed is expected to raise interest rates several times this year, which should contribute to higher spreads and better entry points for investors later in the year.
The market’s structural challenges may also contribute to reduced supply and more instances when crossover buying makes sense. New money issuance seems likely to remain subdued for the foreseeable future as volatile state tax revenue, rising pension costs and a less-reliable federal partner crimp issuers’ inclination to borrow. Low levels of new issue volume, coupled with the recent elimination of advance refundings, may contribute to unusually low tax-exempt municipal/U.S. Treasury ratios from time to time. As a result, there may be more instances in 2018 and beyond when ratios indicate more value in buying taxable securities versus tax-exempt municipals. As outlined in Managing Shifts in Municipal Relative Value, Breckinridge has capabilities across investment grade asset classes and is well-equipped to perform crossover trades.
President Donald Trump’s recently proposed infrastructure program could alter this supply prognosis, but we think this is unlikely. Congress is likely to be consumed with budget, debt-ceiling and immigration legislation over the next few months, and then it will become focused on the mid-term elections. In addition, the president’s plans are unlikely to adequately address infrastructure funding needs, even if some infrastructure legislation passes. The proposal envisions up to $200 billion in unspecified federal aid matched by state and local governments.33 The matching ratio would be 20 percent federal and 80 percent state-local, which likely is too little to spur sufficient state and local participation.
The municipal market exhibits a solid credit footing based on traditional metrics like liquidity, debt and default rates. However, the market’s substructure remains unusually weak given the length and breadth of the economic expansion. Breckinridge expects limited credit improvement over the next year. As such, we believe investors should remain cautious in the current environment, though opportunistic purchases may be available this year as interest rate hikes contribute to spread widening from time to time. The constrained credit environment may also lead to reduced issuance and supply, so investors should be open to crossover opportunities if market conditions demand it.34
 Bureau of Economic Analysis, Bureau of Labor Statistics, Commerce Department and Federal Housing Finance Agency.
 “Distributional Analysis of the Conference Agreement for the Tax Cuts and Jobs Act,” Tax Policy Center, p. 6, December 18, 2017.
 U.S Transportation Sector 2018 Outlook: “Credit Quality Will Largely Be Stable, But Will Infrastructure Finally Take the Spotlight,” Standard & Poor’s, January 17, 2018; and “Airports – 2018 outlook positive due to expectation of strong enplanement growth,” Moody’s Investors Service, November 27, 2017.
 The state of South Dakota has appealed to the Supreme Court a decision of that state’s Supreme Court. See: South Dakota v. Wayfair, No. 2017 S.D. 56 (2017).
 Legislation like the Marketplace Fairness Act, which would empower states and local governments to collect tax from e-commerce sellers regardless of court approval, has stalled for several years in the House and Senate. See: Rebecca Helmes, “Sales Tax Slice: How Much Revenue Do States (Really) Lose from Remote Sales?” Bloomberg BNA, April 3, 2014, and S. 976 – Marketplace Fairness Act of 2017, 115th Congress (2017-18), introduced by Sen. Michael Enzi on April 27, 2017.
 Water-sewer utilities and local governments outlooks, Moody’s Investors Service, December 2016.
 As of January 24, 2018. Measured by par plus accrued. Estimate includes bonds listed under “leasing,” many of which are local appropriations.
 Breckinridge analysis based on Federal Reserve, Treasury and Bureau of Economic Analysis data, December 2017.
 Adam Liptak, “Supreme Court Will Hear Case on Mandatory Fees to Unions,” New York Times, September 28, 2017. Agency fees are charged to workers for costs associated with representing them in collective bargaining negotiations, as opposed to costs associated with the union political activity.
 News Staff, “The Biggest Issues for States to Watch in 2018,” Governing.com, January 2018.
 2016 Credit Outlook, “Muni Market to Begin 2016: Stable, But More Delicate Than Appreciated,” January 2016. https://www.breckinridge.com/insights/details/2016-credit-outlook.
 American Society of Engineers 2017 Infrastructure Report Card. https://www.infrastructurereportcard.org.
 “Pension risks remain high for most of the 50 largest local governments,” Moody’s Investors Service, December 2017.
 Treasury rate from U.S. Treasury. Actuaries’ 6 percent recommendation based on Breckinridge conversations with actuaries.
 “Expenses” refers to total primary government expenses, which include both governmental costs and costs associated with any public enterprises such as a city-owned utility. The numbers reflect a Breckinridge analysis of Merritt Research Services data. The sample size included over 630 U.S. cities in each year from 2010 and 2016.
