This article was released on December 15, 2015. Find our latest municipal fixed income insights here.
Strong jobs report bolsters case for December Fed rate hike
The October jobs report stunned the market in early November. After a relatively weak September report, October employment gained 271,000 jobs and the jobless rate fell to 5% — the lowest rate since April 2008. Wages rose 2.5% from the prior year, the biggest gain since 2009, and this may signal the start of wage pressures. This set a bearish tone for the month and pushed the two-year Treasury to its highest level since 2010. Investors are betting that the Fed now has a strong case to raise interest rates and that downside risks to tightening have diminished. The next challenge for investors is determining the pace of policy normalization. As we close out the month, the market is currently pricing in a 74% chance of a Fed rate hike at its next meeting in December.
The Barclays Municipal Bond Index returned 0.40% for November, the fourth consecutive month of positive returns for the muni market and a significant outperformance of the Treasury market, which posted negative total returns across the maturity spectrum. Tax-exempt performance was helped by institutional demand on the long end of the curve and unusually low issuance for the month of November.
Lower-quality bonds (A and BBB) continued their year to date outperformance of higher-quality bonds in November. Strong demand from mutual funds looking to invest positive fund flows led to BBB bonds outperforming AAA bonds by 44 basis points (0.69% total return versus 0.25%). Year to date, BBB-rated bonds have returned 3.45% versus 2.21% for AAA. Revenue bonds, in which we have a substantial overweight, boosted fund performance returning 0.47% for the month versus 0.36% for general obligation bonds. We continue to favor this overweight.
Supply & demand
Gross issuance of municipal bonds fell 22% from the same period last year, ending November at $23 billion — the lightest November volume since 2000. A large portion of the decline is attributable to a drop in refunding deals. Many market participants believed the relatively low level of municipal yields would spur issuers to refund older, more costly deals. However, this did not occur, leaving investors clamoring for bonds, both in the primary and secondary markets.
Demand for munis continued to be strong with over $2 billion in net flows into municipal funds over the month. We’ve seen eight consecutive weeks of net inflows into municipal funds totaling over $4.8 billion and bringing year-to-date net inflows to over $8 billion.
This supply and demand imbalance for tax-exempt bonds drove municipal bond outperformance versus Treasurys. For example, the 10-year AAA municipal yield went from 95% of the 10-year Treasury yield to 91% by month end.
With the strong jobs report at the start of the month and the market anticipating a December Fed rate hike, Treasury yields ended the month higher across the curve. The two-year Treasury yield increased 20 basis points ending at 0.93%, the highest level for the year, while the 30-year rose by 5 basis points. Treasury returns were negative across the curve. The municipal curve reacted differently with yields in the five-year sector rising while longer maturities fell by as much as 10 basis points. As a result, we saw slightly negative returns on the short end of the municipal curve and positive returns out on the longer end.
At current levels, municipal bonds are looking rich relative to Treasurys over the one-year period. This is largely due to the supply and demand imbalance mentioned above as well as investors more fully pricing in the benefit of tax exemption from purchasing municipal bonds.
On the municipal quality front, S&P upgrades exceeded downgrades in the third quarter of 2015. This is the twelfth consecutive quarter of positive rating actions for the municipal market by S&P and is the longest quarterly streak of upgrades outpacing downgrades since 2001.
The agency cited the ongoing U.S. economic recovery as benefiting municipal issuers in generating higher fees, revenues and jobs. Moody’s also had upgrades exceeding downgrades in the third quarter with 172 upgrades and 132 downgrades across all municipal sectors. While some of the upgrades were the result of changes in rating methodology, two of the past three quarters have exhibited this trend.
Earlier in the month, voters approved $18.9 billion in municipal debt to fund road improvements, water systems, economic development and other capital improvements. While not much of a dent in U.S. infrastructure needs, it does represent 79% of the $23.8 billion that local issuers sought approval for on the November ballot. Last year, voters approved 85% of $44 billion on the ballot. The largest approval was $1.6 billion of debt to replace and renovate schools in the Dallas Independent School District. This is a good sign that U.S. voters may be acknowledging the need for infrastructure improvements in their local communities.
Pennsylvania may be getting a bit closer to a budget deal. Looking to reach a compromise package by December 4, state leaders are now focusing on greater funding for education, a reduction in the state’s structural imbalance and pension cost savings. Moody’s changed its outlook on the Aa3 rating of Pennsylvania (Aa3/AA-/AA-) to Negative. School districts across the state continue to feel the greatest pressure. S&P expressed concern about Pennsylvania school districts and the state budget impasse. State aid varies from 10% to 70% of districts’ operating budgets; 64 schools are on CreditWatch Negative. Moody’s downgraded Pennsylvania’s pre-default intercept programs for school districts to A3 from A2.
