A July summer rally
Although municipal bond trading activity often slows during the summer, it doesn’t mean that the market stands still. During July, investors in municipal bonds enjoyed positive returns across the yield curve. Returns generally ranged from 14 basis points in the one-year area to 1% or more for 20-year-plus maturities according to Barclays Municipal Bond Indices. Buyers in the new issue primary market were responsible for much of the monthly activity, as secondary trading activity exhibited a traditional summer lull. New issue monthly volume is shaping up to be the busiest July since 2008.
As mutual fund performance improved throughout the month, investors placed more buy orders. Lipper reported that municipal bond funds experienced $125 million of inflows during the third week of July, ending what had been 11 weeks of outflow activity. At the same time, the Investment Company Institute (ICI) revised downward the previously reported net mutual fund outflows since May 1, 2015. Turns out approximately $220 million per week had been redeemed, a manageable level in a market that trades greater than $8.5 billion/day.
The impressive July rally took place despite the uncertain backdrop surrounding the timing of a Fed rate increase and an increasing probability of a Puerto Rico default. Comments by Fed Chairwoman Yellen seemed to indicate the Fed will likely move before year-end 2015 to raise rates. Labor market indicators have shown improvement, but wage gains have been mostly subdued. As always, the Fed claims to be data dependent, and since the date has vacillated between weak and strong, no clear consensus for the timetable of the Fed’s first move is apparent. After more than six years of near-zero rates and trillions of dollars in quantitative easing, inflation has languished below the central bank’s target for the last three years. Although the 10-year Treasury has climbed more than a half-percentage point since its low of 1.64% in January, we continue to monitor the two-year Treasury yield as perhaps the best indicator of market sentiment pertaining to Fed action. For the month of July, the two-year Treasury barely budged at all, a clear sign that market participants still question the need for the Fed to raise rates any time soon.
For Puerto Rico, the news has only seemed to worsen, making the July rally in municipal bond market performance all that more impressive. Thus far, no systemic pressure from the continuing collapse in Puerto Rico bond prices is evident.
According to Barclays, July total returns for municipal bonds ranged from approximately 0.34% for a three-year maturity bond to 1.06% for the longest maturities. Higher quality bonds outperformed lower quality bonds, with the Barclays AAA Index showing a 0.68% return while the BAA Index was up 0.39%. Revenue bonds continued to outpace general obligation bonds, with the hospital revenue sector leading the way, up 0.84% for the month.
Unfunded pensions are problematic, don’t forget health care costs
Just as many municipalities are grappling with how to deal with significantly underfunded pension plans, now the reporting of health care obligations will become mandatory too. In June, the Government Accountability Standards Board (GASB) required for the first time that local municipalities report their obligations for retiree health care on their balance sheets for everyone to see. Additionally, local governments will have to calculate the present value of these liabilities using reasonable and uniform methodologies.
The budgets of many cities and states will be impacted by these new rules as many municipalities pay most of the health insurance premiums for retirees until they are eligible for Medicare, and some pay for the lifetime costs of past employees. The Journal of Health Economics conducted a recent study and found that these liabilities are close to $1 trillion from a nationwide perspective. The Pew Charitable Trust also finds that government health plans are only 6% funded on average. Today, most health care costs are paid for out of current budgets, so the growing cost of this care can only be funded via higher taxes or spending cuts elsewhere. Forcing cities to report their health care funding liabilities could ultimately lead to negotiations to reduce union benefits. Unions will be forced to realize the fiscal impact of asking for higher wages versus higher benefits.
For some few cities, there is a concerted effort to prefund retiree health care costs. GASB rules actually encourage local governments to prefund, since assets set aside in trusts can be invested with an earnings assumption that exceeds the high-quality, tax-exempt, 20-year bond rate that must currently be used as the discount rate in present value calculations. If trusts are established, taxpayers should ensure that annual contributions are made while the true liability of future health care costs are not hidden.
