Q4 2017 Credit Commentary – Taxes, Pensions, Ratings

Author: Patricia Healy, CFA, Post Date: January 4, 2018
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The fourth quarter was dominated by tax reform and its effects on the supply and pricing of municipal bonds. The prospect that one of President Trump’s major initiatives would finally be passed by year-end buoyed the stock market http://www.cumber.com/market-volatility-etf-portfolio-4q-2017-review-will-the-bull-market-continue/. For a recap of the tax law changes and effects on the municipal market, please see John Mousseau’s commentary “The Muni Take on the Tax Bill (Round Two)”: http://www.cumber.com/the-muni-take-on-the-tax-bill-round-two/.

As we move on from tax reform, many are hopeful that an infrastructure plan will be addressed this year. The ability of municipalities to continue to issue private activity bonds had been threatened in the tax reform process. These bonds help fund traditional infrastructure projects from hospitals to airports and are expected to be instrumental in furthering an infrastructure initiative. Improvement of our infrastructure is important to our nation’s continued growth, as the country depends on the preparedness of our electric, water, and wastewater utilities and it depends on safe roads and bridges to provide for efficient transport of goods and services.  As we have noted in past commentaries, the American Society of Civil Engineers, while noting some improvement, still gives US infrastructure a D+ rating, similar to the last major assessment in 2013: https://www.infrastructurereportcard.org/americas-grades/.

The quarter also experienced significant natural disasters, which we commented on in our Dec 22nd commentary, “Wildfires Abound” (http://www.cumber.com/wildfires-abound/), and in our October 10th Q3 commentary “Whirlwind Is an Understatement” (http://www.cumber.com/q3-2017-municipal-credit/).

State ratings activity waned a bit in Q4, compared to past quarters. State ratings volatility may continue to decline, as the downgrades of the past few years have targeted attention to the growing liabilities and some states’ overreliance on narrow revenues. Some states and other municipalities are making inroads at reducing large and mounting unfunded pension and other postemployment benefits (OPEB), such as promised healthcare liabilities. These actions include reducing earnings assumptions on invested assets to realistic levels that reflect market conditions, fully funding annual contributions, and gaining concessions from employees. States such as Alaska and Oklahoma, which are overly reliant on oil and gas business or royalties and which have not yet addressed long-term fixes, have already been downgraded.

High-tax states will have to manage the implications of tax law changes that may affect their citizens disproportionately – and in some cases substantially – by reducing the tax deduction for state and local taxes and mortgage interest. These changes effectively raise federal taxes and reduce the flexibility of states and localities to raise taxes. Connecticut is an example of a high tax state that has already lost population in response to high taxes and a difficult operating environment. High-growth states such as Texas and Florida will be watched to see if there is pressure on their budgets for infrastructure and social services. Many municipalities, having learned a lesson from the financial crisis, have made an effort to keep reserves or rainy day funds at healthy levels.

State rating actions this quarter include the following:

Wisconsin was upgraded by Fitch to AA+ on improved fiscal performance as a result of improved reserves, improved liquidity, and reduced dependence on “one shots” or one-time revenue items. This move follows last quarter’s upgrade by Moody’s and an improved outlook by S&P.

In November S&P revised the outlook on Colorado’s AA rating from stable to negative, based on low pension funding levels. For a number of years, Colorado has shorted the annually determined contribution to its pensions, resulting in lower funding ratios than comparatively rated states. This outlook denotes only a trend change, not a ratings watch, which would indicate that S&P could downgrade the state in the near future. However, the rating report cautions that if progress is not made on funding or a plan is not made to address the shortfalls, then Colorado ratings could be lowered. Colorado has a diverse economy and good growth and management, so it is anticipated that the state will take corrective action.

In December, six months late, Pennsylvania finally passed its budget. Fitch removed the state’s negative rating watch and affirmed the AA- rating but with a negative outlook. Although the rating was removed from rating watch negative, the negative outlook speaks to the continuing budgetary pressures that result from growing liabilities (pension and OPEB) and one-time budget-balancing items that reduce reserves. On a positive note, the state recently projected a surplus for fiscal 2018, compared with a deficit in 2017.

