This article was released on September 15, 2015. Find our latest municipal fixed income insights here.
A safe haven in your own back yard?
Broad stock market volatility across the globe unnerved investors while municipal bond owners enjoyed relative tranquility. Fear can sometimes lead to paralysis in the municipal bond market as the high quality nature of the tax exempt marketplace offers a safe haven environment similar to that of Treasury bonds. Since the yield ratios of municipal bonds to Treasury bonds were generous going into the month of August, municipal bond trading activity was closely linked to U.S. government bonds without much of the typical lagged pricing pattern. Comfort can come from previously known places, and investors sought refuge in municipal issuer names that are often as familiar as your own back yard.
Per the Barclays Municipal Bond Indices, total returns for the month ranged from approximately 2 basis points (bps) in the 5-year range to 30 bps in the 10-year bond. In times of fear, higher quality usually wins. August exhibited just that, as the Barclays AAA Index advanced 24 bps while the BAA Index was flat.
While both commodity and equity markets traded wildly during the month, Federal Reserve (Fed) officials reminded us that market volatility alone is not sufficient to alter their economic outlook. The Fed may have a dual mandate to maintain modest levels of inflation and promote full employment, but nowhere is it expected they control daily market volatility. The month of August was a good reminder that the value of owning bonds in a low interest rate environment extends beyond income generation. Preservation of principal can be just as important, a purpose for which high quality municipal bonds are well suited.
Give me a break
In an effort to attract new commerce and jobs, cities and states have long offered tax breaks to businesses in return for their commitment to locate there. Starting next year, the Governmental Accounting Standards Board (GASB) will require government officials to show the value of any waived property, sales and income taxes. For example, Chicago channeled $372 million to nearly 150 special taxing districts in 2014 per the Cook County clerk’s office. In other words, $1 for every $13 of property taxes collected was put into special taxing districts. And it’s not just big cities that make big commitments. Belleville, IL, (population 43,000) sent $15.6 million of property taxes out of $97 million in total revenue to 19 special taxing districts that benefit developers building shopping centers and residential homes.
Deals cut with large companies can amount to billions of dollars. Last fall, Nevada promised Tesla up to $1.3 billion to build a battery plant there. The state of Washington offered Boeing Company and its suppliers a whopping $8.7 billion in order to expand jetliner production. These deals have been subject to complaints from existing businesses and individual taxpayers who ultimately bear the burden of these sweetheart arrangements.
Now, investors will be able to see what amounts of tax revenue won’t be collected due to incentives. In the past, these sorts of agreements reduced tax revenues, but you never were able to see what wasn’t reflected in the accounting system. Investors and some government officials will now be able to determine the effect of tax deals that over the years could significantly limit the financial flexibility of some cities and states. Meanwhile, Chicago has announced plans to eliminate some tax districts while freezing spending in others. Maybe allowing for more transparency in the future will encourage other municipalities to follow suit.
In August, Illinois’ Metropolitan Pier and Exposition Authority was downgraded 7 notches by S&P and 4 notches by Fitch Ratings when the Authority failed to make its monthly transfer of funds to a special trustee-managed debt service account. This failure was a direct result of the state Legislature’s failure to appropriate the sales tax revenue that is intended to support this monthly payment. The Legislature’s lack of action was, in turn, the result of a failure, thus far, to enact a budget for fiscal 2016. Although the Legislature subsequently acted to remedy the failure to appropriate, the damage has been done.
This event caused municipal market participations to rethink the safety of appropriation debt. In financially stressed situations and/ or in bankruptcy cases, it appears there is no security structure safe from restructuring. What certain security structures could provide is a priority of payment in distressed situations.
According to S&P, the rating action reflects their view that the bonds are in fact appropriation obligations of the state, rather than special tax bonds, and are appropriately rated one notch below the state’s rating.
While acknowledging the risk of non-appropriation to be remote, S&P said, “…the absence of a state budget and the inaction to avert a technical default has highlighted the appropriation linkage to the state.”
According to Municipal Securities Rulemaking Board (MSRB), appropriation bonds are typically lease revenue or certificates of participation that commit the issuer to make lease or periodic debt service payments, but only to the extent that funds are budgeted and appropriated on an annual basis. The governing body is not legally obligated to make such appropriation in any year. General obligation (GO) debt has the full faith and credit of the state’s taxing power, while appropriation debt is subject to annual appropriation by the Legislature.
Most appropriation debt is part of the government’s annual budget process and repayment is viewed as no different from its statutory debt. This is especially true where restrictions on GO debt make appropriation debt the go-to means of borrowing. The rating agencies typically “rank” appropriation debt one or two notches below the issuer GO rating.
Appropriation bonds have an excellent historical record of payment; however, they do not offer the strong level of protection of general obligation bonds and can present greater risk when issuers experience financial stress. Nevertheless, municipalities have a strong incentive to appropriate for debt service, i.e., preservation of credit and market access. Appropriation bonds issued at the state level (bankruptcy is not allowed) provide ample payment security. Appropriation bonds issued by lower levels of government (bankruptcy may be allowed) should be evaluated for overall creditworthiness with special attention to essentiality of purpose.
