Podcast recorded August 9, 2018
We are excited to launch a new format for our monthly podcast.
A poll taken the day after the June 23 Brexit vote found that the primary rationale for British voters to leave the European Union (EU) was to honor the principle that “decisions about the U.K. should be taken in the U.K.” The vote was an unexpectedly loud expression of sovereignty, and it was a reminder to investors that political risk—in this case, populism—can impact investment returns.
In our view, the populism that fueled the Brexit vote has material credit implications for municipal investors. The populism in Britain mirrors rhetoric elsewhere in Europe and dovetails with voter preferences being expressed in the 2016 U.S. presidential campaign. The Republican nominee for president, Donald Trump, has to date successfully campaigned on a platform of nativism and protectionism. Sen. Bernie Sanders of Vermont ran competitively for the Democratic nomination on a message of Trump-like economic nationalism plus broadsides against income inequality and Wall Street banks, among other alleged villains.
That the two major political parties in the United States, as in Britain, have been caught flat-footed by widespread voter discontent suggests that long-standing political norms and institutions here in the U.S. may be vulnerable to change. For municipal investors, an uptick in populist-driven political instability is meaningful because it portends greater “willingness” risk for certain bonds at the local and state levels.
Perhaps more profoundly, today’s populism may contribute to changes in the federal-state fiscal relationship. A number of measures suggest that states are better positioned to manage populist sentiment than is the federal government, at least over the next several years. This may result in states, local governments and nonprofit issuers taking on a larger financial burden for domestic spending. The consequence could be greater dispersion in credit quality.
Over the past several years, we have noted that willingness-to-pay is eroding in some corners for the municipal market. Populist sentiment certainly has the potential to amplify this risk.
We first wrote at length about willingness-to-pay in a June 2012 white paper entitled “Assessing Willingness-to-Pay in the Post-Great Recession Muni Market.” There, we explained that “willingness” is correlated with a bond’s legal security and the purpose of the project it finances. The penalty for defaulting on well-secured bonds issued for essential services is high, while the penalty for defaulting on poorly secured bonds for nonessential projects is lower. When a government’s fiscal situation erodes, repaying can sometimes be perceived by voters as “unjust,” especially in the case of bonds with weak security issued to finance a nonessential undertaking.
In the aftermath of the recession, issuers reneged on several nonessential bond deals. In Vadnais Heights, Minnesota, officials refused to appropriate debt service on lease-appropriation bonds issued to finance a local sports complex and hockey arena. In Wenatchee, Washington, city officials refused to advance funds when a similar entertainment facility deal went sour. There are other examples, as well.
Rising populist anger, particularly when it is concentrated in an economically struggling community, seems likely to increase the risk of these kinds of bond defaults in the future.
Rising populism may also contribute to an increase in local Chapter 9 filings. The Brexit vote and populist urges underpinning the Trump and Sanders phenomena suggest that a growing number of voters—and leaders—are willing to throw caution to the wind if it means upending the status quo. To us, this sentiment is on the same risk spectrum as local officials who want a fresh start for their communities. Chapter 9’s gatekeeping functions, namely the requirement that a municipality prove it is insolvent to access the bankruptcy court, mitigate the risk of willy-nilly filings. Still, the mere threat of a Chapter 9 filing may create an incentive for negotiated settlements in the future. And once in bankruptcy court, issuers might be less friendly to creditors. In the bankruptcies of Detroit and Stockton, each city used unusually aggressive tactics to win concessions from bondholders.
Ever since Michigan put Detroit into bankruptcy, more state-level leaders have embraced a let’s-blow-it-up approach to debt restructuring.
States’ credit reputations also have exposure to growing populist attitudes. Ever since Michigan put Detroit into bankruptcy, more state-level leaders have embraced a let’s-blow-it-up approach to debt restructuring. The governor of Illinois has openly advocated for the bankruptcy of Chicago Public Schools; the governor of New Jersey threatened to put Atlantic City in Chapter 9; and, of course, the governor of Puerto Rico recently announced a debt moratorium on general obligation (“GO”) bonds despite a constitutional mandate to pay them.
Apart from ad hoc statements about using Chapter 9 to restructure local governments, some states are also showing an unwillingness to balance ongoing revenues and expenditures. Eroding state-level willingness shows up in at least three common forms:
Spread data for several states also shows evidence of investor concern over willingness, which populist risks could aggravate. The graph below shows that the spread-to-the-AAA scale on a 10-year maturity for a Connecticut, Louisiana or Pennsylvania GO bond is about the same as that for a generic A-rated hospital. These spreads seem a bit divorced from each state’s fundamental capacity to pay.
