Cumberland Advisors Market Commentary – 4Q 2019 Credit Commentary

Author: Patricia Healy, CFA, Post Date: December 30, 2019
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Pensions, budgets, state ratings, climate adaptation, cybersecurity, and investing

 

Market Commentary - Cumberland Advisors - Q4 2019 Municipal Credit Commentary

This fourth-quarter commentary continues discussion on key themes of the year. Many of the themes are long-term in nature and reveal the need for governments and businesses to continue to evolve. Pensions, cybersecurity, climate resiliency, evolving demographic changes, and a globalized world as well as technological development, AI, and digitization will continue to challenge us all to adapt. Technological advancements combined with improved transparency at the corporate and government levels will provide investors with opportunities to make decisions with fuller information.

Pensions continue to be one of the biggest looming issues, not just here in the United States but around the world. Japan recently reduced its discount rate on pension calculations because investment returns have fallen below historical levels. The recent strikes in France highlight the sensitivity of pensioners to any reduction in their benefits. And here in the US, teachers have struck in multiple places because they think pay and benefits are not growing enough.

Affordability issues add to the difficulty of US municipalities moving away from defined-benefit pension plans that are still viewed by civil servants as an important part of their compensation packages. Our citizens have gotten used to having a government responsible for saving for the future for us. Because that attitude is so imbued in our collective memory and because the financial crisis reduced many Boomers’ savings and investments, a substantial portion of the populace may not have the funds to afford the living and healthcare expenses that come with longer life expectancies. Will this trend bring back dependence on the family, or will it lead to even more dependence on the government and social service spending?

Even Japan is telling its citizens to take more responsibility for their retirement, since government pensions are expected to fall short because of the low birth rate (fewer workers to support retiree pensions), lower corporate contributions, longer life expectancies, and lower worldwide interest rates (https://www.japantimes.co.jp/news/2019/06/04/business/financial-markets/japans-pension-system-inadequate-aging-society-council-warns/#.XgZAE_x7lPY).

In the US, the extended General Motors strike resulted in some concessions to unions but not in the areas of pensions and where and how the company operates (https://www.wsj.com/articles/for-gm-the-strike-was-worth-it-for-the-long-run-11572627351?mod=searchresults&page=1&pos=6). Companies and employees need to be mindful of the needed flexibility to change in the face of ever-increasing technological developments, too.

State Pensions

The Pew Charitable Trust recently reported that many state pension funds have been reducing their investment-return assumptions (discount rates) to bring them closer to historical levels. That reduction increases the estimate of the unfunded liability as well as the annual contribution that the state should make to the pension so that the funded level does not fall even further. Lowering the discount rate is realistic and improves funding as long as the state budgets for the full annual contribution! These larger annual contributions can crowd out or compete with other spending needs. In our credit decisions we regularly consider the unfunded level of a municipality and how the municipality is addressing it. For example, we do not buy State of Illinois and some other state GO bonds because of outsized pension and budget issues, and thus we have avoided numerous downgrades over the years.

Illinois had ratings of AA by S&P and Aa by Moody’s in 2009, but by 2017 the state was downgraded all the way to BBB-/Baa3, where the ratings sit today. Similarly, New Jersey went from high ratings in the double-A categories to A-/A3 by 2017. Connecticut left the ranks of AA and sits at A/A1, while Kentucky’s ratings sit at A/Aa3.

US states may have a bit of a reprieve for funding competing demands. The National Association of State Budget Officers (NASBO) reported that state budgets grew by 5.9% in the 2019 fiscal year to about $2.1 trillion, the biggest annual increase since the recession and up from 3.7% growth in 2018. The report notes that states directed more to transportation projects, pensions, and reserves. We have observed that the continued improvement of rainy-day funds have been contributing to upgrades, and it is heartening to see that some infrastructure projects are being funded without an infrastructure plan. The state upgrades noted below both included an increase in reserves that contributed to the upgrades.

NASBO also reports that fiscal 2020 (most states have a June 30 fiscal year end) revenues are expected to grow 4.8%, slower than in 2019 but better than in 2018.

As the new year opens, governors will start giving their state of the state addresses and release executive budget plans. Continued growth is expected; however, many wonder how long the present expansion can last, so the trend of building and preserving reserves is expected to continue. In developing budgets, managers assess both the national and local economies and the health of local businesses and incorporate these assessments into budget expectations.

State Rating Changes

Arizona – upgraded by Moody’s to Aa1 from Aa

The upgrade reflects the state’s continued economic growth, the rebuilding of its reserves, and the reduction to its already-low debt burden. Arizona significantly increased reserves, in large part through the growth of its diverse economy over the last five years. Also, the state has paid down debt incurred prior to and during the recession, while limiting new borrowing. Other key factors in the Aa1 rating include below-average pension liabilities and demonstrated budget discipline.

