Illinois to sell debt as fiscal woes worsen in coronavirus outbreak

Illinois to sell debt as fiscal woes worsen in coronavirus outbreak

by Karen Pierog – May 05, 2020

Cumberland Advisors In The News - John Mousseau

CHICAGO, May 5 (Reuters) – Illinois, the U.S. state in the worst fiscal straits even before the COVID-19 pandemic, faces high borrowing costs when it sells $2.2 billion of debt starting on Wednesday, in part to deal with the economic fallout from the virus.

A BofA Global Research report on Friday said: “Ultimately, we think there is a better than 50-50 chance that Illinois will be downgraded to below investment grade by the end of 2020 by at least one rating agency. That does not mean, however, that we expect the state to default on its debts.”

As long as it retains one investment-grade rating, most funds can continue to buy the state’s debt, according to John Mousseau, president and CEO of Cumberland Advisors. The fact that Illinois bonds have “yield in spades” could draw overseas buyers thirsting for yield to the $300 million of taxable bonds the state is selling next week, he said. “Having a wider audience, particularly if you are a credit that has issues, is better,” he said.

Full story at Reuters: https://www.reuters.com/article/usa-illinois-bonds/illinois-to-sell-debt-as-fiscal-woes-worsen-in-coronavirus-outbreak-idUSL1N2CI2O0https://www.reuters.com/article/usa-illinois-bonds/illinois-to-sell-debt-as-fiscal-woes-worsen-in-coronavirus-outbreak-idUSL1N2CI2O0




Cumberland Advisors Market Commentary – COVID-19 and Municipal Credit Quality

Until recently it was unclear if the new coronavirus would reach the United states. Now we have 88 reported cases in the US, at least two without a clear connection to travel to China, and as of Sunday night two deaths; so we feel it is time to comment on the ability of US municipalities to withstand financial dislocations resulting from the virus. Please see https://cumber.com/category/market-commentary/ for numerous commentaries by David Kotok on COVID-19 and other virus-related discussions.

Market Commentary - Cumberland Advisors - COVID-19 and Municipal Credit Quality

Municipal credit quality continued to improve through the third quarter of 2019, per Moody’s and S&P, with upgrades still more prevalent than downgrades; and from our observations it seems that trend is persisting. One of the reasons for continued upgrades is the growth of rainy-day funds, or set-aside reserves. These balances can counter an unexpected decline in revenues from a reduction in employment or economic activity (think faltering income tax and sales tax revenue) or shocks to expenses (a bad snowstorm or other natural disaster). At the same time, corporate bond credit quality has drifted lower; and, as many economic pundits have opined, a shock from the virus could reduce employment in the US as supply chains are disrupted, consumers pull back on spending, and corporations reduce hiring. To the extent that these impacts materialize, they will affect the level of income and sales taxes that help fund municipal operations.

If the virus follows a SARS or MERS or flu trajectory, the economic dislocation should not last long, and economic conditions would likely rebound, with pent-up demand for certain products and services reversing the slowdown to some extent. An extended dislocation and decline in economic growth could cause reductions in financial flexibility, though we have a long way to go on that front, with the national unemployment rate at a low 3.5%. (See John Mousseau discuss current market conditions with Suncoast News here: https://www.cumber.com/cumberland-advisors-president-ceo-discusses-worst-week-on-wall-street-since-2008-financial-crisis/.)

As the virus takes hold in the US, federal and state aid to municipal health providers would also be expected to improve preparedness around the country and could help soften the blow to rainy day funds.

The healthy reserves of many states and cities are why we think municipalities are well positioned to weather some economic dislocation. We have mentioned numerous times that this build-up of reserves is a function of the memory of dislocations from the financial crisis. The drawdown of reserves to counter lower revenue growth would likely be met with expense reductions as well. The drawdown of reserves, in and of itself, should not result in a ratings downgrade, because a municipality should not be penalized for using a rainy day fund for its intended purpose. However, a municipality that continues to draw down reserves without a stated plan to replenish them may be subject to a downgrade if corrective action is not taken.

Other sectors of the municipal market, such as state housing agencies, utilities, airports, and toll roads, have also improved as a result of good growth and improved financial operations. Granted, there are municipalities that have been downgraded due to increases in debt, reductions in state aid, population declines, and poor pension funding, among other reasons. Consequently, it is important to differentiate among credits when investing.

What about our US healthcare system? How well are our municipal or not-for-profit healthcare systems and standalone hospitals financially prepared to cope with the virus? Municipal healthcare-related bonds are issued mostly by not-for-profit healthcare systems that have been growing and diversifying by acquisition and new construction projects. They are generally large and have been diversifying both geographically and with respect to product delivery (by providing insurance or acquiring doctor groups, for instance), all while trying to keep ahead of ever-mounting patient-information regulatory and technological requirements. Many of these systems have national or regional service areas, adding to diversification.

The rating or credit quality of the healthcare sector has been mixed, with some systems experiencing upgrades as acquisitions add to diversification and a better competitive position, and some systems experiencing downgrades because of increasing leverage and/or having become too large and thus more difficult to manage. There are also standalone hospitals in urban settings and rural areas, and the bonds issued for these institutions are sometimes secured by a general-obligation pledge of a municipality as well as by net hospital revenues.

