Governor Gavin Newsom reported that California will face a $22.5 billion budget deficit in the coming fiscal year, the first for the most populous U.S. state since 2018, as the global stock market rout and efforts to cool inflation take a toll on its tax collections. Newsom detailed the shortfall in a $223.6 billion budget he proposed last Tuesday for the fiscal year that begins July 1st.
His general fund blueprint fills the gap mostly by tapping one-time funds. In addition, the governor wants to reverse plans outlined in this year's budget to cash-fund some capital projects. Using debt financing would allow for more flexibility in the 2023-24 budget. "We had a $73 billion surplus in fiscal year 2020-21 and a $100 billion surplus in fiscal year 2021-22, so we did not need bonds, but we will be tapping bonds this year," Newsom said. "We will be issuing $4.3 billion in bonds to preserve cash."
The deficit brings an abrupt reversal for California, which enjoyed substantial surpluses in the wake of the pandemic, as the stock market rallied on the back of massive stimulus from the federal government. That delivered windfalls to wealthy residents who account for a large percentage of California's income tax revenue.
In addition to falling stock and real estate markets, the State has also seen layoffs at large California-based employers including Salesforce Inc., Meta Platforms Inc., and Twitter Inc., which may lower personal income tax collections. "What is consistent is the inconsistency of our revenue on the basis of a progressive tax structure," Newsom said. "The good news is that because of leadership and because of support of the voters, we've been able to capture a lot of that volatility in terms of set asides that provide us a buffer. "
Newsom will update his proposal in May with the latest revenue collection figures. Legislators are required by law to pass a budget before the end of the day on June 15th or they forfeit their pay for each day they are late. Democrats control both chambers of the legislature. Lawmakers typically propose their own budget then strike a deal with the governor that combines portions of his and theirs.
The governor, a Democrat who was sworn in for a second term two weeks ago, enjoyed a record $100 billion budget surplus this year, about half of which he used for discretionary purposes. That included a $9.5 billion program that gave one-time inflation relief payments of up to $1,050 each to more than 16 million taxpayers and their dependents.
The fiscal about face in the nation's biggest state may be an early sign of trouble for the governors who saw revenue surge after the pandemic, in part due to hundreds of billions of dollars in aid from President Joe Biden's rescue plan. That funding has largely been spent or committed, and the Federal Reserve has raised interest rates aggressively to curb inflation, which has raised the specter of a potential recession. The last two downturns were extremely painful for state governments as large budget shortfalls triggered numerous rounds of fiscal austerity, and credit rating downgrades.
A major challenge for Newsom will be delivering on his ambitious, progressive agenda for his second term as California's budget tips into deficit after years of surplus that helped fund programs Newsom promoted to reduce homelessness, provide universal healthcare and preschool, and free breakfast and lunch to all students who request meal assistance, regardless of family income.
Newsom acknowledged in his inaugural address that the worsening economic climate would make it harder to resolve the overlapping crises of affordability, housing and homelessness he and the legislature were unable to resolve during his first term. He pledged "an honest accounting of where we've fallen short. "
California has long been prone to booms and crippling deficits because of the sensitivity of its revenue to financial markets, and it has put away billions to cover the hit of the next downturn. Lawmakers added $37.2 billion to reserves in the spending plan that began in July.
Newsom said personal income tax withholding receipts have contracted by 4.5% on average on a year-over-year basis from July to November. Revenue from capital gains as a percentage of total general fund tax revenue is projected to decline $17.6 billion in 2023 from $30.4 billion two years ago. "That sums up California's tax structure," Newsom said. "That sums up the boom bust as it relates to revenue." In November, the State's nonpartisan Legislative Analyst's Office projected that the State would see a $24 billion deficit in its next fiscal year due to a shortfall in revenue.
California's finances had benefited from rising stock prices and a boom in Silicon Valley. With tax revenue pouring in, Moody's Investors Service and Fitch Ratings boosted the State's credit rating in 2019 to the highest level since the dot.com boom over two decades ago. Its 10-year bonds yield only slightly more than the top-rated benchmark, showing investors see little risk to the securities.
Newsom has repeatedly denied that he intends a future presidential run, even as he cultivates his national profile as a Democratic leader capable of delivering on a progressive model of governance. In promising to "reconcile our shortcomings" and "bring everyone along in our prosperity," Newsom risks not being able to deliver on expectations that California can spend its way out of deepening inequality.
Some California lawmakers are already pushing back on proposals to fill the projected $22.5 billion deficit that could force them to consider cutting programs key to their policy goals. The governor presented his general fund budget for the world's fourthlargest economy with calls to balance a progressive agenda with fiscal restraint. The budget tempers the shortfall with a combination of funding delays, $5.7 billion in pullbacks, shifting money between funds, and "triggers" to allocations that would be dispersed only if certain conditions are met ahead of the 2024-2025 fiscal year.
Local transit is one area where Newsom proposes to wield his budget knife. Planned funding for the Transit Intercity Rail Capital Program would be cut in half under his plan, from $2 billion to $1 billion annually. A program to encourage walking and biking would face a net $200 million reduction. At least one lawmaker thinks those cuts are a nonstarter. "While I fully understand the tough choices we have to make, we must not let our public transportation systems go over the impending fiscal cliff and enter a death spiral," Senator Scott Wiener (D) said in response to Newsom's proposal.
Newsom's budget also stops short of letting young, low-income undocumented residents sign up for the California Food Assistance Program, and delays plans to let undocumented people 55 and older access the aid. Both Senator Melissa Hurtado (D) and Assemblymember Miguel Santiago (D) said they would push to get that aid in the budget.
Environmentalists, who hold considerable sway in the Democratic-controlled Legislature, pushed back on the $6 billion in planned cuts to climate programs, from $54 billion to $48 billion. "To further delay these investments will further compound the climate crisis and the cost of inaction will be far worse," said Mary Creasman, CEO of California Environmental Voters.
Newsom will release a revised budget by May 14th to reflect a more accurate economic outlook once revenue estimates for the coming fiscal year become more certain. Sometimes the revisions are substantial. In 2020, a rosy January outlook turned dour by May as the COVID-19 pandemic forced the governor to reconsider some policies. Newsom had pledged to extend Medi-Cal, the State's health program for low-income residents, to undocumented seniors, but was forced to delay that plan. Thanks to a comfortable budget surplus last year, all income-eligible Californians, including undocumented residents, will be allowed to enroll in Medi-Cal starting January 1st, 2024.
After Newsom's revised budget is released, the real wrangling begins. Newsom, Assembly Speaker Anthony Rendon (D), and Senate President Pro Tempore Toni Atkins (D)—the "Big Three"—will parse over the details and compromise on any outstanding differences. Newsom must sign or veto the budget bill by June 30th, ahead of the new fiscal year beginning July 1st.
Conclusion
As deadly storms batter California after years of drought, Governor Gavin Newsom is preparing the nation's largest state for an extreme reversal in its finances as well. Last Tuesday, the Democratic governor introduced a $223.6 billion general-fund budget proposal for the fiscal year beginning July 1, pledging that despite a $22.5 billion deficit, the State's first after years of surpluses, his administration would continue "transformative investments" in education, childcare, health care, housing and reducing homelessness, and combating climate change.
Revenue for the upcoming fiscal year is $29.5 billion less than earlier projections due to decreased tax revenues, higher interest rates, and stock market declines affecting the compensation of the highest earners who pay a large share of taxes. California has been long prone to booms and crippling deficits because of the sensitivity of its revenue to financial markets, and lawmakers have added $37.2 billion to reserves, which the governor says he has no plans to tap to cover the anticipated shortfall.
He said his plan relies instead on budgetary maneuvers to delay $7.4 billion of funding for multiyear programs, $5.7 billion in spending cuts and pullbacks, and shifting $4.3 billion of spending from the general fund to other funds. These shifts would include the California State University system selling bonds for capital projects rather than using state funds, and shifting certain Zero Emission Vehicle commitments to the Greenhouse Gas Reduction Fund.
Top Of Page
Municipal Bond Market - Credit Outlook for 2023
Monday, January 9, 2023
Municipal bond issuers will continue to face several credit challenges in 2023, but MTAM expects that the vast majority of municipalities will successfully manage through most difficulties with a combination of spending cuts and revenue enhancement plans.
MTAM has always been, and will continue to be, a conservative asset manager. We are very selective in the municipal sectors and top tier bonds we decide to purchase and hold. This positioned us extremely well to weather the recent pandemic situation.
Notwithstanding the challenges facing municipal bond issuers, there are always good opportunities, even for the very conservative investor. We still expect defensive credits like water and sewer bonds, special tax bonds, and public power bonds to perform better from a fundamental perspective. These types of bonds tend to have revenue streams that are less subject to economic volatility, have strong covenants, or are tied to an “essential service”, making debt service payment more certain. In addition, there is legal precedence that bonds backed by a dedicated revenue stream may be protected in the case of a municipal bankruptcy. We prefer bonds that have a clean flow of funds, broad revenue streams, and high debt service coverage tests.
State and Local Governments
While slowing economic growth in 2023 will weaken the macro conditions facing U.S. states and local governments, MTAM anticipates credit quality will remain stat/e and strong given governments' prudent efforts in recent years to bolster financial resilience. Robust reserves, in many cases exceeding pre-pandemic levels, as well as other prudent budget management measures, leave state and local governments well - positioned to face this economic weakness. Federal support, through direct aid and overall economic Stimulus, was a key driver of the positive budget results for governments in recent years. That support has largely ended.
Employment, income, and GDP growth will all slow in 2023. The real estate market is likely to continue cooling as the Federal Reserve's monetary policy actions tighten credit access. These economic factors will drive slower tax revenue growth, or even declines in some cases, for state and local governments.
The vast majority of state and local government rating outlooks are stable. This is an improvement from the 2021 and especially the 2020 distributions, which were heavily affected by pandemic-driven challenges. The stability 1n 2022 reflects the fundamental strengths of state and local governments, including broad and diverse revenue bases, control over revenues and spending, moderate long-term liabilities, and sound financial cushions.
Since state and local governments rely on tax revenues that respond quickly to changes in the economy, a rapidly cooling housing market and a commercial real estate market adjusting to less people working in the office could pressure property taxes more quickly than in the past. Against these headwinds, ample fiscal buffers are in place and should allow most state and local governments to absorb a moderate downturn. As such, MTAM ant1cipates state and local governments ratings will be largely unaffected.
What will be critical is how long and severe the recession turns out to be. A significantly deeper and prolonged recession could lead governments towards credit negative budget choices such as sustained pension funding deferrals or payment delays. Conversely, state and local budgets will directly benefit should the recession be relatively quick and subsequent economic growth materially exceed expectations.
Return to office trends, which are flattening, are particularly integral for local governments over the med1um and long-term. The ability of cities with large downtown office cores to continue making progress towards pre-pandemic levels of economic activity could become a more salient credit issue over the next several years.
Not-for-Profit Hospitals
MTAM continues to have a negative outlook on the not-for-profit healthcare and hospital sector for 2023. While U.S. not-for-profit hospitals weathered the immediate effects of the coronavirus pandemic quite effectively, our outlook for the sector points to continued struggles with many longer-term pressures from the COVID-19 fallout.
MTAM expects that core credit drivers for the sector will remain challenged for 2023. The sector is seeing labor pressures and generationally elevated inflation, compressing margins for virtually all providers. These macro headw1nds, specifically the labor supply, became highly pronounced in a very short period of time, with sector pressure further compounded by investment losses in 2022. The largest single expense for healthcare providers is labor (salary, wages and benefits) typically at 50% or higher, followed by supplies, which, when including pharmaceuticals, is typically at 25% or higher. Consequently, 75% or more of a providers' expenses are currently under intense expense pressure, and operating metrics are down significantly in 2022 for most providers, with 2023 not expected to show a rapid operational recovery for most.
For providers that suffered significant operational losses in 2022, we believe that break-even on a month-to-month basis should return sometime in 2023, with gradual improvement from there. Others who suffered only modest losses may return to profitability on a month-to-month basis by late 2022 or early 2023. A select few health systems continue to enjoy strong operating margins (excluding one-time supplemental support), which is a mark of distinction in the current sector landscape.
While severe volume disruption to operations appears to be waning, elevated expense pressure remains pronounced. Even if macro inflation cools, labor expenses may be reset at a permanently higher level for 2023, and likely well beyond. Where this will be the most felt is nurses, which were already in high demand pre-pandemic with COVID-19 only exacerbating a glaring shortage of nursing staff.
In addition to elevated labor costs, MTAM expects that persistent COVID-19 surges, supply chain disruptions, and continued cybersecurity investments will also increase expenses. While operating cash flow may grow in 2023, the high expense environment, coupled with modest revenue gains, may limit the profit margin for the not-for-profit healthcare sector. This level of operating cash flow production will likely prove insufficient over the long term to enable adequate reinvestment in facilities, maintain investment in programs, or support organizational growth. Furthermore, higher interest rates will raise the cost of debt and make financing equipment or investing in capital more expensive.
Improved reimbursement and an increase in high-margin service volumes could move the outlook to stable if they result in operating cash flow growth sufficient to enable health systems to support organizational needs going forward.
Transportation
Growth should remain largely undeterred for U.S. airports, toll roads, and ports in 2023 in the face of recession. MTAM holds a stable outlook for the sector and for ratings, despite a significant softening of the broader economy in 2023.
This is not to say that transportation will not need to weather some headwinds. Persistent inflation and higher interest costs will make operating costs and financing of capital projects significantly more expensive. This could lead to delays or paring back of capital improvement projects, though Federal funding could serve as a positive counterbalance.
Federal grant awards have helped jump-start liquidity for many U.S. airports during the pandemic. With national passenger traffic currently at 89% of 2019 levels, the move towards more air travel following years of pandemic restrictions should keep the rate of growth positive.
Traffic growth should continue for toll roads, though it will level off to some extent in 2023. Toll roads with automatic inflation-linked toll rate increases are facing a second year of atypically high annual rate increases, though some toll roads are hitting 'pause' on automatic increases to provide customers some economic relief.
The stable sector outlook reflects our expectation of the continuing resilience of
EMEA transportation infrastructure assets, despite the worsening macro outlook in 2023 due to rising inflation and higher interest rates. The essential nature and inflation-linked revenue profile of most infrastructure credits, as well as their capex flexibility and well-established access to bank and capital markets, make the asset class able to withstand a moderate contraction of economic activity. However, exposure to a deteriorating economic environment will vary by sector. Airports are the most exposed to the recession with inflation eroding consumers' disposable income, their propensity to fly, and ability to spend money in airports. Ultimately, this is likely to bring a more back end loaded recovery to pre-pandemic levels. Ports and toll roads are in a better position as their traffic has at least recovered to prepandemic levels and are now able to cope with a moderate recession.
Airline traffic is increasing but unevenly throughout the year, from a low base and less so than it would in a more favorable environment. This baseline is then coupled with staffing shortages, high airfares, and limited disposable income, among other difficulties for passengers, creating a hindered starting line for U.S. airports in 2023.
Growth in peak summer and holiday periods in 2023 will depend on airlines' ability to add capacity.
Federal grants will help some airports make much needed renovations without taking on large amounts of debt. But the need to use the funds in a defined period, in which inflation and interest rates are high, could lead to rushed due diligence, cost overruns, a need for airports to fill funding gaps, and other execution risks. At the same time, higher inflation and financing costs will drive airports to increase bond issuance amounts. But airports have strong cash balances, which will help them fund capital projects.
The outlook for debt sold by U.S. transit agencies remains negative as systems still reel from reduced ridership, and a looming sunset of federal aid. The coronavirus pandemic seems to have permanently changed ridership patterns. Ridership will continue to substantially lag pre-pandemic levels. Many systems will require changes in service, fares, and operating and capital plans to maintain credit quality.
At the onset of the COVID-19 pandemic ridership plummeted and left many public transit systems without a recovery plan. And now, years after the initial lockdowns, agencies are experiencing a slow rebound as many people work hybrid schedules, returning to offices only part-time. It is expected ridership across the U.S. to reach only 65% to 75% of pre-COVlD-19 levels by the end of 2023.
Federal stimulus aid provided some temporary fiscal relief but without a long-term solution, fare-dependent systems will have to contend with large budget gaps as the aid dries up in the coming years. Since the start of the pandemic, many systems have become more reliant on taxes levied by their parent governments. Those appropriations could decline if tax collections slow in a weaker economic landscape.
While tax growth has provided welcome budget relief during the slow ridership recovery, it will be slower and less predictable in 2023 as economic uncertainty grows. The outlook for mass transit could move to stable if ridership recovers faster than expectations or if strong tax revenue growth supports balanced budgets.
Water and Sewer
MTAM is maintaining a stable outlook on the U.S. water and sewer sector for 2023. The sector's strong fundamentals are underpinned by the essential service provided to users, monopolistic business nature, and high barriers to entry. Additional positive features are low price sensitivity, strong liquidity, and independent local rate-setting authority. These factors insulate the sector to some extent from economic cycles. However, persistent droughts and overregulation could reduce financial flexibility for certain issuers.
We do have an expectation that economic and business conditions will create a more challenging operating environment in 2023, relative to 2022. Strong headwinds related to general inflationary pressures, notably higher chemical, labor, and power costs, and weaker economic growth are expected to contribute to weaker financial performance. This could lead to a weakening in credit quality across the sector, if not offset with commensurate rate adjustments to keep pace with the higher cost environment. Despite these pressures, the sector outlook remains stable, as most utilities still have headroom for absorbing higher costs. We expect limited rating changes in 2023, yet a narrowing of financial margins is likely.
2023 will likely mark a second straight year of cost and capital pressures for water and sewer utilities. General inflationary pressures, notably higher chemical, labor, and power costs, and weaker economic growth are likely to weaken financial performance for water and sewer utilities. Though operating budgets are already reflecting higher costs, financial performance could further erode if utilities are unable to generate revenue to counter rising costs. Helping to offset budgetary pressures to some extent for water and sewer utilities are their strong cash balances and ability to institute cost-saving measures.
Other factors to watch in 2023 are the prospects for increased cyberattacks. Cyberattacks that halt service or requires ransomware payments could negatively affect utility financial performance and could result in widespread public and private sector shutdowns. Additionally, increasingly worsening extreme weather events will continue to be a threat to the sector as utilities work to expand and improve resiliency of water supply and contend with unforeseen expenses that can arise in the aftermath of severe weather events.
Public Power
MTAM's 2023 sector outlook for U.S. public power electric utilities is stable, reflecting strong sector characteristics and a conservative business model that provide issuers with stability and strength, even during periods of uncertainty. The fundamental strengths of the sector include: autonomous rate-making authority, the essential nature of electric service, mandates to serve well-defined areas with monopolistic characteristics, and reliable cash flow.
However, we do have an expectation that economic and business conditions will create a more challenging operating environment in 2023, relative to 2022. Strong headwinds related to general inflationary pressures, higher natural gas prices, and slower economic growth are expected to contribute to diminished operating performance. This could lead to a weakening in credit quality across the sector, absent aggressive efforts to reduce or recover operating costs, and increase rates to preserve margins.
Among the challenges facing the public power sector, risks from generating capacity constraints and energy shortfalls are emerging, raising the possibility of higher wholesale energy prices and rolling blackouts. Extreme temperatures may drive record peak demand for electricity, while drought conditions, plant retirements, and wildfire risks could challenge resource availability.
Projected capacity needs to offset power plant closures and meet growing electricity demand are aggressive and may be hard to meet, given supply chain disruptions. The increased frequency and worsening severity of extreme weather events will continue to be a threat to the sector as utilities work to expand and improve resiliency of electric and gas supply and contend with unforeseen expenses that can arise in the aftermath of severe weather events.
Cyberattacks may also pose major financial risks. A breach of critical utility assets from cyberattacks that halt service or require ransomware payments could negatively affect utility financial performance and could result in widespread public and private sector shutdowns.
We expect energy prices to remain elevated through next year, driving fuel and purchased power costs higher, and reducing financial headroom for the public power sector. It is forecasted that natural gas prices will average $5/thousand cubic feet, down from $6.75/mcf in 2022, but higher than in recent years.
MTAM expects the trend of weakening affordability to continue in the near term, increasing rate pressures and threatening utility operating margins. Residential electric costs will use 2.1% to 2.2% of median household income next year, about the same as this year.
Despite the challenges, public power electric utilities will likely gradually increase their capital spending. New wind and solar generation will dominate near-term added capacity and tax credits in the Inflation Reduction Act should increase direct investment by not-for-profit utilities. This may reverse the trend where capex by wholesale systems fell below depreciation in six of the past eight years. Spending by retail systems should be more robust, led by initiatives to improve grid resiliency. Given the technological risk and unknown path to achieving emerging 100% carbonfree electricity goals, the effect on reliability, customer bills and credit quality remains a long-term concern.
Colleges and Universities
MTAM is maintaining our negative outlook on the higher education sector for 2023. Core credit factors will be challenging sectorwide, with meaningful macroeconomic headwinds in inflation, labor and wage pressure, along with generally soft enrollment. Volatile markets in 2022 drove endowments down, with an average projected loss of 10% across the sector. All of these headwinds have the potential to erode operating margins in 2023.
Inflation may provide practical cover for some limited increases in tuition; however, such increases are unlikely to be sufficient to mitigate increased costs. Continued controls over operational and capital spending are expected to preserve some
budgetary flexibility, but these efforts will yield diminishing returns amid the current macroeconomic environment. Sector bifurcation will continue to widen the credit gap between larger, more selective institutions versus their smaller, less selective and more tuition-dependent counterparts. Despite these conditions, widespread downgrades are not anticipated.
While first-year and international enrollment is trending up for the 2022-23 academic year, that growth has not negated declines in previous years. We point to the likelihood of consistent enrollment challenges over the next decade, particularly in the Northeast and Midwest, where demographic trends show a shrinking college-age population.
MTAM anticipates increasingly challenging operating conditions for U.S. higher education institutions in 2023 as they grapple with inflationary costs, labor pressures, mixed enrollment trends, and a continued need for elevated expenditure controls. Possible countering factors include a relatively favorable state budget environment and early prospects for easing enrollment pressures in incoming and international student groups.
Housing
MTAM views the tax-exempt housing sector as having a stable outlook in 2023. State housing finance agencies (HFAs) throughout the country will head into a likely broader recession in 2023 on firm fiscal footing.
HFA equity growth is still strong, though it leveled off in the past year. Aggregated equity rose 6% in fiscal 2021 and is up 31% since fiscal 2017. Driving the consistent rate of growth has been a favorable operating environment driven by strategic investment and prudent management to offset low interest rates and higher delinquencies. With many economists calling for a broader recession in early-2023, this judicious approach will serve the sector well.
That housing finance agencies were able to maintain modest profitability and stable equity despite the pandemic hangover, rising mortgage rates and elevated home prices speaks to the strength of the sector. While challenges in responding to growing affordable housing needs lie ahead, HFAs remain well positioned to respond while maintaining solid financial profiles.
Though it rose slightly over the last year, leverage remains stable as the median adjusted debt to equity ratio was 2.6x in fiscal 2021. This is below the five-year average median of 2.9x, and now solidifies a trend where the ratio is equal to or below the median debt to equity ratio experienced for the past five fiscals.
Default Outlook
At the end of April 2022, Moody's Investors Service released its annual municipal bond market snapshot, U.S. municipal bond defaults, and recoveries, 1970-2021. In addition to noting that the municipal sector continued to recover from the effects of COVID-19, the report also affirmed two hallmark benefits municipal bonds offer. First, while they may have become more common over the last 15 years, municipal defaults and bankruptcies remain rare overall. (Indeed, there were no new rated municipal bond defaults during the period of significant market stress in 2021 resulting from COVID-19.) Second, municipal bonds continue, on average, to be highly rated compared to corporates. However, even though they may have stabilized during 2021, according to Moody's, cumulative default rates have increased since 2010.
Once again, an important observation noted in this year's report was that over the 52year study period: "Any one default may only reflect the idiosyncrasies of that individual credit, and may not represent a general sector trend. "
In relation to the effects of the pandemic, Moody's notes that, in addition to the acceleration of remote learning and work and the associated movement away from high-density employment and living, there are not only public health impacts but also "potential longer-term effects for K-12, higher education and the mass transit sector..." All these bear watching in the context of the municipal bond market.
The report drew attention, once more, to the fundamental difference between municipal and corporate credits. Even though the average five-year municipal default rate since 2012 has been 0.1%, compared with 0.08% throughout the study period (1970-2021 ), it remains extremely low. This is especially true compared with the five-year default rate of 7.2% in 2012 and 6.8% in 1970 for global corporates.
Vis-å-vis Puerto Rico, Moody's notes in its report that "several more Puerto Rico credits that initially defaulted in 2015-17 have begun recovery in March 2022." And that "the history of the litigation and recoveries for the Commonwealth's debts ... broadly is a reminder of the power of credit fundamentals, such as leverage, operational balance, and economic capacity, over ostensible security features written on paper. While legal security will influence recovery, credit fundamentals drive defaults. "
This year's report notes the "continued absence of rated defaults due to natural disasters" as an "interesting trend." Although the small town of Paradise in California was nearly destroyed, it has continued to make its bond payments. Moody's describes this as demonstrating that "willingness to repay debt can overcome many obstacles, including, in this case, small scale and near total destruction. "
In 2021, there were more rating changes and rating volatility than in prior years, but when compared with that of global corporate bonds, it has been "significantly lower, " with the U.S. public sector exhibiting "great resilience in 2021. " (Credits benefited from a combination of direct federal and market support, active debt management, and "strong reserves going into 2020. And indeed, even with the continuing effects of the pandemic, there were more municipal bond upgrades than downgrades.
According to the report, municipal credits remain, typically, very strong, and "their rating distribution is substantially skewed toward the investment-grade, where ratings tend to be more stable." The report added that the municipal sector overall remains highly rated with 91% of all Moody's-rated municipal credits falling into the A category or higher as of the end of 2021, the same as in 2020. Further, at the end of 2021, the median rating for U.S. municipal credits remained at Aa3 (2020: Aa3). This continued to stand in stark contrast to the median rating for global corporates, which was, once again, at Baa3 (2020: Baa3).
While we continue to argue that municipal bonds still offer a fiscally sound vehicle for generating an income stream free from federal and some state taxes, it remains challenging to obtain the same level of timely disclosure from issuers as one sees in other asset classes. Despite this, the municipal market's behavior during the COVID crisis in 2020 and 2021 is prima facie evidence of both its (and municipal bonds') soundness and resilience.
According to Moody's report, there were only 114 distinct Moody's-rated defaults, representing a little over $72 billion, across the whole universe of more than 50,000 different state, local, and other issuing authorities between 1970 and 2021. There remain, as always, caveats. As Moody's states: "The once-comfortable aphorism that 'munis do not default' is no longer credible: rating volatility, rating transition rates, and cumulative default rates (CDRs) have all increased since 2010, even if they have stabilized through 2021. However, even when subject to virus-related and post virus-related stresses, they have remained surprisingly stable—so far.
Challenges facing this sector continue to be demographic shifts (populations both aging and relocating—affecting tax receipts), substantial increases in pension and retirement health care leverage, and the associated heightened exposures to equity markets. In addition to these, it remains to be seen what the full effects may turn out to be from the new dynamics that became, and are becoming, only too apparent with the arrival of, and devastation wrought by, and the continuing recovery from COVID-19.
Conclusion
MTAM continues to recommend that investors select high-quality municipal issuers that understand the new economic and financial reality, and have made or are making budget adjustments. Essential service revenue bonds without the budgetary concerns of state and local governments and limited payrolls can be attractive, but we stress that an essential service issuer cannot flourish if the underlying governmental entity is in dire economic circumstances. A healthy outlook holds for most infrastructure issuers due to fundamental strengths reflected in the provision of essential public services, adequate balance sheets, and generally sound governance and fiscal management practices. In the case of the enterprise sectors comprised of higher education, health, and housing, credit quality will be maintained primarily as a function of their ability to increase fees, control costs, and improve overall operating margins. Sound debt and fiscal management practices, preservation of adequate liquidity, and strong governance oversight will be significant determinants of credit quality for issuers during the coming period of financial adjustment.
Top Of Page
4th
Quarter 2022 Review and Outlook
Wednesday, December 28, 2022
Nascent signs that peak inflation may be in the rearview mirror allowed bond yields to
stabilize in the waning months of 2022. Municipal bonds had a productive fourth
quarter as yields rallied approximately 50 basis points from the highs seen in
September (see our third quarter commentary: “Municipal bond yields are flat out
just too high to ignore”). Central banks from around the world continued to tap the
brakes down hard on growth, which stabilized long-term interest rates to some
degree. In fact, we tweeted (@MillerTabak) on December 14th that the Federal
Reserve made a horrible mistake that day by tightening policy by 50 basis points (we
believed only a 25 basis point move was warranted). You can’t “kneecap” the
housing market like our central bank has and expect the economy to remain above
water.
Municipal bonds will be moving into a better technical condition come January, as
tax-loss selling should recede. Also assisting the market will be a drop in supply, with
many issuers unable to refinance their debt due to higher market interest rates. As
recessionary fears permeate through financial markets in 2023, we believe the ability
of municipalities to raise taxes will be viewed quite favorably by investors. As such,
we are of the mindset that the tax-free bond returns next year will be surprisingly
strong when all is said and done. Should the Federal Reserve continue raising interest
rates, each move should be viewed bullishly for longer duration assets. That being
said, you should expect Miller Tabak Asset Management to maintain a longer than
benchmark stance until the Federal Reserve realizes that they killed the patient
(economy). We will continue to be “top shelf” buyers when selecting issuers to invest
in on your client’s behalf. When it comes to the Federal Reserve aggressively hiking
interest rates, we have seen this movie before, and it never ends well for the
economy or risk assets. Keep it simple folks - plan now for the inevitable.
Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak
Top Of Page
3rd
Quarter 2022 Review and Outlook
Friday, September 30, 2022
Once again, financial assets of all
shapes and sizes were pressured lower by the Federal Reserve's clear bias
to continue raising interest rates until inflation weakens. Municipal bonds
were swept up in the global bond market weakness, with constant mutual fund
redemptions weighing on the market almost daily. With inflation concerns
permeating all over the globe, the United Kingdom incredibly poured fuel on
the fire by announcing the biggest tax cut in half a century. UK
"gilt" bond yields exploded higher, dragging yields here in
America to new cycle highs. Excessive fiscal spending by our government
(and others abroad) are what got us to these elevated inflation levels.
Cutting taxes at this point was a very risky decision that essentially
challenges central banks to keep rates in restrictive territory.
Given the magnitude of the carnage in the
financial markets, it is difficult to envision a scenario where the real
economy remains afloat. Credit spreads—rightfully so—have begun to widen in
some of the riskier sectors of the municipal market in anticipation of a
deeper recession. Clients of Miller Tabak Asset
Management should be comforted by our ongoing bias to higher quality
credits, regardless of the state of the economy. If something were to
"break" in the municipal market because of too much Federal
Reserve tightening, it would be the "high yield" mutual fund
space. Forced selling of illiquid assets never ends well; we would suggest
reducing exposure in this area of the market.
Higher quality municipal debt is an area
where investors can obtain taxable equivalent yields in excess of 7% right
now, which we view as quite generous. Conservative investors have
historically gravitated towards municipal bonds because of many issuers'
ability to raise taxes or fees to solidify their balance sheets. The higher
rates go, the more investors will be focused on
"return of capital." This makes municipal bonds a core holding in
any sophisticated client's portfolio.
We believe that clients invested in
separately managed bond portfolios are perfectly positioned. If bonds are
held to maturity, no losses have been realized. Also, clients in this
structure reinvest coupon interest into higher market interest rates, which
increase income levels moving forward as long as the bond you hold does not
default on its debt (we are employed by you to make sure that never
happens). Clients should view a time of rising rates as an opportunity.
Municipal bond yields are flat out just too high to ignore. Investors
should allocate more cash to this sector, as we feel strongly that we will
all wistfully look back at this moment in time in 2023. As always, thank
you for being a wonderful client of MTAM.
Top Of Page
Credit Comment on the State of California's Latest Budget Proposal
Friday, January 14, 2022
California Governor Gavin Newsom on
Monday unveiled a $213 billion general fund budget for the next fiscal
year, buttressed by a $45.7 billion surplus as the most populous U.S. state
enjoys strong tax revenue in the lopsided recovery from the pandemic.
The spending plan, up almost 1.4% from
the current year, allocates billions of dollars to coronavirus response,
mitigating wildfires and drought, easing homelessness, and extending health
care coverage to all undocumented residents.
Newsom will revise the budget in May
accounting for the latest revenue figures. Lawmakers have to approve it by
June 15 or forgo pay. Some of what he proposes uses federal dollars and
other sources apart from the general fund. Of the surplus, $20.6 billion
can be used for discretionary purposes. Reserves, including
constitutionally mandated deposits, total $34.6 billion. The budget would
pay down unfunded pension liabilities with additional $3.9 billion in
payments to achieve savings. The State would spend a total $20,855 per pupil,
a record.
Newsom's spending plans include:
- $2.7 billion to bolster Covid
testing and vaccinations; of that, $1.4 billion is an immediate
emergency appropriation
- $1.2 billion over two years on wildfire mitigation
- $750 million for drought relief
- $2 billion for mental health services for homeless
people and clearing encampments
- $2 billion in grants and tax credits to spur more
affordable housing
- $1.6 billion for community colleges
- $3 billion over two years to pay down unemployment
insurance trust fund debt owed to the federal government
- $6 billion over five years to support zero-emission
vehicles and charging infrastructure
- $356 million over three years, including $132
million next year, in grants to law enforcement to combat retail crime
With a progressive tax system that rakes in more revenue when
the income of the highest earners rises, California continues to collect
more than it forecast. Wealthy residents have reaped the benefits of rising
stock prices and stable employment even as lower-income workers lost their
jobs during the pandemic. The top 1% of earners pay nearly half of personal
income-tax collections. This is the second year of the pandemic that the
State's notching a massive surplus. The current budget spends $210 billion.
Proposed
Expansion of California SALT Cap Workaround
Governor Newsom wants lawmakers to act
immediately to expand a workaround for the federal $10,000 cap on personal
state and local tax deductions. The Democratic governor included the
expansion in his proposed budget. He is asking lawmakers to enact the
changes before the March 15, 2022, tax filing payment deadline for
pass-through business entities electing to use the option for the 2021 tax
year.
The existing workaround allows entities
taxed as S corporations or partnerships to elect to pay a 9.3% state income
tax, and their owners can claim a credit on their personal income taxes
equal to the tax the entities pay.
Newsom would allow taxpayers to use the
credit to offset the State's tentative minimum tax, and to expand
eligibility to taxpayers that own a share of the business through a
disregarded entity such as a single-member limited liability company.
Reverse
Corporate Tax Break Limits One Year Early
Two limits on California corporate tax
breaks imposed at the start of the pandemic would be removed this year
under the budget proposal. Governor Newsom said he would restore net
operating loss deductions and lift a $5 million annual cap on business tax
credit claims as of January 1, 2022, one year earlier than planned.
The limitations would apply only to the
2020 and 2021 tax years. Lawmakers enacted the limits in June 2020, when
the State was expecting a large drop in revenue due to the pandemic.
Instead, California has a multibillion dollar surplus. Reversing the
limitations one year early would reduce state revenue by $5.5 billion,
according to the Department of Finance.
Health
Care For All Poor, Undocumented People
Governor Newsom on asked the Legislature
to set aside $614 million to make California the first state to set up
health care for all low-income residents regardless of immigration status.
The plan would expand state Medicaid (Medi-Cal)
coverage, including long-term care and behavioral health care, he said. The
request for the next fiscal year would be annualized to $2.2 billion into
the future.
The move would expand on last year's
decision to allow undocumented residents over 50 to sign up for Medi-Cal, starting May 1. Undocumented children and
young adults up to age 26 also are eligible for the program.
