Cumberland Advisors Market Commentary – Q1 2019 Credit Commentary

Author: Patricia Healy, CFA, Post Date: May 3, 2019
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A positive tone continues for the credit quality of municipal bonds, and municipal performance has been strong as a result of low supply, high demand, and lower rates. (See John Mousseau’s “http://www.cumber.com/1q2019-review-tax-free-municipal-bond-a-shining-first-quarter-for-munis/.”)

Cumberland Advisors Market Commentary - Municipal Credit

After some states reported revenues tracking well below projections in January, fears of a substantial drop-off in state tax collections are being allayed, with tax collections up year-over-year in February and March according to Morgan Stanley’s META 13 state sample (“Municipal Early Tax Analysis”). New Jersey may be bucking that trend, as revenue collections, though somewhat improved, are still under budget.

Source: AlphaWise, Morgan Stanley Research

Last quarter (see “http://www.cumber.com/q4-2018-credit-commentary-and-a-look-ahead-to-2019/”) we pondered whether the credit quality of municipal bonds was plateauing. However, with continued economic growth and upgrades still outpacing downgrades, we have likely not hit a plateau, though the upward slope in the improvement of credit quality is not as steep now. Economic activity and revenues are up generally, and many municipalities have built up rainy day funds, although wage pressure is appearing in budgets. And of course there are a number of municipalities that have not built up reserves or have not been able to attain structural balance and reduction of liabilities. There are numerous long term items that municipalities need to consider addressing sooner rather than later because they could become more burdensome.  These include funding pension plans, improving infrastructure and climate resiliency, adjusting to changing demographics, and being cyber secure.  The improved revenue picture has led some municipalities to add or expand programs and services while some have increased payments to pension plans or reduced debt. How municipalities plan and prepare are some of the determinants in assessing credit quality.

Upgrades continue to outpace downgrades

Moody’s released a rating revisions report for 2018 showing that for the fourth year in a row upgrades outpaced downgrades, demonstrating the continuing trend of improving credit quality across public finance. Rating changes were down almost 30% from 2017, with 480 upgrades compared with 392 downgrades; and, based on par, the value of bonds upgraded was more than double that of debt downgraded, at $99.4 billion compared with $42.0 billion. S&P’s most recent rating activity report, with data through the third quarter, also showed that rating-change activity declined and that upgrades outpaced downgrades. The only sectors to experience more downgrades than upgrades were Higher Education at both Moody’s and S&P and Healthcare at S&P. We have long noted the challenges these types of institutions have faced, such as declining enrollment at higher education institutions and a very competitive landscape for healthcare organizations.

Rating changes generally lag economic activity, for several reasons. A strong financial cushion or rainy day fund built up in good times enables a municipality to withstand a downturn in revenues or an unexpected increase in expenses. Rating agencies do not always immediately downgrade an issue on bad news; before they take action, they wait to see how the issuer will react and whether the issuer addresses the event or negative trend effectively. Other market participants can act sooner by exiting a bond before it is downgraded or buying a bond before it is upgraded. For example, Cumberland exited the bonds of the states of Illinois, New Jersey, and Connecticut years ago and avoided a long string of downgrades. Similarly, ahead of a major storm we compare our holdings with the trajectory of the storm and exit credits that might be affected negatively.

Many general-obligation bonds have lagged revenue collections, so that when the economy declined, revenues collected were based on an earlier period’s property values. This tendency is offset by lower growth in property tax collections during periods of recovery. New York City has a five-year lag in property valuations, and its debt has historically yielded countercyclical benefits.

Moody’s upgraded New York City’s general-obligation bond rating to Aa1 in March. The upgrade reflects continued strengthening and a diversification of New York City’s economy, reducing its reliance on volatile financial services. Moody’s cites the city’s competitive advantages, including a young and highly skilled labor pool, access to higher education and medical centers, strong domestic and international transportation links, and low crime rate. The upgrade also reflects the city’s ongoing strong budgetary and financial management, which includes frequent updates to multi-year financial plans, producing a transparent view of future budgetary pressures. Moody’s notes that although the city’s debt burden is above-average, the fixed costs for debt service, pensions, and retiree health care have decreased and are now below the median for the largest local governments and in the bottom five among the nation’s largest cities.

The municipality has historically budgeted conservatively and has mechanisms that trigger timely spending cuts or revenue increases. Much of the discipline involved in this process was instituted after New York’s financial crisis in the mid-1970s.

Sometimes states or municipalities that have been through a financial crisis emerge stronger. That may not be the case for Puerto Rico, however, because so far there is no discipline, and the people of the commonwealth and its bondholders are suffering. (See “1Q2019 Review: Puerto Rico,” by Shaun Burgess, http://www.cumber.com/1q2019-review-puerto-rico/.)

