State and local governments are no doubt facing unprecedented budgetary challenges, but headlines in early 2011 may have overstated the situation. Although it is true that real estate valuations remain depressed, federal stimulus monies have ended, and rising pension, health care and post-retirement benefit costs are an issue, state and local governments are required to develop a balanced budget each year that takes these into account. The headlines that predicted the demise of the municipal market may have been a bit too dire.
This paper provides a general background of the municipal market, as well as an analysis of six key topics related to the municipal market, which include:
State and Local Budgets are an annual issue – Unlike the federal government, most state and local governments require a balanced budget. Although these governments face real issues, they generally have and likely will manage them through spending adjustments or, in some cases, tax increases.
Municipal Default rate remains Lower than corporate – Despite calls for major defaults in the news, Municipal Market Advisors, Inc. estimates that only $4 billion of the $3 trillion of outstanding municipal debt had an initial payment default over the past two years (0.1%). Historically, investment grade municipal debt has had a 0.06% default rate, compared to 2.50% for investment grade corporate debt (See Exhibit 3).
Municipal Bond Fund Flows mask actual Ownership – Although outflows from municipal bond funds have been significant over the past year, the “Flow of Funds” report from the Federal Reserve shows that household ownership of municipal bonds has not declined. This could indicate that individual investors are selling bond funds and buying individual bonds.
Shrinking Supply could be a Positive Sign – The supply of new municipal bonds has fallen dramatically due to new fiscal conservatism regarding public projects and debt. Issuance for first five months of 2011 was only $83.5 billion, compared with $433.2 billion in the full year 2010. However, the expiration of the Build America Bonds program will return approximately one-third of the annual supply to the tax-exempt market – over $100 billion at an annualized rate.
Market transitioning from rate- to credit-Driven – The credit quality of governmental-purpose municipal bonds remains generally strong and astute credit analysis can help identify high-quality issuers from stable states and local governments. This strength does not apply to nongovernmental sectors of the market, underscoring the need for credit analysis by experienced professionals.
Tax Benefit of municipals Should Only improve – Whatever the direction of tax brackets, it is expected that tax-exempt bonds will continue to have attractive total rate of return on a tax-equivalent basis, with less volatility (as measured by annualized deviation of returns).
For higher tax-bracket investors, tax-exempt securities should remain a core holding, whether held though mutual funds focused on investment-grade bonds, or through a separately managed portfolio.
State and local governments are facing challenging times — the most difficult since the Great Depression. Real estate valuations, the main driver of tax revenue for local governments, have been under pressure for several years and, for most of the country, residential property sales volume and prices have yet to rebound.
In some regions, sales tax and income tax receipts are recovering well – albeit measured against depressed 2010 levels – leading some observers to believe that states have seen the worst on the revenue side. However, none of this has made balancing budgets any easier over the last two years. Federal support, in the form of the American Recovery and Reinvestment Act, popularly known as the “stimulus legislation,” will end in 2011, and many states have depleted their rainy day funds over the last three fiscal years. As a result, most states have adjusted by reducing funding for public education, delaying capital projects, instituting furloughs and layoffs of public employees, and, in a few cases, raising taxes.
In another highly visible move, states have attempted to ratchet down the growth in labor costs by pushing back retirement age, increasing employee retirement contributions, reducing cost-of-living adjustments for current retirees and eliminating public employee collective bargaining. With many public pension plans underfunded – state public pension funds alone are burdened by a collective deficit of $3 trillion [reference – Andrew G. Biggs, “An Options Pricing Method for Calculating the Market Price of Public Sector Pension Liabilities” (AEI Working Paper 164, AEI, Washington, DC, February 26, 2010), available at www.aei.org/paper/100088] the issue of public pension funding will remain a threat to state and local budgets for years to come.
One possible source of relief, opening bankruptcy courts to the states, would have allowed state governments in default to renegotiate union labor contracts. However, after state bankruptcy legislation was proposed in Congress, the National Governors Association testified that the mere discussion of bankruptcy could push the cost of capital higher for all issuers of municipal bonds, and the legislation was taken off the table. Given the historical infrequency of defaults on municipal debt, it appears this move is the right one. In statehouses and city halls, including those most challenged by economic and budgetary problems, like California, Illinois, and New Jersey, the discussion is not whether to consider defaulting on debt, but rather what combination of tax increases and spending cuts are needed to balance current and future budgets.
Despite all of the headlines over the past year depicting the demise of the municipal market, the municipal indexes have generated positive returns, both investment grade and non-investment grade.
