Hey! Mom-and-pop retail investors still own about 75% of the municipal bond market (directly or indirectly). They want a stable asset class with relatively few defaults, high credit ratings and interest income that’s tax free at the federal, state and local levels, if possible. In short, they want their father’s Oldsmobile.
Yet, today we’re seeing more stressed municipal credits than ever. Detroit, Michigan, filed for Chapter 9 bankruptcy protection in 2013 and is now the largest municipal bankruptcy filing in U.S. history at $18 billion. In this environment, there are new risks for municipal bond investors to evaluate. So investors should think again and remember the old advertising slogan: This is notyour father’s Oldsmobile—or his municipal bond either!
Public Finance: Key Issues and Red Flags
To address this timely topic, the CFA Society of Chicago brought a panel of experts together for a program entitled: Uncovering Value and Risks in Stressed Municipal Credits. The panel was moderated by Arlene Bohner, Senior Director U.S. Public Finance, at Fitch Ratings and provided forward-looking insights on how to navigate these uncharted waters.
Bohner opened with a big picture overview of key state credit issues. She noted that U.S. states have broad economies and tax bases with substantial control over spending and raising revenue and this, in turn, generally supports their higher credit ratings. However, most governments made heavy cuts during the ’08-’09 recession and are still challenged by higher labor costs, pension funding deficits and huge infrastructure needs.
Longer-term, Bohner feels states remain significantly exposed to the possibility of federal funding cuts (e.g. Medicaid), although Bohner says, “Fitch believes states would have time to adjust to any significant federal actions.” Even still, Fitch has Connecticut, Illinois, Mississippi, and New Jersey currently on a negative outlook yet feels most state ratings will remain stable. In addition, she notes that steep cuts to vulnerable discretionary programs and/or federal tax code changes could have significant effects on state budgets and economies over time.
At the municipal level, Bohner looks for a number of red flags including:
- Declining revenue base
- Declining population and/or school enrollment
- Increasing unemployment rate, coupled with a declining labor force
- Relatively high tax burden
- High and rising fixed cost burden
- Declining assessed property valuations
- Large debt issuances for controversial / non-essential projects
- High levels of variable rate debt or swap obligations (> 15% of total debt)
- Unusually contentious relationships among officials and/or with the State (including poor relationships between management, labor and taxpayers)
- Inability to resolve labor disputes
- Long-term labor contracts with inflexible terms
- Low pension funding ratios with payments below actuarial required contributions (ARC)
- Agressive budgeting and/or economic assumptions
- Weak disclosure practices
Bohner now expects to see increased debt issuance at the municipal level to address deferred maintenance and capital needs. She notes that “pay-go” capital spending, which uses savings or current cash flow to finance projects, was reduced or eliminated by most governments well into the recovery. She also cautions investors about the increasing use of direct bank loans (private placements) for municipal financing due to their lack of transparency.
Forward-looking Municipal Metrics
Richard Ciccarone, President and CEO, Merritt Research Services LLC, reported that most cities experienced net general fund deficits from 2008 through 2010 and this was a reflection of the economic downturn. During this period, as many as 62% of big cities (over 500,000 population) and 58% of all cities reported deficits. But Ciccarone points out that Meredith Whitney’s prediction of billions being lost in the muni bond market didn’t come true and that general fund deficits returned to the 23% to 41% range between 2011 through 2014 (see graph below).
Percent of Cities with a Net General Fund Deficit
All Cities vs. Biggest Cities (Over 500,000 Population) FY 2006-2014
Source: Merritt Research Services, LLC
But that’s ex post information and investors need effective ex ante tools to guide future investment decisions. Ciccarone says, “in almost all distressed situations the unrestricted net asset ratio is negative.” Ciccarone started using this ratio around 2000 and says it has key predictive capability. As shown below, the ratio compares unrestricted net assets, which are resources considered usable for any purpose (numerator), to governmental activities expenditures, which are outflows of resources recorded on the government-wide financial statements per GASB Statement No. 34 (denominator).
Source: Merritt Research Services, LLC
Like a coverage ratio, this metric illustrates the availability of funds relative to expenditures—so the higher the ratio the better. As shown below, the largest cities (a with population over 500,000) have fallen into negative territory since 2009. Meanwhile, for all of the 2,000 cities in Ciccarone’s study, unrestricted net assets were between 20% to 23% of governmental activities expenditures from 2011 to 2014.
Importantly, we need to look at the government-wide balance sheet rather than the fund accounting statements that ignore long-term liabilities. Remember that governmental fund accounting focuses on the short run. But the government-wide balance sheet will reveal pension obligations, OPEB, debt and contra assets with deficit financing and no assets or revenue supporting them.
In regards to significantly underfunded pension obligations, Ciccarone’s big concern is that they may restrict a municipality’s ability to provide essential services (police, fire, garbage, etc.). He emphasized that Chicago’s actuarially required pension contribution (ARC) was as high as 55% of its general fund expenditures in 2014. That’s more than three times the level of other big cities (with a population over 500,000) as shown below. However, like many big cities, Chicago actually paid in far less to its pension plans than its actuarially required contribution levels.
Pension Requirements for Chicago and Big Cities:
Annual (Actuarial) Pension Cost as a % of General Fund Single Employer Plans only (2007-2014)
Source: Merritt Research Services, LLC
Watch the Early to Mid-Career Numbers
Ciccarone’s final piece of forward-looking advice is to watch the early (25-29 years) to mid-career (30-34 years, 35-39 years) population numbers. These numbers tend to fall in distressed areas and Ciccarone says we need to watch them closely for Chicago. The charts below illustrate the decline for fallen angelslike Detroit and Puerto Rico. Fortunately, Chicago appears to be holding its own on these metrics and/or increasing in some areas.
