Municipal Watch: Let's put all this 'noise' into perspective
Municipal bankruptcies on the rise! The number of municipal bond defaults double! Municipal bonds may lose tax advantages! Municipal …. You get the point. When it comes to the municipal credit market, the scary headlines are back. Now is likely a good time to step back and put things in perspective.
The challenges confronting state and local governments are real—just as they were in late 2010, when high-profile warnings prompted an investor stampede out of municipal mutual funds. So what happened between now and then? Municipal bond funds were among the strongest performers in the fixed-income universe, returning 10.70% in 2011 and 5.31% year-to-date through July, according to the Barclays Municipal Bond Index. By comparison, U.S. Treasuries returned a respective 9.81% and 2.53% the same periods, according to the Barclays U.S. Treasury Bond Index. And the broader bond market gauge, the Barclays Aggregate Bond Index, returned 7.81% and 3.78%, respectively.
This isn’t to suggest that investors should ignore the headlines, only to be careful not to exaggerate the degree of distress. As we wrote in early 2011 and again earlier this year, the vast majority of the nation’s nearly 90,000 state and local governmental units are balancing their budgets and meeting their financial obligations amid the lackluster U.S. recovery. The latest Census Bureau figures show state tax collections rose a ninth straight quarter in this year’s first three months, and the National Conference of State Legislatures says no states expect to end fiscal 2013 with a deficit. It also reports that aggregate fiscal 2013 year-end balances among all 50 states and the District of Columbia are projected to rise 17.8% to $54.8 billion, marking the fourth consecutive year of year-end balance growth.
Most states and localities are doing the right—albeit painful—thing
Granted, many state and local governments continue to confront some stress—a slow economy, declining state and federal aid, rising health-care and benefit costs, and property tax shortfalls spawned by a housing crisis that sent prices plunging have a way of tripping up even the most fiscally responsible political entities. We’ve been saying all along that the difficulties arising from housing’s collapse and the global crisis it spawned will weigh most heavily on local governments for some time. In fact, the limited instances of fiscal distress or bankruptcy filings have been local government units. But far from reneging on their pledges to bondholders, almost all entities confronting budgetary gaps have been cutting projects, laying people off and, yes, even raising taxes and fees to close them.
According to the Center for State and Local Government Center for Excellence’s annual survey, 51% of state and local governments adopted pay freezes this year, 42% adopted hiring freezes and 28% reported layoffs. Remarkably, that represents improvement over 2011, when more than 60% reported pay freezes, nearly 55% reported hiring freezes and slightly more than 40% enacted layoffs. As painful as these actions may be for constituents and public sector workers who have seen their services cut or their jobs terminated (state and local government payrolls have shrunk by 667,000 the past four years), as taxpayers and as investment managers for municipal funds, we applaud the tough decisions by these governments to live within their means.
To be sure, compared to historical standards, we have seen an increase in the number of municipalities under severe fiscal pressure. Moody’s says the number of municipal defaults in its rating universe rose to 5.5 a year in 2010 and 2011, up from an average 2.7 the previous 39 years (though the bulk of defaults have occurred in health care and multifamily housing projects; only five were general obligation (GO) issuers). Some municipalities have even filed for Chapter 9 bankruptcy, including Vallejo, Stockton, Mammoth Lakes and San Bernardino in California; Jefferson County in Alabama; Central Falls in Rhode Island; even Harrisburg in our home state of Pennsylvania (though the courts dismissed the petition). But the reality in almost all of these instances is the cities and counties were often victims of mismanagement, including failed enterprise projects or other government-backed endeavors such as outsized convention centers or sports arenas; judgments following litigation; and generous pension and worker benefits that localities no longer could afford, particularly in California, where local governments confront inflexible revenue and cost structures as a result of voter-approved initiatives.
Voters back pension, benefit reforms
As the aforementioned suggests, these cases are the exception, not the rule. In fact, the rule these days is that most states and localities have brought a sober-minded mentality to their finances and fiscal situation, pressured by a citizenry that, to paraphrase the broadcaster in the movie “Network,’’ are mad as heck and aren’t going to take it anymore. In San Jose and San Diego, residents voted overwhelmingly in June to cut pension benefits not just to retirees but also to existing workers—a move that came on the heels of votes in another left-leaning state, Wisconsin, to retain a Republican governor whose move to cut union bargaining rights led to a nationally watched recall election. In Rhode Island, a very “blue’’ state, lawmakers adopted pension reforms that slashed benefits and toughened eligibility. Even in our headquarters town, unionized bus drivers voted 10-to-1 to accept pay freezes and increased pension and health-care contributions to forestall steep layoffs and service cuts to Pittsburgh’s transit system.
The message is not deny that there are challenges, but to be careful about drawing dire conclusions from them. That’s what happened before, when many investors who pulled out missed a strong market. Looking forward, we can’t be sure that the municipal market may experience the same level of gains as has occurred the past 18 months. Frankly, given the run it’s had since early 2011, it probably won’t. In addition, how the next Congress and president choose to tackle the looming fiscal cliff presents risk factors to the municipal marketplace and municipal credit quality. That said, prudent security selection, credit and sector allocation, and credit research—hallmarks of municipal investing at Federated—can help navigate through what is an increasingly complicated but highly investment-worthy market, where distress may be more frequent but still remains at low and manageable levels. Far from being scary, that’s a story investors may be wise to follow.