Nationwide, 20 states and the District of
Columbia provide funding for prenatal care regardless of immigration
status. Six states and the District of Columbia allow undocumented children
to sign up for Medicaid, according to the National Immigration Law Center.
Only Illinois offers health-care funding for undocumented seniors over 65,
and will lower the age limit to 55 beginning May 30.
The proposal falls short of a recent push
from California Democrats to create a single-payer, "Medicare for
All"-style system in the State. Lawmakers unveiled a plan (ACA 11)
last week to fund a single-payer health-care system through new excise,
payroll, and income taxes. The Assembly must pass a related policy bill
(A.B. 1400) by January 31 for it to be considered in the State Senate.
Conclusion
With cash rolling in from a projected
$45.7 billion budget surplus, California Governor Gavin Newsom proposed a
spending plan designed to address a paradox of the most-populous U.S.
state: It's thriving financially, yet beset with systemic challenges that
threaten its long-term growth.
The Governor aims to tackle the
"existential threats" of COVID-19, climate change, homelessness,
the wealth divide, and public safety with a record $213 billion budget for
the coming fiscal year. The plan unveiled Monday, which still must be
approved by legislators, proposes a tenfold increase -- to $500 million --
to clean up homeless encampments, for example, which the governor called
the State's "most vexing and serious issue."
California is home to the world's
fifth-largest economy and remains a leader in progressive causes such as
banning internal combustion engines in new cars by 2035. Yet it continues
to face crisis after crisis, including wildfires, crime, port congestion,
and now an omicron variant surge, despite some of the toughest
virus-mitigation standards in the nation.
Some of the State's most pressing
problems, like a shrinking population and high cost of living, cannot be
solved by the budget alone. Others like homelessness received increased
funding, but that money pales against the scope of the problem, with an
estimated 161,500 unhoused people across the State as of 2020.
To some, the spending plan is a step in
the right direction, addressing California's income inequality by offering
tax credits to low-income workers, additional funding for pre-kindergarten
classes and universal health care even for undocumented residents. Others
see a recurring issue with Newsom's administration, hopping on issues that
are trending with voters, but rarely solving problems over the long term.
California's population declined for the
first time in history in 2020 and the State lost a congressional seat last
year. A number of high-profile companies have relocated their headquarters,
including Hewlett-Packard Enterprise Co., Oracle Corp., and Tesla Inc., in
part because of the cost of living. But the economy is still strong, with
gross domestic product rising 21% in the five years ended December 2020 and
tax receipts coming in well above plan, thanks to the State's dependence on
high-income earners.
Of the $45.7 billion surplus, $20.6
billion can be used for discretionary purposes. The governor, running for a
second term this year, proposed hundreds of millions of dollars in grants
and tax breaks for small businesses while continuing to spend heavily to
promote California's tourism economy. He also pledged $3 billion over two
years to pay down the State's unemployment fund debt.
In recognition of pocketbook issues that
are hitting the less wealthy harder, Newsom announced he would scrap an
inflation-indexed hike in the gasoline tax for the fiscal year. While not
directly addressing corporate departures, he proposed $250 million in
incentives annually for three years for qualified companies headquartered in
California that are investing in research to mitigate climate change.
The State passed a $7.5 billion bond
proposition in 2014 to address the water crisis and yet no storage projects
have begun. Newsom earmarked an additional $750 million in spending on
drought mitigation efforts in the new budget, including passageways for
fish and technology to reduce farmers' irrigation needs.
Newsom has touted success he has had
finding homes for 58,000 people, with the government leasing or buying old
motels to use as shelters, and said cities will have accountability for
their efforts to address homelessness. His new budget proposes $2 billion
in additional spending to address the issue, even as areas such as San
Francisco and Los Angeles face uphill battles trying to find places to
build temporary housing.
The governor's plan includes $255 million
in grants to local law enforcement and a new "Smash and Grab
Enforcement Unit" designed to address the rash of shoplifting gangs
swarming stores. The proposal illustrates the tough position Democrats find
themselves in this mid-term election year with the more liberal wing of
their party pushing for police and criminal justice reforms, while many
voters are worried about crime rates.
Top Of Page
Municipal Bond Market -
Credit Outlook for 2022
Friday, January 7, 2022
Municipal bond issuers will continue to
face several credit challenges in 2022, but MTAM expects that the vast
majority of municipalities will successfully manage through most
difficulties with a combination of spending cuts and revenue enhancement
plans.
MTAM has always been, and will continue
to be, a conservative asset manager. We are very selective in the municipal
sectors and top tier bonds we decide to purchase and hold. This has
positioned us extremely well to weather the current pandemic situation.
Notwithstanding the challenges facing
municipal bond issuers, there are always good opportunities, even for the
very conservative investor. We still expect defensive credits like water
and sewer bonds, special tax bonds, and public power bonds to perform better
from a fundamental perspective. These types of bonds tend to have revenue
streams that are less subject to economic volatility, have strong
covenants, or are tied to an "essential service", making debt
service payment more certain. In addition, there is legal precedence that
bonds backed by a dedicated revenue stream may be protected in the case of
a municipal bankruptcy. We prefer bonds that have a clean flow of funds,
broad revenue streams, and high debt service coverage tests.
State
and Local Governments
How sustainably Federal stimulus aid is
rolled out will be key for both U.S. state and local governments in 2022
amid labor shortages, a new COVID variant, and other unforeseen
post-pandemic fallout. MTAM's outlook for U.S. states and local governments
in 2022 is stable
relative to surprisingly strong 2021 underlying business conditions.
Economic growth above trend and a
significant boost in resources from federal stimulus will keep states and
local government finances on a positive path in 2022. Rising inflation and
supply constraints will remain challenges.
COVID-19 remains influential and
unpredictable as transmission rates and hospital caseloads can shift
rapidly. This makes the new Omicron variant a potential area of concern as
a new pandemic surge could cause another economic setback, complicating
governments' budget outlooks. The largely unspent infusion of federal aid
in 2021 provides some fiscal cushion.
The recent return of international travel
should improve the outlook for major tourist draws and leisure and
hospitality recovery overall in 2022. That said, state and local
governments most dependent on business travel, including convention
activity, will see the slowest recovery, particularly if Omicron variant
infections become more widespread in the U.S.
Another area of note next year is labor
shortages, which are beginning to trigger wage pressure for government
employees and could in time erode expenditure flexibility for some state
and local governments. Governments with slower or stagnant revenue growth
prospects may see an emerging or growing mismatch and increased pressure on
budget-balancing tools.
Spending by U.S. states in the most
recent fiscal year grew at the fastest pace in at least 35 years as the
governments deployed a surge of federal relief funds. Total spending,
including stimulus, rose 16% to an estimated $2.65 trillion in fiscal 2021,
which for most states ended on June 30. In the past two years, states
reported spending $427.9 billion in federal COVID-19 aid. The unprecedented
spending clip last fiscal year highlights the sheer scale of pandemic aid
the federal government handed to states in an effort to cover the costs of
responding to COVID-19, and to ease the harm to the nation's economy.
Not-for-Profit
Hospitals
MTAM continues to have a negative outlook
on the not-for-profit healthcare and hospital sector for 2022. While U.S.
not-for-profit hospitals weathered the immediate effects of the coronavirus
pandemic quite effectively, our outlook for the sector points to continued
struggles with many longer-term pressures from the COVID fallout.
NFP hospitals have, like many other
sectors, entered a new normal, one that includes significantly heightened
cost pressure on labor and supplies, both of which remain in heavy demand
but in short supply. Best case scenario, MTAM does not expect these
pressures to attenuate for several years. Worst case, these cost increases
could become permanent and may in time lead to a deteriorating outlook for
hospitals.
Personnel shortages in the sector remain
particularly concerning and will reduce margins in 2022 as the sector
struggles with added costs. Additional expense cuts would likely come from
non-labor and non-supply areas, thus limiting any potential positive
financial impact.
Containing costs for hospitals comes at a
crucial point as the country slowly moves towards population health.
Commonly called "capitation" or full-risk, population health
represents a departure from the individual-level care the sector has been
known for traditionally to addressing health care needs at a group level.
Expenses are already difficult to predict
and very challenging to manage amid the current wage-war taking place with
staffing and supplies. As a result, some hospitals may be reluctant to
accept more risk and move towards capitation until the expense instability
currently being seen is resolved or at least limited in its volatility.
Vaccine hesitancy could also lead to
another round of "hot spot" case surges with all eyes currently
on the new Omicron variant. This poses multiple concerns, among them a
weaker payor mix and increased staff shortages if
personnel leave lower-vaccination areas for their own health, safety, and
well-being.
Transportation
MTAM is revising our negative outlook
on the U.S. transportation sector to stable
for 2022. The improving sector outlook reflects our expectation of a
further recovery in the operating environment over the next one to two
years. The pace of recovery among sub-sectors is uneven, mirroring the
impact from the pandemic-induced crisis.
U.S. transportation infrastructure is
likely to see a firmer upward trajectory in 2022, though the path of
inflation could be disruptive for some sectors. Higher inflation will cause
net income to rise as long as revenues grow at the same pace as O&M.
This stands to benefit most toll roads in particular as many of them apply
automatic annual rate increases indexed to inflation. Conversely, some toll
roads that do not have the economic, legal, or political flexibility to
raise revenues in line with inflation may experience some financial
impairment.
Sub-segments focused on moving people,
including airports and toll roads, were the most affected and are still
recovering, whereas infrastructure assets mostly involved in moving goods,
such as ports, were less affected and have already exceeded their 2019
levels. The emergence of more infectious coronavirus variants that could
lead to renewed lockdowns is a key risk for the sector.
Airports continue to see relief of late
thanks to improved leisure traffic. However, international traffic is still
down by more than half as compared with pre-pandemic, while business travel
is also lagging. As a result, full recovery will come quickly in some
markets but also remain elusive for a segment of airports until 2024. The
airport industry's near-term prospects are fragile due to volatile border
rules, spikes in COVID-19 cases, and growing concerns about the
environmental impact of aviation. We expect the recovery to be steady as
passengers become accustomed to flying again, increasing the 2022 traffic
to 65% of 2019 levels.
Ports proved exceptionally resilient
during the pandemic as purchasing activity was transferred to goods from
experiences. However, we expect this additional spending on goods purchases
to reverse, as people start to resume service consumption, and therefore
our long-term view of ports resilience is unaffected by the pandemic. Ports
will be contending with congestion challenges well into 2022. Disrupted
supply chains continue to challenge operational efficiency at gateway
ports, with bottlenecks leading to shipping delays exacerbated by strained
logistics networks and ongoing labor shortages.
The gradual easing of government-imposed
restrictions is sustaining a toll-road traffic recovery across issuers.
Modal shifts from international airports to domestic toll roads are likely
to improve the toll roads' performance further. Most recently, light
vehicle traffic growth has been faster than that of heavy vehicles,
reversing the 2020 trend, and we expect this to continue into 2022. MTAM
expects commercial traffic to continue rising, though passenger traffic
remains below 2019 levels largely due to telecommuting.
Water
and Sewer
MTAM is maintaining a stable outlook on
the U.S. water and sewer sector for 2022. The sector's strong fundamentals
are underpinned by the essential service provided to users, monopolistic
business nature, and high barriers to entry. Additional positive features
are low price sensitivity, strong liquidity, and independent local
rate-setting authority. These factors insulate the sector to some extent
from economic cycles. However, persistent droughts and overregulation could
reduce financial flexibility for certain issuers.
U.S. water and sewer utilities remain
favorably positioned heading into 2022 despite the challenges posed by the
pandemic. Revenue growth is expected to improve from enacted rate increases
which will help to offset expense escalation. Some increase in sector
leverage is expected, but by and large balance sheets remain robust and
there is more than sufficient headroom to absorb the additional leverage
without the sector facing widespread downward rating pressure.
Capital spending is expected to continue
to increase as utilities look to address deferred maintenance, growth, and
inflation pressures. Capital programs are also being influenced by new and
expected regulatory requirements to address lead pipe removal and other
drinking water contaminants. Federal infrastructure and stimulus
legislation will help to meet some of these needs although most funding
will continue to be borne by local users. Consequently, affordability will
continue to be a topic of focus for industry stakeholders.
Public
Power
MTAM's 2022 sector outlook for U.S.
public power electric utilities is stable,
reflecting strong sector characteristics and a conservative business model
that provide issuers with stability and strength, even during periods of
uncertainty. The fundamental strengths of the sector include: autonomous
rate-making authority, the essential nature of electric service, mandates
to serve well-defined areas with monopolistic characteristics, and reliable
cash flow.
The higher ratio of downgrades in 2021
largely reflects the credit implications of the February winter storm event
in Texas, which triggered monumental increases in energy and natural gas
prices.
U.S. public power utilities are well
positioned financially headed into 2022, as sharply higher electric demand,
manageable cost increases, and subdued capital spending helped stabilize
performance following the economic shocks related to the coronavirus
pandemic. However, MTAM has some concerns related to inflationary pressures
and more aggressive environmental policies that could increase spending and
test the sector's history of timely cost recovery.
Electric demand is expected to remain
strong in 2022 as U.S. economic activity remains high and gross domestic
product growth approaches 4.0%. Modest increases in fuel and energy costs,
as well as interest rates, could pressure margins over the near term, but
affordability should remain in line with historically favorable levels.
Assuming timely cost recovery and disciplined rate-setting these factors
should support strong cash flow and moderate leverage throughout the
sector.
Sustained inflationary pressures, as well
as increased spending necessary to ensure electric grid resiliency and meet
increasingly aggressive renewable energy mandates, however, could disrupt
longer term performance. To the extent that recovery is delayed and margins
are sacrificed, leverage and liquidity could weaken and credit quality
could decline.
Colleges
and Universities
MTAM is revising our negative outlook
on the higher education sector to stable
for 2022 reflecting our expectation for some enrollment recovery, solid
state budget prospects, and good levels of budgetary flexibility. Most
universities are planning for a predominantly in-person, on-campus academic
year in 2021–2022,
which should help to stabilize student-driven enterprises, including
auxiliaries. Solid market returns for most endowment portfolios in fiscal
2021 (ended June 30 for most institutions) have also helped to ease revenue
pressures.
The sector continues to benefit from
substantial federal stimulus authorization, with calendar year 2022 likely
the last year of meaningful budgetary support from any remaining stimulus
funds. Relative to 2021, the risk of additional coronavirus outbreaks
should continue to abate as vaccination rates increase. Top choice and
selective four-year institutions have retained solid enrollment, although
others continue to see pressures, particularly in the incoming freshman and
transfer student groups.
Colleges are in a better financial
position this fall, though significant uncertainties remain. With a revenue
lift from students returning to campus, federal relief funding, and robust
investment returns, colleges and universities are in a stronger financial
position than a year ago. Yet financial, operational and reputational
risks, ranging from rising labor costs to increased cyber security
challenges, are increasing in some cases. Beyond the 2021-22 academic year,
individual institutions and the sector as a whole will need to navigate
fundamental changes to maintain credit quality.
The return to campus will boost tuition
and auxiliary revenue. The pandemic, however, continues to cause regular
operational disruption and student success and retention are uncertain.
Also, universities increased tuition discounting (a type of financial aid)
last year, which is difficult to reverse and will likely curb net tuition
revenue growth over the next several years.
Federal relief funding will provide a
degree of stability through fiscal 2023 and prospects for state funding are
favorable for the majority of public universities. Federal assistance has
some universities in better financial shape than before the pandemic.
Proposals to increase Pell Grants and other funding would provide credit
positive support if enacted.
Balance sheets bolstered by robust
investment returns and favorable capital market conditions will enable
universities to cost-effectively fund capital needs. Rising debt levels,
however, will become a greater challenge if financial markets undergo a
correction.
Labor availability and costs, along with
inflation, will increase expenses, squeezing budgets and curbing the
operating performance for some colleges. Rising inflation and supply chain
issues also stand to increase capital costs, offsetting low interest rates.
Environmental, social and governance (ESG) risks and cybersecurity threats
will have negative operational and reputational effects for some. Natural
disasters can disrupt operations and drive up costs while cyber risks have
intensified with more online learning.
Beyond the 2021-22 academic year,
demographic trends and changing consumer preferences will continue to
gradually alter the higher education landscape. The decline in high school
graduates in some regions and debates over the value of a degree will help
some universities and hurt others.
Housing
MTAM views the tax-exempt housing sector
as having a stable
outlook in 2022. After a globally challenging year in 2020, it was expected
that the sector was well positioned financially entering 2021, as the
coronavirus pandemic and its impact to many borrowers and renters presented
unforeseen circumstances that were deemed to be evolving. State housing
finance agencies (HFAs), socially driven lending institutions, and
developers are expected to continue to successfully navigate an environment
of rising barriers for affordable single-family and multifamily housing. In
2021, the sector saw an increase in issuance in lending for affordable
housing, from $19 billion in 2020 to $24 billion as of October 2021. This
trend is expected to continue in 2022. This increase is significant, as
these entities are operating in a single-family lending environment whereby
low interest rates are offset by the overvaluation of single-family
dwellings and rising rental rates that are outpacing U.S. wage growth. HFAs
continued to be well poised to respond to liquidity needs that the
challenging environment may present, with their balance sheets and loan
programs continuing to increase in overall equity.
Default
Outlook
In addition to emphasizing their
resilience in the face of the COVID-19 pandemic, MTAM continues to affirm
two hallmark benefits offered by municipal bonds. First, while they may
have become more common over the past 10 years, municipal defaults and
bankruptcies still remain rare overall. Indeed, during the period of
significant market stress during 2020 resulting from COVID, there were only
two municipal defaults and neither were virus related. Second, municipal
bonds continue to be highly rated compared with corporates. While there
were municipal ratings downgrades during the year, global corporates'
ratings' downgrades were more frequent.
In relation to the pandemic, we note that
the municipal market experienced a very unique set of stresses stemming
from the virus-related shutdowns, and that these have unleashed a series of
new dynamics that will shape municipal finance going forward. These include
the rapid acceleration of remote learning and work and, associated with
these, movement away from high-density employment and living.
According to Moody's, the five-year
all-rated cumulative default rate (CDR) of municipal bonds throughout the
study period (1970-2020) was unchanged at 0.08%, and still remains very
low. This compares with the five-year CDR of 6.89% for global corporates
over the same time period. Of the two municipal defaults in 2020, one was
rated and the other was "by a Moody's rated entity albeit on an
unrated instrument".
In the two years prior to the pandemic,
credit quality stabilization in the municipal bond sector had been helped
by growth and economic recovery in many regions of the U.S. However,
despite growth having been decimated by COVID in 2020, and the stresses
resulting from the virus, not only were there fewer rating changes during
the year than in prior years, but rating volatility also actually fell. In
addition, rating downgrades essentially equaled rating upgrades.
Municipal credits remain strong and,
according to Moody's, "their rating distribution is substantially
skewed toward the investment-grade, where ratings tend to be more
stable." Moody's states that the municipal sector overall remains
highly rated, with 91% of all the municipal credits Moody's rates falling
into the A category or higher as of the end of 2020 (2019: ˜92%). Further, at the end of 2020, the
median rating for U.S. municipal credits had fallen only to Aa3 (2019:
Aa2). This still stood in stark contrast to the median rating for global
corporates, which was Baa3 (2019: Baa2).
We continue to argue that, while it remains
a struggle to obtain the same amount of timely disclosure from issuers of
municipal bonds as one sees in other asset classes, we believe the pure
empirical evidence suggests that municipal bonds still offer a fiscally
sound vehicle for deriving an income stream free from federal, and in some
cases, state taxes. We believe one need only look at the municipal market's
behavior during the COVID crisis in 2020 for evidence of both its soundness
and resilience.
If one looks at long-term municipal bond
obligations, across all sectors, between 1970 and 2020, according to
Moody's, there were only 114 distinct Moody's-rated defaults, representing
a little over $72 billion, out of a universe of more than 50,000 different
state and local governments and other issuing authorities. There remain,
however, as always, caveats. As Moody's states "The once-comfortable
aphorism that 'munis do not default' is no longer
credible: rating volatility, rating transition rates, and cumulative
default rates (CDRs) have all increased since 2010." However, even
when subject to virus-related stresses, they have remained surprisingly
stable.
Challenges facing this sector include
demographic shifts (populations both aging and relocating—affecting tax
receipts), substantial increases in pension and retirement health care
leverage, and the associated heightened exposures to equity markets. In
addition to these challenges, it remains to be seen what the full effects
may turn out to be from the new dynamics that became only too apparent with
the arrival of, and devastation wrought by, COVID.
Conclusion
MTAM continues to recommend that
investors select high-quality municipal issuers that understand the new
economic and financial reality, and have made or are making budget
adjustments. Essential service revenue bonds without the budgetary concerns
of state and local governments and limited payrolls can be attractive, but
we stress that an essential service issuer cannot flourish if the
underlying governmental entity is in dire economic circumstances. A healthy
outlook holds for most infrastructure issuers due to fundamental strengths
reflected in the provision of essential public services, adequate balance
sheets, and generally sound governance and fiscal management practices. In
the case of the enterprise sectors comprised of higher education, health,
and housing, credit quality will be maintained primarily as a function of
their ability to increase fees, control costs, and improve overall
operating margins. Sound debt and fiscal management practices, preservation
of adequate liquidity, and strong governance oversight will be significant
determinants of credit quality for issuers during the coming period of
financial adjustment.
Top Of Page
4th Quarter 2021 Review and
Outlook
Monday, December 20, 2021
Municipal bonds performed admirably in
2021 given the negative returns experienced in the taxable fixed-income
markets. A steady stream of investor cash permeated throughout all areas of
the tax-free market, keeping a lid on yields and suppressing any
significant erosion of credit spreads. Boatloads of federal money gifted to
the states as a result of the pandemic acted as a tailwind to demand for
conservative investors looking to allocate cash in a low-risk asset. Talk
of raising taxes on the wealthy emanating out of Washington D.C. certainly
added to the insatiable demand for municipals throughout the year.
Given our concern that inflation would
spike higher as the year progressed (6% plus and counting!), we focused on
investing client cash in the short end of the municipal yield curve. Our
goal was to minimize price volatility and to have the client portfolios
positioned to outperform benchmarks, as the Federal Reserve moves to a more
restrictive monetary stance (which is essentially right around the corner).
Moving into 2022, our game plan will
remain the same initially. However, should the Federal Reserve actually
show the gumption to raise short-term rates (we are skeptical) in the face
of falling stock prices, our clients would be better served positioned
further out the yield curve. Always remember that by raising rates, the
"Fed" is attempting to slow economic growth and ease inflationary
pressures. History shows that once they have embarked on a tightening
cycle, recessions often follow a number of months later.
Clearly, overnight rates close to zero
with inflation running at 6% is unsustainable. Perhaps it would be best to
view the coming year in the context of a sport: professional basketball. If
the basketball rim represents the yield curve, we will take a "Bill
Russell" approach to investing - defensively oriented and staying
close to the basket when attempting to score. Should the Federal Reserve
muscle the federal funds rate up to 1%, it would be time to insert
"Stephen Curry" into the game. Moving further away from the
basket (and further out the yield curve) while taking a more offensive
stance would then be prudent. Excessively high inflation is already slowing
the economy. Four 25 basis point rate hikes should result in an inverted
U.S. Treasury yield curve (short-term rates above long-term rates), and as
such, a longer duration stance in tax-free portfolios would be warranted.
It is a "jump ball" right now as to whether our central bank can
muster up the courage to do what it takes to tame inflation. The ball is in
their court.
Happy Holidays!
Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak
Top Of Page
3rd Quarter 2021 Review and
Outlook
Monday, October 4, 2021
Returns were mixed in the third quarter
of 2021 for municipal bond investors. July returns were in the positive
column; however, the market ran into some problems in August and September,
as it became apparent that the Federal Reserve was moving closer to
reducing their bond purchases. Generally speaking, shorter maturity bonds
outperformed as inflation concerns continued in the tax-free bond market.
This "steepening" of the yield curve should remain a consistent
trend in the upcoming quarter, as bond markets reprice market yields higher
to account for less buying by the central bank.
Persistently high inflation these last
few months have renewed speculation by some that the economy may be
entering into a period of "stagflation." This is a truly
unattractive mix of high inflation, slowing growth, and relatively high
unemployment. Given that our federal government seems to care very little
about our surging national debt, it is easy to see how inflation
expectations can be biased upwards. In our view, the bond market is at a very
important inflection point. Should the federal government keep spending
beyond its means while the biggest buyer of debt (the Federal Reserve) is
moving to the sideline, a significant repricing of interest rate levels
could be at hand.
The municipal bond market has
outperformed taxable debt so far in 2021, thanks to sizable cash inflows
into mutual funds. MTAM is concerned that this trend is close to reversing,
and as such, advisors need to consider the value separately managed
accounts offer in bear market environments. When mutual funds experience
investor redemptions, they "have to" sell. Quite often in this
type of situation, owners of separately managed accounts benefit by being
the buyer of last resort in a declining market. Once the tide turns and
cash begins to leave the mutual fund space, MTAM will be ready with our
catcher's mitt.
Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak
Top Of Page
State of the States - Midyear
2021
Friday, July 9, 2021
The pandemic has had a significant impact
on U.S. state fiscal conditions. While the effects of COVID-19 on state
budgets were not as severe as anticipated earlier in the crisis, both
general fund spending and revenue levels remain below pre-pandemic
projections.
When governors proposed their fiscal 2022
budgets, fiscal conditions were evolving, uncertain and uneven across
states, though overall they were showing signs of improvement. In this
environment, executive budgets were marked by a growing sense of optimism
as state revenue projections strengthened and vaccine developments improved
the nation's public health and economic outlook. These positive
developments are reflected in state spending levels proposed by governors,
with 39 executive budgets calling for increased general fund spending in
fiscal 2022 compared with the prior fiscal year.
While revenue performance to-date and
projections going forward have improved compared with forecasts earlier in
the pandemic, most states have collected and are projecting to collect less
revenue than what they were expecting before the COVID-19 crisis. States
experienced a decline in general fund revenue in fiscal 2020 for the first
time since the Great Recession, and current estimates show modest general
fund revenue growth for fiscal 2021. State revenue forecasts used to build
governors' budgets for fiscal 2022 also predict modest year-over-year
growth.
State spending and revenue trends vary by
state due to the uneven economic impacts of COVID-19. The pandemic has
affected states in differing ways and differing magnitudes depending on
their economies, tax structures, virus transmission levels, and other
factors. States with an especially strong tourism and leisure industry, a
revenue system highly reliant on the energy sector, or a higher
unemployment rate have tended to see larger negative impacts on their
budgets. These states were more likely to make spending reductions in fiscal
2021 and are recommending more modest budgets for fiscal 2022. They were
also more likely to experience multiple years of declining revenues during
the pandemic, as well as tap their rainy day funds and other reserves.
39
States Call for General Fund Spending Increases in Fiscal 2022
Governors proposed general fund spending
in the amount of $963.6 billion in fiscal 2022 according to recommended
budgets. This represents a 5.0 percent increase compared with estimated
spending levels for fiscal 2021. Overall, 39 states are forecasting nominal
spending increases in fiscal 2022, based on governors' recommendations.
Projected spending growth in fiscal 2022 is driven in part by an increase
in one-time expenditures as states spend down some of their unanticipated
surplus funds from fiscal 2021.
Meanwhile, general fund spending is on
track to total $917.8 billion in fiscal 2021, a 3.0 percent increase. While
state budgets have not fared as badly as was feared during much of the pandemic,
the impact of COVID-19 is still evident when comparing pre-COVID
projections with current estimates and actuals. Fiscal 2021 estimated
general fund spending is roughly 2 percent below what states were expecting
to spend based on governors' budgets reported last year.
It should be noted that governors in the
vast majority of states submitted their budget recommendations to the
legislature in December, January or February, with a few that released in
November and one state that released in March. Variations in budget
calendars across states played a role in shaping the conditions in which
governors' budgets for fiscal 2022 were developed and what they reflect, as
expectations around state revenue performance and federal aid evolved over
the winter months.
Governors'
Recommendations for Fiscal 2022 Call for Net Increases
in All Program Areas
Following Budget Cuts Enacted in Fiscal 2021
Governors proposed general fund
appropriation increases for fiscal 2022 totaling $70.5 billion compared
with fiscal 2021 enacted budget levels, with all program areas seeing net
increases. While this figure demonstrates improvement in state fiscal
conditions, it is also a reflection that some states' enacted budgets for
fiscal 2021 (the baseline year used here) were considerably reduced.
Appropriation increases for fiscal 2022 also reflect a shift from reliance
on federal funds in fiscal 2021 to a greater reliance on general funds in
some areas. This is the case particularly since governors' budgets were
almost all developed before the March 2021 passage of the American Rescue
Plan Act, and in some cases before the federal package passed in December
2020. Some of the increases represent one-time investments as well, as some
governors proposed spending a portion of unanticipated surplus funds from
fiscal 2021. It should also be noted that significant increases recommended
in a couple large states make up the majority of the total appropriation
increase.
States
Turned to Various Strategies to Manage Budgets and Address Shortfalls
States employed a variety of strategies
and tools to enact their budgets in fiscal 2021. The most commonly used
mid-year strategies included targeted cuts, continuing hiring freezes, and
reliance on other state funds, prior-year balances and reserves.
States reported once again turning to
these strategies in governors' recommended budgets for fiscal 2022,
including targeted cuts, hiring freezes and fund transfers, though all to a
lesser extent than in fiscal 2021. Moreover, fiscal 2022 budgets were less likely
to include across-the-board percentage cuts or furloughs compared with
fiscal 2021. On the other hand, there is a notable uptick in states
reporting agency reorganizations proposed for fiscal 2022. This may be a
reflection of fiscal conditions stabilizing in order to allow for more
deliberative, strategic policy and operational changes at the state level
as well as a response to changing organizational needs as a result of the
pandemic.
In addition to reporting on which budget
management strategies were used, states also reported on mid-year spending
actions for fiscal 2021 in quantitative terms. Overall, 18 states reported
net mid-year decreases in general fund spending for fiscal 2021, while 12
states reported increases compared with their enacted budgets. Among the 18
states that reported net mid-year cuts, 12 of these states reported these
cuts were made in response to a revenue shortfall, with spending reductions
totaling $4.1 billion. The other six states reported the reductions were
attributed mostly to lower spending needs or in areas where federal
assistance was able to be used in place of general funds. For the 12 states
that reported net mid-year increases in general fund spending, these
incorporate governors' proposed supplemental appropriations for fiscal 2021
–
including for pandemic response – and
restoration of spending cuts included in originally enacted budgets.
Revenue
Collections Outperform Budget Projections for Most States in Fiscal 2021
General fund collections for fiscal 2021
from all revenue sources are coming in above original projections used to
adopt budgets in 38 states, below forecasts in eight states, and on target
in four states. Overall, revenues have outperformed projections from
earlier in the pandemic (when most states enacted their fiscal 2021
budgets). Compared with the most recent official revenue estimates, fiscal
2021 collections are coming in above those projections in 36 states and on
target in 10 states (four states were unable to report how collections were
performing compared with most recent estimates). This speaks to continued
improvement in state revenue performance, which likely has been helped
further by the passage of the December 2020 federal stimulus package and
the American Rescue Plan Act on March 10, 2021.
Several factors help explain recent
improvements in states' revenue outlooks, including: federal stimulus
measures have put a lot of additional money into the economy, which helped
to lessen state revenue losses; high-income earners have been relatively
insulated from the pandemic's economic effects, which has limited impacts
on personal income tax collections; the types of consumption most curtailed
by the pandemic comprise a relatively small portion of states' sales tax
bases; and the enabling of online sales tax collections following the U.S.
Supreme Court decision in Wayfair v. South Dakota.
General
Fund Revenue Expected to See Modest Growth in Fiscal 2022
General fund revenues are expected to
grow 2.3 percent in fiscal 2022 compared with fiscal 2021 estimated
revenues, based on forecasts used in governors' budgets. The two largest
sources of general fund revenue – sales
taxes and personal income taxes – are
both expected to see moderate growth in fiscal 2022 of 3.9 percent and 4.3
percent, respectively. Meanwhile, fiscal 2021 general fund revenues are on
track to total $908.1 billion based on current estimates, representing 3.7
percent growth over fiscal 2020 actual collections.
In the aggregate, states recorded a
general fund revenue change in fiscal 2020 of -0.6 percent. This marked the
first time state general fund revenues declined year-over-year (without
adjusting for inflation) since states experienced two consecutive years of
declines during the Great Recession in fiscal 2009 and fiscal 2010.
It is important to note that general fund
revenue growth in fiscal 2020, fiscal 2021 and fiscal 2022 was affected by
the shift in the tax deadline from April 15, 2020 to July 15, 2020.
Nineteen states reported that they recognized these revenues due to the deadline
shift in fiscal 2021 instead of fiscal 2020, and 17 of those states were
able to report estimated deferral amounts. After using those reported
deferrals to adjust revenue figures for the three years, general fund
revenue grew 0.6 percent in fiscal 2020, is estimated to increase 1.4
percent in fiscal 2021, and is projected to grow 3.4 percent in fiscal
2022.
Current
Revenue Estimates Compared With Earlier
Projections
States are expected to collect less
revenue than what they were forecasting pre-COVID-19. Specifically, fiscal
2021 general fund revenue collections are 2.7 percent below pre-COVID
forecasts. With fiscal 2021 ongoing, this comparison may change when final
collections are determined but they will still likely be lower than
pre-COVID projections for most states. Looking at fiscal 2020 and fiscal
2021 combined, states are on track to collect 2.8 percent less over those
two years compared with what they were expecting before the COVID-19
crisis.
While general fund revenues continue to
underperform pre-COVID revenue forecasts, current estimates for fiscal 2021
are considerably improved compared with 6 months ago. Several factors made
revenue forecasting especially challenging for states over the past year.
Models for reliably projecting state revenues in unprecedented events such
as a pandemic did not exist. Moreover, public health and economic
conditions have evolved rapidly and unevenly across states over the course
of the pandemic. A large influx of federal stimulus early on, coupled with
uncertainty regarding additional federal aid, contributed to forecasting
challenges as well. Compared with 6 months ago, general fund revenue
estimates for fiscal 2021 are up 8.9 percent.
Governors
Propose Tax and Fee Changes Resulting in Net Revenue Increase
According to executive budgets, 15 states
proposed net increases in taxes and fees while 19 states proposed net
decreases, resulting in a projected net positive revenue impact in fiscal
2022 of $6.5 billion. Nearly all this additional revenue generated by governors'
recommended changes would be deposited into states' general funds, in
contrast to last year before the pandemic, when proposed increases were
heavily skewed towards non-general fund revenue sources such as motor fuel
taxes. The largest increases recommended by governors tended to be in the
personal income and corporate income tax categories. Tax and fee decreases
proposed in executive budgets were mostly modest and included numerous
income tax changes to conform with changes at the federal level.
Overall
State Balances See Small Reductions During Pandemic
Before the COVID-19 crisis hit, state
rainy day funds and total balances were at an all-time high, after a decade
of rebuilding reserves following the Great Recession. In fiscal 2019, rainy
day fund balances reached 9.1 percent as a share of general fund spending
and total balances were at 14.0 percent of spending. As they coped with
weakening revenue projections and increased spending demands in the wake of
COVID-19, some states turned to their rainy day funds, other reserves, and
prior-year balances as a tool to help manage their budgets. However, in the
aggregate, balance levels recorded fairly small reductions in fiscal 2020
as a result of the pandemic, with rainy day fund balances dropping to 8.7
percent and total balances dropping to 12.8 percent. Due to
higher-than-anticipated revenue projections in fiscal 2021, states reported
a net increase in estimated balances at the end of fiscal 2021. Looking
ahead, governors' budgets plan to spend down some of those surplus funds
from their prior-year balances, including for onetime investments, with
total balances projected at 10.6 percent of general fund spending. Rainy
day fund balances are also projected to see a net decline, totaling 7.6
percent of general fund spending at the end of fiscal 2022.