Detroit Early to Mid-Career Population Groups
(25-29 Years, 30-34 Years and 35-39 Years)
Source: Merritt Research Services, LLC & Government Census Data
Puerto Rico Early to Mid-Career Population Groups
(25-29 Years, 30-34 Years and 35-39 Years)
Source: Merritt Research Services, Inc. & Government Census Data
Chicago Early to Mid-Career Population Groups
(25-29 Years, 30-34 Years and 35-39 Years)
Source: Merritt Research Services, Inc. & Government Census Data
Bankruptcy – Is the stigma is gone?
Shawn O’Leary, Senior Vice President, Senior Research Analyst at Nuveen Investments is concerned that the stigma associated with default is gone. O’Leary noted that historically there’s been a significant fear of losing access to credit markets during bankruptcy. Yet he points out that Detroit, Michigan, Jefferson County, Alabama and Stockton, California all refinanced and gained market access after bankruptcy. These cities are among the top five municipal bankruptcies in US history (below).
The 5 Biggest Municipal Bankruptcies in US History
- Detroit, Michigan (2013) $18 billion
- Jefferson County, Alabama (2011) $4 billion
- Orange County, California (1994) $2 billion
- Stockton, California (2012) $1 billion
- San Bernardino County, California (2012) $500 million
Source: Forbes/Capital Economics
Ciccarone agrees with O’Leary and feels that in this environment the potential for more bankruptcies is definitely there—especially if policymakers approve additional bankruptcy statues like the one Governor Rauner proposed in Illinois. Today, approximately 24 states have been granted bankruptcy rights by their State legislatures but U.S. Territories, like Peurto Rico, cannot.
Lessons from Detroit
Bill Grady, CFA, Senior Portfolio Manager, Allstate Investments says that the problems in Detroit were brewing for decades. Grady says, “if you didn’t see them coming—shame on you.” After all, Detroit lost 50% of its population over the last 11 years. And looking even further back, it had been consistently losing population since the 1950s. Today, Grady hears even more municipalities talking about using bankruptcy as a negotiating tool.
O’Leary quickly added that people assume “special revenue bonds” will always pay principal and interest. In the case of Detroit, O’Leary was stunned by a federal judge who wanted to transfer his investors’ collateral (on water and sewer lines) out for ten years in order to redirect payments to unsecured creditors ahead of him. Even some attorneys suggested that he really wasn’t a secured creditor because Detroit had billions in unfunded capital expenditures. Ultimately, he says it took the ratings agencies to help force a tender offer by insisting that paying less than what’s due is recognized as a default.
Puerto Rico – Neither Fish nor Fowl
According to Bloomberg’s Michelle Kaske and Martin Braun, at $72 billion, The Commonwealth of Puerto Rico has more debt than any U.S. state government except California and New York and had been borrowing to pay its debts when they came due, until it defaulted on its payments in August 2015 (see Puerto Rico’s Slide, Bloomberg Quick Take 10/22/15). Notably, Puerto Rico’s bonds are exempt from local, state and federal taxes everywhere in the US—which made it easy for the US territory to double its debt in ten years.
O’Leary explains, “the problem with Puerto Rico is that it’s neither fish nor fowl.” O’Leary says it’s not a true sovereign nation (so they can’t go to the International Monetary Fund) and, unlike municipalities, it doesn’t have collective action clauses which would enable bondholders to implement a debt restructuring plan as long as the majority agrees. Rather, it’s like U.S. states that can’t file for bankruptcy. Hence, Puerto Rico can only ask for a settlement and that encourages creditors to holdout during negotiations. Ultimately, O’Leary feels the federal government needs to step in and make a deal happen.
To that end, on October 21st the Obama Administration announced its support for legislation that would grant Puerto Rico Chapter 9 bankruptcy protection, and a legal framework for U.S. Territories to conduct debt restructuring. Only time will tell if Congress will approve such a measure.
Bill Grady wraps up by saying, “hedge funds are controlling billions of dollars in bonds in Puerto Rico so it’s nearly impossible to take a position there without exceptional research capabilities.” In the end, Ciccarone thinks bondholders will probably recover between 40% to 70% of their investment—at typical sovereign default rates—while noting that the Puerto Rico’s 8% bonds have recently been trading in that range.
A Crisis in Illinois?
Illinois currently has an underfunded pension system of over $100 billion and the lowest credit rating of any state. Notably, Fitch lowered its rating on Illinois’ general obligation bonds to BBB- (just three steps above junk status) on October 19th and Moody’s downgraded the GO bonds to Baa1 on Oct 28th. And we shouldn’t forget that the state of Illinois has been operating without a budget since July 1, 2015. Bill Grady says, “Illinois and Chicago have been penalized but haven’t hit money yet.” So he wouldn’t handicap either as buying opportunities at this point saying, “you would need a cast iron stomach.”
Finally, Ciccarone thinks there will probably be a crisis at the Chicago Public Schools (CPS) first, then there’s the potential for a happy ending. Chicago has a $20 billion unfunded pension liability and has serious structural budget gaps. On the bright side, Ciccarone points out that Chicago’s school, city and county taxes are still only half that of New York on a per capita basis. And on October 28th, the Chicago City Council passed a $543 million property tax increase to be phased in over four years which will help maintain police, fire and other city services. But he still thinks there will be a lot more paper sold and people losing money before it gets better.
In closing, I’d simply add that these risks do not mean that we should avoid the municipal bond market. Rather, we should consider the relevant factors and metrics described above to carefully select the right municipal bond issues for our portfolios. When given a choice, choose well!