Illinois…the land of litigation
City of Chicago: Following the Illinois Supreme Court’s lead, on July 24, a Cook County Circuit Court judge ruled that reforms to its municipal and laborer pension plans, enacted by the city in 2014, are unconstitutional. City attorneys argued that the Illinois Supreme Court decision did not apply to Chicago because the city’s pension changes had been agreed to through collective bargaining before legislators were asked to approve them. In addition, Chicago pension reform would provide “massive net benefits” to workers, i.e., heading off the pension funds’ certain insolvency. Under the reform agreed to by 28 of 31 union members, the city would have increased its annual contributions to the two plans by about 50% in exchange for cost of living adjustment (COLA) reductions, higher employee contributions and a cap on the salary level used to calculate benefits. However, the other unions — as well as a number of individual workers and retirees — filed suit saying that the reform violated a clause in the Illinois constitution that says pension benefits cannot be reduced. The city plans to appeal the case while it continues to work on reforms to its pension funds for police and firefighters as well as the fund that Chicago Public Schools operates for teachers.
Also on July 24, Standard & Poor’s issued a report that said while in the short term the amount of the city’s contributions would decrease, an increase in the city’s pension liability is a significant credit risk. S&P said that they will likely lower the general obligation (GO) rating of Chicago in the next six months if the city fails to incorporate pension contributions in a structurally balanced manner. S&P rates the city at an investment grade BBB+. Moody’s, which already has the city at a below investment grade rating of Ba1, said the decision was credit neutral.
Chicago Public Schools: CPS received another downgrade to below investment grade in July. Fitch Ratings dropped the district to BB+ and maintained a negative watch on the credit. The district is currently facing a $1.1 billion deficit as well as rising pension costs and contentious teacher contract negotiations. The district already has borrowed to make a $634 million pension payment this year; next year’s payment will go up to about $700 million. The district has begun to cut costs but it lacks the flexibility that the city and county have to raise taxes as it falls under property tax caps. Notably, district budget relief is dependent on actions by the state and city, entities that are struggling with their own serious fiscal and/or political challenges.
State of Illinois: The state of Illinois has gone a month without agreeing on a new state budget. Democrats passed a spending plan that was $4 billion short of revenue and was mostly vetoed by the governor. Democratic leaders want more revenues, but the governor first wants “reform” such as workers’ compensation changes, changes in tort law, limits on unions and a property tax freeze. The ideological stalemate could go on for months. Thanks to various court orders, more than half of those getting state checks are still getting them, but soon social services will suffer while both the city of Chicago and its school system are held hostage.
Illinois Attorney General Lisa Madigan is raising the possibility that the battle over Illinois pension reform will head to the U.S. Supreme Court. Madigan says the case “raises important issues regarding the reserved powers doctrine of the U.S. Constitution, which prohibits a state from surrendering ‘an essential attribute of its sovereignty.’ “According to Crain’s, the attorney general’s office is apparently betting that the case presents the U.S. Supreme Court with an opportunity to weigh in on a growing national debate about the influence of public employee unions.
Come fly with me
With relatively stable and largely single-A ratings and no recorded default among U.S. general airport revenue bonds, airports are an attractive sector for above average returns. Adding to this appeal is a strengthening economy, continued growth in passenger enplanements and improving airline financial health. The municipal market has recently seen several successful airport-bond issuances, as well as recent upgrades to airport ratings in Las Vegas, San Antonio and Tampa.
So far in 2015, traffic at U.S. airports has increased by 3%. Summer travel is expected to be at all-time high levels, with nearly 222 million passengers projected to fly in the U.S. between June 1 and August 31. Among the busiest travel days of the year, 13 of 15 take place during the summer travel period.
While generally favorable, individual airport credit quality varies. Airline consolidation, reduced numbers of flights and/or use of larger aircraft are key challenges. These trends have tended to benefit large hubs at the expense of smaller hubs. There are currently 30 large-hub, 31 medium-hub and 71 small-hub commercial service airports in the U.S. The biggest of the large hubs is Atlanta, with more than 96 million yearly passengers, followed by Los Angeles and Chicago, both serving greater than 70 million travelers annually. As an example of the success of larger hubs, enplanements in Chicago are up more than 9% so far in 2015.
Mid-sized airports such as Albuquerque and small airports like Long Beach have seen an approximate 5% reduction in traffic due to service reductions and regional competition. Conversely, a mid-sized airport like Nashville is thriving with enplanements up 6.9% and the small airport of Boise is growing around 4.9%. As always, credit research is the key in finding those airport credits that are thriving versus those experiencing a contraction in traffic.
Moody’s Investors Service has a positive outlook for the U.S. airport sector as the expanding economy adds to number of fliers. S&P and Fitch expect stable credit conditions overall, while the Kroll Bond Rating Agency views U.S. airports as “underrated.”