In Illinois there could be a chance for some action after January 1 when a simple majority is needed to pass legislation. Currently 60% is needed. However, with primary elections on March 15, lawmakers might be afraid to make any controversial votes. Talk is beginning about a two-year budget.
Meanwhile in Chicago, despite a record-breaking property tax increase, budget problems continue to plague the city. The budget included the assumption that the state will approve SB 777, which calls for a 5-year step-up to the state required amounts for the police and fire pension funds; the difference is $220 million for 2016. On November 17, the Illinois Supreme Court looked unfavorably on Mayor Rahm Emanuel’s plan to save two of its troubled pension funds. Tough questions aren’t always an indication of how a court will rule, but when coupled with the court’s earlier ruling overturning the state’s pension reform efforts, the outcome does not look good.
The higher education sector remains pressured. Moody’s released a comment noting that net tuition revenue growth is expected to increase 2% between FY2015 and FY2016. First-year tuition discounting remains near 50% for many private universities. Universities in the South and West are expected to realize greater tuition growth because of continued migration trends, while those in the Northeast will remain pressured. Universities across the country remain focused on attracting the international student, although universities with strong brand recognition have the most to gain.
For the first time in 17 years, Congress passed more than a quick fix to the funding of the nation’s transportation network with a five-year (2020), $305 billion program. The Fixing America’s Surface Infrastructure Act (FAST Act) includes $225 billion for highways and $60.9 billion for mass transit. Funds will also be available for freight projects such as a rail freight tunnel in New York or helping Chicago’s freight bottleneck. Amtrak is expected to receive about $8 billion. The federal gas tax receipts through 2020 are expected to total $208 billion. The remainder is expected to come from capping the Federal Reserve System’s surplus account at $10 billion (providing $53.3 billion), a $7 billion reduction in dividends to large banks from the Federal Reserve and $6.2 billion from the sale of oil from the Strategic Petroleum Reserve.
In addition to transportation the 1,000+ page FAST Act also included the resurrection of the Export-Import Bank through 2019.
Congress now has five years to identify a long-term funding solution for the country’s transportation network.
Municipal bond insurance is making a revival of sorts. Before the financial crisis, tax-exempt insured bonds accounted for over 50% of annual new money issuance. This dropped to less than 2% in the early post-crisis years. However, with the help of a new municipal bond insurer, Build America Mutual, insured bonds accounted for over 6% of new-dollar issuance, or 15% of issuance based on the number of transactions for the first three quarters of 2015.
It has now been eight years since the beginning of the Great Recession, which in the U.S. officially lasted from December 2007 to June 2009. How has state credit quality fared?
State credit quality generally improved in 2007; six states were upgraded, including North Carolina and Vermont, both to triple-A. However, recessionary concerns were rising, home values were declining, states were facing increasing borrowing needs along with growing pension and OPEB costs, while growth in state revenues began to slip. Nevertheless, state general fund revenues reached a peak of $680 billion in 2008.
While most states were expected to easily adjust spending to reflect their softening finances, some were predicted to have a more difficult adjustment, such as: Michigan (auto dependence); New York and New Jersey (Wall Street dependence); Illinois (slowing economy and mismanagement); California, Arizona and Nevada (housing market bubble); and Florida (housing market plus a property tax reform).
As lagging economic indicators, the municipal and state sectors continued to adjust their fiscal positions throughout 2008. However, Moody’s revised the credit outlook for the U.S. state sector for 2008 to negative from stable, and for fiscal year 2009, at least 37 states were facing budget gaps totaling $66 billion — California, Arizona and Florida chief among them.
Stimulus to the rescue
By early 2009, the federal economic stimulus package had been signed. Help also came in the form of $87 billion to help states pay for Medicaid. Tax law changes included the BABs program under which states and local governments could issue taxable governmental bonds in 2009 and 2010 to finance capital expenditures; the issuer could receive a cash subsidy or the bondholder could receive a tax credit from the federal government up to 35% of the interest paid on the bonds.
Although the Great Recession was officially over by June 2009, ongoing economic weakness continued to create serious financial challenges. States with the highest deficits as a percentage of their general funds were: Nevada (32%); Alaska (31%); Arizona (29%); Florida (27%) and California (23%). By July 2009, five states had been downgraded by one or more rating agencies: California, Nevada, Ohio, Illinois and Michigan.
Even amid signs that the worst of the recession was over, the three main sources of state revenues — corporate business tax, personal income tax and sales tax — were all experiencing double-digit declines.
In July 2009 the University of Michigan Consumer Sentiment Index was down to 64.6 from 70.8 in June and unemployment remained in the double digits. Large budget shortfalls troubled the states during much of fiscal years 2009 through 2011.
During 2010, despite receiving approximately $140 billion in federal stimulus funds provided by the American Recovery and Reinvestment Act, states were balancing their budgets using reserves, tax hikes, service cuts, and short-term borrowing, as well as creative financing techniques — selling public assets such as transportation systems or lottery programs. In September 2010, Meredith Whitney released her report rating the financial condition of America’s 15 largest states as measured by their GDP. Her conclusion: “The states represent the new systemic risk to financial markets.”
