Under analysis: insurers must understand the risks and opportunities of investing in municipal bonds.
Current concerns about municipal credit reflect an array of overlapping issues, including stressed state and local operating budgets, unfunded pension and retiree health liabilities, and the potential for increased bankruptcies among local governments.
Although these problems certainly exist, they do not apply equally to all issuers and sectors across the diverse and broad U.S. municipal market. Further, some of these issues will require years to unfold, allowing local governments considerable time to address them.
Municipal credits have many positive characteristics, though the sector does present risks. Given the recent fiscal stress upon state and local governments, and the limited availability of bond insurance, it is more important than ever to construct and monitor a muni portfolio using expertise.
Although 2011 may be difficult for issuers, it will present opportunities for investors who can astutely assess the real risks in the market and separate them from noise in the media.
Muni bonds fall into two broad classes: general obligation and revenue bonds. General obligation bonds are issued by state and local governments. The major sectors of revenue bonds are essential services and transportation.
State and local governments can issue bonds backed by pledges of their "full faith and credit" security to pay principal and interest. Such pledges include their capacity to levy and collect taxes. An issuer's default triggers the bondholders' right to sue the issuer to compel fulfillment of its pledge.
Approximately 90% of state and local government spending is for operations. The remaining 10% is for capital expenditures and typically financed with debt. It is significant that principal and interest average 5% of aggregate state and local annual budgets.
Forty-nine U.S. states mandate by constitution or statute that budgets must be balanced. States, therefore, typically do not finance operating deficits with debt. Further, by statute many states limit debt service as a share of their budgets. For 60 years these measures have constrained state and local borrowing as a percent of gross domestic product (see Chart 1).
A general obligation pledge of a state is among the safest credits, given its flexibility to adjust spending and increase taxes and fees. However, sales and income taxes average 40% of states' aggregate revenues.
Given the sensitivity of both sales and incomes to economic conditions, taxes collected on them are sensitive as well. This cyclicality can contribute to state revenues falling short of spending. Political obstacles to cutting state services exacerbate such budget gaps.
States will be facing budget gaps as projected revenues are less than projected spending for fiscal year 2012, which starts July 1 for most states. Material factors accounting for the likely shortfall are, first, the end to funds received under the American Recovery and Reinvestment Act of 2009, as well as budgets ending June 30, 2011, that contained one-time solutions.
The ARRA has provided states with $135 billion in federal stimulus funds since 2009. Balancing budgets for fiscal year 2012 will require some combination of reduced services and increased taxes and fees. However, it is highly unlikely that budget processes will lead to default under states' general obligation debt.
Local governments--cities, towns, counties and school districts--also issue general obligation debt. These issuers typically have less flexibility than do states in reducing expenses and increasing revenues. Their elected officials are also sometimes less experienced in fiscal policy.
Generally, local governments also receive substantial aid from their states, which the U.S. Census Bureau estimated at 30% of local revenues in 2008. Economic downturns can squeeze state aid to local authorities as states balance their own budgets. Local governments tend to hold relatively higher cash reserves than states to provide for unexpected shortfalls.
Another distinction between state and local revenues, and which favors the latter, is that local revenues derive relatively more from property taxes but less from cyclical sales and income taxes. This relative sensitivity to economic cycles was clear in 2009, when state and local sales and personal income taxes declined by a respective 8% and 18%, while local property taxes actually increased by 8%. Changes in property assessments typically lag changes in other taxes and are subject to caps in some states.
Some of the riskiest muni credits are those from smaller municipalities that infrequently issue debt. With limited demand for their securities, and small tax bases to support them, they may be relatively more prone to default under severe fiscal stress. Many states have programs to support troubled municipalities, such as by assuming financial management of local governments unable to balance their budgets for a given period.
Revenue bonds carry an issuer's pledge of its capacity to generate revenues to service principal and interest. Essential service and transportation are major sectors within revenue bonds.
Essential service issuers include electric utilities and water and sewer authorities. The essential nature of their services generates usage fees that are generally consistent and insensitive to economic cycles.
Transportation bonds finance highways, toll roads, ports, airports and mass-transit authorities. Many transit systems enjoy monopolies that limit competition and increase the consistency of the fees they generate.
Although transportation facilities generally provide essential services, revenues of some do vary with the economy, such as a toll road with a substantial share of interstate users. Close analysis is necessary to evaluate the extent to which a project is essential and the consistency of the revenues it generates.