The use of rainy day funds across the
states has been uneven, reflecting how the pandemic affected states to
differing degrees, as well as how states entered the crisis with varying
reserve levels. Fifteen states reported lower rainy day fund balances (in
nominal dollars) estimated for fiscal 2021 compared with fiscal 2019
levels, with declines for those states totaling $5.9 billion. Meanwhile, 33
states reported higher balances over the same two-year period, with those
increases totaling $8.3 billion (one state reported no change and one state
was not able to report for fiscal 2021).
Medicaid
Spending Saw Large Increase in Fiscal 2021,
With More Moderate
Growth Expected in Fiscal 2022
Medicaid spending figures reported for
fiscal 2020 through fiscal 2022 reflect the impact of the COVID-19 pandemic
and ensuing economic fallout affecting Medicaid enrollment and spending, as
well as the effects of enhanced federal aid for Medicaid. Medicaid spending
from all fund sources is estimated to grow 12.5 percent in fiscal 2021
compared with fiscal 2020 levels. Looking only at state fund sources,
spending is estimated to increase 6.4 percent in fiscal 2021 after
declining 3.4 percent in fiscal 2020. Specifically, general fund spending
on Medicaid is on track to grow 2.7 percent and spending from other state
funds is estimated to grow 13.4 percent in fiscal 2021. Medicaid spending
from federal funds, bolstered by the enhanced Federal Medical Assistance
Percentage (FMAP) provided in the Families First Coronavirus Response Act
that was passed in March 2020, is on track to grow 15.9 percent for fiscal
2021 after increasing 3.3 percent in fiscal 2020.
Looking ahead, Medicaid spending is
forecasted to continue growing in fiscal 2022 but at a slower rate, based
on governors' proposed budgets. Total Medicaid spending is projected to
grow 5.2 percent for fiscal 2022. Spending from state fund sources is
projected to grow 9.6 percent – with
general fund spending increasing 12.5 percent and other state funds
increasing 4.8 percent. Federal fund spending is expected to increase 2.8
percent in fiscal 2022. The impact of the FMAP increase can be seen in how
much faster federal fund spending on Medicaid grew in fiscal 2020 and
fiscal 2021 relative to state fund spending. In contrast, with virtually
all states expecting the FMAP increase to expire sometime before the end of
fiscal 2022, governors' recommended budgets show a faster rate of spending
growth from state funds compared with federal funds.
States also reported on Medicaid
expansion expenditures. As of May 2021, 38 states and the District of
Columbia have adopted Medicaid expansion. For fiscal 2020, 35 states that
expanded Medicaid under the Affordable Care Act (ACA) reported total
spending of $105.9 billion in fiscal 2020, including $10.9 billion in state
funds and $95 billion in federal funds. In fiscal 2021, 36 states are
estimated to spend $131.1 billion in all funds, including $15.8 billion in
state funds, and $115.3 billion in federal funds. In 38 recommended budgets
for fiscal 2022, projected spending for Medicaid expansion totaled $146.1
billion, with $18.8 billion in state funds and $127.3 billion in federal
funds. Medicaid expansion spending from all fund sources increased by an
estimated $25 billion in fiscal 2021 and is projected to increase by
another $15 billion in fiscal 2022.
Additionally, states reported changes to
their Medicaid programs in fiscal 2021 and recommended changes for fiscal
2022, both to contain costs and enhance their programs. In connection with
the pandemic, for example, states made changes to managed care capitation
rates to reflect decreased utilization of health care, while also expanding
telehealth, increasing provider payments for vulnerable providers, and enhancing
behavioral health services.
State
Budget Outlook: Continued Improvement and a Focus on Recovery
State fiscal conditions continue to
strengthen as the economy recovers from the pandemic and additional federal
aid flows to state and local governments. As the data demonstrates, state
budgets were affected by COVID-19 in numerous ways, but overall, the
impacts have been less severe than anticipated earlier in the crisis. This
is due to a combination of factors, including the large influx of federal stimulus,
lower economic impact on high-income earners, consumption patterns, and the
ability of states to tax online sales. State tax collections continue to
outperform forecasts, and states are expected to enter fiscal 2022 in a
stronger position than was expected a year ago. At the same time, the
pandemic's impact has been uneven –
hitting certain states, localities, industries and individuals especially
hard – and
it is uncertain how long it will take some communities and sectors to fully
recover. Looking forward, states are expected to focus additional state
resources as well as the recent influx of federal aid to assist
individuals, businesses, and communities that were most affected by the
pandemic, including with targeted, onetime investments, to support a robust
economic recovery.
Top Of Page
2nd Quarter 2021 Review and
Outlook
Tuesday, July 6, 2021
Municipal bond investors earned modest
positive returns in the second quarter of 2021. Overall, market performance
was propped up by unrelenting cash inflows into the mutual fund space
which, in turn, left buyers in constant search of incremental yield
opportunities. Higher quality municipal bonds significantly underperformed
below investment grade debt (sometimes referred to as "junk
bonds"), as institutional investors flush with cash stretched for
yield in every sector within the tax-free bond space. Given the huge fiscal
stimulus awarded to the states - and the refusal by the Federal Reserve to
take just one toe off the gas pedal as it relates to monetary policy - the
performance of the municipal market in the second quarter should come as no
surprise to those who follow it closely.
High
Yield Municipal Bonds - A Sale Recommendation
The outsized returns of tax-free
"junk bonds" can be directly correlated to the almost $37 billion
added to municipal mutual funds in the first half of 2021. Some funds
within that space have returned as much as 15% over the past twelve months
which, given the low level of interest rates, seems unsustainable to us
moving forward. Ordinarily, we are fundamentally against trying to call a
market top. However, the problem lies with the huge concentration risk
within just a handful of mutual fund companies that manage these junk bond
funds. Should these massive funds begin to see sizable cash redemptions,
they would be liquidating into a virtual black hole, as dealers would be
reluctant to bid these bonds once the cash inflow tide turned. While
everything at the moment seems to be pushing cash into this sector, its
fortunes can turn quickly when the Federal Reserve begins to taper bond
purchases and heads in the inevitable direction of lifting borrowing costs.
Right now, the bond market is being lulled into believing these are events
that will not happen until 2022 or 2023. While this, in fact, may be the
case, all the low-hanging fruit has been picked in tax-free junk bond
space. We see it as better to be vacating this asset class early, as
liquidity can dry up very quickly once the market turns.
Given the strong outperformance of
tax-free bonds relative to taxable debt, there are some valuation concerns
within the higher quality space to take under consideration. Our preference
remains to look for reinvestment opportunities on the very short end of the
yield curve. Conservative management of portfolio durations remain the
focus here at MTAM, as outsized growth and inflation data will eventually
bring the Federal Reserve closer to tightening financial conditions. Right
now, cash equivalents pay virtually nothing to investors. This creates huge
distortions in other financial assets, and investors are seeing the effects
of that now in many markets. Once cash equivalents offer a respectable
return, the bond markets are going to look a lot different than they do
now. The Federal Reserve brought interest rates down to an
"emergency" level due to the pandemic. While that was quite
appropriate at the time, the economy is almost fully reopened, and as such,
interest rates should no longer be at an emergency level. The best returns
are in the rearview mirror - now is the time to preserve capital.
Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak
Top Of Page
By the Mile
Thursday, April 22, 2021
U.S. Transportation Secretary Pete Buttigieg recently announced that he has ruled out
plans to increase the federal gas tax or charge drivers a fee based on
miles driven to pay for the Biden administration's $2 trillion
infrastructure plan. Transportation is expected to be a big part of -- but
not all of -- the likely infrastructure plan, and mileage fees are being
raised as a way to pay for some or all of that in a way that accommodates
the rise of electric vehicles that President Biden also hopes to see.
With a gas tax seemingly off the table in
President Biden's plan to pass an infrastructure bill, many lawmakers and
transportation advocates are looking to vehicle-miles-traveled fees. This
comes as Senate Republicans begin to draft their own infrastructure bill,
that comes in much smaller than President Biden's $2 trillion proposal.
Republicans' $600 billion to $800 billion proposal
would diverge from Biden's plan to pay for it through a higher corporate
tax rate, and instead impose a user fee to raise revenues.
Republican senators are not alone in
wanting infrastructure to be paid for through user fees. Senate Environment
and Public Works Committee Chair Tom Carper, D-Del., told the Brookings
Institution that road and bridge users should pay for infrastructure and
called a vehicle-miles-traveled fee "the future." A VMT fee was
also the consensus to pay for infrastructure during a Senate EPW Committee
hearing. EPW Ranking Member Sen. Shelley Moore Capito,
R-W.Va., said those who use the roads should help pay for them.
The Highway Trust Fund, the source of
funding for federal surface transportation projects, could be bolstered by
a VMT fee. It has been running on gas taxes for years and is running out of
fuel. The HTF spends 20% on transit, while 80% goes to highways. Transit
does not contribute to the fund. General funds transfers authorized in
previous legislation have supported the HTF for the past 13 years. Some
suggested ways to replenish the HTF have been through increasing the
federal gas tax, charging electric vehicle drivers a fee, imposing a
vehicle-miles-traveled charge, and tolling.
These and relying more on private sector
investment through public-private partnerships are all possibilities, the
Congressional Research Service said in a March report.
So far, 15 to 20 states have been
involved in VMT pilots either regionally or independently. Current surface
transportation legislation is expiring at the end of September 2020, and is
making Congress anxious about how to fix the HTF.
Though raising the federal gas tax seems
like a logical solution, Congress has never been able to do it in in recent
decades. That along with U.S. car manufacturers planning to move to an
all-electric fleet, and a recognition that problems with the gas tax are
not going away means lawmakers will look elsewhere.
A vehicle-miles-traveled fee has been
studied in the nation's capital for years though previous versions have
encountered resistance about forcing drivers to place transponders in their
cars to keep track of mileage. But states that have experimented with pilot
programs have found ways around that by letting motorists report odometer
readings electronically or in-person, using plug-in devices or recording
mileage with a smartphone app.
A vehicle-miles-traveled program also
would help close the widening gap in federal highway funding that is
estimated to be as high as $16 billion this year. That is because the
Highway Trust Fund, which pays for roadway and transit systems, is financed
primarily through the federal gas tax, currently 18.4 cent-per-gallon. That
only brings in $34 billion per year while federal spending has topped $50
billion annually and has had to be supported by transfers from the general
fund.
Last year, Highway Trust Fund receipts
from the gas tax were down 9.4% over the previous fiscal year due to a
reduction in driving because of the pandemic. In most parts of the country,
passenger traffic continues to steadily recover, but the pace and magnitude
of the recovery differs by region. The widespread availability of vaccines
will boost economic recovery, with vehicle miles traveled improving as a
result.
The gas tax has not been raised since
1993, and there is little appetite in Washington for increasing it. The
push for plug-in cars is an additional complicating factor because fully
electric vehicle drivers do not pay any gas tax. Several carmakers have pledged
to produce all-electric fleets by the end of the current decade.
Washington has been mostly spinning its
wheels on infrastructure spending for half the past decade, due in part to
a reluctance to raise gas taxes. A five-year, $305 billion transportation
funding law was set to expire in 2020 but was extended until next year. The
House passed a five-year, $494 billion surface transportation bill in July
2020, but the measure was not been approved by the
Senate.
Greg Regan, president of the AFL-CIO's Transportation
Trades Department, said there is "more political will" for the
Biden administration's push for a robust infrastructure bill and there is
growing interest in an alternative to the gas tax. Regan said any mileage
fee program that is included in Biden's infrastructure bill will likely
have to be phased in after another infusion of cash from other areas of the
federal budget for the beleaguered Highway Trust Fund.
Representative Sam Graves, of Missouri,
the top Republican on the House Transportation and Infrastructure
Committee, said a mileage-fee could easily be substituted for the gas tax
without using techniques that raise the thorny privacy issues that tanked
prior versions of the proposal. Graves suggested that for gas- or
diesel-powered vehicles, a per-mile tax can be assessed through a simple
formula at the pump. Graves suggested that the planned modernization of the
U.S. Postal Service vehicle fleet could provide an opportunity to test a
mileage fee program on a national scale because some of the new postal
vehicles will be electric.
The longest-running U. S. mileage tax
program started in 2013 in Oregon, where drivers who join OReGO, as the program is called, are charged 1.8 cents
per mile for trips that take place on the state's roads. Participants are
given the option of using a GPS device to record their miles or using a
non-GPS option that tracks usage based on the mileage odometers of cars. In
return for participating, the drivers are offered a tax credit reimbursing
them for the 36-cent-per-gallon Oregon gas tax that they pay on fill ups.
Drivers in the program receive regular statements of their road charges
based on the reported miles, which also show their fuel tax credits.
In Washington state, a newer pilot
program allows drivers to choose between four methods of tracking mileage,
including pre-paying for an estimated number of miles that will be driven
annually, reporting mileage based on odometer readings either
electronically or in-person, using plug-in devices that in some cases contain
GPS systems or recording mileage with a smartphone app.
California, Delaware, Hawaii, Minnesota,
and Missouri also have federally-funded mileage fee pilot programs. Rep.
Pete Defazio said legislation he has supported in
the past paid for some of the pilot programs. "I continue to support
this approach," Defazio, an Oregon Democrat
who chairs the Transportation and Infrastructure Committee, said in a
statement. "We need to learn from these tests, including about how
revenue gets collected and how we address privacy concerns, before we take
any additional steps at the federal level.
Top Of Page
1st Quarter 2021 Review and
Outlook
Tuesday, March 30, 2021
There were mixed results for municipal
bond investors in the first quarter of 2021. Shorter-term bonds had
positive returns, while longer-term debt experienced marginal losses.
Tax-free bonds, as a whole, significantly outperformed taxable debt as
interest rates climbed during the quarter. Massive fiscal stimulus and
ultra-easy monetary policy weakened longer-term bond prices as inflation
concerns perked up quite noticeably. On the brighter side, many tax-free
bond portfolios saw their overall credit quality move up thanks to the $360
billion in federal aid that was sent to the states as a result of the
pandemic.
Our investment approach during the past
quarter was to be defensively-oriented when allocating cash. Specifically,
our comfort level remained high for shorter-maturing debt as it remained
obvious to us that the overnight federal funds rate was quite anchored
where it currently resides. Relative value between the tax-free and taxable
markets was more attractive in shorter maturities in our view. This
relative value (as measured by "ratio" to U.S. Treasury notes)
provided a much-needed cushion against upward pressure on interest rates
and downward pressure on bond prices.
The post-pandemic economic rebound is
well underway, and as such, we expect strong growth and improved labor
market signals to be the norm in the United States. It is our view that
market interest rates would have moved up even higher if overseas economies
were reopening on par with America. Keep an eye on Europe in general -- and
Germany specifically -- in that regard. Any significant loosening of
pandemic-related restrictions would result in upward pressure on German
"bund" bond yields (which are currently negative in spots). This
could easily ripple across the pond, causing further losses for long-term
bond investors here in the United States.
Moving forward, we as tax-free bond
managers truly appreciated the federal government throwing billions of
dollars of "stimulus" (bailout?) towards states and local
governments as a result of the pandemic. The fiscal problem now resides at
the federal level, where boatloads of U.S. Treasury debt needs to be issued
to pay for this generous act. This amounts to a game of "three-card monte" where bond investors have no chance of
winning in the long run. Exploding deficits, profligate spending, and
ultra-easy monetary policy have the potential to disrupt long-term bond
prices in a negative way.
MTAM will be on the lookout for financial
discipline to re-emerge in Washington D.C. before we can undertake a more
aggressive approach on portfolio duration positioning. Until then, expect
our focus to remain defensively-biased (think 1985 Chicago Bears) when
allocating cash. Sometimes the best offense is a great defense. It would
not surprise us if 2021 turns out to be a year for fixed-income investors
that Buddy Ryan would be proud of.
Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak
Top Of Page
Impact of the Federal
Stimulus on State and Local Governments
Thursday, March 18, 2021
America's state and local governments are
poised to receive a $360 billion lifeline from President Joe Biden's
stimulus bill, enough to virtually assure that budget cutbacks and
public-employee layoffs will not weigh on the economic rebound.
All of the key sectors of the $3.9
trillion municipal bond market are receiving a major boost from Congress,
easing the immediate pandemic-related credit risk concerns. The recently
passed $1.9 trillion Covid-19 relief package includes aid for states, local
governments, schools, universities, airports, and colleges -- all major
issuers of municipal bonds.
Credit concerns have already been
subsiding in the state and local debt market, in part because of the
federal aid that has already been enacted, which has supported municipalities'
tax revenue and helped cover pandemic-related costs. The Committee for a
Responsible Federal Budget estimates that state and local entities have
received $360 billion so far for purposes like transit and school funding.
The money that has trickled into state and local coffers has helped the
market avoid widespread credit-rating downgrades and even defaults that
were feared at the beginning of the pandemic. The hit to state finances is
also much smaller than initially projected.
Municipal issuers will benefit from the
direct aid included in the package, but they also stand to reap the
financial benefits of the plan boosting the U.S. economy as a whole,
helping revenue streams like sales taxes.
The states' fiscal recovery fund will
guarantee at least $500 million for each and the District of Columbia. The
bulk will be divvied up -- as needed -- according to the share of
unemployed workers in each state. That means the largest states will
receive the most, as is typical for federal funding programs based on
population. California's state government could be eligible for $26.1
billion, more than any other state, with another $17 billion available to
local governments there, according to preliminary estimates from the
Government Finance Officers Association, a lobbying group. Texas stands to
get the second most, with almost $17 billion for the state alone, followed
by New York and Florida. More than half the states would get less than $3
billion each, according to the analysis, with just $910 million for Montana.
The money is likely to be more than
enough to address the tax losses states have suffered because of the
pandemic. That leaves open the potential for states to request the funds
for pandemic-related costs and to offset the economic impacts of the recession,
as provided for in the legislation.
California may receive a grand total of
$152 billion from the various provisions of the federal stimulus bill. As
previously stated, under the $360 billion of aid to state and local
governments, California expects $26.1 billion and another $17 billion going
to its cities and counties. In addition, under the $10 billion Capital
Projects Fund, California could receive $550 million. Californians could
receive an additional $30 billion in unemployment insurance benefits; K-12
schools are in line for $15.9 billion and colleges another $5 billion;
Californians could receive $40 billion from $1,400 stimulus checks sent to
individuals under criteria.
As a result, Moody's has raised its
outlook on U.S. state and local government credit ratings to stable from
negative in light of better-than-expected tax revenues and fresh aid from
the federal government. "In most states, tax revenue growth continues
to outpace previous expectations, leaving only a few with looming budget
challenges," Moody's said in a statement. "Meanwhile, federal
support for individuals and state Medicaid programs via Congress's latest
stimulus package will further stabilize state finances." The ratings
company said that most states will retain or add to their reserves in
fiscal 2021.
Conclusion
Many market participants believe that
President Biden's rescue package may spur a wave of new debt sales by
states and cities. The measure provides $360 billion to states and cities
to deal with the financial impacts of the pandemic, eliminating the strain
that led them to cut spending in anticipation of lower tax revenue. With
the $1.9 trillion plan poised to stoke economic growth, analysts anticipate
that governments will feel more comfortable selling debt to finance public
works.
In the municipal market, improving credit
fundamentals, more infrastructure needs, and low municipal interest rates
by historical standards should lead to faster debt growth of state and
local governments.
Top Of Page
The Wayfair Windfall
Friday, March 12, 2021
States have been struggling, with tax
collections having tumbled in the fallout of the coronavirus pandemic. But
there has been a silver lining that was not available in earlier economic
downturns. Thanks to the U.S. Supreme Court's groundbreaking Wayfair
decision, handed down almost three years ago, states are collecting
billions of dollars on e-commerce sales that were previously uncollected.
In the South Dakota vs. Wayfair ruling,
issued June 21, 2018, the Supreme Court tossed out its 25-year-old physical
presence standard limiting state collection of taxes from out-of-state
vendors. The decision led to tax collection-and-remittance requirements on
remote sellers and marketplace facilitators based on their level of
economic activity in a state. Now all but two of the sales tax states are
doing so. States with a sales tax rely heavily on it: Sales and personal
income taxes combined represent 75% of all state general fund revenue
collections.
The adoption of remote sales tax and
marketplace facilitator laws has not been without its growing pains. Food
delivery providers and other gig-economy companies are petitioning states
to be exempt from marketplace laws. Meanwhile, telecommunications companies
are pushing for amendments allowing them to negotiate with marketplace
facilitators on who has the collection obligations. They say they have
historically collected such taxes and fees as the 911 fee and the Universal
Service Fund, and they are better at it than the marketplaces.
But last March, Multistate Tax Commission
member-states turned back an AT&T effort to urge states to adopt a
model law proposed by the National Conference of State Legislatures that
would allow companies with more than $1 billion in sales to collect and
remit taxes in lieu of facilitators. States want to wait and see how their
marketplace facilitator laws shake out before making any adjustments to
them.
For Missouri and Florida, however, the
Covid-19 recession could prompt a change of heart. They are the only two
states that so far have sat out collection of sales taxes on remote
sellers. There is going to be pressure for them to move forward given the
significant revenue impact on their budgets. In this type of environment, a
revenue stream that could be in the tens to hundreds of millions of dollars
cannot be ignored. Revenue pressure may also mean states turn up the
enforcement heat. Once this pandemic passes, hopefully soon, we would
expect more concentrated efforts, particularly in a revenue-starved
environment.
As the pandemic era gives way to more
regular business, some longer-term concerns and challenges may start to
emerge for consideration. A primary concern of sellers has been the
patchwork of state and local sales tax models and minimum sales thresholds
for triggering a remote tax obligation. Many follow the South Dakota model
of $100,000 in sales or 200 transactions into a state annually—which the Supreme
Court ruling suggested would be acceptable constitutionally. A handful have
no transaction thresholds. Kansas has no threshold at all, a fact that may
make that state's law the first target of legal challenge against
remote-seller taxes.
Whether more standardization will develop
is not clear. We expect to see simplification in states like Louisiana,
Colorado, and Alaska, which could increase centralization of returns for
both state and local governments, and make it easier for retailers in
general.
States may ask whether the threshold
dollar figure should rise with inflation or fall as it becomes easier for
smaller businesses to comply. It is possible, too, that states will want to
make more certain of revenue collection in the way tax authorities around
the world are doing to fight value-added tax fraud and bring in billions in
currently unpaid taxes—using computerized real-time reporting and
collection systems.
A further ramification of the Wayfair
ruling that has yet to play out significantly is expansion of the
economic-presence concept to areas other than sales taxes—to company taxes,
for example.
Conclusion
The Wayfair effect has been huge for many
state governments, which have seen other sources of revenue plummet. The
two events together—the Wayfair decision and the pandemic—have
exploded online sales revenues. Most state governments do not separate
online sales taxes from other sales taxes in their accounting, so it is
hard to calculate the impact nationwide. But in California, the world's
fifth-largest economy, online taxable sales more than tripled in the first
half of 2020 compared with a year earlier. In New York, a dramatic shift in
consumer spending led to a significant increase in online purchases, which
bolstered tax collections.
North Carolina's sales tax collections
are expected to jump more than 10% from the previous year. The Wayfair
decision could not have come at a better time for states and local
governments. Although taxes from online sales have mitigated their fiscal
damage, sales taxes generally were still slightly down between March and
December, according to the Urban Institute. Post-Wayfair, Texas and 42
other states that passed laws allowing for the collection of the taxes are
reaping the benefits. Only Florida and Missouri, among the 45 states that
levy sales taxes, have not moved to collect those dollars yet; bills in
both states are making their way through the legislatures.
Texas, which in July faced a $4.6 billion
budget shortfall, now expects a gap that is a fraction of that, in part
because of Texans shopping from home. In the first year of Wayfair-enabled
collections, the state gained $1.3 billion in sales taxes. The trickle-up
effect from internet purchases means that local governments in Texas alone
have collected about half a billion dollars in new sales taxes since the state
started remitting them.
Top Of Page
Credit Comment on the State
of California's Latest Budget Proposal
Wednesday, February 3, 2021
California Governor Gavin Newsom recently
unveiled a $164.5 billion budget for the next fiscal year, detailing how he
plans to spend a $15 billion surplus that the State has accumulated despite
the pandemic-induced recession that has left thousands of businesses
shuttered and 1.5 million people still out of work. Besides his already
announced plans to allocate grants for small businesses, send $600 checks
to low-income Californians, and help schools re-open more quickly, Newsom
said the budget will spend a record amount for public education, dedicate
$4.5 billion to help the State's economy recover, and pay down almost $10
billion in long-term liabilities. He said various savings accounts will
total $22 billion, a record high.
The unexpected windfall, which a budget
watchdog had previously predicted could be as large as $26 billion, is
largely due to tax collections from the State's wealthiest residents, who
have reaped the benefits of rising stock prices and stable employment even
as lower-income workers lost their jobs in the pandemic. At the same time,
Democratic control of the U.S. Senate has increased chances of additional
federal aid to California and other local governments.
Still, California will see deficits over
the next few years as revenue trails expenditures, the nonpartisan
Legislative Analyst's Office warned in November. It is also facing the
exodus of high-profile corporations, with Hewlett Packard Enterprise Co., Oracle
Corp., Palantir Technologies Inc., Charles Schwab
Corp., McKesson Corp., and Colony Capital Inc. announcing their plans to
relocate to lower-tax locales in recent months, as well as the departure of
wealthy entrepreneurs such as Elon Musk. This is of particular concern to
California, given that nearly half of its personal income-tax collections
come from the top 1% of earners.
In May, Newsom's administration said the
State was facing a $54 billion two-year shortfall driven by the pandemic, a
reversal from earlier in the year when it anticipated a $5.6 billion
surplus and padding its rainy-day fund to $18 billion. The Democrat then
signed a $133.9 billion budget for this fiscal year that slashed employee
compensation and aid to the State's two higher-education systems. It also
deferred $12.9 billion in payments to schools and community colleges and
borrowed $9.3 billion from other funds. The cuts were to be backfilled by
additional federal aid by October, which never materialized. Newsom said
recently that two-thirds of deferred school payments would be made in next
year's budget.
But tax collections started to exceed
expectations in July, the first month of the fiscal year. Through November,
revenue is 23% over assumptions. Before Newsom's budget presentation,
Democratic leaders of both legislative chambers said they wanted some of
the windfall to restore the cuts made in the current year budget. The
budget will be revised in May ahead of a June deadline for passage.
The State now projects fiscal 2021 revenues
will be $28 billion (23%) higher than the June 2020 enacted budget
estimate, essentially matching the pre-pandemic forecast. General fund
revenues, prior to transfers, are forecast to further increase 5% to $161.6
billion in fiscal 2022, $39 billion (32%) higher than the June 2020
estimate.
The State attributes the improved revenue
performance to the unusual nature of the coronavirus-related downturn, in
which higher-wage taxpayers have both been protected from job losses and
have benefitted from the strong stock market. This has allowed the State's
progressive personal income tax structure and taxing of capital gains to
generate the higher-than-anticipated tax revenue. It also reflects a less
severe economic downturn than was assumed in the fiscal 2021 budget. The
economic assumptions underlying the governor's budget proposal align with
MTAM's economic outlook for the U.S., with the State assuming 3.1% real
national GDP growth in 2021. However, California's relatively volatile tax
structure leaves it vulnerable to wide swings in economic activity.
The governor is requesting early action
on several items intended to provide immediate relief to individuals and
small businesses considered to be disproportionately affected by the
pandemic. These one-time actions include $2.4 billion to provide $600
payments to low-income workers, $575 million for grants to small businesses
and small non-profit cultural institutions, and additional targeted relief
for other industries, including restaurants and personal services. However,
the budget was developed prior to enactment of the December federal
stimulus bill, and legislative action is likely to take recent and expected
federal actions into account.
The budget also requests immediate action
to provide $2 billion in incentives to schools to re-open as early as
February, and accelerates repayment of deferrals that were incorporated
into the fiscal 2021 budget. Education funding will automatically
significantly increase due to the requirements of Proposition 98 in both the
current year and the budget year.
As has been the State's practice, the
governor takes a fairly conservative approach to using increased revenue by
limiting growth in ongoing spending, rebuilding reserves, and paying down
long-term liabilities. The executive budget begins to restore the $7.8
billion draw on the rainy-day fund, known as the Budget Stabilization
Account (BSA), that helped balance the fiscal 2021 budget. It also provides
$2 billion to continue programs that otherwise would sunset during the coming
fiscal year, applies $3 billion in supplemental payments to reduce
retirement liabilities (required under Proposition 2 and above the
actuarial requirement), and provides limited additional funding for various
policy initiatives.
The proposed budget adds $7.2 billion to
the BSA across fiscal years 2021 and 2022, bringing the balance to $15.6
billion, or 9.6% of revenues. In contrast to prior economic downturns when
the State's reserves were limited, the BSA helped address the anticipated
revenue gap as the pandemic unfolded and continues to provide flexibility
to address revenue volatility. The budget also allocates $6.3 billion to
other operating reserves. We anticipate details of the enacted budget will
vary from the governor's plan, which will be updated in May to reflect
federal actions and any changes in the economy. But, as in recent years,
the general approach of limited recurring spending growth, focus on
one-time actions, and restoring resilience will likely carry through.
Conclusion
The State, with a progressive tax system
that rakes in more revenue when the income of the highest earners rises,
expects to collect a record amount from capital gains as wealthy residents
reap the rewards of a booming stock market. California has taken in more in
sales-tax receipts year to date than it did over the same period last year
as people shop online for mostly everything.
California's reliance on the fortunes of
the rich, which led to multi-billion dollar deficits in the past, is
allowing it to now project a $15 billion surplus after officials had
previously girded for a $54 billion two-year shortfall. As Covid-19
infected more than 3 million people and killed almost 35,000 in California,
officials there, as in other states now scaling back their initial dire
forecasts, failed to estimate the extent of the success of the top 1% amid
the pandemic.
California, which levies a top rate of
13.3% on income, is home to more billionaires than any other U.S. state,
according to the Bloomberg Billionaires Index ranking of the world's
wealthiest 500 people. Nearly half of the State's personal income-tax
collections come from the top 1% of earners.
Meanwhile, nearly half a million leisure
and hospitality jobs in California have been lost year to date, while the
typically higher-paying financial activities sector added 4,300 positions
over the same period, another sign of the uneven recovery. A survey
released in December from the Public Policy Institute of California showed
that 40% households with annual incomes of under $40,000 reduced work hours
or pay in the last 12 months, with a similar share forced to cut back on
food.
The State's finances are likely to be
buttressed even more as the new Biden administration pushes a $1.9 trillion
Covid relief package that could send more federal
aid to the Golden State. That could allow Governor Newsom and lawmakers to
redirect State tax money toward those most in need. Newsom has proposed
tapping the surplus for $600 checks to 4 million low-income Californians.
He also wants to spend $1.75 billion on housing and homelessness programs
and $2 billion to help schools open for in-person education more quickly.
But the State's flush treasury obscures a
disturbing trend: high-profile companies such as HP Inc. and billionaires
such as Elon Musk are leaving the State. While businesses and people have
for years departed the Golden State for lower-tax locations, the pandemic
and the potential of remote work continuing in the future raises concerns
that the exodus could speed up and pose a risk to the vibrancy of the
world's fifth-largest economy. Indeed, despite the surplus, the State still
sees deficits ahead.
When asked during his recent budget
briefing what he can do to prevent more companies and billionaires from
leaving the State, Newsom noted the success of recent initial public
offerings of companies based there. He pointed to his proposed budget
allocations to education and business grants when pressed.
But for some Democratic lawmakers, more
needs to be done to help those hurt most by the pandemic after years of
growing inequality. Several members of the Assembly have introduced a bill
that would raise the corporate tax rate on certain companies for a
dedicated funding stream for homelessness services.
As the pandemic bears down more heavily
on lower-income residents, lawmakers will have to make difficult decisions
while balancing the budget with deficits projected in the future.
Top Of Page
Municipal Bond Market Credit
Outlook for 2021
Thursday, January 7, 2021
Municipal bond issuers will continue to
face several credit challenges in 2021, but MTAM expects that the vast
majority of municipalities will successfully manage through most
difficulties with a combination of spending cuts and revenue enhancement
plans.
MTAM has always been, and will continue
to be, a conservative asset manager. We are very selective in the municipal
sectors and top tier bonds we decide to purchase and hold. This has
positioned us extremely well to weather the current pandemic situation.
Notwithstanding the challenges facing
municipal bond issuers, there are always good opportunities, even for the
very conservative investor. We still expect defensive credits like water
and sewer bonds, special tax bonds, and public power bonds to perform
better from a fundamental perspective. These types of bonds tend to have
revenue streams that are less subject to economic volatility, have strong
covenants, or are tied to an "essential service", making debt service
payment more certain. In addition, there is legal precedence that bonds
backed by a dedicated revenue stream may be protected in the case of a
municipal bankruptcy. We prefer bonds that have a clean flow of funds,
broad revenue streams, and high debt service coverage tests.
State
Governments
MTAM's 2021 outlook for U.S. states is negative due
to continued weak revenue performance amid the coronavirus pandemic. Many
states will not fully recover revenue lost in fiscal 2020 until at least
the latter part of 2021. And while federal assistance to boost consumer
spending and help cover revenue losses has improved state finances,
additional federal aid is uncertain.
After revenue losses in fiscal 2020,
states are left with fewer resources to meet their spending needs. Those
hardest hit by the economic effects of the pandemic will lag amid an uneven
recovery. But several states, notably those levying income taxes, are
performing better than expected.
Additional fiscal intervention from the
federal government via another round of unemployment benefits or new direct
aid to close budget gaps would help states manage the weak economy. We have
not figured additional federal aid into our outlook since such support may
not be forthcoming, leaving states challenged by an ongoing weak job market
and high unemployment. However, the prospect of Democratic control of
Congress has increased the odds that the federal government will extend aid
to cities and states stung by the economic fallout of the coronavirus
pandemic. Additional aid of $80 billion to $100 billion could cover the
forecast for the shortfall facing states and local governments through
mid-2022.
Most states have put off spending cuts in
fiscal 2021, and instead are bridging budget gaps by tapping reserves or
undertaking new borrowing. Although these tactics will preserve K-12 school
funding and other priorities, they also herald greater challenges in fiscal
2022, when fixed costs will be higher and reserves lower, making it more
difficult to address future budget gaps and lingering coronavirus-related
social risks.
The outlook for U.S. states could change
to stable if a stronger recovery in tax revenue takes hold. Employment
levels near or above 95% of pre-pandemic levels in most states, along with
reasonably controlled coronavirus infection rates, would signal a return to
economic health on the back of improved revenue growth.
MTAM does not anticipate a broad downward
shift in ratings across the sector. Most state governments still have ample
access to diverse revenue bases, control over revenues and spending, and
moderate long-term liability burdens, and sound financial cushions will
help preserve a high level of credit quality.
The same holds true for the vast majority
of local governments despite mortgage forbearance agreements and eviction
moratoria that may slow or reduce property tax collections. The impact of
the pandemic on property values will likely be minimal overall but vary
with the size, location, and density of the local government.
Travel and leisure spending, which will
likely not fully recover in 2021 and will reduce resources for tourism-based
economies, is another development to watch in 2021. A sizable additional
federal stimulus program would particularly benefit those states and local
governments with more limited financial resilience.
The continued withdrawal of direct fiscal
support to individuals may further slow state economic recovery in the
coming quarters. The expiration of significant levels of pandemic-related
government transfers has occurred while employment losses from the pandemic
are still significant in many states and may take several years to return
to pre-pandemic levels.
Concerns around weakened economic
activity and an employment recovery that continues to level off, has led
most states to forecast revenues to underperform not only in fiscal year
2021, but also in fiscal year 2022. In response, states have already made
budget adjustments, with more belt tightening likely. While revenue
collections data indicate more positive results in recent months than
initially anticipated, significant uncertainty remains.