State and local budget problems came to the forefront during the “Great Recession” and are still front and center. However, most projected “deficits” have been offset by spending adjustments, as almost all of the 50 state constitutions require a balanced budget. Unlike the federal budget – which contains chronic deficit spending, requires the ongoing issuance of debt for operating purposes and rolls over outstanding debt – state and local governments typically amortize sizable principal each year and seldom need to refinance maturing debt. Except in extreme cases, debt is normally incurred only for capital projects. The most stressed states have recently used gimmicks to balance budgets, often through a sale and leaseback of existing facilities.
RISING PUBLIC BENEFIT COSTS
In addition to continuing negative budget headlines, the adequacy of the funding of public pension systems and the cost of providing other non-salary benefits to employees is another issue not likely to go away anytime soon. Beginning in the upper Midwest this year, there has been a groundswell of sentiment against public-sector benefits, and legislation has been proposed in Congress to dictate that lower return assumptions be used for public employee pension systems. This would mandate contribution rates that are much higher as a percentage of payrolls and eventually force states to reduce retirement benefits or the size of their workforce to prevent the cost of funding retirement plans and other post-employment benefits from skyrocketing.
However, as one observer recently noted, retirement costs are “here and now,” an issue that every level of government feels an immediate need to address, but the real time bomb for all employers is health care spending, a large and growing component of payroll costs in both the public and private sectors – and especially for the federal government.
Municipal bond defaults are big news, but most defaulted debt over the last few years has occurred in risky sectors of the economy, involving issues that were nonrated to begin with. Many were issued to finance real estate developments with revenues dependent on projected increases in assessed valuations – in other words, they presumed a continuation of the residential housing bubble. In some cases, the improvements funded with bond proceeds were not completed, and the assessed value of unsold parcels stagnated when developers could not resell them. Other prominent areas of default are primarily non-governmental tax-exempt finance, including industrial revenue bonds; community not-for-profit hospital systems; private secondary education; senior living facilities; single- and multi-family housing bonds; and other subsectors that make up a significant share of the tax-free marketplace.
There is an estimated $3 trillion of outstanding municipal debt from over 50,000 issuers. Municipal Market Advisors, Inc. estimates that debt totaling about $4 billion has had an initial payment default in the past two years and approximately 75% of these issues were nonrated. The total of outstanding issues with an uncured payment default since the firm began tracking is just $9.5 billion, less than 0.5% of the total municipal bonds outstanding.
Tax-supported general obligations and essential service revenue bonds should maintain their credit quality, though there will be exceptions. For example, Jefferson Co., AL, may file bankruptcy in 2011 because of a poorly conceived and complex debt burden incurred to fund a massive utility system expansion. Similarly, Detroit, MI, is under extreme stress due to population declines, high unemployment and crashing real estate values.
BOND FUND INFLOWS STALLED
Bond funds were the recipients of large shareholder inflows in 2009 and through the third quarter of 2010. The reinvestment of this cash helped drive tax-exempt rates to 30-year lows for most of the curve during the second half of 2010, followed by Treasury yields, which reached lows not seen since the flight-to-quality buying at the end of 2008. This peak in Treasury prices occurred a few months after the peak in municipal bond fund net asset values late in the third quarter 2010. However, Treasury yields reversed direction and rose rapidly starting in early November 2010. Soon thereafter, the flow of new cash into bond funds reversed as well, and the outflow from municipal funds continued into the second quarter of 2011.
BOND FUND OUTFLOWS PERSIST, BUT CAUSES ARE DECEIVING
The net withdrawal from tax-exempt funds since November 2010 has been about $50 billion, with a large portion coming during the first quarter of 2011. Municipal bond funds were, therefore, net sellers of bonds over the last six months, though this trend appears to be reversing, beginning in June 2011. Tax-exempt money market funds have also lost assets, as the Federal Reserve’s “quantitative easing” policy has kept short interest rates near zero, driving rates lower than open-market forces might have accomplished.
The outflow from municipal bond funds was not helped by widespread publicity of budgetary problems and some believe it was spurred on by the downgrades of below-investment-grade paper held by high-yield municipal funds. In the face of constant, negative governmental budget news, many investors mistook declining bond fund NAVs for a pervasive credit problem when, in fact, municipal and other bond markets simply followed Treasury yields higher – as often happens in an improving economy.
THE HOUSEHOLD SECTOR EFFECT
When rates move higher, smaller investors are likely to sell mutual funds and buy replacement bonds in the open market, where yields adjust upward more quickly than a longer-term bond fund’s monthly distribution. Reports from the Federal Reserve seem to indicate that this, in fact, occurred. The total holdings of municipals by the “household sector” does not appear to have declined, but rather were redistributed from fund shares into direct investments or separately managed portfolios. Finally, short- to intermediate-term fixed-income securities and funds faced stiff competition for retail investors’ cash from rebounding worldwide equity markets and a variety of riskier asset classes, including high-yield taxable bonds.