We expect the effects of the pandemic to be uneven. Urban settings may have more resources to fight a pandemic; however, since more travelers pass through densely populated urban areas, the virus could be brought in and spread more rapidly. Conversely, a rural hospital may have little transmission in its service area, but does it have the resources to confront a viral breakout if one occurs? In a pandemic there would likely be a surge in virus treatment at the expense of higher-paying surgical procedures. An important metric to consider when evaluating healthcare credit is number of days of cash on hand. Many higher-rated credits have in excess of a year’s worth of cash to cover expenses, as well as investments whose value exceeds outstanding debt.

It is comforting, to some extent, to be hearing more news about preparedness efforts at states and cities, hospitals, and businesses. The Wall Street Journal had a comprehensive article today on US hospital preparedness: https://www.wsj.com/articles/widespread-coronavirus-cases-could-tax-u-s-hospitals-11582920055. At Cumberland Advisors, our business continuity plan has gone into place as we assess the ability of our employees to work remotely, and we have encouraged folks to stock up on nonperishables. Our location in coastal Sarasota, FL, has many of us conditioned to being prepared for disasters such as hurricanes.

The spread of the virus worldwide, travel bans, and self-imposed reductions in travel will likely affect airports. Airports in the US have various types of contracts with airlines, some that insulate the airport from declines in traffic, some that are are based on traffic, and others that have elements of both. Airports with contacts based on traffic generally have strong debt service coverage and liquidity. Ports have contracts with shippers, which generally include minimum obligatory payments. Enplanements at airports and tonnage through ports are leading indicators for the health of these systems regardless of the contracts and should be monitored for changes and for management’s response to changes in traffic.

At Cumberland Advisors, we are attuned to current developments and keenly aware of past history regarding epidemics and pandemics and the effects they can have on various sectors of the economy and on municipal credits. We will continue to take developments with regard to COVID-19 into careful consideration in our investment decision-making.

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


Upcoming event with Cumberland Advisors that features a panel with Patricia Healy…

Join Cumberland Advisors on Friday, March 20, 2020 for a program called “An Outlook on Energy Policy“. The event is held in partnership with the Global Interdependence Center, the University of South Florida Sarasota-Manatee, and with support from the Alliance for Market Solutions and First Trust. This half-day conference will explore investing in energy, policy approaches to climate change, and energy’s effect on Fed policy. “An Outlook on Energy Policy” will feature Danielle DiMartino Booth, CEO & Chief Strategist for Quill Intelligence LLC, Samuel Rines, Chief Economist, Avalon Advisors, Jim Lucier, Capital Alpha Partners, Former Congresswoman Gwen Graham, Former Congressman Carlos Curbelo, Jim Slutz, Director of Study Operations at the National Petroleum Council, along with other speakers and moderators.

More information and speaker bios can be found at the Global Interdependence Center website: https://www.interdependence.org/events/an-outlook-on-energy-policy/

We look forward to sharing with you an event filled with conversation, thought leadership, and valuable information.


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Cumberland Advisors Market Commentary – 4Q 2019 Credit Commentary

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
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Q3 2019 Municipal Credit: Bond Market Dynamics, Natural Disasters, Green Bonds, State Rating Changes, & an Update on Single Ratings

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.

Moody's Map of where local government debt has been affected by extreme heat events
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.

 

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
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




Cumberland Advisors Market Commentary – Q2 2019 Credit Commentary

The positive trend of upgrades to downgrades continues. S&P reported on May 8th that upgrades outpaced downgrades by 2.39 to 1 in Q1 2019, which compares to 2.09 to 1 for all of 2018. In our monitoring of rating agencies’ actions, this trend appears to have continued in Q2. Please refer to our Q1 commentary for a more detailed discussion of upgrades to downgrades and additional trend information: http://www.cumber.com/cumberland-advisors-market-commentary-q1-2019-credit-commentary/ .

Q2 2019 Municipal Credit Commentary

While the credit quality of municipal bonds continues to improve, the performance of the municipal market has also improved on technical factors, squeezed by high demand and low supply, and lower long-term rates. John Mousseau discusses this trend in a recent piece: http://www.cumber.com/cumberland-advisors-market-commentary-2q2019-review-total-return-taxfree-municipal-bond-the-big-squeeze/ .

Bond markets have priced in two or three additional rate cuts; however, we think the Fed will stick to being data-dependent (see What Does Data Dependent Mean? commentary by Bob Eisenbeis: http://www.cumber.com/the-june-2019-fomc/ ; and although there is recent mixed economic data, growth continues in the US. There may not be as many rate cuts as the market anticipates; so a lack of action by the Fed could cause the curve to steepen; and municipal yields, which had declined relative to Treasuries yields, could creep to higher levels.

Credit Quality
Municipal bond credit quality is higher on average than corporate bond credit quality is. Corporate ratings tend to change faster than municipal ratings do, possibly because there is more frequent and timely reporting by corporates (corporations file quarterly and municipalities annually). Additionally, as companies’ prospects decline or improve, there is a lag between when they conduct layoffs or resume hiring and when those actions affect municipalities. Now, there are signs that corporate credit quality may be turning and may presage a turnover in municipal credit quality.

In the nearby chart, Moody’s Ratings Distribution by Sector, shows that municipal bonds generally have higher ratings than corporate bonds.  The chart has the most recent published data and we expect when Moody’s publishes the 2018 chart it will show municipal ratings skewed higher in credit quality and corporate bond ratings skewed lower.