Making matters worse are coronavirus
cases and hospitalizations, which are surging again and appear to have a
broader geographical scope than the spring and summer waves with all
regions significantly affected. Governors across the country have announced
new restrictions on activity in an effort to control the spread of the
virus and protect healthcare system capacity.
Local
Governments
Our 2021 outlook for U.S. local
governments is negative.
Economic conditions will constrain municipal revenue growth at the beginning
of 2021, while some types of revenue will remain under pressure despite a
nascent economic recovery. Governments' fixed-cost burdens will rise, while
growing demand for public services will strain some budgets and deferred
capital spending will likely delay climate change mitigation projects.
Uneven economic conditions from the
ongoing coronavirus pandemic will strain U.S. local governments' revenue
through early 2021. Sales and income tax revenue will remain soft before
beginning to recover as the economy rebounds in the second quarter.
Despite ongoing low interest rates,
however, rising fixed costs associated with debt and pension liabilities
will consume increasing amounts of revenue, causing fixed-cost burdens to
rise for some local governments.
Meanwhile, additional federal support
remains uncertain. In 2020, the Coronavirus Aid, Relief and Economic
Security (CARES) Act was an important source of both direct and indirect
revenue for local governments, but MTAM's outlook does not assume that further
federal aid will be forthcoming. At the same time, increased public
attention on social inequalities will likely heighten calls for greater
spending in areas such as social services, housing, and healthcare.
Not-for-Profit
Hospitals
MTAM continues to have a negative outlook
on the not-for-profit healthcare and hospital sector for 2021. Volume and
service mix disruption, reduced commercial insurance revenues from elevated
unemployment, and higher expenses will weigh on hospitals amid the
coronavirus crisis. The pace and sustainability of recovery from last
spring's nationwide mandatory elective shut down will be influenced by
containment of the virus and widespread vaccination.
The latest surge in COVID-19 cases and
hospitalizations is positioning U.S. not-for-profit hospitals for a
difficult 2021. The healthcare sector has responded extremely well to past
crises, though the scale of the coronavirus pandemic and nationwide
shutdown of elective procedures was unprecedented. Coming off a year of
weak margins in 2020, we expect more of the same in 2021.
Though COVID-19 hospitalization rates may
limit elective procedures, a nationwide shutdown is not likely this time.
Elective procedures, even at a reduced clip, should not hit hospitals as
hard financially as the nationwide shutdown that cut top line revenues by
40% in spring 2020. Hospitals are also better prepared to handle another
wave of COVID-19 infections.
That said, hospitals will face continued
stress and strain, particularly in the first half of 2021, until a viable vaccine
is widely available and utilized. Hospitals will also be contending with an
increase in operating expenses in 2021. Providers will need to secure a
mini-stockpile of ventilators, masks, gowns, drugs and certain types of
beds, though adequate staffing will be the most critical component.
Patient volumes will remain constrained
due partly to fears about coronavirus exposure. At the same time, labor and
supply costs will increase, especially amid new COVID-19 surges. MTAM's
outlook assumes there will be no additional federal aid similar to CARES
Act grants.
Meanwhile, elevated joblessness will lead
to growth in the Medicaid and uninsured population as individuals lose
employer-sponsored commercial insurance, which is usually more profitable
than government-provided coverage. Additionally, as baby boomers move out
of commercial healthcare plans, hospitals will become more dependent on
Medicare revenue.
The not-for-profit and public healthcare
sector's recovery from the effects of the pandemic will be uneven and
differ by region and by facility. Overall, large, diverse healthcare
systems and/or those with more cash will be best positioned to resume
growth, while smaller standalone hospitals will likely consider
partnerships. Hospitals also stand to lose revenue if the Affordable Care
Act is overturned in the absence of a replacement plan, and if there are
cuts to Medicaid funding.
Transportation
MTAM's 2021 sector outlook for U.S.
airports is negative.
U.S. airports are expected to continue to face pressures in 2021 as the
coronavirus pandemic hinders travel and depresses enplanements.
MTAM expects enplanements of between 25%
and 45% of 2019 levels in the first half of 2021. Enplanement recovery
remains uncertain because of the potential for renewed travel restrictions
or weakened consumer demand as COVID-19 cases increase.
Absent a very strong
passenger recovery airlines may consider curtailing or eliminating
service, eroding both the income airports earn directly from airlines and
nonairline revenue. If passenger numbers do not significantly improve, most
large airports will likely exhaust CARES Act funding within the year and
without further congressional action, will also struggle the most in 2021.
Strong fee setting flexibility and
liquidity will keep most airports numbers stable, though time will tell if
that will be enough to sustain them with pre-pandemic recovery in passenger
traffic to remain elusive for several years.
The outlook could change to stable if
developments indicate a sufficient recovery to minimize airlines' daily
cash burn and could change to positive if medical developments indicate a
very strong recovery to levels that produce sufficient margins to support
debt service payments.
MTAM's 2021 sector outlook for U.S.
public ports is stable.
Cargo volumes are expected to grow 5% over the next 12-18 months after
contracting by the same amount in 2020 as a result of coronavirus-related
business disruptions.
Strengthening economic activity and
normalizing supply chain conditions in the U.S. and globally would boost
cargo volumes in the year ahead. There are significant risks to the still
nascent economic recovery, however, including the uncertain evolution of
COVID-19 and the fragile financial health of the consumer and industrial
sectors.
Cargo demand is strongly correlated with
GDP and retail sales, and forecasts show that both will grow by 3%-5% in
2021, a level that will support consumer spending and business investment.
At the same time, a strengthening global economy will increase demand for
exports.
In 2021, a significantly weakened cruise
sector will begin to gradually recover from pandemic-related disruptions,
with the lifting of a "no sail order" enabling U.S. cruise
operations to resume, though initially capacity and occupancy levels will
be low. Meanwhile, the sector will remain challenged, with minimum revenue
agreements being contested or renegotiated, and recent capital investments
facing weaker cost-recovery prospects.
MTAM's 2021 sector outlook for
government-owned toll roads is stable
based on the expectation for steady tolled traffic and revenue (T&R)
growth. Restrictions implemented to curb the initial outbreak of COVID-19
sharply reduced traffic on toll roads in April 2020, with steady
improvement since about mid-October. Commercial traffic has largely
rebounded and will provide revenue stability until passenger traffic
recovers more by the second half of 2021. Nevertheless, recent outbreaks of
the virus are tempering the recovery in some regions, with passenger
traffic declining again in the past six weeks, which could hamper the
overall recovery, though T&R declines are not expected to be as severe
as those seen earlier this year.
In most parts of the country, passenger traffic
continues to steadily recover, but the pace and magnitude of the recovery
differs by region. For instance, while vehicle miles traveled rebounded
nationally this summer, the South Gulf region led the recovery, while the
Northeast continues to lag.
The widespread availability of a vaccine
will boost economic recovery, with vehicle miles traveled and T&R both
improving as a result. Education services will return to normal and
consumers are likely to unleash their unusually high personal savings on
services, increasing passenger traffic and revenue on toll roads.
Meanwhile, nearly all toll roads maintain
strong cash balances and reserves, a key mitigant
to COVID-related revenue losses. Furthermore, consistent toll increases
support revenue growth for operating and capital needs, as well as rising
debt service costs in some cases. At the same time, older toll roads are
transitioning to all electronic tolling, which will allow them to implement
more refined, incremental toll adjustments, with most toll roads indexing
their tolls to CPI, which has averaged 2% each year for the past decade
despite being quite low in 2020.
Water
and Sewer
MTAM is maintaining a stable outlook
on the U.S. water and sewer sector for 2021. The sector's strong
fundamentals are underpinned by the essential service provided to users,
monopolistic business nature, and high barriers to entry. Additional
positive features are low price sensitivity, strong liquidity, and
independent local rate-setting authority. These factors insulate the sector
to some extent from economic cycles. However, persistent droughts and
overregulation could reduce financial flexibility for certain issuers.
U.S. water and sewer utilities remain
favorably positioned heading into 2021 despite the challenges posed by the
macro environment. With expectations of lower revenue growth than recent
years, utilities are working to limit cost escalation and manage through
capital spending needs. Some increase in sector leverage is expected, but
by and large balance sheets are sufficiently robust to absorb business
disruptions arising from the pandemic.
Local government credit pressures arising
from the pandemic have the potential to spill over to related utility
profiles, although we expect the credit impact across the sector will be
relatively limited. Utilities may be tapped for certain financial support
for their host government, or credit deterioration of the host government
may directly affect a utility's own rating in certain circumstances.
The water and sewer industry will be
paying close attention to regulatory developments in 2021. In particular, a
rule related to lead and copper is expected to be finalized and has the
potential to increase annual costs across the sector by over $342 million
annually. Other regulations are also being considered for additional
contaminants that could add significant costs for the sector over time.
Increased volatility in weather extremes
has the potential to escalate sector capital needs as utilities seek to
harden assets and enhance water supply capability to ensure service
delivery. Added capital demands would likely lead to some increase in
moderate sector leverage levels and further erode sector affordability
levels.
Public
Power
MTAM's 2021 sector outlook for U.S.
public power electric utilities is stable, reflecting a strong
fundamental business model. We expect that utilities will display stable
financial metrics, supported by a steady business environment and the
self-regulated ability to set electricity rates to pay debt service. MTAM
expects the sector to be relatively resilient through the ongoing global
recession.
Public power utilities' business model
inherently helps maintain stability; they provide essential services in a
non-profit oriented manner, have strong liquidity, and have self-regulated
rate-setting ability to help manage cost recovery. At the same time, while
we expect financial metrics to weaken over the next 12-18 months as a
result of lower sales revenue and continued moratoriums on service
disconnects, metrics should still remain within our range for a stable
outlook.
MTAM expects overall net negative load
demand nationally for 2020, with continued recovery and demand growth
through 2021. But loads have not declined evenly throughout the country
because of varying degrees of shelter-in-place orders and weather-related
reasons. We also expect demand growth and recovery to vary depending on how
long it takes local economies to recover. In the event of another national
wave, there could be another significant reduction in commercial and some
industrial activity, with more permanent job losses because of permanent
closures of commercial establishments unable to recover.
Depending on the proportion of industrial
and commercial customers of particular issuers, as well as the types of
industries located in their service territories, some issuers may actually
experience load demand growth, as in food products, hygiene and medical
supply-related industries, as well as home improvement industries.
Although there was an increase in
residential load demand across the board given shelter-in-place orders, for
the most part, this increase is not enough to offset the decline in
commercial and industrial load expected for the full year 2020, as a result
of significantly reduced commercial and industrial activity in the first
half. But demand has continued to improve since the peak declines observed
in April and May.
Issuers with service territories with
high poverty levels are likely to be more severely affected because job
losses during the pandemic have disproportionately fallen on lower income
individuals, many of whom work in the commercial sectors where the virus
has caused the most upheaval, such as retail, restaurants, apparel, hotels,
entertainment and transportation.
These workers will continue to face job
insecurity as long as COVID-19 remains a health threat, with implications
for consumer confidence and spending, demands for social services, and in
some economies, a further divide in access to healthcare.
Although the CARES Act funded $900
million to a program that helps low income households make home energy
payments, according to the American Public Power Association (APPA), more
funding is needed. Federal aid to local governments has provided only
limited short-term relief and is unlikely to alleviate budgetary stress in
2021.
The CARES Act stipulates that funds may
be used only to cover coronavirus-related expenses, not to replace lost
revenue. Further, the relief package has been focused on states, with
cities and counties receiving no more than 45% of each state's allocation.
Disbursement of this aid is on a reimbursement basis for costs incurred
through 30 December 2020. MTAM's forecast assumes limited additional
federal aid.
Colleges
and Universities
MTAM is maintaining our negative
outlook on the higher education sector for 2021 as the effects of the
coronavirus pandemic continue to threaten key revenue streams. Moreover,
the length of the health crisis and pace of economic recovery remain
uncertain, adding additional credit risk for colleges and universities.
Reduced enrollment will lead to tuition
revenue declines at a majority of public and private universities, while
reductions in auxiliary revenue, such as that earned from housing and
dining, will also be significant for some. Other revenue sources, such as
state funding and philanthropy, will also come under increasing stress as
the pandemic persists.
Overall, higher education revenue will
decline by 5%-10% over the next year as universities continue to face
pandemic-related shocks. At the same time, high fixed costs and varied
assumptions about how long the crisis might last hamper universities'
ability to adjust expenses quickly. Operating performance will decline as a
result, with about 75% of public universities and 60% of private
institutions failing to generate cash flow margins above 10%.
Universities will continue to use a
variety of means to help mitigate mounting deficits and shore up liquidity.
Debt refundings, taxable borrowing, and deferring
capital investments will remain important in maintaining budget
flexibility. Ongoing access to the capital markets is a strength for the
sector, and some universities have accelerated borrowing that would have
been undertaken in the next year or two, taking advantage of low interest
rates.
Meanwhile, environmental, social and
governance, or ESG, considerations will become more prevalent as the higher
education sector confronts fundamental changes. The rapid move to a virtual
classroom experience is hastening advances in online delivery that might
have taken much longer before the pandemic. And while near-term shifts are
more reactive, universities will have to embrace this bigger change over
the longer term in order to adapt to students' preferences.
Consolidation is likely to accelerate in
2021 and beyond, which may take multiple forms. Smaller private
institutions remain most susceptible to consolidation either through a
merger, affiliation with another larger institution or in the most serious
scenario, outright closure.
Substantial headwinds aside, the higher
education sector as a whole still retains key fundamental strengths
including significant flexibility and fortitude in the face of operating
and financial pressure. Many institutions maintain sufficient liquidity,
and have been proactive and agile with regard to strategic management,
targeted revenue growth and diversity, expense management, and pursuing
partnerships for mutual benefit.
Housing
MTAM views the tax-exempt housing sector
as having a stable
outlook in 2021. The sector was financially well-positioned in 2020; state
housing finance agencies (HFAs) are expected to adequately navigate in an
environment of rising single and multifamily delinquencies and loan
forbearances. HFAs were well poised to respond to the liquidity needs that
have affected their balance sheets and loan programs due to the pandemic.
Although HFAs will likely continue to experience a decline in equity in
2021 compared with prior years, MTAM does not believe that significant
financial erosion will materialize in 2021. HFA equity ratios have steadily
improved year-over-year with a 23% increase from 2015–2019. We do not expect to see the same
level of increases (YoY avg of 5%) in 2021,
however, the challenges going into 2021 do not rise to widespread financial
pressure given the strength of HFA balance sheets. Single-family and
multifamily housing increases in delinquency rates in 2020 have been
mitigated by stimulus and federal programs that we anticipate to persist in
2021 given the essential need for affordable housing.
Default
Outlook
Defaults in the U.S. municipal bond
market –
meaning an issuer missed a bond payment –
totaled 79 in 2020, the most since 2012, when there were 108, according to
Municipal Market Analytics. The record was 154 in 2009, when the nation was
mired in the Great Recession.
Most of the defaults in 2020 involved
retirement homes (almost 40% of the total), land-secured deals involving
real estate or infrastructure, and industrial developments, like a
recycling mill.
MTAM expects more distress in 2021 with
many local governments facing thin tax collections, tax assessment appeals,
spending austerity, and state aid reductions. Most analysts do not foresee
a full economic recovery until the second half of 2021, after a very
aggressive vaccination campaign.
The coronavirus pandemic has driven the
use of municipal bond insurance to its highest level in more than a decade
as borrowers seek to reassure investors concerned about the rise in
defaults. More than $34 billion of state and local government bonds sold in
2020 were insured, accounting for 7.5% of new issues, according to data
compiled by Bloomberg. That is the highest volume and share of sales since
2009.
The uptick marks a small if notable
resurgence for a business that shriveled after the credit crisis set off by
the housing market collapse, when the major insurers had their credit
ratings slashed because of losses tied to mortgage-related securities.
Until then, governments had been paying insurers to guarantee roughly half
of the municipal bonds sold each year, anticipating that the extra security
would drive down the cost of borrowing. The insurance offers an additional
level of protection for investors by guaranteeing that principal and
interest payments will be made even if an issuer does not cover what is owed.
Conclusion
MTAM continues to recommend that
investors select high-quality municipal issuers that understand the new
economic and financial reality, and have made or are making budget
adjustments. Essential service revenue bonds without the budgetary concerns
of state and local governments and limited payrolls can be attractive, but
we stress that an essential service issuer cannot flourish if the
underlying governmental entity is in dire economic circumstances. A healthy
outlook holds for most infrastructure issuers due to fundamental strengths
reflected in the provision of essential public services, adequate balance
sheets, and generally sound governance and fiscal management practices. In
the case of the enterprise sectors comprised of higher education, health,
and housing, credit quality will be maintained primarily as a function of
their ability to increase fees, control costs, and improve overall
operating margins. Sound debt and fiscal management practices, preservation
of adequate liquidity, and strong governance oversight will be significant
determinants of credit quality for issuers during the coming period of
financial adjustment.
Top Of Page
4th Quarter 2020 Review and
Outlook
Thursday, December 31, 2020
Solid positive returns were prevalent
once again for municipal bond investors in the fourth quarter, as the
economy slowly continued to recover from the pandemic-related shutdown.
Miller Tabak Asset Management saw this coming
months ago as we put out a bullish note to clients on April 10th, stating
"Once the economy gets up and running, this market has significant
"equity-like" upside in many beaten down sectors." It was
obvious to us back in the early stages of the pandemic that way too much
fiscal and monetary stimulus was coming to allow this market to fail in any
meaningful way. Investors who favored longer maturity bonds were rewarded
the most, as the hunt for yield was in full force for most of 2020.
Now that the "low-hanging fruit"
has been scooped up in the municipal market, it is imperative that
investors remain disciplined in their search for tax-free income in 2021.
Professional credit research will be needed to navigate client portfolios
through what will likely be an uneven economic recovery in the months
ahead. We continue to be outright bearish on the State of Illinois
finances, and as such, cannot rule out a drop to below-investment grade
should their economy get hit with another COVID-related shock. Meanwhile,
California and New York are experiencing particularly acute COVID-related
"hangovers" that bear watching over the intermediate term. While
these two states are currently on much stronger financial footing than
Illinois, it needs to be recognized by investors that the severe burdens
being placed on small businesses in these two states can accelerate a
population exodus that can weaken the tax base substantially in the coming
years.
Moving forward, it should be of little
surprise if interest rates move higher from current levels, given the
paltry level of income available these days. However, it is important to
always remember that the pandemic significantly increased the amount of
debt our federal government needs to repay investors. For this overwhelming
debt burden to be manageable, it will require the Federal Reserve's
monetary policy to remain quite accommodating for many months to come. It
is with that in mind that investors should view any notable backup in rates
as a buying opportunity.
Happy New Year!
Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak
Top Of Page
An Update on the State of the
States
Thursday, October 15, 2020
State tax revenues in some parts of the
U.S. are rebounding as the economy emerges from the coronavirus lockdown, a
positive sign for governors who had been bracing for the biggest fiscal
crisis in decades. August sales tax receipts in hard-hit New Jersey rose 3%
from a year earlier and non-partisan legislative analysts are forecasting
that revenue will exceed Governor Phil Murphy's projections by $1.4 billion
for the fiscal year. California's revenue is exceeding forecasts, and
Georgia's collections are on the rise.
The figures are an early sign that the
worst economic collapse since World War II may not decimate governments'
revenues as badly as some feared, potentially reducing the scale of budget
cuts and tax increases that would exert a drag on the nation's recovery. It
is also providing comfort to investors in the $3.9 trillion municipal bond
market who had anticipated that Congress would come through with hundreds
of billions of dollars in aid, a prospect that is seen as increasingly
unlikely until at least after the November election.
There is no impending existential fiscal
crisis that states are facing. That being said, we know from past
recessions, states experience a lagged effect on their tax revenues. So, it
is not to say they are in the clear as budget challenges will certainly
persist. States are still contending with large budget shortfalls and
government officials caution that the good news may be fleeting, given that
the disappearance of enhanced unemployment benefits or a resurgence in the
coronavirus outbreak could deal another setback to the economy. And because
of the lag with which income taxes are collected, states have historically
continued to face big deficits well after recessions end.
But so far, some are seeing that their
tax base did not erode as much as feared. California's revenue exceeded its
estimates by $3.4 billion in July and August, giving the government 9% more
than the budget reflected. Georgia's personal income tax revenue rose 10%
in August from a year earlier.
Latest
State Results
U.S. states saw their tax revenue drop by
$31 billion, or 6%, from March through August, compared with the same
period a year earlier, as the pandemic triggered economic shutdowns across
the country, according to a data from 44 states compiled by the Urban
Institute. The scale of the drop appears smaller than expected, relative to
the depth of the economic contraction, and comes after several states have
reported that their revenue did not decline as much as anticipated despite
business shutdowns and increased unemployment.
In August, when much of the country was
reopening, state revenue climbed 1.1% from a year earlier, the Urban
Institute found. The tax figures come as Republicans in Washington balk at
extending aid to states and cities to help cover budget deficits that are
expected to continue as the coronavirus weighs on the economy. Experts say
that states' financial outlooks could worsen as the effects of the stimulus
bill fade and high unemployment reduces tax bills next year.
The August increase should be viewed with
caution since income tax deadlines were pushed back to July, which could
have resulted in some revenue being processed later. Personal income tax
collections, which rose 3.8% in August, were in some cases supported by
backlogged unemployment insurance benefits subject to withholding tax.
Between March and August, tax revenues fell 6.4% year over year, with 36
states reporting declines over that period. Between March and August, eight
states including Washington and Georgia, reported growth in tax revenue.
Yet that does not mean the toll is behind
states, since full income tax payments for 2020 income will not be made
until next year. The expectation is still that the worst is yet to come.
The severity of the revenue drop so far has been lessened by the $2.2
trillion stimulus plan enacted in March that provided payroll support to
small businesses, direct payments to families, and larger unemployment
checks to millions of out of work Americans. The rescue package also gave
the Federal Reserve the ability to intervene in the municipal market if
needed. But unique elements of the pandemic have also played a role. Income
tax payments have not dropped as much as anticipated because job losses
have disproportionately affected lower-paid workers in the restaurant,
retail and tourism sector. Higher paid white-collar workers who could work
from home have kept earning and spending, unlike during the recession set
off by the housing market collapse, when many high-paid finance and real
estate workers lost jobs.
U.S. state tax collections are expected
to drop 11% by the end of fiscal year 2021 with the declines concentrated
in the states that were hardest hit by the pandemic. Tax collections for
fiscal 2020, which ended for most states on June 30, will finish down more
than 5% from the previous year and then decline another 6% in fiscal 2021.
Tax revenue declines will be concentrated in states hardest hit by
coronavirus infections: California, Illinois, Texas, and New York. These
states are expected to account for a disproportionate share of the total
decline in state tax revenue. Hawaii has recovered the least because of its
high dependence on airborne tourists. States that have avoided the worst of
the economic fallout may still see revenue fall but more moderately than
peers that took a big hit earlier in the pandemic life cycle.
Moody's recently reported that states and
local governments face combined shortfalls of $450 billion through fiscal
2022, less than a prior estimate of a $500 billion hit. Moody's stated that
$200 billion to $400 billion in aid would be more "practicable"
for Congress than the $1 trillion included in House Democrats' stimulus
plan. In June, Moody's called for $500 billion in aid for states and cities
"to avoid major damage to the economy". Moody's said that it
changed its forecast in light of an improving economy and clarity around
the aid that municipalities have gotten so far. States are projected to
have a $273 billion shortfall through 2022, due to about $191 billion of
revenue loss and $83 billion of increased Medicaid costs; that is down from
a $312 billion estimate in June.
At least 17 states dipped into their
rainy day funds to bridge 2020 budget gaps prompted by the Covid-19
pandemic, and more will be forced to drill into reserves in 2021, the Pew
Charitable Trusts reported. Pew found the 50 U.S. states finished 2019 with
a record $118.8 billion in total balances, including $75.2 billion in rainy
day funds. As 2020 opened, 36 states planned to build their reserve funds
further. But the health crisis forced states to burn through reserves and
the situation could get worse in 2021, when Pew expects pandemic-related
losses of between $125 billion and $200 billion. Alaska, Delaware,
Maryland, Michigan, Mississippi, Nevada, New Jersey, New Mexico, Oklahoma,
and Rhode Island used substantial portions of their rainy day funds to
close their 2020 budget gaps. Arizona, California, Georgia, Iowa, Maine,
Nebraska, and Washington withdrew smaller portions in order to prepare for
and respond to the pandemic. Several states included rainy day withdrawals
in their 2021 budgets, and more are under consideration before this budget
year closes next June.
Conclusion
Federal stimulus payments to individuals
helped support tax collections at the end of fiscal 2020. A prolonged
economic downturn without at least one more round will serve as a drag on
revenue for at least the next two years. Additional federal stimulus, a
strong stock market, and an effective vaccine would boost state revenues.
Top Of Page
3rd Quarter 2020 Review and
Outlook
Wednesday, September 30, 2020
Once again, tax-free bond investors were
rewarded with positive returns during the third quarter of 2020. A slow and
steady reopening of American states and cities aided market confidence that
the worst of the pandemic may be behind us. This brought a consistent flow
of investor money into the municipal market, further depressing already low
tax-free bond yields, much to the dismay of those in need of income. To the
surprise of many market participants, the upward burst of supply (both
tax-free and taxable) failed to weaken prices in any meaningful way -- a
true testament to the idea that the Federal Reserve's reflationary policy
is having its desired effect.
Our investing strategy for the past
several quarters has been focused on preserving capital and minimizing
reinvestment risk. This has served our clients well, as a handful of
sectors have seen spreads widening due to investor concerns over possible
defaults related to the pandemic. If a given issuer has exposure to
airlines, shopping malls, hotels, or stadiums -- to name a few -- it is
likely that their debt has underperformed. There are some clouds on the municipal
credit horizon that bear watching. Clients of MTAM should remain confident
that our proprietary research will continue to protect their precious
capital. Our ongoing bias towards investing in lower coupon bonds has
minimized reinvestment risk to some degree. Given the Federal Reserve's
current ultra-easy monetary policy stance, we see no reason to adjust this
approach in the coming months.
Without question, the financial market's
performance will be heavily influenced by the results of the upcoming election
in November. Risk assets are likely to see the most price volatility, which
-- in theory -- should assist in keeping demand for high quality municipal
bonds steady. Municipal bonds will react to any potential for changes in
tax policy as a result of the election outcome. While federal tax policy is
the driving force behind demand for municipal bonds, don't lose sight of
what is going on at the state level. Being that New Jersey has already
raised taxes on "millionaires," it should be assured others will
follow suit, so demand for tax-free bonds will not disappear overnight, in
our view. The "noise level" will increase as we move closer to
the election. Our suggestion for investors is to turn off cable news and go
for a long walk. Emotional investment decisions are often the worst. The
tax-free bond portion of your portfolio is similar to the foundation of
your home, in our view. Rest assured that your foundation is strong with
MTAM. Enjoy your walk.
Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak
Top Of Page
State of the States Midyear
2020
Monday, July 6, 2020
U.S. states are facing unprecedented
fiscal stress and are poised to draw down their reserves as the
pandemic-related shutdowns decimate tax collections. This marks a stark
reversal for state governments that just a year ago were in the strongest
financial position in a decade. We are changing our outlook on the sector's
credit quality to negative from stable because of the coronavirus.
We believe the long-term impact of the
COVID-19 pandemic on states' credit quality will be significant. States are
facing an uphill battle with decreased sales and income tax revenues. They
will have to address funding gaps by either using reserves, issuing debt,
reducing expenditures and/or increasing revenues.
States with growing populations and
strong reserve levels will be able to better weather the downturn. For
states with high fixed costs, like legacy pension liabilities, and low
reserve levels -- including Illinois and Kentucky -- the crisis will be
hard to navigate without major structural changes. These states risk falling
into a "snowball" effect where population loss and high fixed
costs translate into a need to increase taxes, which in turn will make them
less desirable locations to live.
Help
from the Federal Government
State and local governments may need $500
billion in additional federal aid over the next two years to avoid major
economic damage from the coronavirus pandemic. The budget cutbacks by
governments whose revenue is being sharply reduced by business closures
could shave as much as three percentage points from the pace of economic
growth and result in the loss of about 4 million jobs. State governments
alone will face gaps totaling $312 billion through fiscal 2022. Under a
more severe scenario in which a potential second wave of infections leads
to another recession, state budgets would have to grapple with deficits
totaling $498 billion, a level of stress that has not been seen since the
Great Depression.
MTAM urges quick federal action given
that state and local officials are trying to decide how to balance their
budgets that for many start in July and will bear the brunt of the virus
impact. That will provide state and local government policymakers
sufficient breathing room to avoid having to make economically disastrous
fiscal decisions, and should a second virus outbreak actually occur,
federal policymakers will have plenty of time to consider the prospect of
additional aid over future fiscal years if necessary.
Governors who are mostly required to pass
balanced budgets are preparing deep spending cuts that will exacerbate the
economic slowdown. New Jersey, facing a revenue loss of about $10 billion,
may have to lay off as many as 200,000 employees, according to Governor
Phil Murphy. So far, the federal response to the economic and fiscal crisis
facing states has been modest, providing $150 billion to offset costs
related to the coronavirus and giving the Federal Reserve the ability to
extend emergency loans to governments. While House Democrats passed a
stimulus measure that would provide $1 trillion of aid to governments, it
has stalled in the Republican led Senate.
The Fed could purchase long-term
municipal debt to finance, roads, bridges, railways, airports, sewers, and
other infrastructure. Infrastructure spending could serve as a powerful
stimulus for jobs and increase demand for U.S. goods, in turn generating
manufacturing jobs. A quantitative easing program for municipal bonds would
bypass the debate in Congress over how to extend more funding to
infrastructure, which both parties support in principle. It would also
ensure that an increase of borrowing by local governments would be easily
absorbed by giving the Fed the power to buy the securities, preventing
interest rates from rising. Rather than wait on Congress to approve an
infrastructure bill -- something it has not been able to do for years –- states and local government with
eligible projects could turn to the Fed, which has the ability to lend as
much as $4.5 trillion.
If the federal government, hamstrung by
political polarization, fails to pass another stimulus package, states and
local governments could act alone before more businesses and residents fail
or leave. They could sell notes to the Federal Reserve's current Municipal
Liquidity Facility to provide payroll subsidies or tax relief for
struggling businesses that commit to retaining a certain percentage of
employees. Notes purchased by the facility can have maturities as long as 3
years. While states are reluctant to take on more debt, even with interest
rates at historic lows, and they could face the prospect of downgrades from
credit rating companies, such borrowing may be necessary to stimulate the
economy and revitalize businesses and jobs.
New
Fiscal Year
With the end of their fiscal year upon
us, 11 states have yet to enact a full-year fiscal 2021 budget. States'
uncertainty about their finances due to COVID-19 and the recession is
causing some to delay action on fiscal 2021 spending plans beyond the July
1 fiscal start. Fiscal year 2020, which ended on June 30 for all but four states,
closed in the midst of a global pandemic and an accompanying recession that
have led to a sudden and sharp decline in primary tax revenues.
For the 11 states that have yet to enact
a full-year fiscal 2021 budget, reasons include compressed budget negotiations
in a shortened legislative session, prioritizing closing current-year
budget gaps, and waiting for updated economic and revenue estimates.
Several states have passed or plan to pass short-term or interim budgets
until the revenue, expenditure, and federal aid picture comes into sharper
focus, which is not uncommon during recessions.
While late budget enactment is rarely a
good sign, it is not necessarily an immediate threat to credit quality.
Many states have procedures to keep operations going and protect debt
service.
Most state constitutions require balanced
budgets and prohibit deficit spending. As states are likely to incur near
double-digit declines in tax revenue for fiscal 2021, updated economic and
revenue forecasts remain critical inputs that will help determine the
proportionate adjustments to spending.
Cash
Flow
As the COVID-19 pandemic wreaks havoc on
revenue, U.S. states are grappling with how to manage cash flow. Early
forecasts indicate that state revenue declines will likely surpass the
11.6% drop during the Great Recession, exceeding the 8.0% median state
rainy day fund balance. Many states extended tax-filing deadlines to July
from April to provide taxpayer relief, exacerbating cash-flow pressures. At
the same time, they are absorbing significant unbudgeted pandemic-related
costs. Although the Coronavirus Aid Relief and Economic Security (CARES)
Act funds help offset pandemic-related expenses, the federal government has
yet to provide support to offset lost tax revenue.
Although the majority of states will
likely have sufficient cash to weather revenue declines through fiscal
2021, we have seen a notable uptick in short-term borrowing by states and
payment deferrals to address sudden shortfalls. Short-term borrowing can
make sense when states lack the internal cash resources to meet current
obligations and deficits are temporary, but cash shortfalls signal fiscal
stress when they become structural challenges.
Conclusion
The financial crisis amid the pandemic is
forcing U.S states to make tough choices even as they seek help from
Washington. State and local governments may need at least $500 billion in
additional federal aid over the next two years to avoid major economic
damage. While House Democrats passed a stimulus measure that would provide
$1 trillion of aid to governments, the rescue has stalled in the Republican
led Senate.
Thirty-five states have enacted a
full-year budget for fiscal 2021, including two -- Virginia and Wyoming --
that have authorized two-year budgets for both fiscal 2021 and fiscal 2022.
Forty-six states operate on a fiscal year that begins July 1. New York
starts its year on April 1, while Texas begins on September 1, and Alabama
and Michigan start on October 1. For those states that have yet to enact a
full-year budget or temporary budget for fiscal 2021, some are awaiting
their governors' signature, while others are holding off for updated
economic and revenue estimates.
New Jersey opted to extend its fiscal
year through September 30, with lawmakers approving a temporary $7.7
billion spending plan intended to buy the state more time to close the
massive budget shortfall caused by business closings and record
unemployment. It cuts or shifts $5 billion in expenses. Vermont also
expects to enact a three-month temporary budget, and Massachusetts signed a
temporary one-month budget for July. Kentucky, which normally operates on a
two-year budget, passed a one-year spending plan, citing pandemic
uncertainties.
The budget that Illinois enacted earlier
this month allows the state to borrow up to $5 billion from the Federal
Reserve that could be repaid with anticipated federal aid. The state has
already borrowed $1.2 billion from the Municipal Liquidity Facility program
to help pay down bills. California Governor Gavin Newsom Monday signed a
$133.9 billion budget that defers almost $13 billion in payments and
borrows another $9 billion internally to help fill a deficit expected to
reach $54 billion over two years. The spending plan is intended to avoid
steep cuts in the hope that Washington will send additional aid by October.
Most states are not depending on federal
aid in their budgets, but they are strongly advocating for it. State
governments typically benefit from exceptional inherent budget flexibility.
The high ratings for most states reflect our view that they can absorb
deterioration in the fiscal and economic environment without immediate
effects on credit quality. Thanks to previously surging tax collections,
U.S. states collectively had built up the largest fiscal cushion since
2000.
Top Of Page
2nd Quarter 2020 Review and
Outlook
Wednesday, July 1, 2020
Positive returns were prevalent for
municipal bond investors during the second quarter, as massive fiscal and
monetary stimulus assuaged concerns that defaults would spike in the
tax-free space due to the pandemic. Plunging bond yields in the taxable bond
markets brought crossover investors into the municipal market looking to
enhance income and total-return results. Market psychology was also aided
by the reopening of the new issue market, where deals of all kinds were met
by an abundance of investor demand.
Credit spreads slowly tightened during
the quarter as many states moved to reopen their economies. Invariably,
there are likely to be some setbacks with the virus still making its way
across the country. It is our strong belief that investors should remain
very focused on moving up the credit quality ladder as a hedge against
another spike in COVID-19 infections. One specific area we will be watching
closely is how (and if) professional sports get back on track. Bonds that
are secured by revenues generated by stadiums have not participated in the
rally, as skepticism still exists within this space that sizable crowds of
fans will return. MTAM continues to be bearish on these bonds and would
recommend investors sell these securities.
