Municipal bond credit quality remains relatively strong, as indications are still that upgrades are outpacing downgrades. S&P and Moody’s have both recently issued comments that corporate credit quality is weakening.
Per S&P, credits rated AAA to B- with negative outlooks or CreditWatch-negative assignments have been increasing, indicating a negative bias. Similarly, Moody’s estimates that the third-quarter downgrade-per-upgrade ratio for all US high-yield credit-rating revisions increased to over 2.25:1 from January to September 2019; and this is excluding downgrades that were for special events rather than fundamental weaknesses such as in financial operations or business position. The ratio is up from 1.09:1 for 2018.
Interest rates have been low and declining, and corporate and municipal issuers are taking advantage of the positive market conditions. Increased issuance sometimes indicates that market players think rates are attractive and are going to go higher. Municipal volume this year is expected to reach $400 billion, much higher than beginning-of-the-year estimates of $340 billion. The increase has occurred because municipal issuers are rushing to market with taxable municipal bonds to refund outstanding tax-exempt bonds. Remember, the Tax Cuts and Jobs Act eliminated municipalities’ ability to issue tax-exempt bonds to advance-refund outstanding municipal bonds. Continued economic growth here in the US; low unemployment, with employers having a hard time finding the workers they need; and inflation creeping up may all indicate higher rates going forward, notwithstanding the drag on the economy from tariffs and slowing European growth.
Is this the bottom for interest rates, despite low worldwide rates? See John Mousseau’s video, https://youtu.be/en4MJQiShzk, and his quick synopsis of third-quarter municipal market activity, https://www.cumber.com/cumberland-advisors-market-commentary-3q-2019-review-total-return-tax-free-municipal-bond/.
Natural Disasters
The 2019 hurricane season will be with us till the end of November, and the trend of storms moving slowly and causing major flooding has continued. Dorian soaked the Carolinas after battering the Bahamas and caused major damage and lost lives. Imelda soaked parts of Texas and Louisiana with estimates of over 40 inches of rain in South Texas in 72 hours. Damage estimates are still coming in. A presidential federal disaster was declared for the six affected counties in Texas. This declaration entitles those with losses to FEMA funds and other aid. FEMA aid is important in the recovery of areas affected by natural disasters. FEMA aid, receipt of insurance proceeds, and the pick-up in economic activity that occurs with rebuilding have been instrumental in maintaining credit quality in many municipalities that have experienced natural disasters.
Hurricanes are just one of the categories of disasters affecting the US. There was the extreme flooding that caused the failure of levees and crops in the Midwest, and then extreme heat. Wildfires in California have flared up again, this time in the San Fernando Valley, while PG&E has cut off power to many in Northern California to avoid high winds sparking a wildfire. Mudslides, earthquakes, surging seas, and sea level rise are some of the natural disasters that municipalities and investors need to be concerned with.
The Midwest is being affected by tariffs and strikes in addition to natural disasters. The ongoing GM strike has cost the company over $1 billion by some estimates and could be a drag on the economy of Michigan, which is home to numerous GM plants. Much depends on the length of the strike and the result of contract negotiations.
Elevated heat levels are affecting the nation, too. Moody’s recently produced a map of areas of the country where local government debt has been affected by extreme heat events, showing that the greatest exposure is in the Midwest, although Arizona, Florida, and Texas also have some hot spots.
[caption id="attachment_49978" align="aligncenter" width="474"]
Moody’s map of areas of USA where local government debt has been affected by extreme heat events, showing that the greatest exposure is in the Midwest, although Arizona, Florida, and Texas also have some hot spots.[/caption]
Rating agencies continue to include climate resiliency in their rating considerations.
New Orleans was upgraded by Moody’s in September 2019, in part because of its increased resilience: “Investments of over $14 billion by the federal and state governments along with the city have boosted the city’s resilience to environmental risks, as well as continued strategic planning for further capital improvements to mitigate the impact of environmental events. These initiatives on top of the city’s improved financial profile positions the city as better prepared to manage future challenges associated with its significant exposure to environmental risks.”
State and local governments sold $1.9 billion of so-called green bonds during the third quarter. We have mentioned in the past that issuers are not seeing a reduction in yield for selling green bonds and that this may be partially attributable to the low level of interest rates and minimal spread differential between credits. However there is growing awareness by issuers that many investors want their investments to be impactful, and thus the designation could help investors desiring to have socially meaningful investments decide among bond offerings and eventually help the trading value of issuers’ green bonds.
State rating changes
State of Washington upgraded by Moody’s to Aaa from Aa1 (S&P AA+, Fitch AA+)
The upgrade by Moody’s to the highest of ratings reflects a significant increase in financial reserves; the exceptional growth of the state’s economy, driven largely by the technology sector in the Seattle metro area; and the consequent diversification of the state’s economy, with lessened dependence on Boeing. Above-average wealth and income levels and the state’s strong fiscal governance practices are also important considerations. Debt levels are above average but have been declining relative to the 50-state median, and the state’s combined debt and pension liabilities and its fixed costs are comparable to national medians.
