Defined benefit plans, more commonly known as pension plans, are costly for employers, which is why many companies have dropped them over the years. Most private sector employees are now in defined contribution plans (e.g., 401k plans), which often have limited employer contributions as well, but are not as attractive as pension plans with guaranteed payouts typically offered by state and local government entities.
The cost of these plans has been an increasing financial burden for municipal issuers — returns on funds in pension plans have not met expectations and public entities have failed to adequately fund the plans on a regular basis. Despite headlines reporting the dismal state of public pension funds, we do not believe it will be the Achilles heel of the municipal bond market.
There are over 6,000 public retirement plans in the U.S. with about $3.7 trillion in assets supporting 10.3 million retirees. With such a large number of public pension plans, aggregated analysis can be complicated, but some general themes are observable. The gap between assets held by pension plans and the liabilities for municipal pensions (known as the unfunded pension liability) has been growing as a result of poor returns over the past decade. Additionally, there has been an obvious lack of disciplined funding by many municipal plan sponsors due to the financial stress of the last recession. This gap in pension funding is the main concern of municipal credit analysts at this time and will continue to weigh on municipal credit quality for years to come. Rating agencies have acknowledged their concerns by increasing the weight that the health of a municipal issuer’s pension fund has on their overall credit quality rating. With governmental accounting rule changes, unfunded pension obligations are included on state and local government balance sheets. This has made the visibility of the crisis much more apparent to a variety of stakeholders; plan participants, taxpayers, rating agencies, and bondholders. This increased visibility has also ramped up the pressure on state and local governments to address the funding problem.
As the doomsday headlines continue, many issuers have been attempting to make improvements in pension funding. Governments have many tools available to resolve financial challenges. Pension funding is no different. Significant changes to these plans have been occurring on an ongoing basis but are not widely reported. Many states and local issuers have implemented some form of change to their pension plans to help improve future funding levels, including:
- Established new pension tiers for newly hired government workers to reduce overall liabilities
- Introduced the use of defined contribution plans for government workers
- Raised the retirement age of participants
- Increased the required employee contribution
- Eliminated or lowered cost of living adjustments
- Increased funding
- Lowered the investment return assumptions to provide a better picture of the long-term liability
- Privatized services to decrease the number of government employees
The list goes on. The point is that many issuers are addressing the pension funding problem through a variety of changes and improvements. A process with many challenges, both legal and political, but the problem is recognized and being dealt with to varying degrees. Investors should not expect funding levels to return to pre-recession levels in the near-term as most pension funds manage to a 20- or 30-year investment horizon. It’s also important to note that in some quoted studies the media reports on, a minority of the worst-funded pension plans drag the average quoted funding level down considerably. Investors should examine their local governments’ pension funding levels and watch for any policy changes enacted to enhance the long-term pension paying ability. It’s a critical metric to watch, but as always, a well-diversified portfolio is one of the best ways to mitigate pension funding risk as well as many other credit risks.
Economic indicators over the past month continue to point to further Fed tightening, likely raising short-term interest rates at their upcoming June meeting. Under current conditions, we think two additional hikes in 2018 are a given with the potential for a third if inflation continues to trend higher for the rest of the year. The Fed and the market are split on that possibility at this time. However, with the April unemployment rate dropping to 3.9%, the likelihood of a fourth rate hike should be increasing. The last time the unemployment rate was below 4% was late 2000. This is well below the 4.2% to 4.8% that Fed officials believe is normal for the long run and may give workers more leverage in seeking higher wages. The April Consumer Price Index (CPI) came in slightly weaker than expectations, but was still up 2.5% year-over-year. Core CPI (excluding food and energy) was 2.1% year-over-year — both measures above the Fed’s target of 2.0%. The market will wait for the Fed’s preferred measure of inflation, core personal consumption expenditures (PCE), due at the end of the month. The last reading for April came in at 1.9%.
Rates moved higher in April with 10-year Treasury yields up 21 basis points. Municipal 10-year yields outperformed rising only 7 basis points. However, the rest of the municipal curve did not fare as well. The Bloomberg Barclays Municipal Bond Index was down 0.36% for April. The best performance was in the 1-year portion of the curve which was down 0.09%. The 30-year portion of the municipal curve was down 0.64% in total return.
Technical indicators are supportive for municipal bonds over the next few months. Seasonally, June through August will see more coupon payments and redemptions of municipal bonds than is likely to be issued. We have seen estimates of about $30 billion in net negative issuance (more money being received by muni bondholders than is expected to be issued). The wild card is how much banks and insurance companies may sell in the secondary market. These companies find municipal bonds less attractive at the newly lowered 21% corporate income tax rate. Additionally, it will be difficult for municipal bonds to post positive returns if Treasury yields continue to rise in the face of further Fed hikes and inflationary pressures. We remain defensively positioned despite positive technical conditions.
- We will continue to be shorter duration than our benchmark and peers.
- Fixed income markets have been driven to higher yields by heightened concerns of inflation, potential for increased Treasury issuance, and an active Fed. U.S. Treasury 2-year yields have risen about 60 basis points year-to-date while the 10-year yield is 70 basis points higher and well through the 3.00% ceiling that traders had been watching.
- Overweight municipal floating-rate notes. Avoiding fixed-coupon bonds on the shorter end of the yield curve due to expected Fed rate hikes. Continue to monitor inflation and expectations. Fed has indicated a continuation of policy normalization and has steepened the two-year forecast for rate hikes via the “dot plot”.
- The weekly municipal floating rate index (SIFMA rate) is at 1.38% (5/16/2018) versus 0.78% a year ago. SIFMA has been falling from a recent peak of 1.81% in mid-April as tax time selling fades and demand for short floating rate notes increases with Fed tightening.
Credit and structure
- The only notable outlier for credit returns last month was municipal high yield. The Bloomberg Barclays Muni High Yield Index returned 0.45% in April driven higher by tobacco bonds and some recovery in Puerto Rico bonds. Despite rising yields, investors are still willing to take credit risk to eke out some additional yield.
- We continue to be wary of BBB and lower quality bonds with quality spreads at very tight levels.
- We like prepaid gas bonds at this time. These tax-exempt bonds can be issued as floating rate notes with credit support from financial institutions. These institutions are in strong capital positions and benefit from rising interest rates.