Excellent opportunities still exist in
the municipal market as tax-free yields are amongst the highest in the
world. Our focus has been to shop for value in the "secondary"
market, as some panic selling by retail investors opened up opportunities
for us. We would like to thank cable news and the "clickbait"
crowd for their assistance in helping create wonderful entry points for our
clients. Hyperbole creates opportunity sometimes, folks.
Moving forward, it is our view that
returns will continue to improve, albeit at a somewhat slower pace than the
previous quarter. With our central bank focused on keeping short rates
pinned at zero, more money will likely keep moving into the markets looking
for much needed income opportunities. MTAM continues to believe that lower
coupon bonds offer significant income and total-return possibilities, and
as such, said bonds will continue to be favored when considering investing
opportunities with client cash. As always, pristine credit selection will
remain our singular priority in these uncertain times.
Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak
Top Of Page
1st Quarter 2020 Review and
Outlook
Tuesday, March 31, 2020
Significant price volatility (up and
down) permeated throughout the municipal bond market during the quarter
ending March 31, 2020 due to the coronavirus. Tremendous economic
uncertainty has been brought to the forefront as Americans remain sheltered
in place with the hope of not spreading the virus further. While Congress
and the Federal Reserve have come to assist the municipal bond market in
very positive ways never conceived of before, it has to be assumed that
some issuers may run into financial difficulty due to the economic lockdown
currently underway in the United States. Professional management of
municipal bond portfolios is a must in these uncertain times, and you have
hired the best. Below is a review of why clients should sleep well at night
with our team protecting your capital.
MTAM has always been, and will continue
to be, a conservative asset manager. We are very selective in the municipal
sectors and top tier bonds we decide to purchase and hold. This has
positioned us extremely well to weather the current pandemic situation.
To be more specific about our
high-quality credit criteria, MTAM does not purchase:
Municipal-Financed Bonds that have backed
airline projects, shopping malls, hotels, museums, continuing care
retirement centers, or privatized student housing.
Any bonds that are secured solely by
revenues generated by a stadium, arena, convention center, or parking
facility.
Any municipality in which we find a
certain level of taxpayer concentration in the oil industry; or any
municipality in which we find a certain level of taxpayer concentration in
any one or two industries/companies.
Tax Allocation Bonds - Also known as
'dirt bonds', these redevelopment communities, in which bondholder security
is provided by tax increment revenues, are deemed too risky as they involve
construction risk in speculative areas, and the taxpayer concentration
tends to be very high.
Healthcare Bonds – MTAM has always seen the not-for-profit
healthcare sector as containing risks that are unsuitable for most
conservative investors. We believe that regulatory, political, and competitive
challenges will intensify for U.S. not-for-profit hospitals and healthcare
systems. Growth in Medicare and Medicaid volumes are weakening provider payor mixes at a time when providers are moving from
volume-based to value-based reimbursement in greater numbers. There is also
great uncertainty about how prepared the sector is for COVID-19. We now
forecast that revenue will likely decline as an increasing number of
hospitals cancel more profitable elective surgeries or procedures, and halt
other services in preparation for a surge in virus cases. Expenses will
also rise with higher staffing costs and the need for supplies.
Smaller Local Governments – namely, those municipalities with a
population of less than 10,000. We have found that these tend to have a
less diverse tax base/employer base. These also tend to be less
sophisticated in their financial and budgetary controls.
MTAM purchases only those airports and
ports that are major hubs in vibrant economic areas.
We also require very timely information
from the municipalities that we buy and hold; weak disclosure results in an
automatic turndown, or even a sell recommendation.
Notwithstanding the challenges facing
municipal bond issuers, there are always good opportunities, even for the
very conservative investor. Despite our expectations for a recession, we
still expect defensive credits like water and sewer bonds, special tax
bonds, and public power bonds to perform better from a fundamental
perspective. These types of bonds tend to have revenue streams that are
less subject to economic volatility, have strong covenants, or are tied to
an "essential service", making debt service payment more certain.
In addition, there is legal precedence that bonds backed by a dedicated
revenue stream may be protected in the case of a municipal bankruptcy. We
prefer bonds that have a clean flow of funds, broad revenue streams, and
high debt service coverage tests.
MTAM continues to recommend that
investors select high-quality municipal issuers that understand the new
economic and financial reality and have made or are making budget
adjustments. Essential service revenue bonds without the budgetary concerns
of state and local governments and limited payrolls can be attractive, but
we stress that an essential service issuer cannot flourish if the
underlying governmental entity is in dire economic circumstances. A healthy
outlook holds for most infrastructure issuers due to fundamental strengths
reflected in the provision of essential public services, adequate balance sheets,
and generally sound governance and fiscal management practices. In the case
of the enterprise sectors comprised of higher education, health, and
housing, credit quality will be maintained primarily as a function of their
ability to increase fees, control costs, and improve overall operating
margins. Sound debt and fiscal management practices, preservation of
adequate liquidity, and strong governance oversight will be significant
determinants of credit quality for issuers during the coming period of financial
adjustment.
Importantly, and on a positive note, MTAM
believes the vast majority of U.S. state and local governments are
well-positioned to absorb the near-term credit implications from the
coronavirus outbreak, although the situation remains uncertain and is
evolving rapidly. Local government fund balances are generally robust and
state governments typically benefit from exceptional inherent budget
flexibility. The high ratings for most states and locals reflect our view
that they can absorb deterioration in the fiscal and economic environment
without immediate effects on credit quality. For cities, counties, and
school districts, our review of comprehensive annual financial reports
finds that median available general fund balances were between 20%-30% of
fiscal 2019 spending, reflecting the long period of economic expansion most
governments have benefitted from. Thanks to surging tax collections, U.S.
states collectively have built up the largest fiscal cushion since 2000.
States have added to rainy-day funds, also called budget stabilization
funds, for a record total of $74.9 billion as of fiscal 2019.
MTAM has observed anecdotal instances of
coronavirus beginning to affect state and local governments. Fiscal effects
are only just unfolding, and we anticipate more actions. MTAM considers
announced measures within the capacity of state and local governments to
absorb at current rating levels. There will be additional measures from
state and local governments including revenue forecast updates, supplemental
appropriations, and draws on reserve funds. Many state and local
governments are also in the midst of the budget enactment process for the
upcoming fiscal year and enacted budgets are likely to account for
coronavirus effects to the extent possible.
MTAM will continue to monitor state and
local governments in the context of the shifting and complex effects of the
coronavirus.
Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak
Top Of Page
The Coronavirus and its
Current Impact on U.S. Municipalities
Monday, February 3, 2020
China's death toll has reached at least
360 as the coronavirus epidemic continues to spread, with Hubei province at
the epicenter of the outbreak reporting more fatalities and infections. As
China returns from the Lunar New Year holiday, investors are bracing for
the reopening of mainland markets on Monday. China's central bank plans to
avert a potential sell-off by injecting more than $21 billion of liquidity
into markets. The Philippines reported the first virus death outside of
China. Airlines in Asia, Europe, and the Middle East stopped service to the
mainland. The U.S. began limiting the entry of travelers from China, a
process that could disrupt flight plans. President Donald Trump said the
U.S. has offered China help with the outbreak, and that steps have been
taken to prevent the coronavirus from entering the country (currently,
there are 9 cases reported in the U.S.).
Tourism to Hawaii and the U.S.
territories of Guam and the Northern Mariana Islands will be negatively
impacted as a result of the coronavirus outbreak. MTAM believes there will
likely be a minimal effect on credit quality and tourism if the outbreak is
contained in a matter of months. However, if the outbreak drags on, it will
likely have a significant effect on the Pacific island economies. The
Northern Mariana Islands relies heavily on both tourism and on visitors
from China, who make up nearly 40% of visitors to the territory. The
territory is also recovering from two typhoons that struck in 2018. Guam's
tourism sector also relies heavily on tourists from Asia, though Japan and
South Korea make up the majority of its visitors. Hawaii is the least
reliant on tourist from Asia, pulling more than 70% of its visitors from
the U.S. and Canada.
Most U.S. airports should be able to
absorb the impact of air traffic interruptions due to the coronavirus,
although a prolonged suspension of Chinese air travel will depress passenger
volumes and may pressure airport revenues. While we believe that most U.S.
airports are well-positioned to handle such event risks, the situation is
rapidly evolving, as a growing number of countries with exposure to this
latest outbreak are causing additional flight cancellations and border
closures. The duration of the health crisis and associated travel
restrictions will determine if the virus will have longer-lasting effects
on business and leisure air traffic.
Travel bans will primarily affect large
hub and international gateway airports, but these airports should be able
to absorb a short-lived reduction in air traffic as most have strong cash
reserves, and can adjust rates to recover costs. As more companies suspend
Chinese operations and airlines cancel and reduce flights, air traffic
reductions may take longer to recover to pre-epidemic levels. A stall in
overall traffic growth or a sustained dip in volumes could pressure
airports to take defensive actions to protect their cash flows or reserves.
Flight cancellations by carriers, due to
reduced passenger demand because of government-imposed travel restrictions
or negative travel sentiment, will slow traffic growth. However, the
effects on costs and operations of most airports are expected to be minimal
due to the stronger financial profiles of international airports, as air
traffic is generally geographically diversified at these airports. U.S.
airports with non-stop service to China, namely San Francisco, Los Angeles,
Seattle, Chicago O'Hare, and JFK, currently do not have a high dependence
on this market segment, typically less than 10%, and China is not a major
market pair for any U.S. airport. A prolonged service interruption could
certainly constrain growth compared with expectations, and some airport
revenue streams such as terminal concessions could face pressure.
As a quickly developing market, China's
air traffic has grown faster than most markets, although growth slowed
slightly in 2019 due to trade tensions with the U.S. Given the number of
Chinese travelers has increased dramatically since the SARS outbreak in
2003, the effect of travel bans and flight suspensions on air traffic to
and from the country will have a greater effect than past outbreaks.
Nevertheless, based on past event risks, including viral outbreaks, air
travel should rebound, but at this point the timing remains uncertain.
Top Of Page
Credit Comment on the State
of California's Latest Budget Proposal
Tuesday, January 21, 2020
The State of California continues to
enjoy its highest credit ratings (Aa2/AA-/AA)
since the turn of the century, primarily due to the record-setting stock
rally, a resurgent real estate market, and a Silicon Valley boom that swept
away once crippling budget deficits. The recovery of California has been
strong. Its economic growth has outpaced that of the nation's for the past
several years, and it is responsible for more than 15% of the U.S. job
gains since the economic expansion began in February 2010.
MTAM sees California Governor Gavin
Newsom's proposed 2020-21 budget as a slight credit positive,
as the head of the most-populous U.S. state continues to mostly follow the
conservative fiscal management of his predecessor, Jerry Brown. Governor
Newsom's budget seems responsible in most respects.
Newsom in his first budget last year had
eased some concerns that he would plow much of a $21 billion surplus into
expensive programs that would still need funding in the next recession.
Instead, he steered more dollars into the state's rainy-day account to
swell it to $16.5 billion, and paid down liabilities owed to public
employee pensions. Now, Newsom is under pressure to deal with crises that
has left California with a quarter of the country's homeless population,
the most expensive houses in the nation, and wildfires and related power
outages that have become routine. There are also calls for him to spend
more money on schools, as well as health and welfare programs for the poor,
even though it is inevitable a downturn will follow the current record
economic expansion.
California's revenue is volatile because
it draws a large share of taxes from wealthy residents whose incomes are
tied closely to the stock market, which saddled the State with huge budget
deficits after the Internet and real estate bubbles burst. The top 1% of
earners accounted for nearly half of the State's personal income tax
collections in 2016. Voters in November 2016 approved a 12-year extension
of higher tax rates on the wealthy, deepening the reliance on their
fortunes.
There is some volatility and some risk
that California has that other states do not. In periods of economic
growth, the State is going to outperform; in periods of recession, the
State is going to underperform. State officials' ability to mitigate those
swings is going to be manifested through their budgeting practices.
On a constructive note, California bonds
have been supported by legislative changes. Prior to 2010, California
required a legislative super-majority to pass the annual budget, which
frequently led to late budgets; now with a simple majority required, late
budgets have become a thing of the past.
California has $81 billion in outstanding
general obligation and lease revenue debt, down $5 billion from 2016,
according to state treasurer reports.
2020-21
Budget Details
Governor Newsom prioritized programs to
combat homelessness, prevent wildfires, and make healthcare more affordable
as he unveiled his $222.2 billion 2020-21 budget last week. The expansive
budget also included much more than his stated trio of priorities. The
budget proposal anticipates a surplus for the seventh time in eight years,
even as spending increased by 2.3% from last year.
The budget for the fiscal year beginning
in July also proposed padding the state's rainy-day fund, and directed much
of a $5.6 billion surplus to one-time spending such as services for
homeless. The rainy-day fund would grow to $18 billion from $16.5 billion
this year. The budget will be revised in May before legislators must
approve the spending plan by the June 30 deadline.
Newsom's administration expects revenue
from personal income, sales, and corporate taxes to grow 2.1% from this
year, compared with the 3.9% growth from last year to this year.
"We're seeing a slowdown of our economic growth, and this is reflected
in our budget," Newsom told reporters during a briefing in Sacramento.
Additional budget items include:
- A $4.75 billion climate resilience bond for the
November 2020 ballot to address near-term risks from flood, fire, and
drought, as well as future effects of sea level rise and higher
temperatures;
- $750 million to provide rental subsidies and
supportive housing services to help ease homelessness;
- $1.75 billion to increase housing supply; and
- $2 billion for wildfires and emergency management,
including adding hundreds of new firefighters, funding a new threat
forecast center, and hardening infrastructure.
Last year's budget included $1 billion
for emergency response. Newsom's second budget, which the Legislature must
approve, calls for adding 677 firefighters over five years and $200 million
for prescribed burns, vegetation thinning, and other actions to reduce the
fire load in high wildfire threat zones. Another $500 million would go
toward upgrading water infrastructure, emergency shelters and medical
facilities, with a focus on low-income high-hazard areas.
"Combating California's wildfires
will continue to be a top priority for my administration," Newsom said
in a statement. The proposed budget includes $9 million to hire 22
positions across the several state agencies to staff a Wildfire Forecast
and Threat Intelligence Integration Center, created by a bill passed in
2019 aimed at improving coordination, forecasting, and weather data.
Newsom's proposal also sets aside $110
million for a home hardening program, mostly to focus on making homes in
low-income communities that are also in high fire-hazard areas to be more
resilient to wildfires. An additional $50 million for community resiliency
projects is also included.
Other proposed expenditures include:
- $5 million for research grants to California State
University, San Marcos to study improved firefighting equipment and
ways to protect firefighters in wildland urban fire areas;
- $80 million to use airborne Light Detection and
Ranging (LiDAR) data to better assess how to manage forests, see
vegetation changes, and perform hazard assessments;
- $17.3 million for the California Earthquake Safety
Fund;
- $340 million for urban flood risk reduction
efforts; and
- $270 million for flood risk and ecosystem
restoration.
Conclusion
Governor Newsom's $222.2 billion proposed
budget includes $12.5 billion over five years for climate initiatives
focused on decarbonizing transportation, water resilience, and other
measures. As part of the proposal released last week, the administration
will push a $4.75 billion climate resilience bond for the November 2020
ballot to address near-term risks from flood, fire, and drought, as well as
future effects of sea level rise and higher temperatures.
"If approved by the voters, the bond
will help the state move toward achieving carbon neutrality and carbon
sequestration goals, and provide funding for programs that result in
multiple benefits, leverage non-state funding, and help address liabilities
such as the Salton Sea," according to the governor's 2020-2021 budget.
When it comes to accelerating
technologies, the budget includes $250 million in 2020-2021 for a climate
catalyst fund to provide low-interest loans for projects that reduce
transportation emissions, invest in clean agriculture programs, and support
recycling efforts.
The money, which will add up to $1
billion over four years, is meant to help advance technologies that do not
always have access to traditional lending. Newsom's second budget, also
focuses on wildfires, environmental protection, and establishing a circular
economy to reduce waste by increasing recycling efforts.
The climate bond reflects a draft water
resilience plan that California's environmental and agriculture agencies
released January 3rd to help the state grapple with climate change and an
estimated increase in population by 10 million people by 2050. That plan
included more than 100 recommendations focused on diversifying water
supplies, protecting natural ecosystems, improving water infrastructure,
and preparation.
Much of those recommendations did not
come with established funding and the plan came with this note: "Given
limited resources, not all actions can be implemented with equal priority,
but taken together, this suite of actions outlines a vision."
The proposed budget would set aside $3.9
billion for the California Environmental Protection Agency, the state's
umbrella agency that oversees departments regulating toxic substances, air
pollution, water resources, pesticide use, and recycling. The budget also
calls for reforms at the Department of Toxic Substances Control by
installing a 5-member oversight board at the agency, which has been
criticized for years for lax enforcement and is underfunded due to outdated
collection fees.
Environmental groups criticized Newsom
for allocating less money for green initiatives such as clean
transportation. Coalition for Clean Air Policy Director Bill Magavern said funding for electric vehicles would drop
from a current $485 million to $350 million next year.
"This money goes to put the cleanest trucks, buses, and cars on the
road, especially in our disadvantaged communities," Magavern said in a statement. "We are disappointed
in today's proposal, and we call on the Governor to do better."
Newsom said items such as funds for
electric buses, trucks and cars would be discussed with the legislature and
could be changed when the budget is revised in May. Staff added that rather
than one discreet fund that could be accessed in the past, several would
now be available, including from the resilience bond and a climate catalyst
fund.
Top Of Page
Municipal Bond Market – Credit Outlook for
2020
Friday, January 10, 2020
Municipal bond issuers will continue to
face several credit challenges in 2020, but MTAM expects that the vast
majority of municipalities will successfully manage through most
difficulties with a combination of spending cuts and revenue enhancement
plans.
Notwithstanding the challenges facing
municipal bond issuers, there are always good opportunities, even for the
very conservative investor. Despite our expectations for modest levels of
economic growth, we still expect defensive credits like water and sewer
bonds, special tax bonds, and public power bonds to perform better from a
fundamental perspective. These types of bonds tend to have revenue streams
that are less subject to economic volatility, have strong covenants, or are
tied to an "essential service", making debt service payment more
certain. In addition, there is legal precedence that bonds backed by a
dedicated revenue stream may be protected in the case of a municipal
bankruptcy. We prefer bonds that have a clean flow of funds, broad revenue
streams, and high debt service coverage tests.
State
Governments
MTAM has a stable outlook for U.S. state
government ratings for 2020 thanks largely to the sector's overall
strengths - broad economies and tax bases, and substantial control over
revenue raising and spending. The debate in most states will be around
whether to allocate additional revenues to spending priorities or tax
reductions. That said, developments in some states could affect their
rating performance in the coming year.
MTAM expects U.S. states' revenues to
climb in fiscal year 2020, but at a slower pace as economic expansion
cools. We expect state tax revenues will rise 4 percent in 2020, slower
than the 4.9 percent increase in 2019. Rising equity markets will boost
capital gains realizations, and therefore income tax revenues, while
continued employment growth will support income and sales taxes.
The lengthening economic expansion will
support continued revenue growth, helping states to meet rising costs for
priority services and maintain reserves at record levels. Revenue gains
will support higher spending on education at all levels and rainy-day fund
balances, already a record high, will contribute the state sector's
strengthening recession preparedness.
Demographic and economic trends are uneven,
benefiting some states more than others. For example, personal income
growth is regionally concentrated in the large and wealthy economies of New
York and California and technology centers of Washington, Oregon, and Utah.
The decade since the last recession has
left U.S. states well-prepared for the next one. State governments are
using the tax revenue generated during the record-long economic expansion
to build up their savings accounts, pushing a key measure of their reserves
to the highest on record. The median balance in state rainy-day funds was
enough to cover 7.6 percent of their general budgets in 2019, the most ever
and up from 1.6 percent in 2010. They are expected to rise to 8 percent in
the current fiscal year.
The financial cushion will be crucial to
helping state governments avert the kind of steep budget cuts, layoffs, and
tax increases that followed the downturn set off in 2007 by the housing
market crash. Yet, states are also pouring money into government programs.
They approved $39.1 billion in spending increases for the current fiscal
year, driven heavily by $19.4 billion for K-12 and higher education. Given
the favorable financial conditions and substantial savings, even with the
increase in spending states should be better prepared for another
recession.
MTAM will be closely monitoring three
states in 2020 that could see tangible changes in credit quality. 'Alaska
and Illinois both face potential constitutional amendments that could alter
our assessments of credit quality, while Kentucky will have a gubernatorial
transition as it deals with ongoing budgetary challenges.
Alaska will face key questions on
gubernatorial proposals that may weaken operating flexibility. Alaska's
governor will continue to seek a full dividend payment for residents and
legislative approval for a set of constitutional amendments, which, if
enacted, could weaken the state's budgetary operating flexibility and
negatively affect the state's rating.
Illinois voters will decide in November
on a constitutional amendment to allow a graduated individual income tax.
The credit implications depend on whether Illinois uses any increased
revenues to address structural budget challenges, or if the state can
adequately adjust its budget to work toward structural balance if the
amendment fails.
Kentucky's new Democratic governor will
need to work with the Republican-controlled legislature to address
persistent budgetary challenges with enactment of a new biennial budget due
in the first half of 2020. Maintaining structural spending while reducing
reliance on non-recurring budget measures could prove challenging if the
political environment deteriorates.
Rising state pension liabilities reversed
course this past year, although this is likely little more than a
short-term breather. The median state pension liability burden fell to 3.1
percent of personal income in fiscal 2018 from 3.6 percent in fiscal 2017.
States are also seeing a median 6.7 percent drop in their adjusted net
pension liabilities. Despite the improved numbers, they do not reflect a
long-term improvement in states' pension situations, but rather the states'
exposure to short-term market fluctuations now inherent in pension
accounting. The lower fiscal 2018 state net pension liabilities are
capturing the lagged recognition of strong market gains most pension plans
experienced as of their 2017 measurement dates.
State debt burdens drifted lower with the
median burden of state direct debt falling slightly to 2.3 percent of
personal income in fiscal 2018 from 2.4 percent in fiscal 2017. This move,
however, is more reflective of a lasting trend. Unlike with pensions, the
drop in the burden of bonded debt continues a longer-term decline underway
in many states. With both debt and pensions lower in fiscal 2018, the
median state long-term liability burden has also declined year-over-year to
5.7 percent of personal income from 6 percent.
Illinois continues to carry the heaviest
liability burden (27.5 percent of personal income) followed by Connecticut,
Kentucky, New Jersey, Alaska, and Hawaii (rankings unchanged year-over
year). By contrast, 37 states have what MTAM views as low liability burdens
with Nebraska topping the list at only 1.7 percent of personal income.
Local
Governments
Our outlook for U.S. local governments
remains stable
for 2020 as property taxes and total revenue growth should increase
moderately. We project 2%-3% growth in property tax receipts in 2020,
adjusted for inflation, due in part to steady, but restrained, economic
growth through the end of 2020. Operating revenue should continue to grow
by approximately 3 percent in 2020, while personnel costs will drive
expenses.
The stable outlook is underpinned by the
largely steady and predictable growth in property taxes over the outlook
horizon. In addition, most cities, counties, and school districts have
financial flexibility from healthy fund balance reserves to face unforeseen
challenges.
Differences in revenue composition
determine varying risk profiles for local governments, with sales
tax-dependent entities most exposed to the potential for a rapid change in
economic conditions.
Many local governments have also handled
challenges well, including growing pension costs, uncertain or weak state
funding, exposure to federal policy changes, climate shocks and changing
demographics.
Not-for-Profit
Hospitals
MTAM continues to have a negative outlook
on the not-for-profit healthcare and hospital sector for 2020. Hospitals'
and healthcare systems' ability to respond to operational challenges by
cutting costs and improving efficiency could place these entities on surer
footing for the continued headwinds they will face in 2020. Overall balance
sheet stability and slight improvements in operational performance reflect
the sector's adaptation to pressures, such as high levels of labor and
pharmaceutical costs, cost and implementation risks of moving toward more
value-based and at-risk reimbursement models, a shifting payor mix, commercial insurance rate increases, and
competition from non-traditional market entrants. Most providers have begun
to effectively align their cost models to revenue pressures, despite these
challenges.
We believe many providers will continue
to pursue consolidation and alignment in order to extract greater
efficiencies and gain contracting leverage with payors
and suppliers. Although size and scale alone do not necessarily result in
success, further consolidation is a logical outcome given current industry
pressures.
The increase in the share of the U.S.
population over age 65 will generally have a negative longer-term effect on
payor mix as seniors shift from commercial
insurance to Medicare. The aging population should provide an uplift in
volumes, as use rates increase proportionally with age; however, this added
volume will only be beneficial if providers can manage to break-even, or
better, on Medicare rates. Commercial, or managed care, contract
negotiations are critical for providers as they seek to offset the effects
of comparatively weaker governmental reimbursement with favorable commercial
contracts.
The decades-long focus on outpatient
services compared with inpatient services has not moderated, resulting in a
mismatch of fixed costs and declining inpatient volume. The transition from
volume to value-based reimbursement is a longer-term adjustment but in the
short term will result in margin pressures for hospitals as they invest in
new systems and see a decline in overnight admissions.
Non-traditional healthcare entrants will
continue to be a disruptive factor over the medium to long term and are
likely to change the way individuals interact with the sector. Technology
and large retail companies, with potentially deeper pockets, sophisticated
and consumer friendly distribution channels, and data platforms they are
able to leverage are expected to make further inroads into pharmacy and
low-acuity medical services. This will result in a more competitive
operating environment across the patient spectrum.
Positively, in 2019, balance sheet
measures reached levels not seen since before the Great Recession of 2007-2009.
The sector benefited from favorable investment conditions, positive cash
flow, and generally manageable spending on capital expenditures. As a
result, balance sheet strength has largely mitigated operational pressures
faced by hospitals in recent years.
While policy direction in the next few
years will be determined by the 2020 U.S. elections, the acute care sector
would face significant challenges regardless of the outcome. Any systemic
change, whether it be the dismantling of the Affordable Care Act or the
implementation of a 'Medicare for All' plan, would take some time to
implement, and places uncertainty on whether or not our negative outlook
will persist beyond 2020.
Transportation
U.S. transportation infrastructure growth
should continue moving more or less in step with levelling off GDP next
year. Volume growth remains favorable for U.S. airports, ports, and toll
roads and will remain largely tethered to U.S. GDP movement, which many
analysts project will fall below 2 percent for 2020. That said, some
softness in growth may take hold to the extent issuers are exposed to
global economic markets and protectionist trade policies.
Likely to pace volume growth will be U.S.
airports, with MTAM projecting 2%-3% thanks to continued healthy demand for
travel. Passenger traffic will also remain healthy for both large and small
hub airports following a spike this past year. One outlier to watch next
year will be the continued grounding of the Boeing 737 Max.
Moving more closely in tandem with U.S.
GDP next year will be U.S. toll roads and ports. Stronger performance is
expected for toll roads in the Southeast and Southwest regions in
particular, due to stronger demographic trends versus the U.S. overall.
Meanwhile, volumes at East Coast ports are likely to continue outpacing
those of their West Coast counterparts due to their higher exposure to
Chinese tariffs. Over time, revenues may start to decline at West Coast
ports the longer the trade impasse with China continues.
Two other key developments are worth
close watch in 2020, the first being the fate of PPPs (public-private
partnerships) as developer risk allocation has led to some contractors
exiting the U.S. market. The second is emerging technologies like
driverless cars and connected vehicles. Parking assets and managed lanes
appear most vulnerable to this change, though more widespread risk is
unlikely to manifest for at least the next decade.
More specifically, MTAM's 2020 sector
outlook for U.S. airports remains positive,
reflecting strong enplanement growth driven by continued economic expansion
and additional seat capacity added by U.S. airlines. Growth in enplanements
– the
number of passengers using an airport to depart on a flight – generally translates into higher parking
and terminal concession revenue.
We expect aggregate enplanement growth of
3.2 percent in 2020. This represents a slowdown from the 5.4 percent growth
seen in 2018, but is still above our threshold for maintaining a positive
outlook on the sector. Smaller airlines, such as Spirit and Frontier, will
continue a multi-year trend of increasing capacity by at least 10 percent.
Airports in the Southern and Western
regions of the U.S. will continue to experience stronger enplanement growth
than the rest of the country, mirroring demographic trends. Growing,
younger populations support growth in demand for travel, and airports like
the Austin (City of) TX Airport Enterprise and the Boise (City of) ID
Airport Enterprise are well positioned due to their young urban bases.
Increased use of ridesharing services
like Uber and Lyft has had a negative impact on parking and ground
transportation revenue at airports across the U.S., but airports have
adapted by collecting pickup or dropoff fees to
keep overall collections stable. Looking ahead, MTAM believes that emerging
technologies will allow for more effective fee collection and provide
increased revenue generation.
MTAM's 2020 sector outlook for U.S.
public ports is stable,
given healthy cargo and cruise demand. The benefits of continued domestic
and global economic growth (albeit moderating) are balanced by a weak ocean
shipping sector and heightened trade protectionism, which constrains ports'
pricing ability and weakens cost recovery for capital investments.
We expect that shipping container volume
at U.S. public ports will increase 2%-3% in 2020. Consumer demand will also
drive growth in cruise activity as all major cruise lines significantly
expand their capacity.
Tempering the positive effects of this
growth is the still fragile financial state of the container shipping
industry, which will significantly constrain the prices that ports are able
to charge. In addition, consolidation among container shipping lines has
made shipping companies more effective at curbing price increases.
Amid pricing pressures for U.S. ports,
recent or planned capital spending continues to exceed 100 percent of
operating cash flow for the sector in the aggregate, and is likely to
exceed 150 percent in 2020. The sector will remain dependent on new
borrowing and federal and state funding to finance capital investments, and
the benefit of healthy container volume activity will be tempered by higher
debt service costs and capital outlays.
The prolonged trade tensions between the
U.S. and China has created quite a bit of headline risk for U.S. ports,
though it has not trickled down to financial or rating performance. Despite
volume declines, which were expected seeing as West Coast ports are the
most susceptible to U.S.-China trade disruptions, financial and rating
performance has remained quite stable. Landlord ports are generally not
directly exposed to volume volatility, which has insulated cash flow for
ports like Long Beach and Los Angeles despite their tariff-related declines
in volume.
MTAM's 2020 sector outlook for
government-owned toll roads is stable
reflecting the expectation of a continued leveling out in traffic and
revenue growth. The traffic and revenue trends are underpinned by the
expectation that the economy will enter a slower late-stage expansion at
full employment, and that gas prices will continue to gradually rise from
their 2015 lows.
We expect traffic growth of 1.5%-2.5% and
revenue growth of 3%-4% for toll roads in 2020. Toll rate increases,
bolstered by the growing use of tolling indexed to inflation, will also
support revenue growth. Currently, 52 percent of toll roads have enacted
increases indexed to inflation. We also view the implementation of
electronic toll collection systems positively, as they allow greater
flexibility to make refined rate adjustments.
Traffic and revenue growth will continue
to be strongest for new or startup toll roads, as well as those located in
expanding urban or urbanizing centers where they can serve as congestion
relievers. Most toll roads built since 2005 are located in densely
inhabited, rapidly growing areas with population and income growth above
the U.S. average.
The Grant Anticipation Revenue Vehicle
program, which allows states and mass transit entities to issue bonds
backed by anticipated federal funds, will face increased risks in the next
two years as legislation supporting U.S. transportation spending expires in
September 2020. The Federal Highway Fund, which backs GARVEE bonds,
continues to collect less in revenue than it pays out in grant
disbursements. Given the vital importance of transportation infrastructure,
Congress is likely to address these challenges, but the process is likely
to be fraught with uncertainty and delays.
Water
and Sewer
MTAM is maintaining a stable outlook on
the U.S. water and sewer sector for 2020. The sector's strong fundamentals
are underpinned by the essential service provided to users, monopolistic
business nature, and high barriers to entry. Additional positive features
are low price sensitivity, strong liquidity, and independent local
rate-setting authority. These factors insulate the sector to some extent
from economic cycles. However, persistent droughts and overregulation could
reduce financial flexibility for certain issuers.
Most water and sewer utilities are in
solid fiscal shape as we begin 2020, with infrastructure a likely point of
interest leading into the 2020 presidential election. Water and sewer
utilities continue to enact steady rate adjustments to accommodate
operating cost increases and capital needs. The sector is also
well-positioned to absorb any temporary business variations given their
robust balance sheets.
The water and sewer industry will be
paying close attention to infrastructure proposals of the presidential
candidates headed into the 2020 election. Based on the Environmental
Protection Agency's latest figures, $740 billion in capital investment will
be necessary to address water and sewer needs over a 20-year horizon. The
new Water Infrastructure Finance and Innovation Act has afforded EPA the
ability to leverage appropriations at an accelerated rate via credit
subsidies compared with traditional state revolving fund loan programs.
Dramatic escalation in water and sewer infrastructure appropriations is
unlikely, though WIFIA program expansion is a distinct possibility.
Increased volatility in weather extremes
has the potential to escalate sector capital needs as utilities seek to
harden assets and enhance water supply capability to ensure service
delivery. Added capital demands would likely lead to some increase in
moderate sector leverage levels and further erode sector affordability
levels.
Public
Power
MTAM's 2020 sector outlook for U.S.
public power electric utilities is stable,
reflecting a strong fundamental business model. We expect that utilities
will display stable to modestly improving financial metrics, supported by a
steady business environment and the self-regulated ability to set
electricity rates to pay debt service.
Our stable outlook also reflects the
industry's self-regulated cost recovery mechanisms, sound financial
metrics, declining leverage, and growing liquidity amid an operating
environment of low electricity demand, favorable interest rates, and low
natural gas prices. The willingness and ability to set retail electricity
rates is a fundamental credit strength of public power utilities, and
serves as the key indicator for our sector outlook.
Challenges for public power utilities
include the continued transition to clean energy, cybersecurity risks, and
lower electricity demand. However, we are confident in the sector's ability
to adapt given its strong business model. We expect that the sector's fixed
obligation charge coverage ratio will remain strong in 2020 and fall in the
1.80x to 1.90x range. Days liquidity on hand and debt ratios should also
remain stable in the coming year.
Low natural gas prices are expected to
continue, contributing to lower or stable power prices in most regions and
enabling lower rate increases alongside the maintenance of stable credit
metrics. Total debt outstanding is also expected to decline.
Despite easing enforcement of federal and
some state environmental policies, MTAM expects public power utilities to
forge ahead with clean energy and carbon reduction strategies. Absent
significant federal policy, most of the legislative actions on carbon
reduction will occur at the state level. States including California and
New York view utilities as the primary lever for implementing ambitious
renewable energy mandates. Wildfire risk, particularly in California,
remains a concern.
While the sector is taking an
increasingly proactive stance on training to comply with federal cyber
security standards, cyber breaches remain a growing risk given increasingly
digitized and interconnected infrastructure.
Colleges
and Universities
MTAM is maintaining our negative outlook
on the higher education sector for 2020 based on various industry
challenges which are increasingly pressuring U.S. colleges and universities.
Perhaps most prominent are operating and
revenue pressures, which stem from increasing constraints on tuition
growth, and more challenging demographic and competitive markets than seen
in prior years. Increasing competition for students and heightened scrutiny
over the value of a college education have suppressed overall tuition
growth since the recession.
While we are projecting growing revenue
from state appropriations, gifts, and research grants, tuition revenue is
expected to be a drag on overall growth. Good endowment gains and reserves
should help counteract the trend.