Rating activity in the sector tilted more positively in 2013. Moody’s revised its outlook for the state sector to stable from negative in August 2013: “Slow economic recovery has continued and stock market gains and private sector expansion continue to support state revenue growth, and reserves are on the rise.” In addition, states’ appetite for borrowing remained weak resulting in declining debt ratios relative to population and personal income. Pockets of credit weakness remained, however, especially due to rising budgetary pressure from pension contributions and regionally uneven economic growth. In 2014 rating agency activity was mixed. Rating actions reflected the relatively positive state economic news along with improving personal income levels, while some state’s unfunded pension liabilities received heightened attention.
During 2014, California was raised to Aa3/Stable by Moody’s and A+/Stable by S&P and Fitch; New Jersey was lowered to A1/Negative by Moody’s and A/Stable by S&P and Fitch.
Not all states are equal
In 2015, state tax revenues have grown, but because of regional economic differences the growth is uneven among states. More, the growth in pension liabilities weighs heavily on some states more than others. According to Pew Research, “Almost 6 years after the recession’s end, 27 states were still collecting less in real terms than at their individual peaks before or during the recession. In seven states, tax revenue was down 10% or more from those peaks.” Of course these differences among states reflect tax policy changes as well as economic changes. Some states, like California, raised taxes to meet recessionary budget imbalance, while others have cut taxes or fees.
Where are the jobs?
The October 2015 unemployment rate of 5.0% is now equal to the December 2007 unemployment rate. Some states’ reported unemployment rates are lower than at the start of the recession: Michigan at 5.0% now (7.6% then); Ohio at 4.5% now (6.0% then); California at 5.9% now (6.1% then). But unemployment rates don’t tell the whole story, and the Department of Labor indicates that some states still have a long way to go for a full recovery. That is because employment-to-(total)-population ratios are still down in every state. While this ratio has rebounded somewhat after bottoming out at 75%, it remains well below its prerecession 80%.
Slower revenue growth on the horizon
Growth in total state tax collections has fluctuated significantly in the last two years, according to the Nelson A. Rockefeller Institute of Government. Stock market fluctuations, which lead to fluctuations in personal income tax collections, as well as oil price volatility for states dependent on oil and gas revenues, are in part responsible. Early figures for total state tax collections for fiscal year 2015 show growth of 5.6% over fiscal year 2014. Personal income tax collections were strong, at 9.0%, again likely driven by 2014’s strong stock market.
States expect fiscal year 2016 to be a weaker year than fiscal year 2015, largely because of an anticipated slowdown in income tax revenue, which makes up about 36% of state tax revenues. Personal income tax is forecasted to grow an average of 4.4% in 2016, down from state-estimated growth of 5.4% in 2015. Personal income tax revenue collections in fiscal 2016 were expected to grow in 38 states and to decline in three — Illinois, Ohio and Oklahoma — likely due to legislated changes.
Forecasts for fiscal year 2016 also indicate less-robust growth in total sales tax collections: about 4.0% growth on average versus 4.4% last year. (States rely on sales tax for about 30% of tax revenues.) Overall, 40 states are projecting growth in sales tax collections in fiscal 2016, with four states projecting declines: Alabama, Connecticut, Maine and Wyoming.
Moral of the story?
According to Pew Research, states’ financial conditions are improving. But most states have yet to return to prerecession performance on some key measures of fiscal health. And challenges await them: long-term spending pressures on K-12 education, health care, pensions and other critical areas continue to grow, often faster than state revenue growth. In addition, recovery varies widely from state to state.
States that were hit the hardest by the Great Recession are not the states that are in the most distress now. California, Nevada and Michigan were particularly hard-hit, but they have managed state finances to maintain fiscal stability. In fact, during 2015, California, once the lowest-rated state, recovered to the double-A level; Nevada and Michigan have maintained their mid-double-A ratings.
Meanwhile, Illinois has fallen to the lowest state rating (high triple-B), New Jersey to the second-lowest (mid-single-A). While economic recovery has lagged in these two states (unemployment rates at 5.4% and 5.6%, respectively), their creditworthiness is more the result of their unwillingness to take unfavorable actions — raise revenues, cut costs, fund pensions — than their inability to do so.
As the past several years have shown, state governments have the tools to weather economic downturns without jeopardizing debt payments. While states continue to face varied economic conditions and headwinds, it is the management of these conditions that counts. States cannot declare bankruptcy; states cannot go out of business. They are constitutionally required to balance their budgets, and all states recognize the need to rigorously protect their access to the capital markets. States have sovereign powers to raise taxes and other revenues and the ability to make deep cuts in their spending. The question is, are they willing to do so.