Some municipalities wrestling with pension reforms are turning to pension obligation bonds: A recent example of a municipality taking corrective action is the City of Houston, America’s fourth largest city, with a population of over two million. The city issued pension obligation bonds to fund a shortfall in its pension funding level. Moody’s affirmed the city’s Aa3 rating, noting,

“The issuance of pension bonds by themselves is typically an interest rate arbitrage gamble and thus credit neutral at best. In the case of Houston, however, voter approval of the bonds is credit positive because it allows the retirement benefit reforms the state authorized in May to take effect. Savings from reduced pension liabilities will more than offset the increase in the city’s debt burden from issuing the pension bonds.” [Pension obligation bonds are taxable.]

Concessions from employees included a reduction in the cost-of-living adjustment and the ability to reduce costs further for unanticipated cost hikes. Because numerous causes of a growing liability were addressed and Houston has a strong credit rating, this transaction should benefit the city.

However, as noted by S&P, pension obligation bonds, if issued just prior to a market downturn, can produce less than optimal results. When a municipality is distressed or attempting a one-time fix for budgetary weakness, the issuance of POBs could be a negative. When a local government issues a POB, it typically deposits the proceeds in a trust and repays the debt from the general fund. This strategy essentially addresses unfunded pension liabilities by shifting them into debt. The funded ratio for the pension plan is immediately increased, which may have multiple effects, such as lower annual actuarially recommended contributions and improved relations between management and employees, who gain assurance that a promised benefit will be there when they retire. But in exchange for the improved pension funding at the time of issuance, the government entity takes on an increased debt burden.

On another front, National Public Finance Guaranty, a subsidiary of MBIA Inc., no longer requires a rating since it is in run-off.   This past December, in response to National’s notice that it no longer wanted a debt rating, S&P affirmed its A rating as stable for the next year and then withdrew the rating. Kroll also downgraded its rating on National’s claims-paying ability to AA with a negative outlook and then withdrew the rating. So that it can keep its clients informed, Moody’s has retained an outstanding rating on National as long as it continues to have enough information to assess credit quality. (That’s somewhat surprising since its A3 rating was lower than the other agencies’ ratings were.) Moody’s could continue to maintain a rating for National for some time, as bond insurers are generally transparent and have extensive information available on their websites regarding insured risks and investment portfolios as well as required SEC and statutory quarterly filings and there is easy access to investor relations.

In June 2017, S&P downgraded National to A, essentially putting it out of business because its ratings (A/A3/AA+) were not high enough to provide enhancement to issuers. However, at the time, S&P and other rating agencies stated that National continued to have very strong claims-paying resources. Further, in September, after Hurricane Maria devastated Puerto Rico, eroding the estimates of recovery on various Puerto Rico bonds to the range of 35– 65% per Moody’s, Moody’s reiterated its opinion that National has strong claims-paying resources, as did S&P and Kroll.

National has insured very little debt since the 2008 financial crisis and has a very low market share, which is one of the reasons S&P lowered its rating in June. Cumberland does buy bonds insured by National as well as Assured Guaranty and Build America Mutual (BAM). It is expected that the S&P ratings on National insured debt will revert to the rating that S&P may have had on the underlying issuer of the insured bond, or may be non-rated (NR) . The reduced number of ratings may reduce the liquidity of some National insured bonds. However, the bond insurance continues even though the bond insurer is no longer rated. To the extent that National has adequate reserves, investors will continue to have two payment sources. The majority of insured bonds are of BBB or A credit quality, which is considered investment-grade.

Cumberland will continue to follow developments in areas such as tax reform and infrastructure funding, as well as trends in pension funding strategies (or lack thereof), economic growth, and other factors that affect public finance and municipal bonds. As always, we invest only in high-quality bonds that are liquid, a strategy that enables us to move in and out of positions should we see a compelling credit or a structural need to invest in holdings or pull out.

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