Mayday, Mayday …
Mayday is the emergency procedure word used internationally as a distress signal in voice broadcasts. In some ways, it also describes the performance of the municipal bond market during May. The municipal bond market could have used a little help as interest rates rose across the yield curve. One reason for the rise in rates was the significant pick-up in bond supply. Per Citi Research, it is likely May issuance will be around $34 billion, 22% higher than May of 2014. Of course, it didn’t help that Treasury yields also moved higher during the month. Add to the worries the idea that the third largest city in the country is now considered a speculative credit as defined by Moody’s downgrading Chicago to a Ba1 rating and some believe this is a precedent setting action that will impact municipalities across Illinois and elsewhere.
Based on the Barclay’s US Municipal Bond Index, total returns for municipal bonds ranged from approximately -0.21% for a 3-year, AAA-rated bond to worse the further out the maturity spectrum, such as -0.30% or more five years and beyond. General obligation bonds mostly underperformed revenue bonds. From a revenue bond perspective, hospital bonds were the best performing sector, while lease revenue bonds lagged.
Municipal bonds have not outperformed Treasury bonds during the recent correction. Thus, municipal bonds still look attractive versus taxable notes and bonds. In fact, relative value ratios between 10-year, AAA-rated municipal bonds and 10-year Treasuries are near their peak of the last 12 months. Before the credit crisis, the 10-year yield ratio of municipal yields/Treasury bonds averaged 0.8. Today, this same yield ratio is 1.08. In other words, 10-year, AAA-rated municipal bonds are now cheaper than 10-year Treasury bonds on a gross basis before factoring in the tax advantage of municipal bond ownership. The undervaluation of tax-free issues should fuel investor demand as we look forward to the summer timeframe.
Even though interest rates have increased recently, municipalities have picked up their pace of issuance. A big reason for the higher level of issuance is the increase in refunding activity, which still comprised much of May’s supply. With interest rates still not too far away from recent lows, we expect the pace of supply to remain robust, likely to easily exceed the $334 billion of total issuance last year. Street estimates of supply in 2015 now average around $370B, with BofA/Merrill expecting as much as $400B.
Seasonality to the Rescue
Seasonally, June and July represent the two biggest months of the year for coupon payments. In June alone we expect to see $14.8B of coupon reinvestment activity. Add in maturing and called bonds, and the technical demand picture looks strong with about $33B needing to find a home in the next two months alone. Also, on May 21, the Federal Reserve Board proposed adding certain general obligation state and municipal bonds to the range of assets a banking organization may use to satisfy regulatory requirements designed to ensure that large banking organizations have the capacity to meet liquidity needs during times of financial stress. It is encouraging to see the Fed include certain municipal bonds as eligible for inclusion in bank portfolios as part of the High Quality Liquid Asset (HQLA) bucket.
Why the Price of Oil Matters
Energy dependent states (ND, WY, OK, LA, TX) have seen unemployment claims rise to levels that now exceed year-ago levels despite a continuing national economic recovery. These are the very same states that had experienced stellar employment growth and burgeoning tax receipts during the fracking boom.
The need for infrastructure improvements has been hastened by America’s newfound interest in driving greater distances. Although it seems the so-called “oil dividend” has yet to spur the expected upturn in retail sales, people are once again buying large SUVs and trucks. And they aren’t staying parked in garages either. The U.S. Department of Transportation’s Federal Highway Administration reports that Americans drove 3.02 trillion miles in 2014, the most since 2007 and the second highest total in the last 79 years. Anecdotally, here in Wisconsin, we seem to have mega-type road projects everywhere you look. These projects are costly to taxpayers and in many cases are multi-year in nature. Yet there seems to be a realization that roads, bridges and other transportation improvements can lead to positive economic outcomes and many voters view infrastructure renewal and expansion as worthwhile publicly funded efforts.
The Growing Cost of Unfunded Pension Liabilities
The month of May brought additional bad news for the beleaguered state of Illinois, city of Chicago and its related issuers. For many years, the state and city have struggled with major fiscal challenges in the form of structural budget imbalances and high debt burdens in particular, which are very large unfunded pension liabilities.
On May 8, the Illinois Supreme Court unanimously ruled as unconstitutional the 2013 pension reform bill for state government workers and public school teachers outside of Chicago. The Court affirmed that the Illinois Constitution provides that “membership in any pension or retirement system of the state, any unit of local government or school district, or any agency or instrumentality thereof shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.” The message by the Court was that the state must pay—without cutting current benefits—no matter how long it takes and how much it costs. The Court did provide one small loophole, suggesting that a negotiated deal with “consideration” would be legal. In addition, the question remains: Are such “benefits” protected only once they are actually earned or can pension formulas be modified with regard to future years of service?
On May 12, Moody’s downgraded the city’s general obligation, sales tax and motor fuel tax bonds two notches to Ba1 and maintained a negative outlook. Moody’s said this action was based on “the city’s considerably narrowed options for curbing growth in its unfunded pension liabilities as a result of the Court decision.” Despite Moody’s statement that the Ba1 rating means less than a 5% chance of default over five years, the downgrade to “junk” had significant additional implications for the city. The downgrade triggered provisions to Chicago’s variable-rate bond and swap contracts that allows banks to “immediately demand” termination fees and accelerated payments of principal and interest in the total amount of approximately $2.2 billion. As a result, on May 14, Standard & Poor’s downgraded the city two notches to A-/Negative and, on May 15, Fitch downgraded the city one notch to BBB+/Negative due to these short-term liquidity concerns. In the days that followed, Chicago was able to persuade the relevant banks not to demand penalties and was able to proceed with a plan to refinance a portion of its debt. Due to the downgrade, the city’s bonds now have a spread to the 10-year, triple-A benchmark of nearly 293 basis points, more than double what it was a year ago.
With the clock running on the regular session and no progress out of the Illinois Legislature, it could be a long, hot summer in Springfield. Meanwhile, the state of Illinois and the city of Chicago will continue to be exposed to price volatility, headline and downgrade risks. It is no coincidence that the states of Illinois and New Jersey have the most severely underfunded pension liabilities and they were the two worst performing state issuers in May.
Lower Enrollment in Higher Education
Student enrollment in U.S. colleges and universities declined 1.9% year over year (during the period ending with spring semester 2015). According to the National Student Clearinghouse Research Center, public college enrollment showed 0.1% growth, but private school enrollment dropped 0.2%. For smaller, four-year private schools, the numbers look particularly troublesome as enrollment trailed the prior year by 0.8%. We continue to be cautious in the higher education sector as the high cost of tuition and student loans have negatively impacted private schools’ enrollment numbers. Even national universities are trying to attract more students from out of state and other nations since they tend to pay higher levels of tuition.
The Big Picture
Overall, municipal credit has slowly recovered from the financial crisis. After several years of austerity, budgets of state and local governments have benefited from the recovery of revenues as the population headed back to work with an improved stock market, and a recovered real estate market. However, municipal credit in the near term will be challenged despite the positive economic news and improving revenue pictures, due to a long list of funding needs. The list includes K-12 education, affordable higher education, infrastructure, social service programs and pension funding among the top challenges. For oil-dependent states, funding imbalances are significant and will require significant budget cutting and the use of reserves to achieve budgetary balance. Manufacturing is no longer the dominant sector in the recovery having been replaced by lower paying service sector jobs. Municipal revenue structures have yet to adjust to this new economy, possibly leaving their budgets to greater volatility in the future. The ability of states to properly balance their budgets could shift more of the burden to the local government. Municipal credit overall has improved since the recession but the unevenness of the recovery across the country is a concern.