Whirlwind is an understatement.
Harvey, Irma, and Maria were paramount in our minds during the quarter, but there were wildfires and earthquakes and other flooding here and around the world that really made one think about the choices people make about where to live and in many cases the lack of choice. It also made us consider weather variability, building codes and infrastructure sustainability. People have to live with what Mother Nature throws at them and make do with whatever emergency response systems, and other social structures are available to them. But people are resilient. As always, our thoughts go out to all those affected here and around the globe.
According to an S&P report[1], the federal government spent $209 billion to repair storm-related damage between 2000 and 2015; more than half of that amount was for the destruction Katrina wrought and a quarter for Sandy’s toll. Aid comes from a combination of funds funneled through FEMA, the Housing and Urban Development Corp., and the Small Business Administration and is further supplemented by the National Flood Insurance Program and special appropriations enacted by Congress, such as the $4.5 billion allocated to the Department of Transportation to rebuild roads after the 2005 hurricane season. It will be quite a while until the full damages and costs of the recent storms will be determined. On Tuesday, Sept. 26, the White House approved 100% funding of FEMA aid to Puerto Rico, so there are no matching funds required of the financially beleaguered Commonwealth. The same goes for the US Virgin Islands. Usually the recipient is required to contribute 10% to 25% of the total aid, depending on the type of project, and that will be the case for Florida and Texas. Please go to the Market Commentary section of our website to read our numerous accounts related to the hurricanes: http://cumber.com/category/market-commentary/.
Not only were the winds from three major hurricanes swirling in the third quarter, but the municipal credit markets were active, too. There were state rating changes, improved stock market performance that helped pension funding for a change, and a state capital city considering bankruptcy. Affordable Care Act repeal was feared to affect the 31 states that have expanded Medicaid, which now have a greater dependence on federal Medicaid payments. The bond market also dealt with the perception of overall improvement in the economy and employment, while the Municipal Securities Rulemaking Board offered a new service to make the municipal market more transparent. The Equifax hacking shined a light on the need for vigilance and increased cybersecurity. This is especially true for our municipalities, which not only have access to citizens’ personal information but also provide water and electric service, transportation, healthcare, and other social and infrastructural services that may be vulnerable to hacking.
State Ratings
There are still two states that have not approved a budget for the fiscal year beginning July 1, 2017 – a full three months into the fiscal year! They are Pennsylvania and Connecticut.
Pennsylvania (rated Aa3/A+/AA- by Moody’s, S&P and Fitch, respectively) has again failed to pass its budget on time. Because of short-term liquidity concerns and its chronically late budgets, S&P downgraded Pennsylvania to A+ from AA-. It is now one of five states that have at least one rating below the AA category. Short-term liquidity needs have arisen because the state started the year with a large deficit and has adopted a spending plan but does not have the revenues to pay for it. There is discussion of some additional taxes and internal borrowing to balance the budget, but no word on when a final budget might be hammered out.
The governor of Connecticut (rated A1/A+/A+) vetoed that state legislature’s most recent budget proposal because not enough aid had been designated to cities and other municipalities. The state is operating under an executive order that limits spending to available revenues. As we have written in the past, Connecticut suffers from declining population and employment, high pension obligations, and other fixed costs, even as it remains one of the wealthiest states. Reduced state aid to municipalities could lead to downgrades of various jurisdictions in the state, including the already downgraded capital city of Hartford.
In August, Hartford hired counsel known for its prowess in bankruptcy and restructurings. The city was downgraded two times during the quarter, most recently to Caa3 by Moody’s and to CC by S&P. Approximately half the property of the capital city is exempt from taxation because the buildings are owned by government-related entities. Historically, about half the city’s revenue was in the form of state aid, which so far this year is limited and could be further reduced, given the state’s budgetary issues. There is a note payment due in October, and the city reportedly does not have enough liquidity to make the payment – thus the downgrades by Moody’s and S&P, which reflect the threat of default and less than 100% recovery. Cities in Connecticut need specific state approval to enter into bankruptcy, and a negotiated restructuring of its debt may be the most likely outcome for Hartford. Assured Guaranty, which insures the majority of the city’s outstanding debt, and other bond insurers have offered to work on a restructuring.
Other State Rating Changes
Alaska (rated Aa3/AA/AA+): In July both Moody’s and S&P downgraded the state’s ratings due to the continual lack of agreement on reforms to bring the state into structural balance (where revenues cover expenditures) and to reduce dependence on substantial reserves that have accumulated from taxes, royalties, and other levies related to oil production. The declines in oil prices and a protracted economic slump have led to substantially reduced income to the state, and reserves have been drawn down to balance operations for many years in a row. The large reserves also provide investment returns to the state. Both rating agencies have negative trends on their ratings, indicating that if the drawdown of reserves continues, the ratings could be further downgraded.