S&P Global, in its June 27 report “Trade Tensions Cloud the Outlook,” notes that downgrades, defaults, and negative ratings bias are up slightly. In contrast to state governments, which have not increased bonded debt levels, corporations have increased leverage; and some are experiencing declining margins, which have led to downgrades and could lead to more. For example, Oracle was downgraded by S&P to A+ from AA on continuing elevated leverage as a result of a large increase in share buybacks. And IBM was downgraded by Moody’s to A2 with its acquisition of Red Hat, which is expected to be strategically positive but represents increased leverage. Low interest rates and changes from the Tax Cuts and Jobs Act are helping to spur corporations to increase leverage.

Taxable municipal bonds can be a good alternative to corporate bonds, and we utilize them at Cumberland Advisors in our taxable bond strategies. We expect a continued supply of taxable municipal bonds to be available, because there are certain projects financed by hospitals, airports, universities, and other issuers that are not eligible for tax-exempt financing. Additionally, issuers can avoid the cost of jumping through compliance hoops required for tax-exempt financing; and with the present low level of rates, the difference in yield is not that great. The expected 2019 volume of taxable municipals is $45 billion, according to a Citibank estimate. This figure compares with tax-exempt volume of between $330 billion to $385 billion for 2019, according to a wide range of estimates. Although municipalities can no longer issue tax-exempt advanced-refunding bonds to refinance existing tax-exempt bonds, they can issue tax-exempt bonds to refinance Build America Bonds (BABs) which are taxable. Morgan Stanley Research in a June 10th report titled Mid-Year Supply Check-Up anticipates that $16 billion of BABs will be refunded in 2019 and somewhat offsetting that reduction in taxable supply is the expectation of $8 billion issuance of taxable municipal bonds to refund tax-exempt municipal bonds.

Budgets
Seven states began the year without a finalized budget, pointing up disconnects between factions of the government and potentially signaling governance weakness. The majority of disconnects this year revolved around educational and environmental concerns. Incidentally, the seven states have mechanisms in place to continue to operate (continuing resolution or continuing appropriation), whether by passing an interim budget or by having a law that requires the prior year’s budget levels to be used until a budget is passed. Both options may give legislators and governors relief from impending deadlines. In a report commenting on late state budgets, Moody’s notes that late budgets can reflect governance weakness and that some states are notorious for late budgets. Massachusetts is one of those states, and this year it put an interim budget in place through October, while the fiscal year began July 1. As of July 5th five states still had not passed a budget according to the National Association of State Budget Officers (NASBO). In addition to Massachusetts, the states are New Hampshire, North Carolina, Ohio, and Oregon.

Last year virtually no state budget was late – possibly because of midterm elections. The State of New Jersey passed its budget on time, for fear of a government shutdown; however, it did not do so without a dislocation. The legislature turned down the governor’s proposed “millionaire’s tax,” which some feared would push out some residents. The legislature also rejected extra deposits to the rainy day fund; however, a large payment was budgeted for payments into the pension system. As we have noted in the past, New Jersey has one the lowest pension funding levels of all states. For fiscal 2017, the most recent year for which comprehensive data is available, the level stood at 35.8% according to a June 27 report by Pew Charitable Trusts. This is the second worst level, just above Kentucky’s 33.9%, and just below Illinois’ 38.4%.

Positive economic growth projections have led to budgets based on continued expected revenue growth and increases in taxes and fees. Significantly, states have continued to bolster their rainy day funds in fiscal 2019. With the memory of the financial crisis still crystal clear, most budget proposals addressed one-time needs rather than instituting new programs that need to be funded with dedicated levels of increased revenue. There are headwinds to the positive growth, such as a potential business slowdown, possible reductions in federal aid as our national debt grows, and the demographics of an aging population, as well as looming liabilities such as pension and other post-employment benefits (OPEB)  funding needs and infrastructure projects.

Notably, the level of state net tax-supported debt has remained essentially flat since 2012 on various measures, including as a percentage of GDP, as a percentage of personal income, and as well as a percentage of debt service to expenditures. The flat level of net tax-supported debt is due to fiscal constraints, and it may also be that other fixed long-term liabilities, such as pensions and OPEB, which are now required to be reported in financial statements, are consuming a greater share of state budgets. Waiting for a federal infrastructure plan, states delayed projects which may have also contributed to the flat debt levels. In the chart below, note states’ rating levels compared with their debt levels and the components of those long term obligations.

State Ratings and Actions
Once again there were no rating changes or trend changes in state ratings in the quarter. Although, just after quarter end, Fitch downgraded Vermont to AA+ from AAA due to lower growth prospects of an aging population.  The Fitch rating is now inline with the Aa1 and AA+ ratings of Moody’s and S&P, and the trend is stable.  There were however other state actions taken that can have an effect on the credit quality of state related entities or localities.  On July 2, University of Alaska was put under review for a downgrade by Moody’s because the state’s budgeted payments to the university were reduced by 42%. This reduction is one among others proposed by the state to help reduce a $1.6 billion deficit and gain more structural balance. We have often noted that when states have some fiscal pressure, payments to their agencies and localities are subject to reduced state aid. Alaska is dependent on oil royalties for much of its revenue, and this revenue has been volatile and contributed to the state’s losing its AAA ratings a few years ago and to subsequent downgrades to Aa3 by Moody’s and AA by S&P.