A subset of the revenue bond sector is special revenue bonds. Special revenue bonds have a specific revenue stream that is dedicated for payment of principal and interest. These bonds must pay principal and interest from available revenues even if the issuer has filed for bankruptcy protection.
Across the Muni Market
Since 2000, new issuance has been roughly two-thirds revenue bonds and one-third general obligation bonds, according to the daily newspaper The Bond Buyer Many general obligation issuers face painful and unpopular fiscal repairs. By marked contrast, credits backed by specific revenues will likely see strengthened revenue collections as the economy improves.
Optimum portfolio construction requires diversification by the issuers' regions and sectors as well as analysis of the specific securities. Diversification tends to limit deterioration in portfolio credit quality from events that affect specific regions or sectors. Analysis of the specific security can, however, be more important to portfolio performance. It focuses on aspects such as the issuer's creditworthiness, timely disclosure of audited financial statements, adequacy of cash reserves and the quality of the revenue stream for debt service.
Unfunded pension and health care obligations to current and past employees are major challenges to government issuers. For instance, estimates of the states' total unfunded pensions range from $500 billion (Pew Center on the States) to $3 trillion (Now-Marx, Rauh), varying widely with discount rates applied in present valuing the liabilities.
This is a serious concern for municipal issuers, though it can be solved if states make their required annual contributions, reduce benefits for new employees and increase contributions for existing ones.
Another systemic concern is that fiscal stress will trigger a wave of bankruptcies among local governments as officials seek quick solutions to financial dilemmas. Just over half the states authorize their municipalities to seek reorganization under Chapter 9 of the U.S. bankruptcy code, which is the federal bankruptcy process for local governments. Many states that allow bankruptcy require municipalities to obtain their approval before filing.
Bankruptcy statutes require municipalities to prove insolvency before they file, obtain approval of their reorganization from creditors with claims that a restructuring would impair, and receive the bankruptcy judge's approval of the planned reorganization.
Without authority to compel parties to consent to a plan, bankruptcy judges can only approve or reject whatever plan the parties may propose. Unlike Chapter 11 for private bankruptcies, Chapter 9 does not provide for a liquidation of assets, removing a powerful incentive for agreeing on a plan.
Consequently, Chapter 9 proceedings can be long and expensive. Vallejo, Calif., filed for bankruptcy in May 2008 but was prepared to file a plan of adjustment only in January 2011, fully two-and-a-haft years later. The municipality's legal fees had reached $9 million, equal to 14% of its expenditures budgeted for fiscal year 2011. Given the obvious drawbacks of the process, its limited use is unsurprising (see Chart 2).
With the steep downgrades in credit ratings of municipal bond insurers, new issuance with payment guaranties has plummeted. In 2010, only 6% of new issues were insured versus an average of 51% for the five years ending in 2008. This has caused a widening in credit spreads as the share of new issues from lower rated and uninsured municipals has increased.
Demand for insured bonds will likely continue, since retail buyers comprise more than one-third of the market and have a strong preference for insured issues.
By contrast, the increased supply of lower rated credits widens opportunities for institutional buyers to add value by virtue of their analytical expertise.
* What Happened: Problems such as stressed state and local operating budgets and unfunded pension and retiree health liabilities are affecting investments in municipal bonds.
* The Situation: These situations do not apply equally to all municipal bond issuers and sectors.
* What Needs to Happen: Due to fiscal stress on state and local governments and the limited availability of bond insurance, investors in municipal bonds must manage their portfolio carefully.
Contributors: Matthew Caggiano is managing director and head of Insurance Municipal Portfolio Management, and Carol Flynn is managing director and head of Municipal Bond Research, at Deustche Asset Management. They can be reached at matthew. firstname.lastname@example.org and carol. email@example.com.
Chart 2 Chapter 9 Filings by Year--1980-2010 As of 5/7/2010 1980 1 1981 2 1982 3 1983 5 1984 5 1985 6 1986 11 1987 20 1988 9 1989 9 1990 11 1991 19 1992 13 1993 11 1994 13 1995 10 1996 5 1997 4 1998 2 1999 4 2000 10 2001 8 2002 6 2003 6 2004 6 2005 9 2006 5 2007 5 2008 4 2009 10 2010 5 Source: Chapman and Cutler LLP Note: Table made from bar graph.
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|Title Annotation:||Property/Casualty: Investments|
|Author:||Caggiano, Matthew; Flynn, Carol|
|Date:||Mar 1, 2011|
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