The credit cycle does not yet seem to have turned; at worst it is mixed. Last quarter we were wondering in our Q1 commentary, will this be the year credit trends reverse?
Corporate spreads are tight; job growth has been strong enough to keep the Fed from easing; consumers are spending, albeit more slowly and getting accustomed to higher interest rates. There is the underlying issue that the housing market is stuck, and younger folks are spending instead of saving for a down payment and taking on mortgages, while those who have low-rate mortgages are loath to give them up and have slim pickings for another abode. There is some weakness in private, sovereign, and other credit markets as well as the office segment of commercial real estate and the banking sector, which has bifurcated credit quality between the big banks, which have more flexibility and products, and the regional banks that are not faring as well. Early-July economic releases, which show signs of a cooling job market, and the third straight month of rising unemployment may indicate the economy is slowing. The ups and downs in economic data affected muni market returns as well – please see John Mousseau’s commentary “Two Tales in a Quarter.”
On the muni front governments and agencies are determined to maintain strong fund balances or reserves and are cutting costs or raising taxes to have balanced operations in the face of the drawdown of pandemic funds, higher wages and prices, and slower economic growth. Some municipalities are experiencing increasing population, and that might be causing growing pains; then there are some that have declining demographics, cost overruns, or management issues, resulting in lower fund balances and, potentially, downgrades. For example, the outlook on Memphis’ AA rated GO bonds was recently changed to negative by S&P for budgetary imbalance and reduction of reserves as well as continuing expense pressure and loss of population. If the city does not improve budgeting and build up reserves or improve desirability to attract more residents, there is the chance of a downgrade.
We would expect to see more budgetary-stress and reserve reductions for municipalities if the economy were to go into a recession. A late April S&P report titled “US Public Finance Credit Quality Makes the Smallest Gain Since 2021” noted there were still more upgrades than downgrades in Q1 2024, at 153 upgrades compared with 79 downgrades.
One of the most notable events of the quarter for muni bondholders was the First Circuit Court of Appeals overturning a lower court’s ruling that had cast doubt on bondholders’ security. The court affirmed that bondholders do have a claim on the net revenue of the system. The ruling was regarding utility bondholder claims in the bankruptcy of the Puerto Rico Electric Power Authority (PREPA). The lower court had ruled that only monies collected and held in funds totaling $2.3 billion were available to bondholders, negating the net revenue pledge. This ruling was contrary to what was understood by market participants, from issuers to lawyers to investors. It was a relief to the market when the First Circuit court reaffirmed that the security interest for bondholders was the revenue-generating ability of the authority, such that the claim is $8.5 billion, reflecting unpaid principal and interest. Very few municipalities enter bankruptcy, so this ruling helps solidify the market’s understanding of bondholder protections.
The NY Metropolitan Transportation Authority (MTA) congestion pricing, which many accepted as a fait accompli, was abruptly halted by New York State Governor Hochul on June 5th. The surcharge (toll) on vehicles traveling below 60th Street in Manhattan was supposed to go into effect on June 30. It was estimated to generate $1 billion annually, which would contribute $15 billion for the MTA capital plan. In nixing the congestion pricing, the governor stated that it was bad timing and would be a burden to citizens and commuters. Last year the governor reaffirmed verbally and by increasing state grants that the MTA was extremely important to the state, which calmed rating agencies and market participants. That affirmation remains important, because the funding to replace the revenue that would have been generated by congestion pricing has yet to be established. The MTA meanwhile is publicizing cuts to service and the capital plan that would need to be made if the state does not find an alternative or reimplement congestion pricing. Given the importance of a safe and resilient mass transit system to NYC, it is expected the state will produce alternative funding. It is interesting to note that while many motorists praised the move, those concerned about the climate lambasted the governor for halting congestion pricing, as many other large cities such as London have successfully implemented it. MTA is a large issuer, with about $40 billion in bonds outstanding as of June 20 under various names, security provisions, and ratings.
We have written in the past about holding bonds with only one rating, which can leave an investor subject to the changes of that sole agency, and that there is less regular surveillance than if a bond is rated by two or more agencies. Last quarter we discussed the shortage of accountants for both corporations and municipalities. A May 2024 report by the Municipal Securities Rulemaking Board concluded that municipal issuers are increasingly late in filing audited annual financial reports, and in June Moody’s discussed how late financials can be a sign of credit weakness. One of our muni bond holdings had only one rating, which was AA- by S&P. Two months ago the rating was withdrawn for lack of timely audited financial statements, so we were left holding a bond with no rating. We contacted the issuer to see what their plan was and felt comfortable that the bonds would be rerated upon S&P receiving and viewing audited information. We thought that the new rating might be lower than AA-, since lack of timely financials may reflect poor governance; however, the AA- was reinstated. There were some rumblings that the state auditor was not timely in auditing many municipalities in the state, but the ratings agencies cannot always depend on draft or unaudited financials. The municipal market has about $4 trillion in bonds outstanding by over 50,000 issuers, and many of them are small, so it is not unusual to hold bonds with only one rating.
State Ratings
State rating actions this quarter were mostly positive and recognized better budgeting practices and increases in reserves, with one negative outlook change reflecting a planned drawdown in reserves for the State of Maryland. Pension funding was not as prominent as last quarter as an explanation for rating and outlook adjustments, and progress in that area was noted in a number of cases. We highlight state rating actions each quarter because of the importance of the overall economy, financial operations, and funding commitments to local governments.
Arkansas’s outlook was revised to positive from stable by S&P. The state has ratings of AA by S&P and Aa1 stable by Moody’s. The S&P positive outlook reflects Arkansas' demonstrated strong budget management practices and financial resiliency across economic cycles, along with an exceptionally high accumulation of reserves.
Maine’s GO rating was upgraded to Aa1 by Moody’s with a stable outlook. The upgrade was based on sustained financial improvements including a large increase in reserves and solid pension contributions practices, counterbalancing economic and fiscal risks stemming from an ageing population. The state has AA stable and AA positive ratings from S&P and Fitch, respectively.
Alaska's outlook was revised to positive by Moody’s, and the Aa3 rating was affirmed. The improved outlook is based on an improved reserve fund, conservative financial management, substantial reductions in long-term liabilities, and progress on large North Slope projects that will support and extend petroleum revenue – the major resource of the state. S&P rates the state AA stable and Fitch rates it A+.
Connecticut's outlook was revised to positive by Moody’s and Fitch on their Aa3 and AA- ratings, respectively. The positive outlooks reflect the state's prudent financial policies, increased reserves, and consistent pension contributions that have begun moderating the state's very high unfunded pension liabilities; and Fitch expects good revenue growth above their inflation expectations. S&P rates Connecticut AA- stable.
Maryland’s outlook was revised to negative by Moody’s. The change on the Aaa rating was driven by expected structural imbalances and planned depletion of the general fund surplus and reserves by about 60% from fiscal 2023 through fiscal 2025, which threatens to undermine performance relative to peers. S&P and Fitch both rate Maryland AAA stable. We note that a triple-A rated municipality has many strengths and resources; consequently, the likelihood is that the state will put its house back in order.
At Cumberland Advisors we invest mostly in high-quality municipal bonds, including some taxable munis in our taxable strategies, such that the average client portfolio credit rating is AA. We take a top-down approach to analysis and will be watching global developments, the economy, and interest-rate movements, as well as how municipalities are addressing longer-term risks.
Patricia Healy, CFA
Senior Vice President of Research & Portfolio Manager
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