Other examples of states restricting a local issuers’ flexibility include the State of Texas’s SB 2, which if passed would restrict local governments from increasing property taxes by more than 3.5% annually, down from 8% annually, without voter approval (there are exceptions for certain districts). Many Texas communities have been raising taxes above this level, and to the extent that additional growth doesn’t occur or reductions in expenditures aren’t implemented, financial cushions could erode.

The State of Florida passed legislation usurping the power of the Miami Dade Expressway Authority (MDX) to raise rates and build projects by replacing it with the Greater Miami Expressway Authority (GMX), mandating a toll decrease, and allowing toll increases only to meet the rate covenant, which requires that net revenues cover 1.2x debt service, while the most recent level was over 2.0x. The legislation is being challenged; and even if the challenge is successful, it is clear the entity has had its independent rate-setting authority compromised.

Transparency
The Governmental Accounting Standards Board’s (GASB) Statement 91 will require municipalities to disclose debt that was sold in its name as a conduit for another entity and the amount of debt service the municipality is likely to pay. Sometimes a municipality issues debt on behalf of another entity, usually in relation to economic development. The obligation of the municipality to pay for the debt can range from no obligation at all to partial or full. Sometimes the underlying borrower can’t or doesn’t pay, and the municipality could lend its help.  This information is required to be reported for fiscal years beginning after Dec 15, 2020. This level of disclosure is intended to make government officials and taxpayers aware of potential claims that may arise. It also increases transparency for investors.

GASB continues to work on projects to improve transparency for taxpayers, issuers, and investors and is currently accepting comments on proposed reporting for public-private partnerships (P3 or PPP) and concession agreements with private partners. There continue to be political and practical reasons for municipalities to engage in P3, for example to achieve economies of scale or a large upfront capital commitment; so the focus on these arrangements and how they are presented in financial reporting is welcome.

At Cumberland Advisors we closely follow state and municipal credit developments and related news items, incorporate them into our views of the economy and markets, and employ them in our buy and sell decisions. The majority of our municipal bond holdings, both taxable and tax-exempt, have AA ratings, generally reflecting diverse economic bases and strong financial performance.




SCOTUS

Readers are invited to check out the background of this case scheduled for SCOTUS at the end of this month: https://en.wikipedia.org/wiki/Gamble_v._United_States. Here is the Wikipedia summary: “Gamble v. United States is a pending United States Supreme Court case about the separate sovereignty exception to the Double Jeopardy Clause of the Fifth Amendment to the United States Constitution, which allows both federal and state prosecution of the same crime as the governments are “separate sovereigns”. Terance Martez Gamble was prosecuted under both state and then federal laws for possessing a gun while being a felon; his petition arguing that doing so was double jeopardy was denied due to the exception. In June 2018, the Supreme Court agreed to hear the case.”

Market Commentary - Cumberland Advisors - SCOTUS

A further excerpt from Wikipedia states:

“According to The Atlantic, the U.S. federal government contends that “overturning the dual-sovereignty doctrine would upend the country’s federalist system”, and that the increasing number of federal criminal laws means that it is important that states be allowed to “preserve their own sphere of influence and prevent federal encroachment on law enforcement”. The American Civil Liberties Union, the Cato Institute, and the Constitutional Accountability Center filed a joint amicus brief on the case, arguing that there is no textual basis in the Double Jeopardy Clause, which states that “[n]o person shall be … subject for the same offense to be twice put in jeopardy of life or limb”, for the doctrine, and that the rising amount of federal criminal laws and state-federal task forces means there will be more dual state-federal prosecution. The case has been analyzed in the context of the Special Counsel investigation into the Trump campaign; if the separate sovereigns doctrine is overruled, a pardon for federal crimes from Donald Trump may prevent state prosecution. United States Senator Orrin Hatch filed an amicus brief in the case, arguing against the separate sovereigns doctrine; a spokesperson for him denied any relation of the brief to the investigation, saying that Hatch wants the doctrine to be overturned due to “the rapid expansion of both the scope and substance of modern federal criminal law.” According to Columbia Law professor Daniel Richman, state and federal charges usually have “no overlap, or almost no overlap, that would ring Fifth Amendment chimes in the absence of the dual sovereign analysis”, and so the impact of overturning the separate sovereigns doctrine would be minimal.”

There are numerous accusatory comments about this case and there are various explanations offered as to why there is a sense of urgency to complete the SCOTUS process so that a full nine-judge SCOTUS is in place to decide this case. The SCOTUS docket is public as are the briefs and arguments. So, too, are the many viewpoints expressed on the internet. We will leave it to serious readers to research and decide for themselves.

Readers have asked us about the Kavanaugh saga and its market impacts. Given the galvanizing media show and the intensity of political partisanship, this seems to be a fair question. First, my personal views about SCOTUS nominee Judge Kavanaugh are my own and are private and have not been shared publicly. I have refused to offer them in any interview.

In our 45-person firm, the range of views on Kavanaugh spans from intensely opposed to strongly in favor, with some “I don’t care” and “I can’t do anything about it” and “it is all a sick system” views among our folks. Yes or no on Kavanaugh does not make the agenda for our morning strategy conference calls.

