Municipal Credit: First Quarter 2017 Review

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Includes: AFB, BAF, BBF, BBK, BFK, BKN, BLE, BSD, BYM, CXH, DMB, DMF, DSM, DTF, EIM, EIV, EOT, EVN, EXD, FMB, FMN, IIM, IQI, KSM, KTF, LEO, MEN, MFL, MFM, MFT, MHD, MMU, MNP, MQT, MQY, MUA, MUB, MUE, MUH, MUS, MVF, MVT, MYD, MYF, MYI, MZF, NAD, NEA, NEV, NIM, NMI, NUV, NUW, NVG, NXP, NXQ, NXR, NZF, OIA, PMF, PML, PMM, PMO, PMX, PRB, PVI, PZA, RVNU, TFI, VFL, VGM, VKI, VKQ, VMO, VTEB, XMPT
by: David Kotok

By Patricia Healy, CFA

There may be credit challenges in public finance; but for the fifth year in a row, per S&P, upgrades outpaced downgrades.

Healthcare bill update: Without enough votes in the House of Representatives to replace the Affordable Care Act, there will be no change to the healthcare law in the near future; and Congress can focus on tax reform that many hope will bring increased economic activity. There were fears in the market that a repeal of Obamacare would result in a reduction in Medicaid funding, which is the largest expense for states. Thus repeal would pressure states - especially those that opted to expand Medicaid - and could result in less funding for K-12 and higher education, the next largest spending item for states. For now, we will just wait to see how healthcare funding and insurance progress and assess what the impact to states and their municipalities may be.

Infrastructure: Trump plan uncertainty continues while states make progress.

Although Trump's $1 trillion infrastructure plan has yet to be unveiled or decided upon, state and local governments are making progress on repairing our nation's infrastructure. As reported by Moody's, the American Road and Transportation Builders Association annual report shows that the number of structurally deficient bridges decreased by 4.8% in 2016, on top of a 12% reduction from 2012 to 2015. State governments are responsible for 77% of bridges as measured by deck area, with local governments responsible for the rest. Highway and road needs are also substantial. The median cost to replace all structurally deficient bridges amounts to 2.9% of fiscal 2015 revenue, a figure that appears manageable but competes with other budgetary needs. Building infrastructure boosts economic activity, and improved roads and bridges facilitate the increased traffic volumes that population growth and economic activity bring; allowing activity to continue rather than impeding growth.

And speaking of infrastructure, with the potential reduction in federal administrative agency budgets, there is concern that environmental regulations and/or enforcement may be reduced; and that concern is leading to an increase in demand for sustainable investing. According to the US Forum for Sustainable and Responsible Investment, $1 out of every $5 invested by asset managers in the US - or more than $8 trillion - is for sustainable, responsible, and impact investing. Managers that specialize in impact investing are noticing an increase in demand in response to perceived threats to the environment and to social programs.

Green bonds have emerged as a growing sector of the municipal market as standards for issuance and continued surveillance of compliance with green principles have evolved. Green bonds are issued for myriad sectors including affordable housing, in addition to bonds to finance greenhouse gas emission reductions and water and sewer projects. The New York State Homes and Community Renewal Housing Finance Agency made the Empire State the first state in the nation to have affordable housing bonds certified by the Climate Bonds Standards Board. The board, in addition to setting rigorous criteria for "green" eligibility, requires transparency and annual reporting.

Globally, in 2016, green bond issuance reached $93.4 billion. Of that amount, we estimate that $6 billion was offered by municipal issuers; and year to date, municipal green bond issuance has already reached $1.4 billion, per Bloomberg. Green bonds are clearly a sector that appeals to issuers and investors alike, and we expect issuance to grow.

More Negative State Credit Rating Actions

Upgrades exceeded downgrades overall in 2016, with issuers in California and Texas accounting for more than a third of all upgrades. This was the fifth year in a row that upgrades outpaced downgrades. However, the states continue to have budgetary and ratings pressure: Exposure to the oil industry and pension underfunding continued to be the pinch points contributing to state downgrades in the first quarter.

The State of Louisiana (Aa3/AA) was downgraded by S&P to AA- with the negative outlook continued. This development reflects the state's persistently weak revenue collections stemming from prolonged contraction in the oil and gas industry, coupled with weak income tax collections and one-time measures used to close the budget gap. The negative outlook remains as certain taxes sunset and may or may not be replaced in the upcoming legislative session.

Oklahoma (Aa2/AA) was downgraded by S&P to AA with a stable outlook and is another of the eight states with large exposure to the oil industry. The state's financial position has deteriorated to a point that further precludes the state from building up reserves in upcoming fiscal years. The stable outlook reflects the state's low debt burden and historically strong liquidity.

West Virginia (Aa2/AA-) was downgraded by Moody's to Aa2 stable. The downgrade is due to a multiyear trend of growing structural imbalances - a mismatch between revenues and expenses. The state's demographic profile remains below average; pension funding shortfalls are higher than average; and the state's debt burden could increase under the governor's new infrastructure proposal. Moody's notes the stabilization of the state's economy, and infrastructure spending could further spur economic growth.

The State of Kansas (Aa2/AA-) outlook was revised by S&P to negative based on weak economic trends and budgetary pressure that could last through 2019, along with continued underfunding of its pension funds that could lead to larger fixed charges in the future.

Kentucky's S&P outlook was revised to negative on its A+ rating, which is already a low rating for a state. Moody's rates the state's debt Aa2. The revision to negative is due to the increasing probability that funding levels of the state's pension plans could significantly weaken and associated fixed costs could grow to a level that might significantly pressure budgetary performance and flexibility.

The states continue to experience budgetary pressures while numerous municipalities continue to do well, as evidenced by the excess of upgrades to downgrades. However, there are geographic regions that continue to lose population and have reduced economic activity. In states that are experiencing budgetary issues, municipalities and regional agencies may see reduced funding. These trends confirm our strategy: to invest in high-quality credits that can withstand reductions in funding and in essential-service revenue bonds such as water and sewer utilities that have rate autonomy. Higher interest rates tend to lead to wider credit spreads, so higher-quality bonds will perform better than lower-rated issues will.

We will monitor developments in the municipal market, especially regarding the slower pace of change in major policies and any executive orders or rule writing that may occur short of any policy overhaul to health care, taxes and infrastructure investment. Changes may be different than initially proposed during the election, producing better or worse ramifications to municipal credit quality than originally anticipated. We will continue to relay our thoughts to clients and make adjustments to portfolios as required to maintain investment in high quality holdings.