Nevada – upgraded by Moody’s to Aa1 from Aa and by S&P to AA+ from AA

The upgrades reflect the state’s strong and growing economy, strong employment and population growth, and an increase in rainy-day reserves. The state also has moderate debt and pension burdens. Economic concentration in gaming and tourism add volatility to the revenue structure, but that is balanced by strong governance practices.

Battling the effects of climate change

A December 4th New York Times article started like this: “Officials in the Florida Keys announced what many coastal governments nationwide have long feared, but few have been willing to admit: As seas rise and flooding gets worse, not everyone can be saved. And in some places, it doesn’t even make sense to try.” The article was about Sugarloaf Key, which is in the process of likely deciding not to raise a three-mile stretch of road to protect the 12 homes along the road. The cost is prohibitive. To keep those three miles of road dry year-round in 2025 would require raising the road by 1.3 feet, at a cost of $75 million, or $25 million per mile. Keeping the road dry in 2045 would mean elevating it 2.2 feet, at a cost of $128 million. The debate about what happens to those homes and who pays or loses will remain lively, not just for Sugarloaf Key but for all municipalities that need to manage climate adaptation, including fireprone areas. (This year’s fires were not as monumental as it was feared they might be: See our “Fire and Water” commentary, https://www.cumber.com/cumberland-advisors-market-commentary-fire-and-water/.)

Municipal Markets Analytics, Inc. (MMA) notes that yield spreads between 2-year and 10-year bonds, which can be a measure of longer-term risks, are greatest for the states of Illinois, New Jersey, and Connecticut because of headline risk, which includes the sheer liability of pension shortfalls, as well as other budget problems. However, MMA notes that the differential in short- and long-term yields for North Carolina and Florida do not reflect potential long-term effects of climate change, even though both states have coastal areas with high property values and intensely concentrated economic activity. Perhaps investors are not worried about the long-term risks to the credit quality of those states because their economies and financial operations are currently strong and the states both have AAA ratings. Time will tell if the states and folks in those states adapt in a way that protects credit quality and ratings. As with Sugarloaf Key, the local response with or without the guidance of the state will be case studies in addressing climate adaptation risk.

Q4-2019-Credit-Commentary-Chart

In Sarasota, the Climate Adaptation Center (CAC) was introduced by means of the Global to Local: Adapting to a Warming Climate Conference in February (https://www.interdependence.org/events/browse/adaptive-climate-change/). The CAC intends to be one of the first of many regional centers bringing industry, academia, and government together in joint session to foster understanding of climate change and its Florida-specific impacts. The hope is to help society adapt to and mitigate the worst impacts in the most expeditious and cost-effective ways.

Cybersecurity

Cybersecurity risk is being addressed by numerous states and municipalities, and it remains a risk municipalities cannot afford to ignore. The State of Louisiana suffered a cyberattack/ransomware event on Nov. 18, which resulted in the state’s closing down agency systems for days while dealing with the attack.
The following are positive developments that will help address cyber risk.

  • The State of Ohio set up the Ohio Civilian Cybersecurity Reserve Force as a section of the National Guard. In a cyber event the 50 reservists currently in the program would be deployed while continuing to receive pay for their normal employment during that time. The state budgeted $100 million for the effort in 2020 and $500 million in 2021. Ohio also now has a chief information security officer (CISO), a position that is becoming the norm for municipalities and companies.
  • In Washington State, municipalities are required to have cybersecurity audits.
  • The Florida Center for Cybersecurity (Cyber Florida), hosted by the University of South Florida, is working on education, research, and outreach.

Credit Spreads

At Cumberland we are investors in high-quality bonds; however, we do pay attention to the high-yield market, which has performed well as investors reach for yield. This trend causes credit spreads – the difference in yield between high-quality and low-quality bonds – to narrow. We have noted for some time that corporate bond quality has trended down over the past few years, mostly due to increasing leverage. (See our Q3 Credit Commentary:  https://www.cumber.com/q3-2019-municipal-credit-bond-market-dynamics-natural-disasters-green-bonds-state-rating-changes-an-update-on-single-ratings/.) And just last week, numerous market outlets, including the rating agencies and broker dealers, commented that the high-yield bond market seems to have gotten ahead of itself and could be due for a correction.

Taxable municipal bonds still have relative value compared with corporate bonds in the longer end of the curve, an advantage of about 10 to 15 basis points. Taxable municipal bonds are not on all investors’ radar screens, and municipal bond issue sizes are not as large as those for corporate bonds, so large taxable funds do not participate as much.

At Cumberland we focus on high-quality municipal and corporate bonds because that quality is important to our clients. High-quality bonds are also more liquid, which is important for our active total return bond-management strategies.

All of us at Cumberland wish you a happy and healthy new year.

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