Market reaction to the SCOTUS appointment process is a different subject. We are in the independent investment advisor business. That means government actions require constant scrutiny; and government, by definition, is political, whether its representatives are elected or appointed. Judges, Fed governors, SEC or other board appointees, cabinet secretaries or advisors, all define government and all influence markets.

Here is a research piece, “Q3 2018 Municipal Credit Commentary,” written by our colleague Patty Healy that references two SCOTUS decisions. Each has a large impact on financial markets and alters risk analysis and portfolio composition: http://www.cumber.com/q3-2018-municipal-credit-commentary/

Note, in Patty’s analysis, how important the five-vote SCOTUS majority is in order for the Court to resolve issues. Having an odd number of justices on the Court is critical to governance. Recall how SCOTUS deferred certain decisions when it was four–four with a seat unfilled. There is a reason why the highest court in our rule-of-law society operates with nine justices (though it might be able to function with five or seven). We have a decision-making process; and when that process is disabled, our nation pays a severe price.

Financial markets have largely ignored the pro-Kavanaugh versus anti-Kavanaugh debate. They have looked at the Fed and trade war risk and earnings forecasts and reports. That tendency is likely to continue.

Financial market agents, however, don’t like the nasty, divisive behavior of the political operatives to whom we’re constantly exposed. Ask financial market professionals about political behavior, and they will set aside party preferences and give you an earful on how broken our system is and how ugly it has become.

In markets, financial agents have no methods to deal with anonymous allegations, secret transmissions, and revelations after hearings are over and decades have passed. Financial agents are used to factual reports and audits and opinions rendered as accounting certifications from independent and unconflicted professionals.

There has been real harm done by the many-months-long SCOTUS process. When Republicans screamed harshly and rudely, they harmed us. When Democrats walked out of hearings like petulant children, their behavior harmed us. The SCOTUS process showed us our politics at its worst.

There are also longer-term debilitating impacts. Capable, well-placed financial markets agents are increasingly loath to take on civic duties, accept appointments, expose their personal lives to scrutiny, and watch the mainstream and social media dismember them.

In my view the real casualty from this SCOTUS process is how it has further discouraged participation in government and therefore governance. That reluctance to serve can undermine our nation, our freedoms, and our financial well-being.

Markets are not pricing in the longer-term deleterious effects of failing political systems. Market agents don’t know how to estimate the cost.

Maybe market agents are looking beyond the political ugliness perpetrated by Democrats and Republicans and betting instead on the enduring stability of the United States in spite of the corrosive acts of those who govern us. Maybe that is the explanation for market inaction during this SCOTUS debacle.

But that perception is only a guess. There is no way to know exactly why markets have ignored the SCOTUS saga so far. We who are in this business are all just guessing.

Let me add this postscript to my SCOTUS commentary. Like you, I have heard statements from US Senators of both political parties. Democrats and Republicans alike assert that one of the witnesses lied. Both sides cannot be right. In fact, both may be wrong. The study of memory and experience is an academic discipline that has evolved rapidly in recent years. Please take a few minutes to listen to this TED talk by Daniel Kahneman, a globally recognized expert and lifetime student of behavioral economics: “The Riddle of Experience vs. Memory,” https://www.ted.com/talks/daniel_kahneman_the_riddle_of_experience_vs_memory?language=en. We thank Datatrek for the citation.

And finally, I want to thank those Democrats and Republicans who have remained well-behaved, maintained decorum, and respected the process of governance during this trying episode in our national political life. You exemplify how things ought to be done in our democratic republic.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


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Q3 2018 Municipal Credit Commentary

Updates, budgets, potential future stresses, state ratings, default study, and last but not least, storms

Market Commentary - Cumberland Advisors - Q3 2018 Municipal Credit Commentary

Last quarter we focused our 2Q 2018 municipal credit commentary on two SCOTUS (Supreme Court of the United States) rulings. One allows states to collect tax on out-of-state internet sales while the other restricts public unions from requiring that non-union public sector employees pay agency fees to contribute to the cost of collective bargaining and other activities through fair-share agreements. We consider both rulings positive for municipal credit (http://www.cumber.com/scotus-two-major-rulings-with-positive-implications-for-municipal-bond-credit-quality/). In particular, the ability to collect online sales taxes should help financial operations. A study by the National Conference of State Legislators (NCSL) and the International Council of Shopping Centers (ICSC) estimates that total U.S. uncollected sales and use taxes increased to almost $26 billion in the year 2015. Of this $26 billion, more than $17 billion in uncollected taxes were projected to be from electronic sales. http://www.ncsl.org/research/fiscal-policy/e-fairness-legislation-overview.aspx

Updates

Regarding the sales tax ruling, some states are working toward collecting sales tax retroactively; however, a bill entitled the Online Sales Simplicity and Small Business Relief Act has been proposed that would ban retroactive imposition of a sales tax on out-of-state internet sales, delay implementation to January 2019, and establish a small-seller exemption for companies with gross annual receipts below $10 million, (compared with the $100,000 threshold or 200 transactions per year in the case of South Dakota). The proposed legislation, if passed, should not be a burden, because states have already been adjusting to the lower collections as internet sales have increased over the years. Regarding the fair-share agreements, it may take some time for the SCOTUS ruling to have an effect on public sector-union coffers and political influence. We noted in our Q1 commentary the abundance of teacher strikes (http://www.cumber.com/q1-2018-municipal-credit/). They continued this quarter, with strikes or threatened strikes in a number of Washington state school districts and a vote by the teachers of Los Angeles Unified School District to strike if state mediation does not result in a satisfactory contract.

