A Muni-Picker's Market? Our Answer to the State Budget Crisis Is Selectivity

08.23.2017 - Jeffrey S. MacDonald, CFA

Every year, before the calendar page turns from June into July, most states get ready to close the books on one fiscal year and prepare a budget for the next. The process is usually messy, as state legislators, governors and other interested parties wrangle to find a compromise that keeps the books balanced.

But 2017 was different. Slow post-recession economic growth and other fiscal challenges have put significant strain on state budgets. By early July, several states had already entered the new fiscal year without enacting a budget—a stalemate that is rarely seen when the country is not in a recession.

What Does This Situation Mean for Municipal Bond Investors?

As we pointed out in our municipal bond market commentary last summer, we have been closely monitoring these budget developments for quite some time. While we see challenges for the muni market, we do not believe it has been systemically compromised. We continue to carefully analyze the creditworthiness of each issuer and find tax-advantaged income opportunities across this broad and diverse market.

States Feel the Squeeze

This year’s budget season was unusually painful for many states, as income growth slowed and spending mandates continued to push costs higher, resulting in long, drawn-out debates. While partisan politics certainly contributed to the logjam, the broader issue is a slow and shallow economic recovery, low interest rates and lower-than-expected inflation. State revenues are growing at half their normal pace and many state pension plans are faced with payout schedules that were based on much more optimistic assumptions for economic growth. Some 33 states face revenue shortfalls in fiscal 2017and 2018, according to the Center on Budget and Policy Priorities.

The most extreme case of budgetary pressure is Illinois, which has endured persistent financial troubles and a deep division between the Democratic state legislature and its Republican governor. Other financially challenged states—including Connecticut, New Jersey, and Pennsylvania—also encountered unusual, but less severe, budget crunches. In Alaska, where the state’s credit rating has been slipping all year, legislators averted a fiscal deadlock by draining the state’s rainy day funds.

This climate also affected states that are financially healthy. In Washington state, which has a AAA credit rating, the governor prevented a partial shutdown with a late-night signature that ended the longest legislative session in the history of the state.

Anxiety in Illinois

As Illinois entered the budget season, the state was already operating without an approved budget for a full two years, triggering a wave of credit downgrades and putting pressure on the state’s bond issuers. The state accumulated $16 billion worth of unpaid bills in the process.

Illinois finally passed a budget on July 6th, but only after the legislature overrode the Governor’s veto. While the budget will raise revenues, it offers little in the way of reforms to structural imbalances and budget backlogs that remain. In fact, it appears that revenues gained by the tax hike will be more than offset by the growth in pension liabilities. Faced with a declining population and the prospects of borrowing $14 billion to pay its bills, Illinois could be downgraded to “junk” status by the major credit rating agencies. Further, the state’s struggles mean it is likely to reduce the aid it offers local governments, schools and public transportation systems.

Nervousness in the Northeast

Connecticut, which has been struggling with flat-lining population growth, also finds itself in a precarious position. The state carries the third-highest general obligation debt load in the country, on a per capita basis, surpassed only by two small issuers: Hawaii and the District of Columbia. In light of these mounting challenges, investors have demanded higher compensation for investing in the state’s bonds, making a bad situation worse. Well into the fiscal year, the deadlock showed few signs of abating.

Similarly, New Jersey’s budget is structurally unbalanced, relying on temporary fixes to bring it into alignment. Like Connecticut, a higher percentage of the state’s operating budget is made up of fixed costs such as pension and healthcare obligations.

Then there are states like Pennsylvania that technically have budgets in place, but have yet to agree on how to actually pay for them. Pennsylvania faces many of the same structural issues as Connecticut and New Jersey, like an aging population and generous pension promises. It could benefit from its newfound status as an energy producer. But state Democrats are proposing a tax hike on natural resources that, along with lower energy prices, could dampen future activity.

The Weight of Washington DC

Budgetary pressures are especially heavy in these four states, but a shift in federal spending priorities could impact every state in the nation. Budget cuts in a variety of federal programs present headaches for governors who are already struggling to fill budgetary gaps.

For example, the Affordable Care Act has been a huge relief for states, reducing the percentage of revenues they set aside for Medicaid. But the “repeal and replace” proposals offered by Republicans in Washington indicate that a reversal could still happen, with Medicaid costs shifting, once again, back to individual states. Medicaid is the second-largest budget item for states, surpassed only by K-12 education.

Likewise, a trillion-dollar federal infrastructure package is uncertain, placing more pressure on states to fund their own capital improvement projects.

Security Selection is Key

We have been monitoring these state budget pressures for several years, expecting unfunded pension liabilities, healthcare promises and other structural issues to trigger credit deterioration in the general obligation sector of the municipal bond market. This has driven our preference for revenue bonds over general obligation bonds, in broad terms, as we construct and manage portfolios for our clients.

While general obligation bonds typically carry higher credit ratings, their ability to repay debts is based largely on the ability of a municipality to raise taxes—a prospect that seems increasingly difficult in this environment. Revenue bonds, on the other hand, are backed by cash flows from a specific entity, service or levy (sales, gasoline tax, etc.). So the income generated by revenue bonds tends to be fairly predictable. With revenue bonds, we can evaluate not only the quality of the bond itself but also the cash flow that is dedicated to servicing the debt.

We have also positioned client portfolios on the upper tier of credit quality, focusing on credits that offer liquidity. This allows us to buy and sell munis relatively quickly when credit ratings change. General obligation bonds still represent an important sector of the municipal bond market where we continue to find opportunities that benefit client portfolios. But this recent cycle of budget negotiations reinforces our view that certain risks for the general obligation sector are mounting. While this has manifested in political budget bickering, the longer-term risk is that the creditworthiness of a number of these issues becomes seriously compromised, putting bondholders at risk.

As the storm clouds gather over certain regions of the fixed income market, we will continue to follow our disciplined investment process, carefully analyzing every municipal bond we purchase.

This analysis is provided for illustration and discussion purposes only and does not guarantee future results. Please speak to your Fiduciary Trust contact if you have questions or would like more information. This communication is intended solely to provide general information. The information and opinions stated are as of August 23, 2017, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process.Historical performance does not guarantee future results and results may differ over future time periods.   CFA® and Chartered Financial Analyst® are trademarks owned by CFA institute.


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