Overall revenue is expected to grow
3%-4%, driven by larger public and private universities. More comprehensive
universities with diversified revenue streams should outperform
tuition-dependent institutions.
Any declines in state funding, stock
market performance, and enrollment could further pressure the sector;
however, revenue growth above 5 percent that outpaces expense growth could
result in a positive adjustment to a more stable outlook.
Consolidation is likely to accelerate in
2020 and beyond, which may take multiple forms. Smaller private
institutions remain most susceptible to consolidation either through a
merger, affiliation with another larger institution or in the most serious
scenario, outright closure.
Substantial headwinds aside, the higher
education sector as a whole still retains key fundamental strengths
including significant flexibility and fortitude in the face of operating
and financial pressure. Many institutions maintain sufficient liquidity,
and have been proactive and agile with regard to strategic management,
targeted revenue growth and diversity, expense management, and pursuing
partnerships for mutual benefit.
Housing
MTAM is maintaining its stable outlook for
the U.S. state housing finance agency (HFA) sector for 2020. Margins and
asset-to-debt ratios will decline due to interest rate cuts and an increase
in bond issuance, but will remain at healthy levels. Increased issuance
will cause HFA margins to soften to 11 percent, but the rise in on-balance
sheet, full-spread mortgage loans will provide a stable, recurring revenue
stream. More bond issuance will drive an increase in issuance costs and a
decline in loan sale revenue; however, these negative effects will be
offset by the stabilized revenue streams from the new loans. Additionally,
many HFAs are choosing to use new issuance to finance mortgage-backed
securities rather than whole loans, which generally improves the credit
profile of their loan portfolios. Whole loans, which continue to make up a
large percentage of many HFAs' assets, continue to improve their
performance, with delinquency and foreclosure rates having reached their
lowest point since 2008. We expect that HFA multifamily performances will
remain solid in 2020 given strong demand for affordable housing among the
low-to-median income population. Limited supply and high demand from large
pools of eligible tenants will keep vacancy levels low for HFAs. Looking
ahead, demographic trends will be a major driver of demand for both
affordable single-family homes and multi-family rental units. HFAs'
low-interest loan products and downpayment
assistance programs position them well to attract millennial homebuyers,
many of whom are saddled with student debt. HFAs are also well-positioned
to meet the imminent surge in senior demand for affordable rental housing
due to their experience making loans that leverage federal subsidies
supporting projects for the elderly.
Default
Outlook
Defaults in the U.S. municipal bond
market have continued to be small, fragmented, and idiosyncratic, which
means credit distress has not moved the market over the past year. The par
amount of first-time payment defaults in the municipal bond market totaled
$1 billion for the first three quarters of 2019, or just 0.2 percent of the
$3.82 trillion municipal market. Fully 75 percent of these are in three
sectors: nursing homes (55.0 percent); industrial development (11.3
percent); and multifamily housing (8.7 percent).
We believe these defaulting projects are
most likely explained by idiosyncratic factors, such as poor management,
bad locations, or excessive debt levels rather than any broad-based theme
cutting across the economy or the asset class as a whole.
Conclusion
Despite uncertain fiscal, economic, and
regulatory pressures, U.S. municipalities should benefit from modest
economic expansion that will support revenue growth and stability. MTAM
continues to recommend that investors select high-quality municipal issuers
that understand the new financial reality and have made or are making
budget adjustments. Essential service revenue bonds without the budgetary
concerns of state and local governments and limited payrolls can be
attractive, but we stress that an essential service issuer cannot flourish
if the underlying governmental entity is in dire economic circumstances. A
healthy outlook holds for most infrastructure issuers due to fundamental
strengths reflected in the provision of essential public services, adequate
balance sheets, and generally sound governance and fiscal management
practices. In the case of the enterprise sectors comprised of higher
education, health, and housing, credit quality will be maintained primarily
as a function of their ability to increase fees, control costs, and improve
overall operating margins. Sound debt and fiscal management practices,
preservation of adequate liquidity, and strong governance oversight will be
significant determinants of credit quality for issuers during the coming
period of financial adjustment.
Top Of Page
4th Quarter 2019 Review and
Outlook
Friday, December 27, 2019
Investors in municipal bonds earned
positive returns in the fourth quarter, as weak global growth continued to
keep interest rates here and abroad historically low. Significant amounts
of money continued to pour into the municipal market unabated as investors
found the tax-exempt nature of the asset class quite compelling, given the
low overall level of interest rates. Also aiding demand into municipal
bonds were surging stock markets here in America, which kept wealth
advisors in rebalancing mode. Due to the low correlation between stocks and
municipal bonds, it is fair to expect a continuation of the equity bull
market to stoke more rebalancing demand for tax-exempt bonds.
Given the sizeable returns for financial
markets in 2019, it is fair to assume some mean reversion occurs in 2020.
Within the municipal bond market, we would expect a small correction higher
in yields on the very long end of the yield curve (20 to 30-year
maturities) as the Federal Reserve clearly would favor a pickup in
inflation (and inflation expectations) at this time. Combine that dovish
inflation stance by our central bank with the substantial borrowing needs
of the U.S. Treasury, and logic dictates some upward pressure on yields is
likely to occur. In our view, investors in municipal bond closed end funds
should prepare to hit the eject button, as the leverage embedded in these
products could elevate losses if interest rates move higher. Preserving the
substantial gains made in 2019 in these products should be the first
priority for conservative oriented investors.
Our preference in the coming quarter is
to allocate significant client capital to the very short end of the
municipal yield curve. Some opportunities to buy one- and two-year
municipals at yields higher than five-year bonds has presented itself on
occasion in the secondary market, and we look to continue to exploit this
anomaly should it carry over to 2020. We also continue to prefer lower
coupon bonds that offer higher yields to maturity as opposed to premium
bonds, which can sport purchase prices well north of 120—not attractive in our view.
Given that we are entering the new year
with financial asset valuations perhaps a little on the
"stretched" side, it makes sense to remember it is not what you
earn, but what you keep. Municipal bonds are tax-free; take a guess where
we think investors will do relatively well in 2020.
Happy New Year!
Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak
Top Of Page
Increasing Financial Pressure
on U.S. Cities
Monday, November 4, 2019
After waning optimism in recent years,
nearly two in three finance officers in large cities now predict a
recession as soon as 2020, according to the National League of Cities. This
forecast comes on the heels of weakening major economic indicators,
including in manufacturing, agriculture and service sectors, home sales,
and business sentiment. While the slowing economy is largely a global
phenomenon, the U.S.'s trade disputes with China, Canada, Mexico, and the
European Union have added more uncertainty to the future. These factors are
starting to affect city finances.
For the first time in seven years, cities
anticipate a decline in revenue as they close the books on fiscal 2019.
While this drop was expected after revenue growth plateaued in fiscal 2018,
these findings signal that economic pressures on city budgets are mounting.
In fiscal 2018, total constant-dollar general fund revenue growth slowed to
0.6 percent. Income tax and property tax revenues slowed, while sales tax
revenue growth was unchanged from the prior year. Property tax revenues
grew by 1.8 percent, compared with 2.6 percent in FY 2017. Sales tax
revenues grew by 1.9 percent, compared with 1.8 percent in FY 2017. Income
tax revenues grew by 0.6 percent, compared with 1.3 percent in FY 2017.
Meanwhile, expenditures are climbing,
increasing by 1.8 percent in fiscal 2018. While that growth rate is
slightly lower than the prior three years, officials also expect it to
climb again to 2.3 percent for fiscal 2019. Infrastructure needs, public
safety spending, and pension costs are among the most significant
expenditures.
The declining fiscal conditions are
sharpest in the Midwest as overall general fund revenues in cities there
declined by 4.4 percent. Much of that appears to be driven by large revenue
drops in big cities. Chicago recorded an 11.7 percent revenue decline in
fiscal 2018 while Minneapolis dropped by 9.6 percent.
Elsewhere across the South, West, and
Northeast, cities in all population categories experienced slower growth in
general fund revenues and property tax receipts over the last year, but
growth nonetheless. Still, three out of four finance officers across the
country remain confident in the ability of their local government to
address expenditures and meet the financial needs of their communities.
City budgets continue to be buoyed by generally healthy local economies and
robust tax bases. Finance officers in the Midwest, however, are most likely
to report that their cities' budgets were less able to support the
community over the past year.
Looking beyond 2019, the resilience of
city fiscal conditions will be tested by looming economic headwinds,
largely driven by trade. Meanwhile, the cost of healthcare and pensions are
rising faster than inflation and placing pressure on spending. Combined
with state policies that impede local fiscal autonomy, these factors all
have the potential to further constrain city budgets.
Predicting the exact timing of an
economic downturn is very difficult, but it is telling to know what those
who manage government budgets are seeing. According to the National League
of Cities, finance officers from large (63%) and larger mid-sized cities
(49%) are more likely than finance officers from smaller mid-sized cities
(38%) and small cities (35%) to predict that the next recession will occur
in the next one to two years. This is counterintuitive given that many
industry drivers of smaller communities, including manufacturing and
agriculture, have typically been among the first to show signs of an
economic slowdown.
The difference between the perspectives
of officials in large cities versus smaller cities is likely due to a few
factors. For one, large cities are experiencing a bigger gap between
revenue growth and spending growth than their smaller counterparts. Housing
market growth is also reaching its peak in large cities and is already
slumping in some large West Coast cities such as Seattle and San Francisco.
June home prices for major West Coast cities fell for the first time since 2012,
declining by 1.7 percent. Business investment in 2019 is also on the
decline, a metric which tends to hit larger cities first. Lastly, large
cities also have fairly robust economic forecasting tools and a larger
budget staff than smaller cities. This difference may also be playing into
their different timelines in forecasting the next downturn.
Changes in general fund revenues are
typically a good proxy for local economic and fiscal conditions. General
fund revenues are derived primarily from property and sales taxes, while
some cities also tax income. Utility and other taxes, user fees, and shared
revenues round out the picture for cities. General fund expenditures
provide funding to cities' general operations, such as infrastructure,
employee wages and public safety. On average, they account for more than 55
percent of total city spending.
In fiscal 2018, total general fund
revenues slowed to their lowest annual growth rate since 2013, increasing
by less than 1 percent in constant dollars. This was mostly driven by the
Midwest's collective drop by 4.4 percent in reported 2018 revenue. In
creating their budgets for 2019, finance officers on average estimated that
revenues will decline by 1 percent in real terms.
Still, spending growth has outpaced
revenue growth in recent years and we expect this trend to continue.
Expenditures in fiscal 2018 collectively grew by 2 percent, a figure that
is in-line with what was budgeted for that year. Even greater spending
growth (2.3%) is budgeted for fiscal 2019.
Infrastructure needs, public safety
needs, and pensions were reported as the top three burdens on city budgets
in 2019. Those pressures are similar to previous years and are likely to
continue. In her recent State of the City address, for example, Chicago
Mayor Lori Lightfoot warned the city was facing an $838 million budget gap
in 2020 that was driven by increased pension costs and needed
infrastructure investment.
Looking at the differences across city
sizes, general fund revenue growth in fiscal 2018 increased the most in
smaller mid-sized cities (1.1%). Small cities (0.7%) and large cities
(0.6%) showed slight growth while larger mid-sized cities showed the
slowest growth at 0.3 percent. On the spending side, large cities saw the
steepest rise (2.9%) in expenditures in fiscal 2018 while larger mid-sized
cities had kept spending essentially flat.
The revenue slowdown combined with the
increased spending pressure evident in larger cities also helps explain
their more pessimistic view of the economy compared with their smaller city
counterparts. For example, in Santa Ana (population 334,000), expenses rose
nearly 6 percent in fiscal 2018, driven largely by increases in fire
spending and higher pension payments required by the state. General fund
revenues, however, only increased by 2 percent.
For fiscal 2019, large cities tended to
budget for a bigger revenue decline (-1.2%) than did smaller cities, which
have budgeted for flat revenue. As such, large cities are expecting slower
expenditure growth (2.1%) in 2019 than small cities (4.7%).
By region, revenue growth in Midwestern
cities fell by 4.4 percent in fiscal 2018 while cities in the West saw a
bigger-than-average growth rate (2.3%). In expenditures, Northeastern and
Southern cities saw the biggest growth in fiscal 2018, reporting increases
by 2.8 percent and 2.6 percent, respectively. Western (1.2%) and Midwestern
cities (0.5%) reported the slowest growth for that year.
In fiscal 2019, finance officers in the
Northeast (-2.8%) and West (-1.5%) have budgeted for revenue declines while
elsewhere, cities are expecting nominal growth of a half-percent or less.
Northeastern cities have also planned for an average spending decrease of
1.5 percent. Elsewhere, planned spending increases range from 1.4 percent
in the Midwest to 4.7 percent in the West.
In fiscal 2018, income tax and property
tax revenues slowed, while sales tax revenue growth was unchanged. Sales
and income taxes are considered "elastic" sources in that they
are more responsive to economic changes than other tax sources and often
better reflect economic shifts. These two revenue streams hit their growth
peaks in 2015. Meanwhile, property tax collections, which tend to lag
economic conditions, hit a growth peak in 2016.
Local property tax revenues are driven by
the value of residential and commercial property, with property tax bills
determined by local governments' assessment of property values. Because of
assessment practices, property tax revenues typically reflect the value of
a property anywhere from 18 months to several years prior, so they are less
responsive to economic changes than other types of taxes. In fiscal 2018,
total collections grew by 2 percent and are anticipated to grow by another
2 percent when the books close on fiscal 2019.
Large cities (2.8%) saw the biggest
property tax revenue growth in 2018. The increase likely reflects the rise
in housing prices over recent years that has led to an affordability
problem in many places. Property value assessments can also occur more
frequently in large cities than smaller ones and therefore might reflect
changes in the market sooner. Tellingly, for fiscal 2019, large cities have
budgeted for more moderate property tax growth of 1.4 percent. Small
cities, meanwhile, are still planning on significant growth and have
budgeted for growth of 3.7 percent.
Broken down by region, property tax
revenues increased everywhere except the Midwest, which declined by 0.6% in
fiscal 2018, when adjusting for inflation. This may be primarily due to the
outsized influence of Detroit. The Motor City reported more than 8 percent
decline in property tax revenue alone for fiscal 2018, part of a multi-year
trend in that city as it struggles to collect all of the taxes it is owed.
For fiscal 2019, the Midwest and South are each expecting just under 3.2
percent growth in property tax collections, while Northeastern cities have
budgeted growth of 2.1 percent. The West is expecting anemic property tax
growth of just 0.1 percent.
While property tax revenues are
considered a lagged indicator of economic changes, sales taxes are elastic – or more responsive to economic changes – and often better reflect fiscal shifts.
This is because people tend to spend more on goods and services when
consumer confidence is high, and vice versa.
Last year represented a somewhat pleasant
surprise for governments as they had budgeted for anemic growth (0.2%), and
instead total sales tax revenues grew by 1.9 percent in fiscal 2018.
However, officials are remaining cautious and have budgeted for just 0.3
percent growth in fiscal 2019.
Last year, smaller cities saw faster
sales tax revenue growth than larger cities. The differences may indicate
that while larger cities are nearing the end of their economic expansion,
smaller cities have a little more room to grow. Tempe, in its annual report
noted its nearly 6 percent increase in sales tax revenues was due to a
commercial and residential development construction boom in recent years.
Smaller mid-sized cities saw the biggest growth (2.7%) while larger
midsized cities posted the lowest growth (1.2%). The picture for 2019,
however, looks very different. Smaller- and larger mid-sized cities are
expecting essentially flat revenue or a slight decline. Meanwhile the
smallest and largest cities have budgeted for revenue increases by 0.8
percent and 0.6 percent, respectively.
By region, the Midwest saw the most
robust growth of sales tax receipts in fiscal 2018, with revenues
increasing by 3.8 percent. The South saw the slowest growth of 1.1 percent.
Looking ahead, all other regions have muted expectations, with the Midwest
and South expecting slight declines. Cities in the West are expecting
minimal growth of 0.7 percent.
Like sales taxes, income taxes are a more
elastic source of revenue. At the city level, income tax revenues are
driven primarily by income and wages, rather than by capital gains (New
York City is a notable exception). On the whole, income tax receipts grew
0.6 percent in fiscal 2018, with an anticipated growth of 0.7 percent in
fiscal 2019.
Conclusion
Despite slower growth and in some cases,
decline, in city fiscal conditions, finance officers are generally
optimistic about the ability of their local government to meet financial
needs. Three in four finance officers (76%) report that their city was
better able this year over last to meet the financial needs of their
community. By population size and region, more large
city finance officers (88%) and those in the South (82%) are optimistic
than finance officers in other types of communities.
The general optimism that finance
officers demonstrate in some parts of the country (especially the nation's
large cities outside the Midwest) is somewhat tempered by their
expectations of future challenges. Cities in the Midwest appear to be
struggling most, and perhaps are the first to show signs of the next economic
downturn. Interestingly, finance officers in the Midwest and in small
cities are also least likely to think a recession will occur in the short
term. Beyond 2019, several factors, including inflation and city-state
fiscal relations, will significantly impact the ability of cities to remain
fiscally resilient in the face of looming economic headwinds. A majority of
cities are maintaining taxation and fee levels heading into 2020.
Although inflation in the broader economy
has been extremely low over the past few years, this has not been the case
for the local government sector. In stark contrast to the Consumer Price
Index, U.S. Bureau of Economic Analysis' Implicit Price Deflator for State
& Local Government Purchases rose 3.2 percent between 2017 and 2018. The
price of goods and services purchased by local governments, especially
healthcare, is rising much more quickly than the basket of goods and
services purchased by the typical consumer. This means that the purchasing
power of the public sector is weakening in relation to other parts of the
economy, and having a large impact on city budgets. When not adjusted for
inflation, revenue growth is weak but still positive. In real terms,
however, general fund revenues for the sector overall are budgeted for decline
in FY 2019.
In addition, in recent years, many state
governments have pursued aggressive actions that impede the ability of
cities to raise revenues, to spend according to community priorities and to
respond to economic and other local conditions. For example, this year the
Texas state legislature signed into law a bill to cap local property tax
revenue growth at 3.5 percent. When paired with the rapid rise in the cost
of goods and services purchased by local governments, this limited revenue
growth pushes the limits of fiscal sustainability.
In addition to preemptions that have been
in place for years in states like Michigan and Colorado, new legislation
was passed this year to cap local spending in Iowa, to require elections
for tax increases in Texas, and to prevent cities from imposing their own
commercial activity taxes in Oregon. These regulations and policies
restrict cities from accessing revenues and making impactful investments
during economic growth periods, which in turn makes them less resilient
during downturns.
City fiscal conditions are a reflection
of underlying economic factors. An overall positive assessment by finance
directors signals their confidence in the state of the economy over the
past year. Budgeted revenue declines for upcoming fiscal year, however,
portend more turbulent times ahead as economic pressures on city budgets
begin to mount. Cautious optimism defines city fiscal conditions in 2019.
Top Of Page
3rd Quarter 2019 Review and
Outlook
Tuesday, October 1, 2019
Positive returns were realized by
municipal bond investors in the third quarter as the Federal Reserve
lowered interest rates in response to a slowing U.S. economy. Substantial
demand appeared in the fixed-income sector during the past three months as
trade tensions between China and the United States heated up. Adding to the
downward pressure on U.S. interest rates were more signs that
"negative" yielding debt was here to stay in many areas of the
global bond market, thanks to central bank quantitative easing policies.
Strangely enough, it can be easily detected that municipal bond yields—while
historically very low—are amongst the highest on the planet. This
should bode well for municipal bond returns in the coming months.
Miller Tabak
Asset Management has long been concerned that investors have paid too
little attention to the risk that interest rates would remain low for a
long period of time. With that in mind, we have been investing in lower
coupon bonds, which are less likely to be called away by issuers looking to
lower their debt burdens. We have also brought levels of uninvested cash in client portfolios to very low
levels, as the coming months are likely to see increased demand for the
asset class as recession risks rise. Given the weak economic output
globally, we continue to focus on investing in higher rated issuers who
have the financial strength to retain their value, should recession
concerns become reality.
The upcoming months may see an uptick in
volatility as headlines on potential trade deals combine with more heated
political discourse while the 2020 election moves closer into focus. Our
suggestion to investors would be to pay little attention to the day-to-day
headline noise, and to pay more attention to the trajectory of the U.S.
economy. As we see things right now, the manufacturing sector of the
economy is already in recession. For this reason, far more importance is
thus put on the back of the U.S. consumer, which currently seems in reasonable
shape thanks to a still buoyant employment backdrop. Should the job market
weaken, we sense many investors will be surprised how much further interest
rates could fall. We chimed in on August 19th as
we tweeted that our view was the 10-year U.S. Treasury note yield would
likely bottom at a 0.98%. Perhaps it might be best to keep this definition
close by:
Reinvestment risk: refers to the
possibility that an investor will be unable to reinvest cash flows at a
rate comparable with their current rate of return.
Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak
Top Of Page
Cyberattacks in the U.S.
Public Finance Sector
Monday, August 19, 2019
The recent data breach at San Diego
Unified School District, affecting the personal data of as many as 500,000
students, underscores the heightened threat of cyberattacks that
educational, governmental, and healthcare organizations face due to the
sizable amount of personal data housed on their networks. Cyber risk is not
a driver of credit risk or rating actions. However, MTAM's internal ratings
reflect issuers' overall resilience to manage and respond to changes in its
operating environment, including risks associated with cyberattacks.
There have been at least 24 reported
ransomware attacks on municipalities this year, including a high-profile
attack on Baltimore, and 46 last year. In a
ransomware attack, hackers infiltrate a computer system and deploy
malicious software that locks a victim's data until the owner pays a
ransom. The May 7 attack on Baltimore has hobbled its ability to collect
water bills, property taxes, and parking revenue. It also shut down the
system to process home sales. The City's online payment portal is still offline.
Baltimore has refused to pay the ransom.
Although it is too early to assess the
full monetary effect of the cyberattack, we understand the City's estimated
costs to date total about $18 million. Despite the significant cost, we do
not anticipate the breach will lead to a credit event, given Baltimore's
sizable reserves equal to $385.3 million at fiscal year-end 2018, or 20% of
operating expenses, as well as its liquidity equal to 52% of total
governmental expenditures, which we consider very strong.
In addition, through April 2019, the City
estimated a surplus for fiscal 2019 of as much as $40 million, although we
believe the costs associated with the May cyberattack should erode some of
the anticipated surplus. We will continue to monitor the degree to which
these costs affect Baltimore's financial performance. We understand that
the City could seek a federal emergency and disaster declaration; if
granted, this could result in some reimbursement from the federal
government for emergency expenditures. However, it is unclear at this time
whether such a declaration and receipt of federal aid will occur.
The cyberattack in Baltimore follows last
year's high profile ransomware attack in Atlanta, which cost the City an
estimated $17 million to fix, about 2.6% of the City's budget.
Syracuse City School District in upstate
New York said it experienced a cyberattack that could "impact its
financial position," marking another example of a municipal government
affected by such an incident, according to a July 31 regulatory filing. The
School District said it experienced an attack in July 2019 which made
computer files and systems inoperable temporarily. As a result of the
attack, the District has incurred and will continue to incur significant
costs to restore operability of its systems and conduct an investigation.
The District said it is using liability insurance to offset costs but that
it cannot predict future costs. Further, the District could incur future
liabilities related to this incident, and the incident may negatively
impact the District's ability to obtain insurance coverage in the future.
A city in Florida's Palm Beach County
authorized its insurer to pay a ransom of almost $600,000 to hackers that
unleashed a virus crippling the city's computer systems. Riviera Beach, a
city of about 35,000, approved the payment of 65 Bitcoins, valued at
$592,000. The City's computer system was paralyzed May 29 after a police
department employee opened an email that unleashed a virus. Two weeks after
the attack was first disclosed, the City's email and computer system were
only partially back online and data encrypted by the attackers remains
beyond reach. The FBI continues to investigate.
Data breaches in the education,
governmental (including federal and military), and healthcare sectors
accounted for 40% of total data breaches in 2017 and 2018, according to the
Identity Theft Resource Center (ITRC). Approximately 27% of total breaches
occurred in the healthcare sector. Combined data breaches for these sectors
have increased 160% since 2005, with healthcare having the highest
attributable growth, while governmental organizations realized modest
improvement. The growth of Internet of Things (IoT),
interconnected sensors embedded in technology, such as WIFI networks,
building maintenance systems, medical devices, and traffic sensors, further
contribute to cyber risk. IoT devices outnumbered
the world's population in 2017 and are projected to double by 2020,
according to Gartner technology consultants.
Cyberattacks create service disruptions
for educational, healthcare, and governmental organizations, adversely
affecting their public service missions and resulting in increased costs.
Incident response, crisis management, forensic services and restoration can
cost millions of dollars for resource-challenged operations. Some
organizations have also paid ransomware demands to retrieve data. Exposure
of personal and sensitive data can lead to direct costs to personal
consumers. Fifty-three percent of data breaches during 2017 exposed Social
Security numbers and 19% exposed credit/debit card numbers, according to
the ITRC.
Cyberattacks also threaten to erode
public confidence in government, and can suggest weak governance.
Cyberattacks can hurt issuers' reputations, evidenced by the fact that many
cities and states avoid reporting them. However, the lack of consistent
reporting of cyberattacks could leave many issuers complacent about the
risks or unaware of some of their own vulnerabilities.
The Department of Education has suggested
that schools conduct security audits and train staff and students on data
security best practices to mitigate cyberattacks. However, there are
challenges to adopting cybersecurity best practices within schools as laws
do not generally mandate comprehensive standards. Furthermore, these
activities compete for scarce budget dollars. Governmental resources are
available for guidance and support, such as those provided by The National
Institute of Standards and Technology (NIST). However, NIST services have
been recently curtailed.
Cyberattacks could have even more harmful
affects on smaller state and local governments,
which have less funding for cybersecurity and may see themselves as less of
a target that big cities or states. Ransomware criminals may see smaller
school districts or towns as easier targets, as their focus on
cybersecurity is less than that of larger cities such as Los Angeles, which
has a cybersecurity working group in place.
Conclusion
Credit risks stemming from cyberattacks
on U.S. cities, school districts, and other municipal bond issuers are
likely to grow as the public sector remains an easy target for hackers. The
U.S. public sector has broadly and quickly adopted new technologies to
provide public services, such as online bill payment systems, but it has
had a difficult time guarding against increasingly frequent and
sophisticated cyberattacks.
The public sector struggles with
retaining information security talent and keeping an aging workforce up to
speed on emerging cyber risks. The transparent nature of government, where
information is more accessible compared with private companies, makes
public entities increasingly vulnerable. Cyber criminals are also getting
more organized and more professional. On the so-called darkweb,
where illegal activity can be engaged in freely, purchasers of ransomware — software designed to block access to a
computer system until a sum of money is paid — are offered moneyback guarantees.
Repeated successful attacks can eat away
at credits over time by eroding public trust. That would potentially make
it harder for municipal issuers to increase tax rates and take other
measures needing public support.
Despite concerns about losing public
confidence, municipal issuers should stop concealing cyberattacks, which they
often do out of embarrassment. Instead, we recommend sharing details of
attacks broadly with the municipal bond market and law enforcement. Public
entities should also report the attacks through an event notice on the
Municipal Securities Rulemaking Board website, EMMA. Only with consistent
and transparent disclosure can the evolving sophistication of cyber
criminals be recognized, and prudent mitigation measures taken and
disseminated.
Investors need to determine whether
states and local governments take cybersecurity seriously as a risk, and
issuers need to assess and share information about the defenses in place
against cyberattacks. MTAM considers a municipality's preparedness for a
cyberattack by evaluating whether they have a written response plan, the
size of the cybersecurity budget, and the presence of cyberinsurance.
Top Of Page
Update on Late State Budgets
Tuesday, July 30, 2019
Seven states started the fiscal year
without an enacted budget, a change from 2018 when the budget process was
relatively drama-free and nearly all states enacted a spending plan by the
start of the year on July 1.
Massachusetts, New Hampshire, North Carolina,
Ohio, Oregon, and Rhode Island did not have a full-year budget in place
(Wisconsin Governor Tony Evers signed the state's biennial budget on July 3
with partial vetoes.) Continuing appropriations and state bond laws make it
highly unlikely that debt payments will be affected, but local governments,
school districts, and other downstream entities --- like colleges and
universities --- may face fiscal stress from delayed funding.
Late budgets are a sign of governance
weakness which, in extreme cases, can be negative for state credit quality.
At present, only New Hampshire and North Carolina have not yet come to a
full-year budget agreement. In both states, the legislatures presented a
budget that the governor then vetoed:
* New Hampshire's Governor Christopher
Sununu vetoed a spending package in part because it contained business
taxes he opposed.
* North Carolina's Governor Roy Cooper
vetoed the budget sent by the state's Republican-controlled legislature
because of a disagreement on funding for Medicaid expansion and teacher
salaries.
We do not believe late budgets for either
state pose a significant credit risk, since they have been operating under
continuing resolutions that do not pose structural budget risks, and the
lack of full-year budgets is the result of policy disagreements rather than
large structural financial gaps that need to be closed.
New
Hampshire
On June 28, 2019, the governor vetoed the
2020-2021 budget plan – New
Hampshire's first budget veto since 2015. However, the state has enacted a
three-month continuing resolution, funding state operations at 2019 levels
through September 30. Although funding increases for new hiring and
programs remain at a standstill, the continuing resolution appropriates
necessary funding to meet New Hampshire's debt service obligations, which
alleviates a potential credit risk to the state's outstanding general
obligation and appropriation-backed debt.
The budget veto stems from policy
differences between the administration and legislature on how to balance
increased education and social services spending with additional revenue
over the biennium. The legislature's budget proposed halting a series of
tax rate reductions that took effect on January 1, 2019, for two of the
state's primary revenue sources -- the business profits and business
enterprise taxes -- to pay for these initiatives, but the governor asked
the legislature to revisit alternative revenue measures that do not roll
back planned tax reductions. The state legislature and administration have
yet to agree on a compromise budget, but we believe the delay does not
reflect acute stress on New Hampshire's finances because the state
estimates a $260 million operating surplus at the end of fiscal 2019.
However, we will continue to monitor these negotiations for potential
effects on New Hampshire's structural balance and preparedness for shifting
economic and financial conditions.
North
Carolina
On June 28, 2019, the governor vetoed
House Bill 966, the fiscal 2020-2021 biennial budget, that totals $24.0
billion and $24.8 billion in each respective year. Among the items not
included in the legislature's budget were a $3.9 billion GO bond referendum
(Invest NC) for November 2020, Medicaid expansion to more than 500,000
residents, and various education spending increases the governor had
proposed. It is unclear how much longer budget negotiations will continue
before the state enacts a budget or if the legislature will have sufficient
votes to override the governor's veto.
A late budget is not uncommon for North
Carolina. Historically, the legislative session has several times extended
past the end of the fiscal year, including 2015, when the fiscal 2016-2017
biennial budget was enacted in September. In 2016, the legislature amended
the State Budget Act to allow the Director of the Budget to continue to
allocate funds for expenditures at prior-year levels with no further legislative
action if the budget does not pass by June 30. According to the Act, when
making allocations, the Director of the Budget will ensure the prompt
payment of the principal and interest on bonds and notes of the state
according to their terms.
Conclusion
Although seven states with July 1
starting fiscal years were without fully enacted fiscal 2020 budgets at the
start of their fiscal years, MTAM does not view these temporarily late
budgets as a sign of significant credit distress because no state had an
operational shutdown due to the use of continuing budget resolutions. Most
late budgets stemmed from extended policy discussions rather than financial
emergencies. Deciding how to spend extra money during economically good
times can sometimes prompt longer policy discussion than when everyone
agrees that expenses must be cut, especially since new programs, once
established, can become tomorrow's entitlements.
Top Of Page
2nd Quarter 2019 Review and
Outlook
Monday, July 1, 2019
Solid returns were prevalent once again
for municipal bond investors in the second quarter as a more dovish Federal
Reserve provoked a wave of buying in U.S. fixed-income assets. While all
areas of the municipal yield curve saw yields decline (prices rise) during
the quarter, it was longer-maturity bonds that returned the most to
investors as inflation expectations failed to materially move higher once
again.
Surprisingly to many (including us),
"BBB" rated municipals continued to significantly outperform
"AAA" rated debt, as the lurch for extra yield showed no signs of
slowing down. Given the notable deceleration of global growth currently
underway, we would suggest moving portfolios up in credit quality as recession
risks continue to rise. Should the Federal Reserve fail to promptly lower
rates as many currently expect, a recalculation of credit risk could ensue.
Given the very tight spreads between high quality and lower quality
municipal issuers these days, it might be best to watch a few episodes of
The Addams Family if you have the urge to "Lurch."
"Between
A Rock and A Hard Place"
The Federal Reserve has a dual mandate to
promote maximum employment and relatively stable inflation as close to 2%
as possible. The good news for the "Fed" is that the unemployment
rate is currently near a fifty-year low. The not so good news is that
inflation expectations are softening and are in danger of falling should
the economy weaken further. This dichotomy creates the potential for a policy
error to emerge should the Fed make the wrong move on interest rates in the
coming months. Compounding the Fed's dilemma right now is the enormous
political pressure they are encountering, quite publicly now, to lower
interest rates. MTAM believes the market could be disappointed in the pace
and depth of any easing cycle by our central bank, specifically related to
this institution's desire to be seen as independent from outside influence.
Bond market volatility has been quite muted these past three months, but in
our view, this is about to change. We would expect sizable gyrations to
occur in the shape of the yield curve on a daily basis as profession
investors flip back and forth between "steepeners"
and "flattening" trades. The good news for our client base is
that this curve volatility will open up some opportunities to find value in
a low yield and low tax-free bond supply environment.
Our expectations for the upcoming quarter
are for municipal bond returns to remain positive, but to moderate somewhat
from the pace seen in the first half of 2019. As always, capital
preservation will be first and foremost on our agenda.
Have a wonderful summer.
Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak
Top Of Page
State of the States - Midyear
2019
Thursday, June 20, 2019
In the middle of the fiscal 2020 budget
season, U.S. state budgets appear ready to support stable credit quality
after a long period of national economic expansion. Most U.S. states
forecast improvement in fiscal 2019 fund balances, and preliminary
indications are that April income tax collections will be strong.
Nevertheless, state revenue forecasts for fiscal 2020 remain mostly
cautious. We note the various tax-raising strategies some states propose to
add to their fiscal 2020 budgets, including raising top taxpayers' income
taxes, increasing gas taxes, and implementing new "sin" taxes for
such items as marijuana, sugary drinks, and plastic bags. Still others plan
to budget for more funding for education, workforce development, and
infrastructure.
Governors have recommended budgets for
fiscal 2020 calling for moderate general fund spending and revenue growth.
Proposed spending plans would increase general fund expenditures by 3.7 percent
in fiscal 2020, with 47 states proposing spending increases and governors
directing the majority of new money to education. Most states entered
fiscal 2019 with sizable budget surpluses from robust revenue growth in
fiscal 2018, which helped bolster state general fund spending and reserves.
Most states have seen general fund revenue collections exceed their budget
forecasts for fiscal 2019, and no states had to make mid-year budget cuts
due to a revenue shortfall. Moderate general fund revenue growth is
expected to continue in fiscal 2020 in line with economic growth forecasts.
Governors have recommended a series of revenue changes for fiscal 2020
consisting mostly of tax increases along with some modest decreases, with
much of the new proposed revenue going towards transportation. Most states
continue to strengthen their reserves as they leverage the recently
improved revenue conditions and resulting budget surpluses to bolster rainy
day fund balances. While fiscal conditions are stable overall, states continue
to face long-term budget challenges to varying degrees, as spending demands
for fixed costs such as pension contributions and health care are expected
to grow faster than revenues over the long term. States are also budgeting
cautiously as they remain vigilant for any signs of weakness in revenues or
the potential for the next recession.