Just for the health of it
This month, Fitch released a report regarding the nonprofit Healthcare sector after reviewing results through the first half of 2015. Fitch had placed a negative outlook on the sector in December 2014, yet Fitch experienced a 3:1 ratio of upgrades to downgrades during the period. Fitch cited the reduction in capital spending and the resulting improvement in liquidity and the increase in volumes—especially in Medicaid-expanding states— as key contributors to the positive rating actions. Fitch is now expecting the positive trends to continue through 2015. No surprise that the larger, higher-rated healthcare entities displayed overall improvement while the smaller, lower-rated healthcare entities became weaker, overall.
Moody’s revised their outlook on the nonprofit Healthcare sector from negative to stable, citing the significant increase to the number of people with insurance, growing volumes and sizeable reductions in bad debt, which all contributed to very strong operating cash flows.
The Centers for Disease Control and Prevention reports that the number of uninsured individuals fell from 45 million in 2013 to 29 million as of Q1 2015. In essence, this means 16 million more people are now paying customers, which translates to lower amounts of bad debt expenses for healthcare providers.
We continue to have a more constructive view of the Healthcare sector in general while emphasizing the larger, multi-state systems and favoring those that have a stronger presence in states with expanded Medicaid. Market returns for the sector reinforce this positive viewpoint. According to a JP Morgan report, healthcare is the highest returning municipal bond sector year-to-date as of August 20, 2015, with a total return of 2.15%.
Looking far ahead, successful population health strategies will likely lead to declining inpatient volumes and less expensive services. Low cost clinics now found in a Walgreens or CVS store drives up competition. And don’t forget aging baby boomers will ultimately enroll in Medicare, which has lower reimbursement rates than commercial insurers. We must be aware that current tailwinds can become future headwinds in this sector.
Power to the people
In early August, the Environmental Protection Agency (EPA) released their final report on the Clean Power Plan (CPP). The CPP’s goal is to reduce carbon dioxide emissions across the U.S. by 32% by 2030, with each state given a designated goal in reducing its carbon footprint. The cost of meeting the CPP has put states and utilities on the defensive. Fifteen states have asked a federal court to block the CPP, citing the lack of consideration of expense to achieve the stated goals.
Over the past decade, the Utility sector has benefited from improving credit metrics, as a result of limited capital needs and improving sales. Leverage ratios improved as the recession resulted in limited need for new generation. Utilities continue to benefit from energy conservation programs and improved technology. The cost of meeting new emission standards and statewide emission goals could reverse that trend.
Utilities, particularly those in the public power segment , with rate setting autonomy are better positioned than their investor-owned counterparts to meet the new emissions standards. Utilities’ future financial profile will be dependent upon their ability to recover costs of closed plants as well as the higher costs of renewable energy sources. Many utilities have already begun addressing their carbon footprint. There have been over 200 coal-fired plants in the past five years as utilities moved to meet the EPA’s Cross-State Air Pollution Rule. The more stringent emission standards of the CPP will force the continuation of that trend. Utilities ability to maintain their financial profile over the long term will be aided by the longer lead time provided in the final CPP, technological advancement in renewable energy sources and conservation programs.
Two steps forward, one step back
Municipal credit continues to benefit from the current economic recovery; however, there appears to have developed several bumps in the road. State and local governments over the near term will need to navigate the lower energy prices, the strength of the dollar and weakness in China, the move to renewable energy sources and the uptick in merger and acquisition activity. Positive economic news and improved financial profiles have placed government credits in a position to meet these challenges.
Low oil prices that are expected to last through 2016 or longer will continue to have a drag on the energy dependent areas across the country. The low oil prices will result in layoffs and lower capital spending or reduced sales tax dollars and higher unemployment. Today, many energy dependent states benefit from greater economic diversification but some areas will not escape the economic drag of the depressed energy market.
In other parts of the country, the strength of the U.S. dollar and weakness of the Chinese economy will affect the tourism industry and import/exports. Areas reliant on the international tourist can experience slower sales-tax dollar growth.
The Clean Power Plan requires the U.S. to reduce its carbon footprint and places emphasis on the renewable energy market. The most effective way to reduce carbon emissions is through the reduction in coal-fired generation. Higher energy costs across the country are expected with the continued closure of older generation plants and the construction of new renewable energy resources. Renewable energy is more expensive due to technology and the need to compensate for lower reliability factor. States and local governments have the most to lose from the recent merger and acquisition activity. Mergers and acquisitions tend to result in job losses and higher commercial vacancy rates. International firms move jobs out of the country for low-wage workers. We expect some softness in municipal credit over the near term but longer term, the continued positive economic trends should minimize the overall effects.