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Municipal

Perspective published on May 19, 2017

The Nutmeg State’s Economy Needs More Spice

Since May 12, each of the major three rating agencies has downgraded the State of Connecticut’s general obligation (GO) bond rating. Standard & Poor’s, Moody’s and Fitch now rate Connecticut A+/A1/A+, with stable outlooks from all three agencies. Previous ratings were AA-/Aa3/AA-.

The downgrades reflect Connecticut’s still-lagging economy, elevated debt and legacy costs, limited liquidity, and most urgently, an unexpected $400 million drop in spring income tax collections. Rating agency concerns also reflect the state’s projected FY18 budget deficit,1 which totals $2 billion or about 11 percent of general fund revenue. Connecticut now joins Illinois and New Jersey as one of only three states with bond ratings below AA-/Aa3 from all three rating agencies.

Complicating matters, Connecticut’s capital city is flirting with insolvency. Hartford faces a FY18 budget gap of just under $50 million partly due to higher debt service costs owed by the city. Its new mayor seeks more state aid and has proposed politically unappealing solutions, such as regionalizing services and taxes in metro Hartford. The city has also recently sought advice from bankruptcy attorneys. Connecticut’s other urban centers, including New Haven, Waterbury and Bridgeport are less fiscally stressed, but only marginally so.

As the graph below illustrates, Connecticut’s long-term fiscal trajectory is worrying investors. Spreads on Connecticut GO bonds maturing in 10 years are now in the +75 basis point range. For perspective, this is in line with a generic A-rated hospital bond, per Municipal Market Data.

 

 

Widening credit spreads are warranted, in our view, although we think recent downgrades ought to be put in perspective. In our opinion, Connecticut is not (yet) Illinois or New Jersey. Consider:

  • Recent weakness in income tax receipts likely reflects deferrals of investment income taxable gains by Fairfield County residents. Connecticut is notoriously reliant on volatile investment income to balance operations, and roughly 44 percent of all state income taxes originate in finance-reliant Fairfield County. Many of these residents likely anticipated lower investment income tax rates next year given President Trump’s tax proposals, which call for lower rates on capital gains and dividends income. Also, total employment in Connecticut was up 1.8 percent on a year-over-year basis through March 2017, and appears to be accelerating modestly.
  • Connecticut has generally exhibited strong willingness to meet its obligations over the past several years. Political gridlock has been relatively subdued, and budgets have been passed on time. For the most part, taxes have been raised to match ongoing revenues and expenditures, and, crucially, the state has contributed actuarially recommended amounts to its pension systems.
  • Connecticut’s debt burden, while high, partially reflects the concentration of borrowing at the state level. While other states push down borrowing to their cities or school districts, Connecticut generally centralizes it. This tends to overstate the burden of Connecticut’s debt relative to entire range of state and local resources. It also means that many local governments in Connecticut exhibit very reasonable credit fundamentals. We note that median debt-to-full value was 1.2 percent in FY15.
  • The state’s wealth levels remain among the highest in the U.S., and state law empowers policymakers to balance revenues and expenditures with relative ease. The Connecticut Constitution lacks a tax cap, and a super-majority vote is not required for any specific fiscal policies. The constitution does, however, have a spending cap, but it is (technically) a dormant provision.
  • Connecticut’s top income tax rate remains below those in neighboring New Jersey and New York. This tends to keep some taxpayers in-state who might otherwise work in the New York City metro area. Tax expenditures are also available to tap for new revenue.

Still, in the recent budget session, lawmakers began pulling on some of the policy levers that had underpinned Connecticut’s AA- rating. This includes cutting municipal aid, shifting a portion of annual costs for teacher pensions to local governments and re-amortizing state pension debt. Each time the state draws on its policy flexibility, it narrows its fiscal options in the future.

Keeping a Close Watch

There’s little sign that Connecticut’s economy will turn around anytime soon. The state has been losing population for several years, especially outside of Fairfield County. Home-price appreciation has been weak for over a decade, and the unemployment rate, at 5.3 percent, is higher than the national average (4.7 percent). Another year or two of economic stagnation will heighten concern that Connecticut’s ability-to-pay is weakening, regardless of its recent show of legislative willingness.

Over the next few years, policy innovation is likely to play a role in restoring the state to fiscal balance. This may include a mix of approaches, including taking a tougher stance in labor negotiations, rethinking pension and healthcare benefits, protecting local GO bonds with statutory liens and considering more heavy-handed regionalization of services, among other ideas. Investors should expect a bumpier ride ahead as an uptick in political dysfunction seems probable.

 

[1] Connecticut’s fiscal year ends June 30.

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.