Budgets

In addition to the SCOTUS rulings, Q2 was notable because all states passed budgets on time or nearly on time – even the states notorious for passing late budgets, such as Illinois, Connecticut, and Pennsylvania. Common threads for this phenomenon include election-year politics, good revenue growth driven by a generally improved economy, and the acceleration of tax collections in 2017 due to the Tax Cut and Jobs Act.

Future expectations

States

A number of states’ rainy day funds are not up to pre-recession levels, leaving analysts and others to worry what might happen in the next downturn. S&P released a September 2018 report in which they subjected state financial operations to the stresses of moderate and severe recessions and then compared 2018 reserves to expected drawdowns. Only 20 states had reserves sufficient to cover loss of revenue and increased social service spending during a moderate recession, and overall the states showed an average revenue shortfall of 9.9%. S&P went further and made adjustments for dependence on more cyclical revenue streams (capital gains taxes for example), level of social-service spending, and fixed costs including pensions and OPEB. After the adjustments 14 states were considered low risk, 21 moderate, and 14 elevated. S&P contends, however, that states have the capacity to make fiscal adjustments in response to a downturn. S&P also notes, though, that there were 19 state downgrades from the beginning of 2016 through August 2018, compared with just four upgrades, and observes that this ratio is abnormal this far into a recovery. The downgrades could reflect increased reliance on income taxes, eroding tax bases, rising entitlement costs, and liability growth.

 

Cities

The National League of Cities’ annual City Fiscal Conditions report, a survey of 341 of its members, found that while cities’ fiscal health is not yet declining, growth is slowing, and there are cautionary signals that echo previous economic downturns. Cities are facing wage pressure as well as shortfalls in required and/or needed contributions to pensions and healthcare. Although revenues are not in decline, they grew only 1.25% in FY 2017 and are expected to stagnate in FY 2018. Expenditures grew 2.16% in FY 2017, with growth for FY 2018 budgeted at 1.97%. The results are uneven. Communities in the Midwest are faring worse than those in other regions. Smaller cities, too, have a poorer fiscal outlook than their larger counterparts do. The report attributes these differences to population declines and industrial losses that began before the Great Recession but were accelerated by it. And not surprisingly, the report found 35% of finance officers report seeing negative fiscal impacts associated with the elimination of tax-exempt advance refunding bonds. According to the NLC, this critical municipal finance tool saved taxpayers more than $2.5 billion last year.

This picture may sound dire; however, municipal analysts are generally a conservative group. In Moody’s annual US Municipal Bond Defaults and Recoveries, 1970–2017, released in July, the rating agency notes that municipal bankruptcies have become more common in the last decade (think Puerto Rico) but are still rare overall. The five-year municipal default rate since 2008 was 0.18%, compared to 0.09% for the entire study period. This figure compares with the global corporate five-year default rate of 6.6% since 2008. The ten-year municipal default rate is 0.17%, while the corporate default rate is 10.24%.

The Municipal Analysts Group of New York (MAGNY), a constituent group of the National Federation of Municipal Analysts (NFMA) staged a luncheon program at the beginning of summer, in which panelists discussed what the next recession may look like. Their conclusion? It depends. Is weakness going to be on the consumption side and affect sales taxes, or will it be on the employment or stock market fronts and affect income taxes? Recently, oil prices have been predicted to rise, so states that are dependent on energy taxes may benefit from additional revenue.

Given the risk of future revenue declines, it is important to know where the risks could rise to determine whether a municipality is preparing for those risks and striving for structural balance. Are revenues at least equal to expenditures, and are those expenditure needs being realistically addressed? When evaluating an issuer we like to see flexibility in the form of conservative assumptions built into a budget. This prudent practice generally means overestimating expenses and underestimating revenue, so that the entity can end the year with a positive balance, contributing to the buildup of a rainy day fund. Rainy day funds are used to address revenue shortfalls or unexpected expenses. Conservative budgeting and the willingness to cut spending or increase revenues are characteristics of strong financial management. This principle is true for the issuers of general-obligation bonds as well as revenue bonds.

State Ratings

Why do we always have a section on states in our quarterly municipal credit commentaries? States provide funds and services to municipalities and institutions in the state, so what is happening at the state level can have implications at the local level. Additionally, as I mentioned in my inaugural commentary at the firm (http://www.cumber.com/3q2016-municipal-credit-its-never-boring-in-muniland/) – wow, has it been two years already?), state ratings are now more volatile than they were in the past.

Since June 2016 there has been only one quarter that has not seen a state rating change, and that was the first quarter of 2018. Historically, state ratings were fairly stable (with some exceptions, such as California). The variability in the past few years is unusual and is attributable to rising pension costs and OPEB expenses, political gridlock, and/or exposure to energy-related revenues.

Some states’ ratings are naturally more cyclical because those states depend more heavily on a cyclical revenue stream. For example California, which is AA-/Aa3 rated now, has been as high as AAA and as low as A because it is a high tax state with high-income earners, which creates swings in income and budgeting. This history contrasts to that of Georgia, which has been rated Aaa by Moody’s since 1974. Fitch has rated the state’s GOs AAA since 1993, while S&P gave its highest rating to the Peach State in 1997.