State Ratings Changes

There were no state rating changes in the quarter; however, the outlook for Connecticut’s rating was changed to positive by S&P, based on the increased likelihood that the state will preserve until the end of fiscal 2019 its recently replenished reserves at what S&P considers to be the strong level of 10.2%, and also based on prospects that the state’s high debt levels could moderate if the governor’s proposal for a “debt diet” is carried through into policy. The state has a plan to budget conservatively, use any excess income tax revenues above-budget to bolster reserves, and limit general-obligation debt borrowing. However, S&P notes that a budgetary balance could come from reductions in local aid, a tactic we have discussed before that provides states with flexibility, albeit at the expense of agencies and municipalities. Connecticut has a number of wealthy, highly rated municipalities that may have to raise taxes, a move which could cause a further exodus from the state. The state capital and other sizable cities have already challenged finances and ratings.

Internet Sales Tax Update

States’ 2020 budgets show incremental increases in sales tax collections through the taxing of transactions within a state from retailers that do not have a physical presence in that state – a result of the South Dakota v. Wayfair decision. We discussed the Wayfair decision in a commentary last July: http://www.cumber.com/scotus-two-major-rulings-with-positive-implications-for-municipal-bond-credit-quality/?print=pdf. Moody’s notes that, though small so far, the increases are a positive development for state governments, and a majority of sales tax growth is expected to come from remote retailers. Revenue estimates are just that, since data is currently limited and reporting issues need to be worked out. According to The National Law Review, 36 states have enacted laws allowing them to collect remote online sales taxes and an additional seven are considering legislation. Moody’s estimates these changes will help states that are rural and have few retailers, while states that have dense populations and numerous retailers will see less of an increase. All in all, this is a good development for municipal credits, because the trend of online purchasing continues to grow, and thus the new laws save a revenue source that had started to slow without the ability to collect on remote sales.

Changes in Accounting Improve Municipal Transparency – to a Point

Governmental Accounting Standards Board (GASB) Statement 88 requires that notes to financial statements present direct borrowings and direct placements of debt separately from other types of debt. Direct borrowings and direct placements may expose a government to risks that are different from or additional to those incurred with other types of debt, such as the option for early prepayment making direct debt a priority over public debt. Statement 88 also requires the disclosure of amounts of unused lines of credit, assets pledged as collateral for debt, and terms specified in debt agreements related to significant (1) events of default with finance-related consequences, (2) termination events with finance-related consequences, and (3) subjective acceleration clauses. This requirement will help to make evaluating a municipality’s’ debt picture much more transparent.

Incidentally, for years the National Federation of Municipal Analysts has encouraged municipalities to disclose information on new direct borrowings when those agreements are entered into, instead of disclosing those obligations only in financial statements. Such disclosures are especially important because most municipalities issue financial statements only annually, and many months after the end of the fiscal year. During the financial crisis, some bank loans and swap agreements resulted in bumped-up costs or large termination payments to municipalities, causing negative credit situations, so it is important for these items to be disclosed.

Infrastructure Plan: Desires Are High, But Prospects Are Meagre

Many agree that US infrastructure is in need of an overhaul. The American Society of Civil Engineers report card on the quality of US infrastructure grades it D+! There is bipartisan agreement that something needs to be done and that the federal government should lead the way or at least provide some funding, but there are now disparate proposals and suggestions that go beyond giving municipalities better access to federal funds to finance infrastructure investment. Some ideas include resurrecting the Build America Bond program or forming an infrastructure bond bank, and in February the Senate Finance Committee introduced a Public Buildings Renewal Act that would authorize $5 billion in private activity bonds (PABs) for construction and restoration of public buildings and permit government-owned buildings to be eligible for public-private partnerships without giving up their tax-exempt status. However, with election-year politics already taking up Congresspersons’ time, the prospects for a full plan this year or next are waning. We expect there to be lots of activity around Infrastructure Week, May 13–20, but a final program is not likely.

Short of a full infrastructure plan there may be hope that some changes can be introduced to make financing of infrastructure more affordable. Municipal Bonds for America (MBFA), a nonpartisan coalition of municipal bond issuers and state and local government officials and other municipal-market professionals are working to explain the benefits of the tax-exempt municipal bond market. MBFA and other groups such as the National Association of Bond Lawyers have submitted suggestions for encouraging more investment in infrastructure to congressional committees. Major suggestions include the following:

  • -Restore advanced refundings
  • -Expand private activity bonds
  • -Restore direct pay bonds (BABs)
  • -Increase the bank-qualified loan limit

At Cumberland Advisors, we continuously follow legislative developments, accounting pronouncements, economic and demographic trends, and other news items, incorporate them into our views of the economy and markets, and employ them in our buy and sell decisions. The majority of our municipal bond holdings have AA ratings with diverse economic bases and strong financial performance.

Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
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