Meredith Whitney made a call back in 2010 forecasting big trouble in the municipal bond market. It generated a large selloff and widespread condemnation. The defaults predicted never materialized but it drew attention to an important issue that seems to be coming to a head right now.
I believe Whitney was wrong (temporarily) for two main reasons. One, the weak economic recovery was enough to keep many states and municipalities alive. Two, unprecedented Central Bank intervention (ZIRP, QE, etc) intentionally suppressed interest rates and allowed them to kick the can down the road.
However, the problems are so severe that even those two items are not enough anymore. Puerto Rico was the first domino to fall and Illinois seems next. There are several states right behind Illinois that will join them in the headlines.
In this article, we will discuss what happened to Illinois, what to look for in your investments, and my own personal predictions regarding these troubled states.
Downgrades, Unpaid Bills, and Population Loss
Unfunded State Pension debt is one of the main causes of Illinois' malaise. The state’s leadership has reacted to this with an unending string of tax hikes. Despite all of that, the pension system sits at less than 40% funded.
(Source: Illinois Policy)
The problem is so bad that certain pensions will run out of money entirely by 2021 like the Chicago Police Pension Fund:
(Source: Chicago City Wire)
Unpaid bills to vendors have reached $14.54 billion (billion with a b, not a typo).
(Source: Illinois Policy)
Citizens have responded to this dysfunction by fleeing the state. One person leaves Illinois every 4.6 minutes and the population has actually been shrinking since 2013:
(Source: Illinois Policy)
The end result is the lowest credit rating of any state in the country at one level above junk. (This is actually quite generous in my opinion.) Ratings agencies are promising an actual downgrade to junk if a budget isn’t passed by the end of the month.
Gerrymandering and Political Control
The purpose of this section is not to endorse any one of our two lousy political parties but to point out a factor many don’t consider.
A bankrupt state (like Illinois) whose legislature is dominated by one political party is a nightmare scenario for muni bond holders. You might think that dominance would lead to easier reform and recovery. It is the exact opposite. Politicians who are guaranteed to be re-elected (possibly through gerrymandering) simply couldn’t care less about the situation their state is in.
Illinois has this problem as seen by the legislative map below which results in Democratic majorities in both houses.
(Source: University of Illinois Springfield)
If party X is guaranteed to stay in power, real reform will not happen and muni bond holders will end up in trouble. The state’s political machine will have no problem not paying you if it means favoring a local political constituency.
Know what you own
When Puerto Rico started to falter, everyone started looking in their funds to see if they had exposure. It makes sense to do the same now with Illinois.
I picked the three largest Nation Muni CEF at CEFConnect.com. All three were from Nuveen and Illinois was the largest holding in each one:
The usual retort is that picking individual bonds within a troubled state is a good strategy. My response is you are picking the best chair on a sinking ship. You have no idea what actions state level politicians might take that will turn your “good” bond into a “bad” bond.
Maybe they change K-12 school funding formulas. Maybe they eliminate funding to universities which your local economy may depend on. It’s not worth the risks for the low yields these bonds offer anyway.
Illinois is in real trouble. Years of mismanagement are coming to a head and the state is careening toward junk status. The state’s tax hikes have caused population loss and done little but aggravate the problem.
The scariest part for muni bond holders is there are states right behind Illinois. Kentucky, New Jersey, Connecticut, and Massachusetts will soon join the club.
Here are my ideas on how this plays out:
- A recession will eventually hit the US economy.
- The recession will make the problems worse by decreasing tax revenues and hurting pension funding levels
- The worst states will make no serious effort to reform because politicians will keep getting re-elected regardless of how bad the situation gets. They will keep hiking taxes.
- Many will see population loss as residents flee because the taxes in many of these states are already very high. (Already happening in Illinois. New Jersey population is just barely growing). Companies and individuals are more mobile today. A growing number of workers are location independent and can work from home.
- A vicious cycle will kick in involving escalating taxes and population loss.
- At some point, Congress will have to step in and allow states to declare bankruptcy.
- Some may dismiss this as crazy but I believe in certain cases, the Federal Government will have to intervene directly. This might involve conservatorship of state finances because I believe certain states will refuse reform. Illinois and New Jersey are high on the list. (I’m sure the Constitution says this isn’t possible but we’ll see!)
I don’t see any positive scenario for muni bond holders of Illinois, New Jersey, Connecticut, Massachusetts, or Kentucky. You may see durations extended, coupons reduced, or outright defaults.
Buyer beware and check what you own.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.