Oklahoma (rated Aa2/AA/AA) was downgraded by Fitch to AA from AA+, again due to the downturn in the energy markets and drawdown of its reserve levels. Stable rating outlooks reflect the expectation that the state will take action to reduce its structural imbalance.
As we have noted in the past, states generally have stable ratings, but for the past couple of years that has not been the case as pension and OPEB liabilities have grown, and those states dependent on revenues associated with oil were blindsided by price erosion.
On the bright side for states, Wisconsin was upgraded by Moody’s to Aa1 in August, while in September S&P assigned a positive outlook to its Michigan’s AA- rating. And after numerous ratings downgrades, the outlook on Illinois’ BBB- S&P rating was changed to positive due to passage of the state’s budget, while Fitch and Moody’s removed their BBB/Baa3 ratings from being under review for a potential downgrades. Additionally, in a reversal to a longstanding trend, the outlook on New Jersey’s A- rating was changed to positive by S&P. S&P recognized that although New Jersey has one of the most poorly funded pensions at only 40% on an actuarial basis, projections show that the plan should stabilize or improve over the next year.
Higher returns offered some bright news for pensions. According to Moody’s[2], average pension plan investment returns in fiscal 2017 (most municipalities have a fiscal year from July 1 to June 30) were in the range of 12%, compared with average returns of 2.4% in 2015 and 0.5% in 2016. Moody’s estimates that the higher return will lead to a 7% decline in total state adjusted net pension liability (ANPL), quite a relief from recent years’ increases. However, because of years of paying less than the annually required amount to keep funding levels stable or increasing, and because investment returns have fallen below pension plan return assumptions, those states that have large unfunded pension liabilities will continue to be challenged.
Bond Insurers – Assured Guaranty Municipal (AGM) and National Public Finance Guaranty: The devastation in Puerto Rico cast a light on the bond insurers once again, as did the Commonwealth’s default on its debt last year. However, the bond insurers remain well capitalized and have had their portfolios stress tested internally and by the rating agencies, even for a 100% loss on Puerto Rico. Remember, the bond insurers pay regularly scheduled principal and interest on municipal bonds that have serial or annual repayment terms over 20 to 40 years – and the bond insurers are not required to accelerate. This minimizes draws on its liquidity and gives the defaulting municipality time to regain its financial footing. Assured’s $12 billion in claims-paying resources compares with over $298 billion in net par insured as of March 31, 2017, which is a large number however if the insurers do pay a claim, we emphasize it is only for annual debt service. Puerto Rico exposure is only 1.9% of net par insured, while the exposure to Hartford is less than 0.14%. The bond insurers often help provide an orderly exit from a distressed situation; and the companies are generally repaid, albeit over a period of time, for funds used to cover debt service. Despite an uptick in reported defaults and bankruptcies, the municipal default rate remains very low. Moody’s, in its annual default study dated June 27, 2017, reports that although municipal defaults and bankruptcies have become more common, they are still overall rare. The five-year municipal default rate since 2007 was 0.15% which compares to 0.07% for the period 1970 to 2016. The bond insurers insure a large, diverse portfolio of municipal bonds with credit quality predominantly in the single A and triple B categories. Further, the insurers have surveillance staff that monitors credit quality and can often help solve identified problems to avoid distress.
The municipal market is at times not as transparent as the corporate bond and equity markets. Municipalities are not regulated by the SEC, which requires certain filings and disclosures (although firms that underwrite municipal bonds are required to disclose numerous data points). Individual state standards do not always require audited financials and regular reporting. However, efforts are being made by industry players to increase transparency, and municipalities themselves understand that better market access is a benefit of transparency. In early September the Municipal Securities Rulemaking Board (MSRB) unveiled market-wide trading statistics (price, yield, volume, trade size) for its Electronic Municipal Market Access system (EMMA). This is a welcome addition to the other information that is available, including official statements, financial reports, call and other notices, and interim disclosures such as for rating changes. MSRB maintains a free website so that there can be public access.
At Cumberland we continuously monitor municipal credit and market developments – and increasingly focus on unexpected events such as multiple consecutive storms. We consider the short- and long-term ramifications of these developments, and we evaluate them in the context of how they may affect our municipal holdings and present opportunities to preserve wealth and increase returns.
Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
Email | Bio
[1] S&P Global Ratings An Overview of U.S. Federal Disaster Funding dated September 19, 2017
[2] Moody’s Investor Service Stable outlook for states reflects continued slow revenue growth dated September 7, 2017 page 7
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