Understanding Complexities in the Municipal Bond Market

This post was originally published in the Washington Business Journal’s WBJBizBeat Blog. | Washington Business Journal

The municipal bond marketplace is diverse, with over $3.7 trillion in outstanding bonds and more than 60,000 state and local governments, districts and authorities active in the municipal market. By comparison, the total number of U.S. companies with actively traded public stock is just over 4,000.

How has the municipal market changed and how will financial stresses affect how municipalities view their outstanding obligations?

The most severe recession since the 1930s has brought a new economic reality to many municipalities. Some issuers have responded to lower revenue projections by reducing spending, raising taxes and advocating for federal stimulus and state funding. Other issuers have had a more difficult time and have been unable or unwilling to make difficult decisions.

Recent attention has focused on Chapter 9 bankruptcy filings by a few municipalities. Chapter 9 is the chapter of the United States Bankruptcy code available exclusively to municipalities to assist them in restructuring debt. Harrisburg, Pa.; Jefferson County, Ala.; Stockton, Calif.; and San Bernardino, Calif., have been recent headliners. Interestingly, two of these were felled by inept management of a special project.

Still, there are reasons for concern:

Unfunded state pension liabilities are over $3 trillion and unfunded health benefit liabilities are more than $1 trillion;

Municipal downgrades by Moody’s have outnumbered upgrades in 2009-2011 by 3-1;

Bankruptcy decisions by larger cities, like Stockton and San Bernardino, may be a sign more cities may decline to honor their debt obligations;

State aid to local governments, which represents the largest source of revenues at approximately 34% of budgets, is falling and will likely continue to decline;

At least 27 states allow municipalities to file for Chapter 9 bankruptcy protection;

Annual pension payments for state and local plans rose to 15.7% of payrolls in 2011 from 6.4% in 2001; and

A deep recession or US debt crisis would likely increase municipal defaults.

While municipal defaults may increase, they will likely remain relatively rare events:

The stigma associated with bankruptcy is still a significant deterrent. Issuers recognize Chapter 9 filing as a last resort with undesirable consequences to future financing. It is our belief that filings will be limited to issuers with significantly weaker credit, severe budget shortfalls and event driven stress. We do not believe that recent Chapter 9 filings are indicative of contagion;

Debt expense is typically only 5 percent to 7 percent of municipal costs. Significantly greater savings can be found in addressing structural issues such as spending decisions, pension obligations and medical expenses;

The current historically low rate environment has provided an opportunity for restructuring debt, reducing interest expenses and locking in lower predictable costs;

There are significant legal hurdles to filing a Chapter 9 bankruptcy;

In 2011 state tax revenues surpassed $776 billion and reached a pre-recession peak;

From 1970 through 2011, only 5 of the 71 Moody’s rated defaults involved a local government that chose default due to a lack of willingness rather than ability to pay;

Rated bond defaults have largely been concentrated in the health care and multifamily sectors. These two sectors have accounted for roughly 70 percent of all defaults;

Defaults in the municipal bond market have effectively been zero in the rated bond sector. Moody’s reports that the historical default rate on investment-grade municipals over the past 40 years was .03 percent, much lower than comparably rated corporate issues;

Defaulting cities in California are not representative of typical municipal issuers. In California, financial problems are exacerbated by Proposition 13 which significantly limits the revenue options available to lawmakers;

Bond investors have been protected in recent court rulings. The U.S. Bankruptcy Court in Alabama ruled that revenues securing sewer bonds could not be diverted to cover other expenses. This is a positive for all municipal revenue bonds;

Many revenue sectors are benefitting from economic improvements over the past three years and a low rate environment. Low leverage and strong margins characterize sectors such as water & sewer, airports, power, and higher education. These sectors do not require strong growth to maintain stable credit; and

While ratings downgrades outnumber upgrades, ratings in general continue to be stable. More than 90% of Moody’s ratings were unchanged over every 12 month period between 1970 and 2011.

The economic woes of local governments are somewhat regional in nature, affected largely by real estate values and regional economic activity. The Washington region is a good example of an economic region which has fared relatively well throughout the recession.

The D.C. region is a large and diverse area with excellent demographic characteristics. It has one of the highest educated and highest paid populations in the nation, an unemployment rate of 5.7 percent (below the national average of 8.2 percent) and strong support from Federal expenditures. Federal support, while declining during a period of Federal retrenchment, will always be a sustaining contributor.

Evidence of the demand for quality bonds from the DC region can be seen by looking at the trading history of some local issuers. Historically, bonds issued by the states of Maryland and Virginia rank as the first and second lowest yielding, highest priced bonds of all states, an indicator of strong demand and high credit quality. The economic strength of the region also translates to city and authority issuers.

Maryland and Virginia are two of only 13 “Aaa” (Moody’s) rated states. While Moody’s has both states on negative credit review due to indirect linkage to the Federal government, they remain two of the most solid financial issuers in the U.S. Many of the highest Aaa rated counties are also found in our backyard; Montgomery, Fairfax, Baltimore, Prince George’s, Loudoun and Arlington to name a few. Additionally, while the District of Columbia may face embarrassing local politics, it has seen significant ratings increases and financial improvement over the past two decades. We believe the nation’s capital will always enjoy substantial financial and economic support from the federal government.

We take seriously the extraordinary challenges facing municipalities throughout the U.S., challenges also seen at the federal level as well as with sovereigns around the developed world. Chevy Chase Trust closely follows credit trends, mitigates risk and strives to maintain reasonable interest income for clients in a yield-starved environment. We have the ability to react quickly to both changes in interest rates as well as to material changes in credit conditions, and we will continue to periodically keep you informed of our views.