SHRINKING SUPPLY – FISCAL CONSERVATISM
During 2011, the supply of new municipal bonds has fallen dramatically for a variety of reasons, including a new fiscal conservatism among both the electorate and elected officials regarding public projects and debt. Issuance for first five months of 2011 was only $83.5 billion, as some 2011 project finance likely was accelerated into fourth quarter 2010, when volume was well-above normal.
SHRINKING SUPPLY – THE END OF BABs
Beginning in 2009, the federal government assisted the states with stimulus appropriations and the creation of Build America Bonds (BABs), a taxable municipal bond with a 35% interest subsidy. However, the BAB program expired in 2010 without further Congressional authorization, and direct stimulus ended June 30, 2011. The effect of ending the taxable BAB program after only 21 months will be to return approximately one-third of the annual supply to the tax-exempt market – over $100 billion at an annualized rate. Whether tax-exempt or taxable, some see the 2011 supply falling to the $250 to $300 billion range, a level not seen since the 1990s, and significantly down from the $400 billion annual levels that persisted through most of the last decade.
CREDIT QUALITY TRUMPS RATES
Many market participants have described the municipal bond market as transitioning from a rate-driven market to a credit-driven market. In the current environment, credit quality is more important than ever before. Astute credit analysis by professional managers and investment advisors can help identify high-quality issuers from stable states and local governments. Diversification across sectors and states can help lower investors’ risk exposures, especially when combined with duration management, yield curve positioning and individual security selection.
GOVERNMENTAL-PURPOSE BONDS REMAIN STRONG
That said, the credit quality of governmental-purpose municipal bonds, specifically general obligation bonds and public-utility revenue bonds, remains generally strong. The bondholder protections provided in the various state constitutions are substantial. In many states, these provisions include a “first lien” on tax revenues; authorization for fiscal officers to make debt payments with or without an adopted budget law; “state intercept” language that allows appropriations from the state to local governments to be redirected to bondholders in certain instances; state oversight programs; and other protections. These statutory protections are not offered by all states and do not apply to “private activity bonds,” underscoring the need for credit analysis by experienced professionals. Given the generally lower quality and recent default history of non-governmental debt, these securities represent a portion of the market that requires more stringent credit analysis by investors.
THE GREAT TAX-RATE DEBATE
Many observers believe that the ultimate solution to our federal budgetary deficit problems will require action on both the spending and revenue sides of the budget and that Congress
will eventually have to deal with the question of personal income tax rates – an issue that was sidestepped at the end of 2010, with the compromise to continue the Bush-era tax cuts through 2012. While the recent proposal from House Republicans would generate a substantial deficit reduction, the deficit itself would remain despite a large projected decline in the growth in spending and growth in the economy. Various Republican leaders continue to insist that raising income tax rates will not be on the table, asserting that the nation has a spending problem, not a revenue problem. Others disagree and are determined to see income tax brackets rise.
The outcome remains unclear. Income tax rates could be pushed higher in an effort to balance the federal budget, but they could just as easily be lowered – especially if Congress accepts the recommendations of The National Commission on Fiscal Responsibility and Reform and eliminates corporate loopholes and certain itemized deductions for individuals. Unlike 2010, when tax-exempt yields were driven relentlessly lower by the near-certainty that tax rates would be higher in 2011, no one is venturing a guess as to how tax rates will affect the taxable equivalent yield of municipals after 2012.
Whatever the direction of tax brackets, it is expected that tax-exempt bonds will not be outlawed by Congress and will continue to be an element of balanced investment portfolio for individuals, with the precise weighting and diversification determined by an investor and his or her advisor.
Undoubtedly, cross-market ratios will change if tax rates change substantially, but a large reduction in the supply of tax-exempt bonds could mitigate the impact of the bracket changes.
The graph below illustrates the total return performance of tax-exempt municipal bonds compared to other assets classes for the 10 years ended May 31, 2011. On a taxable equivalent basis, investment grade municipals and high-yield municipals – treated as separate asset classes – have the highest total rate of return for the period. They become even more attractive when the annualized deviation of returns is considered.
Given the challenges faced by state and local governments, credit quality and diversification will be the keys to maintaining a successful municipal bond strategy in these tumultuous times. High quality governmental-purpose municipal bonds, from states with secure credit ratings, should form the core of an investor’s municipal holdings. Security selection is critical in constructing municipal bond portfolios in this environment – especially with nongovernmental bonds – as is duration management, yield curve positioning and sector selection. An investor may wish to consider national municipal funds that are geographically diverse, and state-specific funds from states that are AAA-rated and contain highly rated local governments.
About the Author
See information about Ridgeworth Investments and caveats regarding their analysis at the end of their pdf post of this article here.