Governors' budgets call for general fund
spending to grow 3.7 percent in fiscal 2020, totaling $915.9 billion across
all 50 states. Overall, 47 states proposed general fund spending increases
in fiscal 2020, with 23 of those states recommending increases greater than
4.0 percent, 14 states with spending growth between 2.0 and 4.0 percent,
and 10 states with spending increasing between 0 and 2.0 percent, compared
with fiscal 2019 spending levels. Three states reported fiscal 2020 budget
recommendations that call for flat or declining general fund spending.
Estimated annual spending growth for
fiscal 2019 came in at 5.8 percent, considerably higher than the 4.3
percent growth originally budgeted for fiscal 2019. The strong expenditure
growth observed in the states in fiscal 2019 can be attributed to rapid
general fund revenue growth in fiscal 2018 that led to large surpluses in
many states, rising revenue estimates in a number of states for the current
fiscal year, and mid-year spending increases for specific purposes, such as
disaster recovery efforts, child welfare services, and rainy day fund
deposits. Estimated general fund spending in fiscal 2019 surpasses the prerecession
peak level in fiscal 2008 in real terms. However, on a state-by-state
basis, only half of the states spent more from their general funds in
fiscal 2019 than they did in fiscal 2008, after adjusting for inflation.
Governors' recommended appropriation
changes for fiscal 2020 also reflect a strong state fiscal environment
contributing to a significant amount of "new money" available to
spend on key gubernatorial priorities. For fiscal 2020, governors proposed
spending increases across all program areas totaling $30.8 billion
(compared with enacted fiscal 2019 appropriation levels). Elementary and
secondary education stood out as the largest recipient of new money in
fiscal 2020 by far, receiving $14.1 billion in proposed appropriation
increases. When combined with recommended higher education spending
increases of $3.6 billion, total education spending received the majority
of new resources in governors' general fund budgets, totaling $17.7 billion
or 58 percent of the new money for fiscal 2020. By comparison, in their
fiscal 2019 budgets, governors proposed increases for education totaling
$8.6 billion, less than half the boost they have recommended for fiscal
2020. This difference is largely a function of timing. When governors were
putting their budgets together for fiscal 2019, states were for the most
part just beginning to see revenue growth tick upwards. In contrast,
governors were developing their fiscal 2020 budgets after states had
already seen strong revenue gains in fiscal 2018 and early fiscal 2019,
giving chief executives more time to craft and refine their investment
proposals for education and other funding priorities.
The "all other" category of
general fund spending also received sizeable proposed general fund
appropriation increases in fiscal 2020 budget recommendations, with
governors directing $7.4 billion in additional funding to this broad
category comprised of a diverse range of programs. Proposed appropriation
changes in this category include spending increases for housing programs,
other health programs besides Medicaid, deposits to reserve funds, pension
fund contributions, public safety, environment and conservation projects,
economic development, capital construction and debt service, children and
family services, local government assistance, and state parks. Thanks in
part to a strong economy and low unemployment, Medicaid's share of new
money in fiscal 2020 is relatively small compared with most years, with
governors calling for a $2.7 billion increase (accounting for 9 percent of
the total new appropriations by program area).
Mid-year budget actions include any
actions, whether legislative or executive (e.g., executive order,
withholding of excess funds), that change the appropriated or authorized
expenditure level compared with the original enacted budget. Looking at
mid-year budget actions in fiscal 2019 offers another indicator of strong
state fiscal conditions relative to a couple years ago. Notably, in fiscal
2019, no states reported making mid-year budget reductions due to a revenue
shortfall. Just three states reported mid-year budget reductions made for
other reasons, such as using offsetting resources available from another
fund source, and the reduction amounts were modest, totaling just -$76
million. In contrast, two years ago in fiscal 2017, 22 states made net
mid-year spending decreases totaling $3.5 billion. Meanwhile, 21 states
reported making mid-year spending increases so far in fiscal 2019 totaling
$5.6 billion, for a net mid-year increase of $5.5 billion in general fund
spending after accounting for minimal reductions. This is the highest net
dollar amount of mid-year spending increases recorded in the last six
years. Revenue surpluses from fiscal 2018 and upward revisions to fiscal
2019 revenue estimates provided most of the resources for these increases.
The "all other" category was the largest recipient of mid-year (postenacted) spending increases, which included funding
for disaster response activities, rainy day fund deposits, and child
welfare services.
After states saw robust revenue growth in
fiscal 2018 of 7.0 percent overall (the highest growth rate observed since
fiscal 2013), most states projected more moderate growth in general fund
collections in fiscal 2019. Total general fund revenues are estimated to
have increased 2.7 percent in fiscal 2019 compared with fiscal 2018, with a
median growth rate of 3.3 percent. The figures reported predate April tax
collections, when many states saw a substantial uptick in income tax collections,
so it is expected that estimated revenue growth in fiscal 2019 is
understated.
Overall, fiscal 2019 general fund
revenues are estimated to total $877.8 billion, above the level projected
in states' enacted budgets for fiscal 2019 ($868.4 billion). This reflects
the fact that most states have made upward revisions to their revenue
estimates compared with original budget projections. Compared with original
budget projections, 28 states reported general fund revenues were exceeding
their targets for fiscal 2019, while 10 states were seeing revenues on
target and 12 states reported coming in below projections at the time of
data collection. Again, the figures reported predate April tax collections,
which are likely to help even more states beat their budgeted revenue
projections for fiscal 2019.
According to governors' recommended
budgets for fiscal 2020, revenues are expected to total $912.5 billion, a
4.0 percent increase compared with fiscal 2019 estimated revenues; the
median revenue growth rate for fiscal 2020 is 3.1 percent. Compared with
estimated revenue collections for fiscal 2019, general fund revenues from
sales taxes are budgeted to grow 4.8 percent, personal income taxes 4.2
percent and corporate income taxes 4.0 percent in fiscal 2020.
Governors recommended a series of revenue
actions, mostly tax increases along with some more modest decreases,
resulting in a projected net positive revenue impact in fiscal 2020 of $8.1
billion, including $3.9 billion in additional general fund revenues. A significant
portion of the new revenue would be directed towards special revenue funds,
particularly state transportation funds. Overall, 21 governors recommended
net tax and fee increases totaling $8.9 billion in fiscal 2020, while 11
governors proposed smaller net decreases totaling -$0.7 billion. Seven
states proposed general fund revenue increases greater than one percent.
Some of the more significant tax changes included personal and corporate
income tax conformity changes in California, Minnesota, and Virginia;
expanding the sales tax base and increasing health provider taxes in
Connecticut; a new millionaire's tax on high-income earners in New Jersey;
extension of higher personal income tax rates in New York; motor fuel tax
hikes in Alabama, Arkansas, Michigan, Ohio and Wisconsin; a business and
occupations tax in Washington; and miscellaneous tax changes in Illinois.
One particularly promising trend in state
finances in recent years has been the strengthening of states' reserves.
Improved revenue conditions recently have helped many states continue to
bolster their ending balances and savings accounts, known as rainy day
funds. States have made building up their reserves a priority since the
Great Recession. Since fiscal 2010, the median rainy day fund balance level
as a percentage of general fund spending has grown from 1.6 percent to 7.5
percent in fiscal 2019. Rainy day fund balances are estimated to total
$68.2 billion in fiscal 2019, excluding three states unable to report
estimated or future balance levels. Governors' recommended budgets predict
that total rainy day fund balances will continue to rise, reaching $74.7
billion at the end of fiscal 2020. Thirty-seven states estimate increases
in their rainy day fund balances in fiscal 2019, and 32 states are
projecting increases in fiscal 2020.
Total balances include ending balances
and the amounts in states' rainy day or budget stabilization funds. Total
balances reflect the surplus funds and reserves that states may use for
liquidity to respond to unforeseen circumstances and to help resolve
revenue shortfalls, though in some states, part of the ending balance may
already be reserved for expenditure in a subsequent year. In fiscal 2018,
total balances reached a new all-time high in both nominal dollars and as a
share of general fund spending in fiscal 2018, totaling $98.9 billion.
Total balances are estimated to have remained flat overall in fiscal 2019,
at $98.7 billion, and are projected to decline slightly to $93.8 billion in
fiscal 2020, based on governors' budgets.
Medicaid spending from all fund sources
is estimated to grow 5.3 percent in fiscal 2019 compared with fiscal 2018
levels, after growing at a similar rate of 5.2 percent in fiscal 2018.
Looking just at spending from state fund sources, the growth rate for
fiscal 2019 is a moderate 3.6 percent (3.6 percent general fund growth and
3.7 percent growth in other state funds). Medicaid spending from federal
funds is estimated to grow 6.3 percent in fiscal 2019. Looking ahead,
Medicaid spending growth is forecasted to slow slightly in fiscal 2020,
based on governors' budgets. The growth rate for total Medicaid spending is
projected at 4.0 percent for the upcoming fiscal year. State fund spending
is projected to grow by 3.1 percent (3.7 percent general fund growth and
1.8 percent other state fund growth), while federal fund spending is
expected to increase 4.5 percent.
States that expanded Medicaid also
reported on their expenditures for the new adult eligibility group
(including both "newly eligible" and "not newly
eligible") by fund source. States began paying 5 percent of the costs
for newly eligible adults in calendar year 2017, with the state share
gradually set to increase to 10 percent by 2020. Thirty-one states reported
Medicaid expansion spending in fiscal 2018, 33 states in fiscal 2019 with
the addition of Maine and Virginia, and 38 states in fiscal 2020, with
Idaho, Nebraska, and Utah as well as proposals by the governors of North
Carolina and Wisconsin. As states have begun to pick up a larger share of
the cost and more states have elected Medicaid expansion, spending from
state funds is estimated to increase by $927 million in fiscal 2019, and is
projected to grow by another $2.9 billion in fiscal 2020. Fiscal year 2020
also represents the first year of implementation in several states that
recently adopted Medicaid expansion.
States reported on changes to their
Medicaid programs implemented in fiscal 2019 and recommended in governors'
budgets for fiscal 2020. With fiscal conditions fairly stable, a number of
states reported increasing provider payments, expanding Medicaid benefits
and enhancing access to behavioral health, while fewer states reported
restricting payments or benefits. At the same time, cost containment and
service delivery reform efforts continue, with states passing or
considering policies to cut drug costs, enhance program integrity, and
expand managed care.
Conclusion
Governors' spending plans for fiscal 2020
reflect stable fiscal conditions and invest significant new resources in
key policy priorities such as education and transportation. After robust
revenue gains led to large budget surpluses in many states in fiscal 2018,
revenue growth was expected to continue but at a slower pace in fiscal
2019. At the time of data collection, more than half of the states were
beating their budgeted revenue estimates for fiscal 2019, and since that
time, many states experienced a positive "April surprise" with
strong growth in income tax collections. This is likely to help even more
states meet or exceed their revenue projections for fiscal 2019. Despite
favorable revenue conditions, governors and other state officials are
mindful that some of the recent revenue gains, especially from non-wage
income, are likely temporary, and therefore are choosing to direct some new
money in fiscal 2020 budgets towards one-time expenditures including paying
down debt and making extra pension fund contributions. State officials are
also continuing to bolster their states' rainy day fund balances in anticipation
of the next economic downturn.
Top Of Page
The Opioid Predicament
Tuesday, May 14, 2019
States and local governments are taking
legal action to recover costs related to the opioid crisis, but potential
litigation awards may not fully account for the budgetary expenditures.
Lawsuits may be able to recoup some governmental outlays for treating addiction
and the social fallout of addiction, but compensation as a result of court
decisions or legal settlements is not likely to substantially affect
government budgets. Compensation will not be as much as provided for in the
1998 tobacco master settlement agreement (MSA), proceeds of which were not
sufficient to significantly impact state and local government credit
quality.
U.S. state attorneys
general launched lawsuits against Purdue Pharma LP for the unlawful
marketing and promotion of its prescription painkillers, including
OxyContin. The attorneys general claim the
Stamford, Conn.-based company engaged in deceptive marketing regarding the
risks and benefits of prescription opioids, fueling the opioid crisis — which caused almost 64,000 overdose-related
deaths in the U.S. in 2016. The lawsuits allege that Purdue minimized the
risks and overstated the benefits of the long-term use of opioids,
downplayed the risk of addiction, and denied or failed to disclose the
greater risks of opioid use at higher doses. Drug overdoses have caused
632,331 deaths in between 1999 to 2016 in the U.S., and out of these,
351,630 were related to opioids, according to the Centers for Disease
Control and Prevention.
Direct and indirect economic loss to
governments from opioid abuse results from decreased productivity, lost
wages, healthcare, substance abuse treatment, social services, and court
and correctional expenses. These costs affect state and local governments
in two ways: by diverting resources from other expenditures, and by
depriving governments of economic growth. A study in the journal Medical
Care by researchers at Pennsylvania State University estimated opioid
misuse reduced state tax revenue by $11.8 billion between 2000 and 2016.
Some expenses are direct and easy to
quantify. For example, Pennsylvania estimates it is spending $5 million a
year on the overdose-reversal drug naloxone. In the case of Middletown,
Ohio, City Councilman Dan Picard estimates that each ambulance run for an
overdose costs the city $1,140, which includes the cost of naloxone and
wear-and-tear on the ambulance. From October 2016 to October 2017,
Middletown answered 916 overdose calls, taking more than $1 million out of
its $30 million annual budget.
But most expenses are harder to measure. These
include such big-ticket items as healthcare, social services, and criminal
justice spending. Medicaid is particularly heavily impacted. It has been
estimated that 3 in 10 non-elderly adults on Medicaid struggled with opioid
addiction in 2015—double
the rate of 2010. In West Virginia, the total number of substance abuse
patients in its Medicaid population more than tripled in just two years to
100,209 in 2017. Kentucky, New Hampshire, Ohio, Rhode Island, and West
Virginia, which have some of the nation's highest overdose death rates, are
likely to see the biggest impact on their finances.
In recent court cases, governments
alleged drug manufacturers, distributors and pharmacies misled the public
on the dangers of opioids, which contributed to opioid overdose deaths,
arguing these parties are responsible for abetting the crisis and related
fallout. Oklahoma recently settled a lawsuit against Purdue Pharma LP for
$270 million in which the state alleged the company aggressively and
deceptively marketed OxyContin. The settlement includes $20 million for
treatment drugs and $12 million to Oklahoma cities and towns. The
settlement is carved out of any potential bankruptcy filing by Purdue.
Thirty-five other states have sued
manufacturers in state courts, in addition to approximately 1,600
independent cases brought by states, counties, cities, tribes, and other
entities, such as unions and hospitals that have been consolidated in a
multidistrict lawsuit in a U.S. district court in Ohio, expected to be
heard in October. Lawsuits were also brought by New York, Vermont, and
Washington against drug distributers Rochester Drug Cooperative, Cardinal
Health, McKesson, and AmerisourceBergen.
The outcome of the federal case may be a
tobacco-style MSA. However, we expect any settlement would result in a
smaller award than the tobacco litigation, which was $200 billion, as
opioids are FDA approved prescription medications, and the sale of opioids
are a small fraction of tobacco product sales. State costs related to the
crisis are believed to be significantly less than the decades of healthcare
expenses incurred by states tied to tobacco usage.
It is unknown how proceeds from any
successful litigation will be allocated. Previous opioid settlement awards
have been spent in various ways and not always directly for the benefit of
those struggling with addiction. This outcome is similar to the MSA, in
which the agreement with states did not specify how proceeds should be
spent, and indeed, tobacco MSA proceeds have been used for many different
purposes.
The U.S. Council of Economic Advisers
estimates the economic cost of the opioid crisis was $504 billion in 2015,
including fatalities from opioid overdoses. However, the effect on
individual states and counties varies widely. The Penn State University study
underscored that estimates of lost tax revenues by state is dependent upon
each state's tax rates and population size. The disparate effect on various
parties will mean the allocation of any settlement proceeds will be
adjudicated based on related effects to the many plaintiffs.
State
Pension Funds
State pension funds have historically
taken stands against controversial industries, like firearms and tobacco,
sometimes divesting their investments to push companies to act. But in the
opioid crisis, which has generated hundreds of lawsuits seeking to hold
manufacturers and distributors accountable, the funds have mostly stayed on
the sideline so far. Some of the biggest ones, including New York and
California pension funds, hold investments in Endo International, the
largest maker of branded opioids after privately held Purdue Pharma LP.
Even in West Virginia, which has been racked by opioid-related deaths, the
state pension fund has a $1.8 million equity stake in Endo.
The opioid investments, to be sure, are tiny
relative to the funds' overall assets. And pension fund members may not
know they are invested in the opioid industry. Many fund investments are
held through indexes, which are passive vehicles. The New York State
Teachers' Retirement System, which manages $122 billion, holds $3.1 million
in Endo stock, 75% through passively held indexes.
Funds including California's and New
York's say they generally oppose divesting from controversial companies
because it does not change corporate behavior. Instead, they say they try
to engage with management through activist measures. The California State
Teachers' Retirement System, CalSTRS, has been
active with a group called Investors for Opioid Accountability, which
represents 54 institutions. New York's fund said it has asked opioid
manufacturers to address potential financial, legal, and reputational
risks.
Still, the opioid epidemic has made for
awkward situations. In Florida, former state attorney general Pam Bondi
filed a lawsuit in late 2018 against more than a dozen opioid manufacturers
and distributors, including Endo. At the time, Bondi sat on the board of
the Florida Retirement System Pension Fund. The fund is invested in both
Endo and Insys Therapeutics, Inc., another opioid
maker that was part of her lawsuit. The attorney general "does not get
involved in the day-to-day operations of the pension fund," said John Kuczwanski, the fund's manager of external affairs.
Unlike the firearms industry, which has
not yielded notable returns in years, Endo was a profitable investment for
nearly a decade, hitting a peak in 2015. It has since fallen dramatically,
falling 24% after OxyContin maker Purdue was reported to be exploring
bankruptcy.
Endo has been open to talking to
institutional investors and recently held a "constructive
engagement" with them, according to a spokesperson. The company no
longer markets opioid products and withdrew one pain product, Opana ER, from the market altogether.
Top Of Page
New York City's
Congestion-Pricing
Friday, April 5, 2019
New York State lawmakers approved a
budget last week that allows for tolls on cars entering midtown Manhattan.
'Congestion-pricing' is slated to begin
at the end of 2020, which may give its opponents time to launch a
counter-attack. Officials still must determine how much drivers will pay to
enter Manhattan south of 60th Street. Also left unanswered: which motorists
might be exempt, and what break, if any, should Manhattan-bound suburban
commuters get after paying stiff tolls for tunnels and bridges.
U.S. Senator Bob Menendez of New Jersey
took to Twitter to suggest that the legislature's budget vote will not
bring an end to efforts to alter the plan. "@GovMurphy
and I agree that the burden of NYC's congestion-pricing is unfairly placed
on the backs of NJ drivers. We already pay enough on tolls to get into
Manhattan. Any more is a double tax on NJans."
While well-established in London, New
York would be the first city in the U.S. to charge drivers for access.
Congestion-pricing is projected to raise $1 billion that could be used to
pay debt service on $15 billion in municipal bonds for New York's
Metropolitan Transportation Authority, which runs the City's subways and
buses and regional commuter rail lines. The plan received praise from
groups as varied as the Environmental Defense Fund, the Regional Plan
Association, the Real Estate Board of New York, Move NY, Uber, and many
other environmental, business, labor, transportation, and civic
organizations.
Kathryn Wylde,
president of the Partnership for New York City, a civic group of corporate
chief executives, hailed the congestion-pricing vote as "a
breakthrough" for management of Manhattan traffic and mass transit. A
study conducted for her group found Manhattan congestion costs the region
$20 billion a year in delays and lost productivity.
For motorists dreading New York City's
planned congestion-pricing fees to enter Manhattan south of 60th Street, an
alternative may seem obvious: just add tolls to the bridges and tunnels
connecting the island to the outer boroughs. Politicians have tried and
failed to do that for decades. The threat of losing voters from Brooklyn
and Queens was enough to stop forward progress in the City Council. Another
worry: that any money the City reaped from bridge tolls might merely
encourage state lawmakers to cut funding for the spans' upkeep and repairs.
The congestion-pricing plan would avoid
that political tangle, raising billions for transit and reducing traffic
without imposing tolls on those spans.
The latest congestion-pricing plan will
set up electronic devices on the periphery of a zone south of Manhattan's
60th Street to identify and charge all entering vehicles and assess a
once-daily charge. The exact hours and amount of the tolls -- and who will
be exempt -– will
be decided by a yet-to-be appointed board before the program begins at the
end of 2020. Though a study last year proposed flat daily charges of about
$11.50 for cars and $25 for trucks, the budget passed last week did not
specify fees.
New Yorkers do not seem excited about the
prospect. The City's voters oppose congestion-pricing by 54-to-41 percent,
according to a Quinnipiac University poll, even though traffic is a near
universal complaint and most think the subways are not in good shape.
Commercial truckers want out of the City's congestion-pricing. So do
advocates for the disabled, taxi drivers, and swaths of the suburbs.
Bondholders should be pleased, however,
as the congestion charge will raise revenue to support as much as $15
billion of debt for the Metropolitan Transportation Authority. That is
positive for the credit ratings of the MTA, New York City, and New York
State. The new revenue helps resolve uncertainty over the future of the
MTA's funding, which has weighed on both the city and state governments.
It will provide the MTA, which faces a
substantial deferred maintenance backlog, a significant funding injection
for critical infrastructure investment and service improvements, and will
improve the competitive position of the Agency's subways, buses, and bridge
and tunnel crossings.
This could be a historic moment in New
York City and the U.S. in terms of adopting new strategies that will reduce
congestion and help improve crumbling infrastructure. Other cities in the
nation are watching New York. Two Massachusetts lawmakers are sponsoring
legislation to require traffic studies and start congestion pricing at
Boston's heavily traveled Sumner Tunnel, which sends travelers through East
Boston to Logan Airport. The average Boston driver lost 164 hours to
congestion in 2018, according to Inrix, a
transportation analytics company that ranked Boston the most
traffic-clogged U.S. city. Two weeks ago, the Southern California
Association of Governments called for a test of "Mobility Go
Zones," which it says could cut travel time by 24 percent during peak
hours and raise almost $70 million a year. In Seattle, officials are
awaiting study results after Mayor Jenny Durkan
suggested congestion pricing there.
Top Of Page
1st Quarter 2019 Review and
Outlook
Monday, April 1, 2019
Strong returns were prevalent for
municipal bond investors in the first quarter as global growth downshifted
and the Federal Reserve backed away from further tightening of monetary
policy. Demand for municipal bonds continued to rise as the quarter progressed
and investors became acutely aware that changes to the state and local tax
(SALT) deduction made the tax-free nature of this asset class more
appealing. Investors in three high tax states in particular (California,
New York, and New Jersey) had periods of chronic shortages of bonds to
consider, as demand could almost be characterized as insatiable. Without a
doubt, it seemed that some uncomfortable conversations with investors'
accountants were occurring throughout the country. Unless there is a radical
change in tax policy (unlikely in our view), one should assume that the
demand for tax-free bonds will remain omnipresent.
Fed Blooper: Jerome Powell Meet Jim
Marshall
In October 1964, famed Minnesota Viking
defensive end Jim Marshall picked up a fumble and raced over sixty yards
into the wrong end zone, resulting in two points for the opposing team.
"It'll be a hard thing to live down," said Marshall at the time.
We feel the same way about the Federal Reserve's decision in December 2018
to once again raise interest rates. In fact, on December 19th, we tweeted:
"With today's hike in rates by the Federal Reserve,
Miller Tabak Asset Management now believes
monetary policy is slightly RESTRICTIVE. The "pancake" watch is
on, as the yield curve will flatten further or perhaps invert."
Well, right on cue, the yield curve flattened further during
the first quarter and ended inverted, much to many bankers' dismay. Besides
recognizing that the Fed does not follow us on Twitter, it became quite
apparent to us and the market that future growth will be challenged as the
incentive to lend becomes compromised by an inverted yield curve. While the
Fed seemingly recognized their mistake by softening their hawkish tone, in
our view, it's going to be very difficult for them to lower rates anytime
soon for fear of being seen as acquiescing to political pressure from
Washington D.C. With this in mind, investors may be surprised by how much
further long-term interest rates decline.
As a firm that spends a predominant
amount of our time shopping for bonds in the secondary market, we still see
excellent value in certain pockets of the tax-free bond market. Lingering
inflation phobia has created a distortion in the valuation of lower coupon
bonds that we will continue to take advantage of, should this condition
persist. The upcoming summer months will be a cranky time for those with
cash to invest as the technical condition is quite favorable to the
municipal bond asset class during this time.
While Jim Marshall's blunder lives on in
NFL football lore, his team did come back and ultimately win the game.
Let's hope for the sake of the U.S. economy that the members of the Federal
Reserve strap on their helmets and start heading to the correct end zone.
Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak
Top Of Page
The Impact of an Aging U.S.
Population on States
Friday, March 8, 2019
Societal aging in the United States is
expected to accelerate over the next twenty years as population growth
slows and the baby boomer generation reaches retirement age. While there
will be marked variation between states, general demographic trends point
to more aging and slower working-age population growth in almost every
state.
A state's high median age can develop
through aging of the existing population, out-migration of younger
residents, or in-migration of older residents.
Aging demographics and slowing or
declining working-age populations is expected to constrain GDP growth. As
state budgets largely rely on income and sales taxes, slower economic
growth will be clearly linked to slower revenue growth. Concurrently, state
expenditures will face greater pressures from higher healthcare and
retirement cost demands. Boomers will be earning less, requiring more
services, drawing Social Security checks, and moving to downsized housing
with property accessorized for older residents.
MTAM sees the U.S. population aging at a
rate that will hurt revenue growth for states over time, particularly for
several states that will be "super-aged" within a decade. The
over-65 population in 17 states is expected to
eclipse 20% (or what the United Nations refers to as
"super-aged"). This is a somewhat surprising statistic
considering that no state was deemed "super-aged" as recently as
two years ago. A closer look also shows that several other states will be
within striking distance of "super-aged" status by 2026.
This rapid increase in aging populations
will affect the finances of state governments in two general ways. First,
the working-age population shrinks as the population ages, constraining
economic and revenue growth. Second, a rapidly aging demographic profile
changes a state's expenditure profile as expenses related to healthcare and
retirement cost grow.
Among the 17 states that will have
"super-aged" populations by 2026 are Florida, Connecticut,
Michigan, Ohio, and Pennsylvania. Additionally, New York, New Jersey, and
Illinois are among some of the other states that will fall just short of
"super-aged" status less than a decade from now. Smaller states
such as Maine, Vermont, New Hampshire, and West Virginia are forecast by
the Census Bureau to have the highest percentage of population aged over 65
by 2026. They are also likely to continue to be among the states with the
largest working-age population decline.
Economic growth is a function of growth
in working-age populations, labor utilization, and labor productivity. As
such, there is potential for better labor utilization and productivity
growth to offset the decline in working-age populations.
With several states facing declines in
working-age population in the coming years, improvements to labor
utilization and productivity could help stem the prospect of falling
revenue growth. Economic growth prospects for many states with negative
demographic trends will likely hinge on improvements to labor productivity.
However, the median state labor
utilization rate for the past decade has been flat and greater labor market
participation rates for over-65s is projected by the Census Bureau to be
offset by lower rates in the 16-24 age group. Productivity growth could be
more promising and is likely to offset at least some of the negative
long-term labor force trends. But the outlook remains highly uncertain and
variable across states.
Immigration could play a pivotal role in
slowing the pace of U.S. aging. Net positive international migration will
likely mitigate domestic out-migration in many states. Immigrants tend to
be younger than the native-born population and so provide an immediate
boost to the working-age population. Notably, positive net international
migration should remain a key factor offsetting net negative domestic
migration in states such as New York, Illinois, New Jersey, Pennsylvania,
Massachusetts, and Rhode Island. However, a more restrictive national
immigration policy environment would likely accelerate population and
working-age population declines in these states.
Conclusion
All U.S. states except Utah are projected
to see growth in their 65-and-older population concentration, and
contraction in their prime working-age adult concentration. Those states
unable to adapt tax and expenditure policy to address these demographic
changes are likely to face revenue shortfalls over the medium- and
long-term.
With the most aged population in the
country, the Northeast may experience revenue shortfalls from aging
demographics earlier than other parts of the nation, while long-range
population projections suggest parts of the U.S., such as the Sunbelt, have
less exposure to demographic shifts than those of already older-aged
states.
MTAM views forward-looking financial
planning as fundamental to strong fiscal management. We believe
incorporating demographic trends into financial planning is an important
factor for states to consider since relying on historical revenue analysis
alone could prove insufficient to predict future revenues. As the
population continues to get older, states will need to consider the
effectiveness of their revenue and expenditure policies to adapt to
demographic headwinds.
Top Of Page
Planned PG&E Bankruptcy
and Its Impact on California
Friday, January 25, 2019
PG&E Corporation announced last week
that it intends to file a petition for Chapter 11 bankruptcy protection on
or about January 29, 2019. MTAM believes that PG&E Corporation's
planned bankruptcy filing is not likely to adversely affect the credit
quality of the State of California, its local governments, or
publicly-owned utilities (POUs).
California's biggest utility owner faces
$30 billion in potential wildfire-related liabilities, and its bankruptcy
plan has reverberated across the power industry. Investigators are probing
whether PG&E's equipment ignited the 2018 Camp Fire, the deadliest and
most destructive in California history, which killed 86 people. Lawmakers
including newly installed Governor Gavin Newsom have made it clear they
have little desire to intervene with a bailout for the company, at least
not until it actually has gone bankrupt.
On a positive note, on Thursday, PG&E
was cleared of blame for the deadly 2017 Tubbs Fire. And yet the company
has given no indication that it is changing course. The finding by the
California Department of Forestry and Fire Protection could reduce PG&E's
projected $30 billion in liabilities from 2017 and 2018 wildfires by $17
billion. But some analysts were giving smaller estimates – closer to $8 billion - and PG&E said
in a statement that it still faces "significant potential" costs.
The Tubbs fire that the company's
equipment was cleared of igniting was the second-most-destructive blaze in
state history, destroying thousands of homes and killing 22 people. Whether
the report will be enough to save the company from insolvency remains to be
seen. The 2018 Camp Fire remains a major financial concern for PG&E,
and the company may still want to push its liability issues into federal
jurisdiction in bankruptcy court.
The utility provides power to 16 million
natural gas and electric customers over 70,000 square miles in northern and
central California, and is among the largest taxpayers in several cities
and counties.
The planned bankruptcy filing reflects
the impact of potential substantial wildfire-related liabilities without a
clear path to timely recovery of such costs under California law.
California applies the doctrine of inverse condemnation to privately-owned
utilities. Inverse condemnation typically holds governmental agencies
responsible for compensating property owners for the damage to or taking of
property by the government.
Our analysis of the potential impact on
the State of California and its local governments indicate minimal threat
to revenues and financial operations. If the utility were unable to emerge
from a bankruptcy, the State would likely step in in some fashion to ensure
service continues without interruption. We expect that either rates (if
PG&E emerges from bankruptcy) or taxes (if the State steps in and the
utility assets become non-taxable, which would likely take several years)
would have to increase to fund legal liabilities. In either scenario, the
increased cost of running the utility would not be enough to affect either
the State's ability to remain economically competitive or its credit
quality. We also do not foresee a meaningful impact on employment or
earnings as the utility would continue to function in some form.
We assume that as a regulated utility,
PG&E will continue to provide service and be required to pay property
taxes throughout a Chapter 11 bankruptcy as it did during its 2001-2004
bankruptcy. According to the company website, PG&E paid $462 million in
property taxes and another $137 million in franchise fees in the tax year
ended June 30, 2018 to the 50 counties and 247 cities in which it owns and
operates infrastructure throughout the State.
Several local governments have PG&E
as a major taxpayer. The largest are San Luis Obispo County, in which
PG&E is the largest taxpayer at 5% of assessed value (AV) in fiscal
2018 and Fresno County, in which PG&E (also the largest taxpayer) makes
up 3% of AV in fiscal 2017 (latest data available).
San Luis Obispo County reports it
received $10 million in property taxes from PG&E in fiscal 2018 (2% of
governmental revenues). Even if PG&E failed to pay any property taxes
going forward or the assets in the county eventually became non-taxable, we
do not believe such a loss would affect San Luis Obispo County's credit
quality. The county retains solid expenditure flexibility and the highest
gap-closing capacity with $260 million in unrestricted fund balance (52.5%
of spending) as of the end of fiscal 2018. PG&E AV in San Luis Obispo
County is comprised mainly of the Diablo Canyon Nuclear Power Plant.
PG&E plans to close the plant by 2025. In September 2018, the Governor
of California signed legislation directing the PUC to fully fund a
community mitigation settlement meant to soften the decrease in taxes.
If PG&E failed to pay property taxes
to Fresno County or the assets became non-taxable, we estimate the impact
would be even smaller at 0.5% of governmental revenues based on 3% of the
$255 million (17% of governmental revenues) in property taxes the county
received in fiscal 2017. The county retains solid expenditure flexibility
and adequate gap-closing capacity to address a moderate revenue decline.
The county had $157 million in unrestricted fund balance at the end of
fiscal 2017, equal to 12% of spending.
Total fiscal 2017 license, permit and
franchise fee revenues from all payers in San Luis Obispo County were $11
million, or 2% of governmental revenues; franchise fee revenues were $17
million or 1% of governmental revenues in Fresno County.
In California, all counties are
responsible for assessing and collecting property taxes. Most local
California jurisdictions are guaranteed 100% of their property taxes by
their respective counties under a tax distribution plan known as the
"Teeter Plan". The Teeter Plan requires participating counties to
establish a tax loss reserve fund, used exclusively to cover losses
occurring on tax delinquencies. All delinquent payments and penalties
collected are deposited into the tax loss reserve fund. While counties can
choose to disallow Teeter Plan payments to localities experiencing high tax
delinquencies, it is unlikely they would do so for major issuers such as
cities and school districts. Thus, if a PG&E bankruptcy interrupts its
tax payments, most of the credit impact will be felt at the county level.
However, we believe an interruption in PG&E's tax payments would not
diminish most counties' creditworthiness.
MTAM will be monitoring the affected
counties to determine whether any delays in full and timely tax payment
result in any adverse credit effects. During PG&E's last bankruptcy in
2001, we observed at the time that the company did not initially make its
full property tax payments to multiple counties in the State. However, we
only noted minimal credit impacts at that time.
California's POUs are not expected to see
material erosion in credit quality as a result of PG&E's ongoing
financial and legal challenges. That said, issues driving PG&E's
current challenges, the State's wildfire risks, and California's inverse
condemnation rules remain a long-term risk for the State's POUs. A
potential PG&E bankruptcy should be manageable for POUs in the short to
medium term due to the nature of the relationship between most POUs and
PG&E, POUs' generally healthy liquidity levels, and the market and
operational constructs within the State.
POUs have many connections to PG&E,
ranging from physical interconnections between systems, joint projects,
operational agreements, and others. However, POUs have few direct contracts
with PG&E for power supply and generally are not reliant on
PG&E-owned generation to meet their system loads. Potential slowdowns
in PG&E projects, some of which are joint projects with POUs, could
result in delays and additional costs. However, we view them as unlikely to
significantly impact POU credit ratings. Indirect effects from a potential
PG&E bankruptcy include market volatility that could increase the cost
of purchased power for some POUs and, longer term, potential changes in
market tariffs or operational rules and financial requirements that could
increase the cost of operations. At this point, we do not expect potential
rule changes to materially affect POU cost of operations.
Top Of Page
Credit Comment on the State
of California's Latest Budget Proposal
Thursday, January 24, 2019
The State of California continues to
enjoy its highest credit ratings (Aa3/AA-/AA-) since the turn of the
century, primarily due to last year's record-setting stock rally, a
resurgent real estate market, and a Silicon Valley boom that swept away
once crippling budget deficits.