There is little doubt that each of these states suffers from slow growth, pension challenges and structural imbalances. Connecticut anticipates a $700 million deficit (4 percent of operating revenue) in FY 18. Louisiana has shrunk its state workforce by 28.5 percent since May 2009 and the drop in oil prices has worsened its structural budget gap. And in Pennsylvania, the now two-year-old budget fight seems likely to continue for the remaining two years of the governor’s term.
But in our view, the risk in all three credits is in performance and pricing. Each of these states is much less likely to actually default on their GO bonds than is an A-rated hospital that issues unsecured debt. We believe the data is more reflective of investor doubt that each state will be willing to take the steps necessary to close budget gaps over the next several years.
Consider the graph below, which makes the point a bit more forcefully. It shows that all three states can likely afford to meet the increased costs associated with paying down unfunded pension and OPEB liabilities over 30 years, assuming the pension liability is valued using a 5 percent discount rate.
While populism has the potential to increase willingness risk for certain state and local credits, it also threatens to alter the state-federal fiscal relationship. Evidence suggests that states can more- nimbly manage populist tendencies than can the federal government. In the near-term, this could result in state, local governments and nonprofits being asked to bear more of the financial burden for domestic spending priorities.
States seem better positioned than the federal government to manage populist sentiment for the following reasons:
Public support for state government generally outpaces that for the federal government even in geographically large states and in states with divided government.
The Congressional Budget Office (CBO) projects that without substantial policy changes, the federal debt will increase from 76 percent of GDP today to 110 percent by 2036. In just the next 10 years, spending on health-related programs and Social Security will increase from 10.4 percent of GDP to 12.4 percent. Assuming no new revenue or program reforms, this increase will cause spending (excluding interest payments) on all other budget items to fall from 44 percent of federal expenditures to only 33 percent. This includes spending on defense, research and development and other discretionary programs.
In prior periods of rising public debt, at the local and state levels, Americans have opted to shift public financing responsibilities from one level of government to another. These shifts often reflect changes in the economic and political costs of raising capital for public needs (e.g., through borrowing or by increasing taxes). They are also often accompanied by new fiscal constraints on governments that over borrowed or overspent. For example, many of the debt limits and balanced budget requirements outlined in today’s state constitutions and local charters were born out of the state bond defaults of the 1840s and 1870s and local insolvencies during the depression. Figure 5 belowsuggests that we may be flirting with a similar period in which the economic and political costs—to raising additional federal tax, borrowing more or cutting popular programs—outweighs the political benefits, especially given the lack of public confidence in federal institutions.
Taken together, the relative health of the states, federal legislative gridlock, political polarization and a rising federal debt suggest that federal discretionary spending may continue to decrease (as a percentage of GDP) over the next several years while state responsibilities for domestic prerogatives increase. In particular, a future recession may force reconsideration of the federal-state partnership for transportation and Medicaid funding. Communities that benefit from defense spending and research-and-development grants, such as those anchored by Army bases, large hospitals or colleges, might be affected. A reduction in federal aid might also lead to greater dispersion in credit quality across states and local governments. As issuers are asked to shoulder a greater portion of the costs of domestic public services, each government’s ability to meet its debt obligations, independently, should become a more important credit characteristic.
A reduction in federal aid might also lead to greater dispersion in credit quality across states and local governments.
The populism expressing itself throughout the Western world carries risks for municipal investors. At the local level, populist sentiment is likely to weaken issuers’ willingness to honor poorly secured, nonessential debts and avoid bankruptcy. At the state level, it may contribute to insouciance regarding balanced budgets. Still, several indicators suggest that populist sentiment may have its biggest effect on federal spending priorities. We plan to monitor closely how and whether the state-federal relationship changes in the face of a rising populist mood.
 Lord Ashcroft Polls at: http://lordashcroftpolls.com/2016/06/how-the-united-kingdom-voted-and-why/
 Breckinridge White Papers: Assessing Willingness-to-Pay in the Post-Great Recession Muni Market (June 2012) and Credit Outlook 2015 (December 2014), among others.
 Yvette Shield, “Minnesota City Cancels Sports Lease Backing $27M of Bonds,” The Bond Buyer (September 11, 2012).
 “Recent Local Government Defaults and Bankruptcies May Indicate A Shift in Willingness to Pay Debt,” Moody’s Investors Service (July 19, 2012).
 For example, Detroit threatened to upend priorities under the city’s capital structure. It also threatened to cram down bondholders and issued debtor-in-possession financing. In Stockton, the city used its creditor classification powers to achieve a cram down by other means.