State of California upgraded by Fitch to AA from AA- & Moody’s to Aa from Aa3 (S&P AA-)
California has one of the most cyclical ratings, and its ratings change often. Looking at only Moody’s ratings, since 1980 the state’s rating has changed 18 times. The range has been wide, from Aaa to Baa1. The last time the rating was Aaa was in 1992, when it was downgraded to Aa1. The rating was first downgraded to Baa1 in 2003. It crept up to A1 by 2006 but headed back to Baa1 in 2009.
The upgrades of California’s GO bond ratings reflect the improved fiscal management that has become institutionalized across administrations, which may allow the state to better withstand economic and revenue cyclicality by using temporary tax increases and a disciplined approach to limiting ongoing spending growth. The state eliminated the overhang of budgetary borrowing that had accumulated through two recessions and continues to set aside funds in its budget stabilization account (BSA). And of course, both rating agencies point to California’s large and diverse economy, which supports strong, though cyclical, revenue growth prospects and a moderate level of liabilities.
Louisiana outlook on Aa3 rating changed to positive by Moody’s (S&P AA-, Fitch AA-)
The positive rating outlook on the state’s bonds reflects significant improvement in Louisiana’s financial position, its recent record of closing budget gaps with recurring solutions, and the relative stabilization of its economy. Moody’s expects the state to continue to balance its budget, but also expects reserves to continue to fall short of a cushion commensurate with a volatile economic base. The state has a large and diverse tax base and moderate combined debt and pension burden. The rating is lower than the average state rating because it also reflects the state’s vulnerability to volatility in the energy sector and its below-average socioeconomic profile, including slow population growth, low per capita personal income, and low labor force participation rate.
Alaska downgraded by Fitch to AA- from AA, & Moody’s assigns a negative outlook to its Aa3 rating (S&P AA)
The downgrade of Alaska’s GO rating is based on deterioration in the state’s advancement of financial policies that ensure stable performance and continued resiliency through future economic downturns, following an almost six-year recession and attendant revenue weakness. Alaska stands in contrast to the states of Louisiana and California, which have put big efforts into bettering their budgeting and fiscal management.
In Alaska, revenue and economic weakness began in 2013 and was exacerbated by the extended effects of sharply lower crude oil prices beginning in 2014. Operating revenue remains anemic, and the administration’s commitment to funding a full permanent fund (PF) dividend payment despite projected revenue loss has contributed to the enactment of a fiscal 2020 budget that includes deep cuts to core state services. We mentioned this situation in our 2Q credit commentary (https://www.cumber.com/cumberland-advisors-market-commentary-q2-2019-credit-commentary/), when the state pulled funding from its university system, causing downgrades in the system’s rating. The state does have substantial reserves from past oil royalties and can draw on a reserve fund to address large revenue shortfalls. Moody’s notes in its assignment of a negative outlook that the new focus on distributing increased shares of permanent fund earnings to residents, combined with political paralysis and other factors that prevent a return to a balanced budget, may make the current fiscal approach unsustainable over time, particularly in the event of financial market downturns or an inability to sufficiently contain spending growth. Moody’s further comments that Alaska’s credit position benefits from an ability to fund operations partly from earnings derived from the Alaska Permanent Fund. Credit challenges, such as a narrow economic base, comparatively large net pension liability, elevated exposure to climate change, and high reliance on the state’s oil production industry, have been largely offset by sizable budgetary reserves.
Single Ratings
Municipal Market Analytics (MMA) estimates that the percentage of bonds selling with only one rating continues to increase, up from 21.6% in 2017 to 23.6% in 2019. MMA further notes that about 8.3% of bonds have no ratings at all. This trend is reflective of the strong demand for bonds and reduced supply, as well as the small difference in interest rates for bonds of different ratings. This difference is referred to as the “spread” among differently rated quality credits. We suspect that when interest rates rise and spreads widen, the single-rated bonds could widen even more. We try to avoid single-rated bonds because they are not reviewed as often; and if the single rating agency changes criteria, the bond rating could be subject to larger changes than bonds that have more than one rating.
At Cumberland Advisors the majority of our municipal bond holdings, both taxable and tax-exempt, have AA ratings, which generally imply a diverse economic base and strong financial performance. The high credit quality of our portfolios allows us to practice active bond management, as high-quality bonds are generally more liquid. (See https://www.cumber.com/cumberland-advisors-market-commentary-the-rise-of-separately-managed-accounts-2019-update/.) We evaluate markets and trends, follow credit developments and related news items, incorporate them according to our experience, and employ those factors in our buy and sell decisions.
Patricia Healy, CFA
Senior Vice President of Research & Portfolio Manager
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