 To be clear, while the long-term trend remains negative, we continue to expect most issuers to meet their pension funding challenges, even over the long term. Pension stress and funding discipline varies widely by state and issuer, and annual pension costs remain manageable for most. In addition, the legal environment for pension benefits continues to change, with most courts concluding that pension rights are less robust than previously believed (notwithstanding more stringent rulings in Illinois and Arizona). Notably, this year the California Supreme Court will consider whether its decades-old California rule remains good law. The rule prohibits public employers from closing existing pension plans and opening less expensive ones for current employees. At least 12 other states follow the California rule, and a decision in favor of more public employers could have national repercussions. See: Jonathan Cooper, “Cases could open door to pension cuts for California workers,” Associated Press, December 28, 2017.
 Dan White, “Stress-Testing States,” Moody’s Analytics, October 2017.
 Amanda Albright and Danielle Moran, “Hartford Mayor Says City Needs to Reduce its Debt Bills,” Bloomberg.com, October 30, 2017.
 Kim Geiger and Monique Garcia, “Rauner compares tax hike to ‘two-by-four’ as veto override vote is set,” Chicago Tribune, July 6, 2017.
 Letter to Mr. José B. Carrión, chairman of the Financial Oversight and Management Board for Puerto Rico, November 15, 2017.
 We note that the mayor of Hartford is a former Treasury official and chief of staff at the Hartford’s Property and Casualty Division, the governor of Illinois is former private equity executive, and Sen. Warren is a former bankruptcy law professor and mastermind of the Consumer Financial Protection Bureau. For a nice comparison, contrast Rhode Island Gov. Gina Raimondo’s statement regarding that state’s obligation to repay poorly secured moral obligation debt after a failed industrial development financing in 2012: “You don’t want to be the state that walks away from its moral obligations.” Raimondo was then the Treasurer of Rhode Island. She made the statement in an interview with The Providence Journal in July 2012. http://www.golocalprov.com/news/state-report-strippers-marijuana-dispensaries-legislive-payraises.
 Jane Ridley, “For U.S. Municipal Debt, Credit Fundamentals Remain the Key to Ratings,” Standard & Poor’s, May 4, 2016.
 In re: Financial oversight and Management Board For Puerto Rico v. Peaje Investments LLC, No. 17 BK 3283-LTS, 9/8/17.
 The ruling’s substantive rationale hinged on whether the bonds were supported with a statutory lien, and the judge determined none existed. But its result was to allow diversion of a flow of special revenues to the general government and from bondholders.
 National Association of State Budget Officers, Fiscal Survey of the States, Fall 2017.
 Don Boyd and Lucy Dadayan, “State Tax Revenue Forecasting Accuracy,” Technical Report, Rockefeller Institute of Government, September 2014.
 Jared Walczak, “State Strategies to Preserve SALT Deductions for High-Income Taxpayers: Will They Work?” Tax Foundation, January 5, 2018.
 Vital Statistics on Congress, 2017, Brookings Institution.
 National Association of State Budget Officers, State Expenditure Report, FY 2015-17.
 “CHIP funding’s potential expiration or delay is credit negative for children’s hospitals,” Moody’s Investors Service, January 17, 2018.
 Joey Flechas, “Miami Beach to begin new $100 million flood prevention project in face of sea level rise,” Miami Herald, January 28, 2017.
 “Understanding Climate Change Risk and U.S. Municipal Ratings,” Standard & Poor’s Global Ratings, October 17, 2017; “Moody’s approach to assessing ESG in credit analysis,” Moody’s Investors Service, October 25, 2017; “Jersey Shore counties well prepared to handle next superstorm,” Moody’s Investors Service, October 25, 2017.
 Paul Page, “Funding Questions Abound Over Trump’s Infrastructure Plan,” January 31, 2017. Note also that the leaked document outlining the president’s plan has a “grab bag” feel to it. It suggests that state volume caps for private activity bonds be eliminated, would require value capture financing as a condition for receipt of federal transit funds and would authorize tolls on U.S. interstates. These ideas are likely to be controversial.
 Investors should speak with their financial adviser before making any investment decisions.
DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.
Nothing contained herein should be construed or relied upon as financial, legal or tax advice. All investments involve risks, including the loss of principal. An investor should consult with their financial professional before making any investment decisions.
Some information has been taken directly from unaffiliated third party sources. Breckinridge believes such information is reliable, but does not guarantee its accuracy or completeness.
Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.