 See: Puerto Rico Emergency Moratorium and Financial Rehabilitation Act No. 21-2016.
 See Article VIII, Section 2 of Illinois’ Constitution.
 See Public Act 99-0524, enacted June 30, 2016.
 See: “Break in Illinois’ Budget Impasse Allows for Partial Spending Plan,” The Civic Federation (July 1, 2016). Available at: https://www.civicfed.org/iifs/blog/break-illinois-budget-impasse-allows-partial-spending-plan.
 See S&P’s July 11, 2016 summary on Pennsylvania and Article VII, Sec. 12 of the Pennsylvania Constitution.
 See: “Kansas Tax Receipts Are Shy of Estimates Yet Again Amid Modest National Revenue Growth,” Moody’s Investors Service (July 11, 2016).
 See: “State Budget Finalized; $178M In Proposed Tax Increases Rescinded,” Hartford Courant (July 13, 2016).
 See: National Association of State Budget Officers, Spring 2016 Fiscal Survey of States, p. 44. See also, “Oil Price Rebound Is Not Enough to Solve Alaska’s Fiscal Problems,” Moody’s Investors Service (June 20, 2016). Note that Alaska has additional reserves beyond those that Moody’s expects could be depleted in just five years.
 See: Center for Retirement Research at Boston College, “The Funding of State and Local Pensions: 2015-2020” (June 2016). According to the Center’s data set, the largest state and local governments contributed 91 percent of annual required contributions, on average, in FY 15.
 See Office of Fiscal Analysis’ “Three Year Budget Report” (February 2016) p. 1, and “Budget Summary Revised FY 17 Budget” (June 28, 2016). Available at: https://www.cga.ct.gov/ofa/add-budinfo17.asp.
 Breckinridge calculation based on seasonally adjusted Bureau of Labor Statistics data.
 “Rating Changes for the 50 States from 1970,” Moody’s Investors Service (July 5, 2016).
 “U.S. Ratings and Outlooks,” Standard & Poor’s (July 13, 2016).
 See: Gallup 50-state poll, conducted March through December 2015. Available at: http://www.gallup.com/poll/189281/illinois-residents-least-confident-state-government.aspx?g_source=state%20government&g_medium=search&g_campaign=tiles
 See Above-noted Gallup 50-state poll and the Pew Research Center’s “Public Trust in Government” poll, November 23, 2015.
 See: CQ Roll Call data. Available at: http://cqrollcall.com/statetrackers/states-six-times-more-productive-than-congress/.
 Bill Bishop, “The Big Sort” (Houghton Mifflin, 2008).
 Robert Putnam, “Bowling Alone (Simon & Schuster, 2000).
 For a good review of the literature on this topic, see: Markus Prior, “Media and Political Polarization,” Annual Review of Political Science 2013 (February 1, 2013).
 For example, Bruce Katz of the Brookings Institution (left-of-center) believes that “power is devolving to those who are closest to the ground and oriented toward collaborative action,” and Yuval Levin of the National Review (right-of-center) seeks to “modernize our public institutions to bring them into line with a decentralizing society where choice and competition are the norm.” See Katz and Levin’s books: Bruce Katz and Jennifer Bradley, The Metropolitan Revolution, p. 5. (Brookings Institution Press, 2013) and Yuval Levin, The Fractured Republic, p. 6 (Basic Books, 2016).
 See the Congressional Budget Office’s “long-term budget projections, updated July 12, 2016.
 Breckinridge calculations based on CBO’s GDP estimates. See Summary Data for the Extended Baseline, July 12, 2016.
 See: John Joseph Wallis, “American Government Finance in the Long Run: 1790 to 1990,” Journal of Economic Perspectives, Vol. 14, Number 1 (Winter 2000).
 Wallis, 79-80.
 Alice Rivlin, “Rethinking Federalism for More Effective Governance,” The Brookings Institution (June 2012).
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. This document may contain material directly taken from unaffiliated third party sources, including but not limited to federal and various state & local government documents, official financial reports, academic articles, and other public materials. If third party material is included, it is believed to be accurate, and reliable. However, none of the third party information should be relied upon without independent verification. All information contained in this document is current as of the date(s) indicated, and is subject to change without notice. No assurance can be given that any forward looking statements or estimates will prove accurate or profitable.
Podcast recorded August 9, 2018
We are excited to launch a new format for our monthly podcast.
Refresh yourself on the calculation for tax-equivalent yield and learn why it matters given the new tax rules.
By Adam Stern
In this piece, we summarize the recent court decision arising from a bond default by the Puerto Rico Highways and Transportation Authority (PRHTA).