State Rating Changes

After no changes in Q1, the changes seemed to accelerate in Q2 and Q3. In Q2 there were three downgrades, one upgrade, and a few improvements in outlooks or trend. In the third quarter all rating actions were positive!

 

Finally, our thoughts are with those in North and South Carolina who are still dealing with the aftermath of Florence. In addition, many around the country and the world were affected by fires, volcanoes, and tsunamis this quarter. The initial costs to communities affected by natural disasters can be great; however in the U.S., after a natural disaster, there is usually a surge of economic activity that continues for an extended period as people and communities rebuild and money (insurance and federal aid) and workers flow into the area, increasing income tax and sales tax revenues to municipalities. That economic flip side, however, is not much immediate comfort for those who have lost homes and other property, pets, livestock, income, and for some, even family members. Our hearts go out to those whose lives have been impacted.

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


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More on Muni Credit

My colleague Patty Healy discussed the muni sector’s credit scoring and status in her recent quarterly commentary. See http://www.cumber.com/q1-2018-municipal-credit/. Readers who missed her missive may want to take a look at it, as it recites lots of evidence of upgrades and downgrades in municipal credit and why they happened. Patty is an expert on municipal credit.

Let me address a market reaction to these credit changes and why that gives separately managed accounts an edge over certain mutual funds and passive muni portfolios. In the latter there are often a set of fairly rigid allocation limits. We know that edge is real from our observation of funds.

When a fund has an allocation method that is rigid, it must watch the weights of its holdings. Thus it may have an allocation to California and another to New Jersey and so forth. Now what happens in the marketplace when California gets a credit upgrade and New Jersey gets a credit downgrade? The market values of California bonds go up while the market values of New Jersey bonds go down.

For a separately managed account this credit shift doesn’t require an allocation change if there are no allocation constraints. The manager can adjust in anticipation and will quite likely use an advanced forecasting credit-scoring system to make those adjustments prior to the actual credit-rating changes. At Cumberland, we try to do that all the time. We want to be ahead of the tsunami.

The passive mutual fund faces a different situation. It is governed by the rules in its prospectus and must comply with them. If it is a state-specific fund, it has to continue to own the New Jersey bond whether it wants to or not. The same is true for a California state-specific fund.

But if it is a national fund, it may encounter a different problem. The fund’s holdings are imbalanced after the credit-rating changes. The New Jersey allocation is down in price while the California allocation is up. Thus the weighting scheme, which is required by the mutual fund’s specific rules, may be out of whack. The fund must make an adjustment, and that usually means the trader has to do something he doesn’t want to do. He has to reduce the position of his higher-rated California bonds because it is now overweight, and he has to increase the position in his lower-rated New Jersey bonds. Additionally, there are usually time limits that govern how long a trader has to make these changes.

Market agents like Cumberland know this and can therefore anticipate that certain bonds may become cheap while other bonds become more richly priced. These distortions affect the entire muni bond market but are not well understood by the retail bond buyer or by the passive-allocation community of family offices and consultants. The nuances are frequently missed. The distortions create market inefficiencies, which can then be seized upon by a separate account manager.

The evidence of these distortions is seen in muni pricing. Remember, this is a freely operating market. The price and yield of any single municipal bond that trades is a direct result of a market transaction between a buyer and a seller. That seller or buyer may be a separate account manager like Cumberland, or it may be an uninformed or unskilled individual, or it may be a passive family office. It makes no difference that the players are diverse or have different levels of skill: It is the price that reveals the market’s inefficiencies.

Here is a recent example:   A very-high-quality housing finance agency bond came to market with a yield above 4%. The bond was secured by a block of mortgages, and most of the collateral had the direct or contingent guarantee of the federal government. At the same time the new issue was coming to market, the US Treasury 30-year bond was trading at about 3%. The housing agency bond became available when the market was experiencing reallocations, so that meant that its pricing was a second-order derivative of the reallocation of other bonds.

Why was the housing bond in excess of 4% tax-free versus the 3% taxable Treasury? On the face of it, this makes no sense at all. But when the muni market is distorted, the ripples of those distortions impact many bonds, and such opportunities to present themselves to those prepared to seize them. At Cumberland we bought the 4% plus tax-free housing bond for our clients. We avoided the 3% long-term US Treasury bond. Note that the actual credit exposure taken by our client was about the same.

Patty has explained the dynamics of muni credit in her quarterly piece. All we want to add to her excellent commentary is that there are market dynamics that allow an active separate account manager to seize opportunities. The bottom line is the same: Dig deep in the weeds and understand the credit and the dynamics of its market pricing. Thorough research works to your advantage.




Q1 2018 Municipal Credit

Ratings, Teachers’ Strikes, Pensions, Higher Education

During the quarter, Moody’s and S&P reported that upgrades of municipal bonds continued to dominate downgrades in 2017. For S&P it was the sixth year in a row, with California leading the way in the number of upgraded issuers, followed by Florida and Texas. For Moody’s it was the third year in a row that upgrades surpassed downgrades. Moody’s noted, however, that the dollar amount of downgrades did exceed that for upgrades. The downgrades of New Jersey, Illinois, Connecticut, Puerto Rico, and related issuers accounted for almost 70% of downgraded debt. As our readers know, we have avoided the mentioned issuers’ bonds – except for selected insured bonds of Puerto Rico. Overall, the positive ratings environment is expected to continue with projected economic growth, although S&P notes that the tax reform limits on the deduction of interest for mortgages larger than $700,000 could constrain home prices in high-cost places like California (limiting the flexibility to raise property taxes); and the cap on federal deductions for state and local taxes could also produce stress in high-tax states, thus limiting upside ratings movements and potentially resulting in downgrades. Notwithstanding the positive growth, outlooks show that pockets of weakness are expected to remain in healthcare and higher education.

State Ratings

We noted in our last quarterly municipal credit commentary (http://www.cumber.com/q4-2017-credit-commentary-taxes-pensions-ratings/) that state rating activity had waned; and now the first quarter of 2018 is the first quarter in at least seven when there was no rating action on any state by Moody’s, S&P, Fitch, or Kroll; and that includes trend changes.

There was plenty of state news, however, focused on teachers’ strikes.

The West Virginia teacher’s strike closed all schools in the state for nine weekdays ending March 6th. The teachers prevailed and secured a 5% pay increase for public employees and a pledge to review healthcare coverage. The raises will likely come from reductions in other services. Oklahoma teachers have a strike planned for April 2nd, and although the state did grant a pay raise to public employees on March 26th, as of this writing the strike has yet to be called off. The pay increase will be funded by increasing taxes on oil and gas production, hotels, tobacco, diesel fuel, and gasoline. Arizona teachers are looking for pay raises, too, and a strike could be on the horizon after teachers’ success in West Virginia. There are also rumblings from teachers in Kentucky, who are worried about potential changes to their health and pension benefits. K–12 education is one of the largest spending items for states, second only to Medicaid, though it declined from 22% of states’ spending in 2008 to 19.4% in 2017, according to a report by the National Association of State Budget Officers. Overall spending on education increased 3.9% in 2017; however, the growth in Medicaid spending was 6.1%.

Pensions and OPEB 

Wages are only one form of compensation that public teachers receive. They also receive pensions and other post-employment benefits (OPEB) such as healthcare. For the past three years, governments have been required to report pension liabilities in greater detail, with historical information and illustrations of how their pension liabilities will change with changes in assumptions (such as a 1% change in the discount rate). As we have commented in the past, the lowering of the discount rate increases a future pension liability and raises the annual amount that must be paid into the pension plan to keep the liability from growing further. This factor is important, as the funded level of many plans is below 100% and the average was just 72% for fiscal 2015, as reported by Pew Charitable Trust. According to the Government Accounting Standards Board (GASB), accounting standards 67 and 68 are designed to improve the decision usefulness of reported pension information and to increase the transparency, consistency, and comparability of pension information across state and local governments. Starting in fiscal years ending June 30, 2017, GASB statements 74 and 75 require similar reporting of OPEB obligations. Although OPEB obligations are less contractual than pension promises are, they are not politically easy to reduce, and they are generally lower-funded or not funded and paid on a pay-as-you-go basis.

Reducing benefits is one way governments have been trying to reduce growth in unfunded liabilities. As governments are challenged by the decline in the ratio of current employees to retirees, as well as by competing demands for resources, the greater transparency required by GASB is welcome to analysts and stakeholders alike.

Speaking of Education

In February, Moody’s published an article, “Declining international student enrollment dampens US universities’ tuition revenue growth,” that cited two studies showing declines in international student enrollment. The Council of Graduate Schools found that international undergraduate applications declined by 3% and enrollment at the graduate level fell by 1% in 2017, reversing a decade-long expansion. In a January report, the National Science Foundation (NSF) found that international undergraduate enrollment declined by 2.2% and international graduate student enrollment declined by 5.5% 2017. Variations in the two studies are attributed to the different samples used. International students generally pay full tuition; and although international students account for less than 5% of overall enrollment, they represent good business in the margin. Declines were most noticed in schools with less brand recognition and in non-research-intensive programs. The NSF report concludes that the effect of new immigration policies, changes to visa regulations, and uncertainties around job opportunities post-graduation may continue to hamper application and matriculation rates of international students over the next several years. In January 2017 we noted the potential risk to higher education in a commentary “Higher Grounds for Higher Education” (http://www.cumber.com/higher-ground-for-higher-education/) and emphasized that our strategy is to invest in larger, well-established institutions with strong demand characteristics.

Notwithstanding the international student effect, increased competition due to declining student populations and ever-rising tuition costs have caused some smaller private colleges to struggle financially. In an early March article, Bloomberg noted that these challenges have led to some schools merging with each other or being absorbed into larger institutions. There were at least 55 merger and acquisition transactions among colleges and universities between 2010 and 2017. The Northeast is particularly affected since it has a high concentration of colleges while the number of high school graduates is expected to decline. A number of years ago we decided to avoid small private colleges noting declining enrollment trends, higher costs, and increased competition from public institutions.

Cumberland is sponsoring the second annual Financial Literacy Day on April 5th at the University of South Florida Sarasota Manatee campus. The event is open to public participation. All are invited and welcome. You can make your reservation online and learn more at https://www.interdependence.org/events/second-annual-financial-literacy-day-update-financial-markets-economy/.

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


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