MTAM sees California Governor Gavin
Newsom's proposed budget as a credit positive, as the newly inaugurated
head of the most-populous U.S. state indicates he may follow the
conservative fiscal management of his predecessor, Jerry Brown. Governor
Newsom's budget has eased our concerns to a large extent given that it
seems responsible in most respects.
The $13.6 billion allocation to budget
resiliency and paying down unfunded liabilities is key in preparing the
State for an economic downturn. The one-time nature of increased funding is
viewed favorably as it keeps the State's budget more flexible heading into
uncertain economic times.
California's revenue is volatile because
it draws a large share of taxes from wealthy residents whose incomes are
tied closely to the stock market, which saddled the State with huge budget
deficits after the Internet and real estate bubbles burst. The top 1% of
earners accounted for nearly half of the State's personal income tax
collections in 2016. Voters in November 2016 approved a 12-year extension
of higher tax rates on the wealthy, deepening the reliance on their
fortunes.
There is some volatility and some risk
that California has that other states do not. In periods of economic
growth, the State is going to outperform; in periods of recession, the
State is going to underperform. State officials' ability to mitigate those swings
is going to be manifested through their budgeting practices.
2019-20
Budget Details
Governor Newsom proposed a $144 billion
budget for the State of California last week that pays down pension debt
and other liabilities, pads the rainy-day fund, and directs money to health
care and education.
Newsom's first spending plan since taking
office is a 4 percent increase from the current year. The budget will be
revised in May and then must be approved by legislators. What has helped
Newsom's budget-making: an overall surplus that has grown to more than $21
billion. The nonpartisan Legislative Analyst's Office in December had
estimated a $15 billion surplus. The amount grew largely because Medicaid
costs were less than expected. Buttressed by a $1.8 billion payment, a
voter-mandated rainy-day fund would reach $15.3 billion next year (an
estimated 10 percent of fiscal 2019 revenues).
The budget also allocates $3 billion to
pay down the State's unfunded liabilities to the California Public
Employees' Retirement System and an extra $1.1 billion to the California
State Teachers' Retirement System. In addition, Newsom would give $3
billion to school districts to help reduce their unfunded Calstrs liabilities. This would provide immediate
relief and reduce their contribution rates by half a percentage point,
according to budget documents. Many California school districts face
significant financial obstacles partly because of rising retirement costs.
The budget would also direct $2.4 billion to pay off internal debts from
outstanding loans to special funds and transportation accounts extended
when the State was in fiscal straits.
Other key areas of the budget include:
doubling the size of State's earned income tax credit to $1 billion; extend
the State's Medicaid coverage to undocumented young adults; expand
subsidies under the Affordable Care Act to provide financial assistance to
individuals earning up to $72,840 and families of 4 earning up to $150,600;
phased in expansion of pre-kindergarten and full-day kindergarten; and $1.4
billion for higher education, including higher enrollment, tuition freezes,
and two full years of free community college.
Governor Newsom did not campaign on
bolstering public pensions, but they figure prominently in his first
budget. In the spending plan for the fiscal year beginning in July, he
proposed making an extra $3 billion payment to the California Public
Employees' Retirement System to pay down what the State owes to the fund --
a debt that grows each year. That is on top of the $6.8 billion
contribution California is required to make to the nation's largest public
pension.
By trying to pay off as much of the
unfunded liabilities up front, the State could collectively save about
$14.6 billion over 30 years. That is because unfunded liabilities grow at
the same rate as the pensions' expected investment returns, which
compensates the funds for gains they would have received if the money had
been used to buy stocks and other assets.
Newsom, in a Sacramento briefing four
days after assuming office, called the additional funding an historic step.
His predecessor, Jerry Brown, was the first in 2017 to propose an extra Calpers payment, though his $6 billion infusion relied
on a loan from an internal investment account, not on general-fund budget
dollars.
The moves continue the work under Brown
to curb the growth in California's prodigious pension and retiree health
liabilities, which tally $256 billion, budget documents show. Even as
California enjoys rising revenue and surpluses amid an economic boom,
pressures to meet promises made years ago continue to mount. The required Calpers payment for the next fiscal year is more than
double the amount a decade ago.
Addressing
California Wildfires
Governor Newsom announced a series of
proposals and signed two executive orders related to wildfire risk
abatement and remedy throughout the State. Part of the governor's proposal
includes backfilling lost property tax revenue in Butte and Lake counties,
due to the recent wildfires in the area. While the State has backfilled
property taxes associated with fire losses in the past, they have been on
an annual basis, while the governor's proposal would span three years. We
would view a multi-year commitment as a credit positive for the affected
tax bases.
We also view the proposal as further
indication of the State's strong support for local governments affected by
wildfires, which could improve our view of these governments' ability to
maintain their credit quality. When property taxes were previously
backfilled on an annual basis, local governments were susceptible to
revenue declines if the State failed to provide funding the next year.
Should the Legislature adopt the governor's multi-year pledge, this may
improve our outlook on affected communities' performance by providing
additional assurances that they will be supported over the medium-term.
However, we note that these funds would need to be appropriated annually,
which the State may not elect to do during an economic downturn, and
evidence suggests that wildfire risk is growing.
Also announced during the press
conference was the governor's plan to seek legislative approval for $300
million in wildfire prevention-related spending. Roughly two-thirds of the
funding would be for the removal of combustible vegetation (with an
additional $800 million spent over the following four years), while the
remainder would be used for hiring additional firefighters, purchasing fire
engines, and improving the State's 911 network.
Top Of Page
Municipal Bond Market – Credit Outlook for
2019
Friday, January 18, 2019
Municipal bond issuers will continue to
face several credit challenges in 2019, but MTAM expects that the vast
majority of municipalities will successfully manage through most
difficulties with a combination of spending cuts and revenue enhancement
plans.
Notwithstanding the challenges facing
municipal bond issuers, there are always good opportunities, even for the
very conservative investor. Despite our expectations for modest levels of
economic growth, we still expect defensive credits like water and sewer
bonds, special tax bonds, and public power bonds to perform better from a
fundamental perspective. These types of bonds tend to have revenue streams
that are less subject to economic volatility, have strong covenants, or are
tied to an "essential service", making debt service payment more
certain. In addition, there is legal precedence that bonds backed by a
dedicated revenue stream may be protected in the case of a municipal
bankruptcy. We prefer bonds that have a clean flow of funds, broad revenue
streams, and high debt service coverage tests.
The ongoing federal government shutdown
should not have a significant impact on U.S. public finance credits. The
partial shutdown is only affecting approximately 20 percent of the federal
government, and funding critical to public sectors remains in place.
However, there are risks of localized economic effects in areas with large
concentrations of federal employees, and the potential for credit risks
will grow the longer the shutdown continues. In addition, the political
deadlock in Washington is a negative signal for federal policymaking that
could have longer-term implications for states.
State
Governments
U.S. state governments are up against
numerous potential headwinds heading into 2019, though revenues should
continue to grow so long as the broader economy continues its upward
trajectory. MTAM has a stable
outlook for U.S. state government ratings for 2019 thanks largely to the
sector's overall strengths - broad economies and tax bases and substantial
control over revenue raising and spending. The debate in most states will
be around whether to allocate additional revenues to spending priorities or
tax reductions. That said, developments in some states could affect their
rating performance in the coming year.
Federal government action remains the
biggest risk for U.S. state government ratings, though a House/Senate split
following the midterm elections has alleviated some concern. Medicaid
spending will remain one of the largest fiscal hurdles of state budgets
despite an expected near-term respite from congressional attempts to
fundamentally restructure the program.
While Medicaid is likely at or near the top
of the priority list of items state governments will be focused on, the
inadequacy of current transportation funding remains a concern for state
policymakers. Interestingly, infrastructure funding seems a potential area
of bipartisan agreement on the federal level at a time of divided
government.
Most states will be debating budgets this
year, at a time of many new governors and state revenues that have become
more difficult to forecast. MTAM rates to fundamentals rather than the
political cycle, though a material change in fiscal policy could become a
credit issue, particularly if economic conditions deteriorate notably.
Focusing on the lowest-rated U.S. state,
Illinois, J.B. Pritzker has been sworn in as Illinois's new governor,
taking over for a Republican predecessor whose term was marred by struggles
with the Democratic-led legislature over unpaid bills, pension debt, and
chronic budget shortfalls that left the state's bond rating on the cusp of
junk.
The election of Pritzker, a 53-year-old
Democrat, promises to put an end to the partisan gridlock that gripped the
state for much of the past four years under Governor Bruce Rauner, a businessman whose agenda was opposed by
legislative leaders. The clash blocked efforts to address Illinois's
swelling pension debt and resulted in a two-year standoff on the budget
that was resolved only when Democrats enacted tax increases over his veto
in mid-2017. The resolution of that fight eliminated the risk that Illinois
would soon be the first state whose bonds were cut to junk, sharply
reducing the extra interest that bondholders demand from the state.
Pritzker's transition team previously
said that a balanced budget is the "top priority". The state's
budget proposals are released early in the year so it can be finalized
before the new fiscal year begins in July. During his campaign, Pritzker
advocated for a graduated income-tax and the legalization of marijuana to
generate revenue. While a graduated income-tax is the norm in most states,
Illinois has a constitutionally-protected flat tax, which would require a
voter-approved amendment to implement. One of the state's biggest financial
strains is its debt to the workers' retirement funds, which is the third
worst in the U.S. behind Kentucky and New Jersey, according to data
compiled by Bloomberg. Just 38 percent of its $222.3 billion in total
pension obligations are funded. MTAM will be closely monitoring the state's
progress in addressing its fiscal challenges in 2019.
Local
Governments
Our outlook for U.S. local governments
remains stable
for 2019 as property taxes and total revenue growth should increase
moderately. We project 2%-3% growth in property tax receipts in 2019,
adjusted for inflation, due in part to steady, but restrained, economic
growth through the end of 2019. Operating revenue should continue to grow
by approximately 3 percent in 2019, while personnel costs will drive
expenses.
The stable outlook is underpinned by the
largely steady and predictable growth in property taxes over the outlook
horizon. In addition, most cities, counties, and school districts have
financial flexibility from healthy fund balance reserves to face unforeseen
challenges.
Differences in revenue composition
determine varying risk profiles for local governments, with sales
tax-dependent entities most exposed to the potential for a rapid change in
economic conditions.
Many local governments have also handled
challenges well, including growing pension costs, uncertain or weak state
funding, exposure to federal policy changes, climate shocks and changing
demographics.
Not-for-Profit
Hospitals
MTAM continues to have a negative outlook
on the not-for-profit healthcare and hospital sector for 2019. The outlook
reflects our expectation that operating cash flow in the sector will be
flat or decline, and bad debt will rise this year.
Operating cash flow will either remain
flat or decline by up to 1 percent in 2019. Performance will largely depend
on how well hospitals manage expense growth. We expect cost-cutting
measures and lower increases in drug prices to cause expense growth to slow
in 2019. However, expenses will still outpace revenues due to several
factors, including the ongoing need for temporary nurses and continued
recruitment of employed physicians.
Hospital bad debt is expected to grow
8%-9% this year as health plans place greater financial burden on patients.
An aging population will increase hospital reliance on Medicare, which will
also constrain revenue growth.
Volumes generally are still stable,
despite decade-long pressures and overall trends to reduce inpatient
admissions. Reasons vary and include simple population growth in many
markets, and the effective capture or stealing of market share from
competitors.
Recently, managed care contract
negotiations have become more adversarial as providers look to greatly
offset the impact of comparatively weaker governmental payment through
their commercial contracts. Volume impacts and bad debt impacts are
expected from the continued shifting of healthcare costs by employers onto
employees through high-deductible health plans.
An improved U.S. economy and falling
unemployment rates have caused labor markets in most areas to tighten,
resulting in overall pressure on salary and wages. Competition for
clinicians in most markets has increased due to the movement toward
population health management and a growing focus on chronic disease
management.
Large-system providers still have a
longer-term goal of cutting billions of dollars from their expense bases
through a combination of "basic" cost-cutting (efficiency),
clinical efficacy (waste elimination), and a rethinking of how health care
is delivered (transformation) to become break-even or better on Medicare
rates. Most large-system providers have the resources available to allow
ongoing focus on improving both clinical and nonclinical efficiencies to
help offset the impact of compressed commercial rate increases and little,
if any, net rate increases from Medicare and Medicaid. In contrast, small-system
providers are less able to trim expenses or to negotiate higher rates from
commercial insurers as a must-have provider in their markets.
We expect healthcare systems will
continue to focus on increased size, scale, and geography to enact a
practical long-term strategic plan for each specific market. As such,
consolidation and alignment activity is expected to continue. MTAM believes
that size and scale alone do not necessarily result in success, but
consolidation is a logical outcome, given CMS's value-based payment models,
growing Medicare and Medicaid populations, increasing wage pressures and
what we view to be a more adversarial managed care contracting environment.
Transportation
Volume growth remains favorable for
airports, ports, and toll roads and should continue to track close to U.S.
GDP growth rates for the foreseeable future. That said, external factors
like protectionist trade policies, rising interest rates, and volatility in
fuel prices bear close watch.
Stiffer tariffs and trade policies may
start affecting transportation activity. This will leave some ports with
higher exposure to commodities that are vulnerable to some performance
volatility. These disruptors, however, will not be enough to impair volumes
overall, which are still trending at above-average levels.
As interest rates rise, so will the cost
to fund new infrastructure projects. Large, greenfield projects with
lengthy construction periods may face continued execution risks that could
delay overall progress of the project during the construction phase. The
transportation sector's abundance of fixed-rate debt, however, should keep
interest rate increases largely at bay.
Gas prices have been on a steady upward
trajectory over the past several months, which has led to a sizable decline
in vehicle miles travelled (VMT) for most toll roads throughout the
country. Although gas prices have levelled off somewhat of late, VMT growth
may be weighed down next year if gas prices begin increasing again.
More specifically, MTAM's 2019 sector
outlook for U.S. airports remains positive,
reflecting strong enplanement growth driven by continued economic expansion
and additional seat capacity added by U.S. airlines. Growth in enplanements
– the
number of passengers using an airport to depart on a flight – generally translates into higher parking
and terminal concession revenue.
We expect aggregate enplanement growth of
3.2 percent in 2019. This represents a slowdown from the 5.4 percent growth
seen in 2018, but is still above our threshold for maintaining a positive
outlook on the sector. Smaller airlines, such as Spirit and Frontier, will
continue a multi-year trend of increasing capacity by at least 10 percent.
Airports in the Southern and Western
regions of the U.S. will continue to experience stronger enplanement growth
than the rest of the country, mirroring demographic trends. Growing,
younger populations support growth in demand for travel, and airports like
the Austin (City of) TX Airport Enterprise and the Boise (City of) ID
Airport Enterprise are well positioned due to their young urban bases.
Increased use of ridesharing services
like Uber and Lyft has had a negative impact on parking and ground
transportation revenue at airports across the U.S., but airports have
adapted by collecting pickup or dropoff fees to
keep overall collections stable. Looking ahead, MTAM believes that emerging
technologies will allow for more effective fee collection and provide
increased revenue generation.
MTAM's 2019 sector outlook for U.S.
public ports is stable,
given healthy cargo and cruise demand. The benefits of continued domestic
and global economic growth (albeit moderating) are balanced by a weak ocean
shipping sector and heightened trade protectionism, which constrains ports'
pricing ability and weakens cost recovery for capital investments.
We expect that shipping container volume
at U.S. public ports will increase 2%-3% in 2019. Consumer demand will also
drive growth in cruise activity as all major cruise lines significantly
expand their capacity.
Tempering the positive effects of this
growth is the still fragile financial state of the container shipping
industry, which will significantly constrain the prices that ports are able
to charge. In addition, consolidation among container shipping lines has made
shipping companies more effective at curbing price increases.
Amid pricing pressures for U.S. ports,
recent or planned capital spending continues to exceed 100 percent of
operating cash flow for the sector in the aggregate, and is likely to
exceed 150 percent in 2019. The sector will remain dependent on new borrowing
and federal and state funding to finance capital investments, and the
benefit of healthy container volume activity will be tempered by higher
debt service costs and capital outlays.
The deceleration in domestic and global
growth comes against a backdrop of rising trade protectionism, and without
a major change in sourcing or a de-escalation of the U.S.-China dispute,
cargo owners will face higher prices on a wider range of products in 2019.
MTAM would consider changing its outlook on the U.S. public ports sector if
expected container volume growth were to decelerate below 1 percent over
the next 12 to 18 months.
MTAM's 2019 sector outlook for
government-owned toll roads is stable
reflecting the expectation of a continued leveling out in traffic and
revenue growth. The traffic and revenue trends are underpinned by the
expectation that the economy will enter a slower late-stage expansion at
full employment, and that gas prices will continue to gradually rise from
their 2015 lows.
We expect traffic growth of 1.5%-2.5% and
revenue growth of 3%-4% for toll roads in 2019. Toll rate increases,
bolstered by the growing use of tolling indexed to inflation, will also
support revenue growth. Currently, 52 percent of toll roads have enacted
increases indexed to inflation. We also view the implementation of
electronic toll collection systems positively, as they allow greater
flexibility to make refined rate adjustments.
Traffic and revenue growth will continue
to be strongest for new or startup toll roads, as well as those located in
expanding urban or urbanizing centers where they can serve as congestion
relievers. Most toll roads built since 2005 are located in densely
inhabited, rapidly growing areas with population and income growth above
the U.S. average.
The Grant Anticipation Revenue Vehicle
program, which allows states and mass transit entities to issue bonds
backed by anticipated federal funds, will face increased risks in the next
two years as legislation supporting U.S. transportation spending expires in
September 2020. The Federal Highway Fund, which backs GARVEE bonds,
continues to collect less in revenue than it pays out in grant
disbursements. Given the vital importance of transportation infrastructure,
Congress is likely to address these challenges, but the process is likely
to be fraught with uncertainty and delays. The federal government shutdown
is not likely to impact GARVEE bonds since most of the debt service is at
the middle or end of the U.S. fiscal year.
Water
and Sewer
MTAM is maintaining a stable outlook on
the U.S. water and sewer sector for 2019. The sector's strong fundamentals
are underpinned by the essential service provided to users, monopolistic
business nature and high barriers to entry. Additional positive features
are low price sensitivity, strong liquidity and independent local rate
setting authority. These factors insulate the sector to some extent from
economic cycles. However, persistent droughts and overregulation could
reduce financial flexibility for certain issuers.
The Water Infrastructure Act will
facilitate $4.4 billion in federal funding to the state revolving funds
over three years. This should help local issuers' access low cost financing
as they face aging infrastructure. Additionally, the Act allows the
Environmental Protection Agency to provide low-interest loans to cover up
to 49 percent of large infrastructure and water reuse projects, with
utilities or states responsible for the remainder.
Current rates are affordable. However,
rates may continue to rise faster than inflation as infrastructure needs
mount. Many water and sewer authorities having aging infrastructure and
need funding to meet EPA mandates. This, along with population growth,
continues to drive capital investment.
Post-recession, debt service coverage and
liquidity levels have trended upward. This has supported the balance sheets
of water and sewer utilities. We expect fiscal stability to continue in
2019.
Public
Power
MTAM's 2019 sector outlook for U.S.
public power electric utilities is stable,
reflecting a strong fundamental business model. We expect that utilities
will display stable to modestly improving financial metrics, supported by a
steady business environment and the self-regulated ability to set
electricity rates to pay debt service.
Our stable outlook also reflects the
industry's self-regulated cost recovery mechanisms, sound financial
metrics, and competitive product. The willingness and ability to set retail
electricity rates is a fundamental credit strength of public power
utilities, and serves as the key indicator for our sector outlook.
Challenges for public power utilities
include the continued transition to clean energy, cybersecurity risks, and
lower electricity demand. However, we are confident in the sector's ability
to adapt given its strong business model. We expect that the sector's fixed
obligation charge coverage ratio will remain strong in 2019 and fall in the
1.80x to 1.90x range. Days liquidity on hand and debt ratios should also
remain stable in the coming year.
Despite easing enforcement of federal and
some state environmental policies, MTAM expects public power utilities to
forge ahead with clean energy and carbon reduction strategies. Absent
significant federal policy, most of the legislative actions on carbon
reduction will occur at the state level. States including California and
New York view utilities as the primary lever for implementing ambitious
renewable energy mandates.
While the sector is taking an
increasingly proactive stance on training to comply with federal cyber
security standards, cyber breaches remain a growing risk given increasingly
digitized and interconnected infrastructure.
Colleges
and Universities
MTAM is revising our higher education
sector outlook for 2019 to
negative from stable based on various industry challenges
which are increasingly pressuring U.S. colleges and universities.
Perhaps most prominent are operating and
revenue pressures, which stem from increasing constraints on tuition growth
and more challenging demographic and competitive markets than seen in prior
years. Increasing competition for students and heightened scrutiny over the
value of a college education have suppressed overall tuition growth since
the recession.
The regulatory environment is not likely
to add much clarity. The Higher Education Act (HEA) is still in limbo, and
the newly elected Congress is not likely to consider reauthorization.
Unexpected policy decisions that constrain access to student loans, Pell
grants, or to research funding could create pressures across the sector.
Consolidation is likely to accelerate in
2019 and beyond, which may take multiple forms. Smaller private
institutions remain most susceptible to consolidation either through a
merger, affiliation with another larger institution or in the most serious
scenario, outright closure.
Substantial headwinds aside, the higher
education sector as a whole still retains key fundamental strengths
including significant flexibility and fortitude in the face of operating
and financial pressure. Many institutions maintain sufficient liquidity,
and have been proactive and agile with regard to strategic management,
targeted revenue growth and diversity, expense management, and pursuing
partnerships for mutual benefit.
Housing
MTAM is maintaining its stable outlook for
the U.S. state housing finance agency (HFA) sector for 2019 as margins
tighten. Increased issuance will cause HFA margins to soften to 11 percent,
but the rise in on-balance sheet, full-spread mortgage loans will provide a
stable, recurring revenue stream. More bond issuance will drive an increase
in issuance costs and a decline in loan sale revenue; however, these
negative effects will be offset by the stabilized revenue streams from the
new loans. Additionally, many HFAs are choosing to use new issuance to
finance mortgage-backed securities rather than whole loans, which generally
improves the credit profile of their loan portfolios. Whole loans, which
continue to make up a large percentage of many HFAs' assets, continue to
improve their performance, with delinquency and foreclosure rates having
reached their lowest point since 2008. We expect that HFA multifamily
performances will remain solid in 2019 given strong demand for affordable
housing among the low-to-median income population. Limited supply and high
demand from large pools of eligible tenants will keep vacancy levels low
for HFAs. Looking ahead, demographic trends will be a major driver of
demand for both affordable single-family homes and multi-family rental
units. HFAs' low-interest loan products and downpayment
assistance programs position them well to attract millennial homebuyers,
many of whom are saddled with student debt. HFAs are also well positioned
to meet the imminent surge in senior demand for affordable rental housing
due to their experience making loans that leverage federal subsidies
supporting projects for the elderly.
Default
Outlook
Defaults in the U.S. municipal bond
market continue to be rare, with just $2.2 billion in par value
experiencing a first-time payment default through the end of September
2018. Of this amount, 68 percent were municipals issued by First Energy
Solutions (FES), an Ohio power company. We consider FES municipal bonds to
be an opportunistic distressed debt situation with high recovery potential.
Outside of FES, municipal bond defaults are well under $1 billion,
representing a very small percentage of the $3.8 trillion municipal market.
Conclusion
Despite uncertain fiscal, economic, and
regulatory pressures, U.S. municipalities should benefit from modest
economic expansion that will support revenue growth and stability. MTAM
continues to recommend that investors select high-quality municipal issuers
that understand the new financial reality and have made or are making
budget adjustments. Essential service revenue bonds without the budgetary
concerns of state and local governments and limited payrolls can be
attractive, but we stress that an essential service issuer cannot flourish
if the underlying governmental entity is in dire economic circumstances. A
healthy outlook holds for most infrastructure issuers due to fundamental
strengths reflected in the provision of essential public services, adequate
balance sheets, and generally sound governance and fiscal management
practices. In the case of the enterprise sectors comprised of higher
education, health, and housing, credit quality will be maintained primarily
as a function of their ability to increase fees, control costs, and improve
overall operating margins. Sound debt and fiscal management practices,
preservation of adequate liquidity, and strong governance oversight will be
significant determinants of credit quality for issuers during the coming period
of financial adjustment.
Top Of Page
Impact of the Federal
Government Shutdown on Municipal Bond Credits
Friday, January 11, 2019
The ongoing federal government shutdown
should not have a significant impact on U.S. public finance credits. The
partial shutdown is only affecting approximately 20 percent of the federal
government, and funding critical to public sectors remains in place.
However, there are risks of localized economic effects in areas with large
concentrations of federal employees, and the potential for credit risks
will grow the longer the shutdown continues. In addition, the political
deadlock in Washington is a negative signal for federal policymaking that
could have longer-term implications for states.
Meanwhile, House Democrats are trying to
put pressure on Republicans by passing spending measures piecemeal. The
House voted 244 to 180 on Thursday to approve a 2019 spending bill for the
departments of Transportation and Housing and Urban Development and 243 to
183 for 2019 funding for the Agriculture, Rural Development, the Food and
Drug Administration, and Related Agencies Appropriations Act. Both bills
were approved by the Senate 92 to 6 in the last Congress as was a spending
bill the House approved on Wednesday for the Internal Revenue Service,
Treasury Department, the Securities and Exchange Commission, other
financial services agencies and general government operations.
But House Republicans criticized the
spending bills because they are Senate measures that do not include
bipartisan House priorities that were subject to lengthy deliberations last
year. The Republican-controlled Senate would still need to approve any of
the House-passed bills for them to take effect, and President Trump would
have to approve them.
The subcommittee's new Democratic
chairman, Rep. David Price of North Carolina, said Republicans missed their
opportunity to pass the House bill last year and a vote on the
Senate-passed bills represents the best opportunity to re-open the
governments.
State
and Local Governments
Federal government transfers to states
are largely for Medicaid and, to a lesser extent, transportation. Both
areas are largely unaffected by the current shutdown. Indirect economic
effects could feed very quickly to state revenues, given state governments'
reliance on personal income and sales taxes. However, the partial nature of
the shutdown should limit these effects.
At the local level, the shutdown could
have a disproportionate effect on areas with a high concentration of
federal employees, particularly if it continues for much longer. The
federal government accounts for approximately 25% of non-farm payrolls in
the District of Columbia. Maryland, Hawaii, Alaska, and Virginia are the states
with the highest proportion of federal employment but only account for
about 5% in each of these states. Moreover, most federal employees,
including Defense and the U.S. Postal Service, which account for about 40%
of federal employees nationally, are not affected by the shutdown. In
addition, furloughed federal employees have been compensated for missed pay
during previous shutdowns, so assuming this remains the case, consumption
that has been affected is likely to only be deferred.
That said, a prolonged shutdown without a
clear path or timeline to resolution could trigger significant concern
among unpaid federal employees leading to at least temporary economic
effects in localities with high federal employment concentration. The first
potential missed federal payroll date since the start of the shutdown will
be on Friday.
The District of Columbia is operating
fully under its locally enacted fiscal 2019 budget owing to a provision in
the federal fiscal 2018 budget bill. This is a notable difference from the
2013 shutdown when the District did not have full authorization to operate
its local budget and instead made temporary draws on ample reserves to
remain operational.
Not-For-Profit
Hospitals
Healthcare credits should be unaffected
by the federal government shutdown as Medicare and Medicaid programs are
not part of the shutdown.
Universities
Higher education and non-profit credits
maintain sufficient expense flexibility and liquidity to manage a
short-term revenue impact but will also see a greater effect in the event
of a prolonged shutdown. The Department of Education is not affected by the
shutdown; however, grant funding agencies such as the National Science
Foundation and National Endowment for the Humanities (among others) have
been impacted. As such, the effect of the shutdown on recipient
institutions will increase the longer it lasts, as grant funds are not
being disbursed and new grant applications are not being processed. Grant
revenue is not a primary source of revenue for the sector but can be
material for some research institutions.
Housing
Parts of Housing and Urban Development
are affected, specifically the Housing Finance Agencies (HFA). Federal
Housing Administration (FHA) loan applications will be delayed for new
single-family FHA mortgages and multifamily properties with FHA risk share loans.
This will delay the addition of new mortgage assets to programs, and there
will be a negative impact on HFA loan programs and debt repayments.
Transportation
The partial federal government shutdown
will be negative for the bond ratings of U.S. transit systems if it extends
longer than previous closures. The shutdown has interrupted operating,
capital, and debt-service funding for transit systems across the country,
since they count of federal grants for about 20% of their operating
revenue. A continued lack of funding will lead to weaker financial
positions, deferred capital projects, and higher debt-service costs.
Municipal bonds backed by federal
mass-transit aid are the most vulnerable to the U.S. government shutdown.
Grant Anticipation Revenue Vehicles, known as Garvees,
are sold by states or transit agencies and backed by federal highway or
transportation aid. At least $10 billion of the bonds are outstanding in
the $3.8 trillion municipal market. While money will continue to flow to
pay debt service on highway Garvees,
appropriations for the securities through the Federal Transit
Administration would be affected by a shutdown. The transit debt will not
face missed payments immediately, but in a very prolonged shutdown
scenario, some of those bonds might need some type of intervention, such as
using reserve funds or other state money.
Top Of Page
4th Quarter 2018 Review and
Outlook
Thursday, December 27, 2018
Strong positive returns were prevalent
for municipal bond investors in the final three months of 2018. Continued
tightening of monetary policy by the Federal Reserve, combined with nascent
signs of slowing economic growth, drove investors out of riskier assets and
into the perceived safety of municipal bonds. Capital preservation was a
theme even within the municipal market as the performance of
"AAA"-rated bonds kept pace with much higher yielding
"junk" debt. This strong showing by higher quality bonds could be
perceived as investors anticipating a notable slowing of growth in the
coming months.
We left off our last commentary opining
that the Federal Reserve should pause in their tightening of monetary
policy for a period of time in order to assess where consumers and
businesses are after the tailwinds of the tax cuts begin to wane.
Unfortunately, it seems that these folks at the central bank do not read
our commentary. Stock markets here and around the world experienced that
"Wile E. Coyote" moment we feared they would at the realization
that higher rates were beginning to slow growth (as they eventually always
do). Given that the financial markets were clearly signaling that the
Federal Reserve was overzealous in their desire to "normalize" rates,
we were a bit surprised to see them once again raising rates in their last
meeting of the year. As such, we took to Twitter with this tweet on
December 19th:
@MillerTabak:
"With today's hike in rates by the Federal Reserve, Miller Tabak Asset Management now believes monetary policy is
slightly RESTRICTIVE. The "pancake" watch is on, as the yield
curve will flatten further or perhaps invert."
Moving forward, we see the municipal
market becoming more judicious where it relates to market access. Issuers
with marginal financial flexibility may find investors less willing to take
a chance on their debt as the economy weakens into 2019. Liquidity in the
secondary market will likely be impaired somewhat for credits that are
rated below investment grade as default fears spike. Our bias here at
Miller Tabak Asset Management has always been
towards higher quality municipal bonds. It is for that reason we believe
you will sleep better at night in the coming weeks knowing we are "on
the job."
Happy New Year!
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak
Top Of Page
Mid-Term Elections 2018
Monday, November 5, 2018
This week's mid-term
elections will determine who will lead states in the coming years, with
voters also deciding the fate of wide-ranging initiatives that are relevant
for state, health care, and public power credits.
Voters will decide on $76.3 billion of
bond sales on Tuesday, the most in an election since 2006. States and
cities are less hesitant to borrow amid a growing economy that has pushed
unemployment to the lowest levels in 48 years. That is a shift after
delaying infrastructure investment following the last recession.
The referendums would support water
infrastructure projects and housing programs in California, road and bridge
expansions in Colorado, school construction in San Diego, Texas, and North
Carolina, and affordable housing development in Oregon.
A bulk of the bond ballots are in
California, with nearly $16.4 billion of state borrowing proposed to
upgrade water infrastructure, support housing programs, and renovate
children's hospitals. Cities and school districts in Texas will weigh in on
$9.2 billion of proposed bond issues.
Votes for governor in 36 states and the
majority of state legislative seats will be determined this week. Although
MTAM rates to fundamentals rather than the political cycle, a material
change in fiscal policy and/or increased or reduced contention in financial
decision-making can be relevant for credit performance, particularly if and
when the broader economy slides into recession. Due to biennial cycles,
most states will be debating budgets in 2019.
Voters in several states are considering
limits on revenue raising powers, a trend that we note with concern because
it reduces operating flexibility. States to watch in this area include
California and Florida.
Medicaid expansion, a proven boost for
health care providers in expansion states, will come to the forefront for
voters in Idaho, Montana, Nebraska, and Utah, who are weighing in on
Medicaid expansion under the Affordable Care Act.
The broader wildcard is party control at
the federal Congressional level, which is relevant for state credit.
Uncertainty at the federal level, particularly as it relates to Medicaid
funding and tax and trade policy, continues to be a key risk for states.
More clarity about future federal policy direction would support more
informed forecasting and policymaking at the state level.
If Democrats win control of the U.S.
House, it could lead lawmakers to push for proposals that would support
municipal bond issuance, including the revival of subsidies for a key type
of refinancing. A Democratic victory could mean a change in leadership for
some committees to members who are in interested in making it easier for
states and local governments to take advantage of the municipal bond
market, such as by restoring the ability to advance refund older, higher
interest rate debt and to provide a new mechanism to encourage the use of
municipal bonds to finance infrastructure.
Top Of Page
3rd Quarter 2018 Review and
Outlook
Thursday, September 27, 2018
Negative returns were prevalent for
municipal bond investors in the third quarter, as the market succumbed to a
constant flow of strong economic data. Even the previously stalwart demand
for shorter-maturity bonds gave way as market yields climbed all along the
yield curve. While lower-than-expected municipal bond supply acted as a
shock absorber of sorts on the path to higher yields, it was clear to
participants that diminished liquidity in the asset class required a
repricing lower of bond prices.
Overall, municipal credit quality
continued to improve during the previous quarter as a strong domestic
economy kept finances of many municipalities firmly in the black. Market
returns reflected greater enthusiasm for lower-rated credits as investor
concern over potential defaults diminished somewhat. Perhaps participants
are too apathetic concerning municipal credit quality in our view. What
should always be considered during Federal Reserve tightening cycles is
that, historically, our central bank has tended to go too far. Investors
should pay attention to the puny spread between two-year and ten-year U.S.
Treasury note yields. In our view, this reflects market participants'
rising concerns over the potential for much slower economic growth down the
road. Given all the good news priced into municipal credit spreads, we
believe some caution should be exercised in the coming quarters. Look no
further than a recent proclamation from a major rating agency that
currently no state has been assigned a "negative" outlook. Sounds
to us like a top in credit is close at hand. Our focus here at MTAM will be
to bias overall portfolio credit quality higher as the Federal Reserve
continues its tightening of credit.
Moving forward, investors have a full
plate of potential market moving events. These include the midterm
elections, trade tensions with China, and the possibility of the European
Central Bank stepping away from its quantitative easing policy. However,
from our perspective, America's own Federal Reserve and its ongoing
tightening of monetary policy will be what ultimately dictates the tone of
our financial markets. MTAM is concerned that the historically lagged
effects of the many rate hikes already enacted by the Federal Reserve have
yet to fully work their way through the United States economy. Simply put,
we believe it is time for the Fed to pause in their tightening of monetary
policy for a period of time in order to fully assess where consumers and
businesses are after the tailwinds of the tax cuts begin to wane. Unfortunately,
we do not hold out a lot of hope that this Federal Reserve will take this
precaution. Should the central bank of the United States proceed to raise
rates without a pause, we figure that the economy will experience a
"Wile E. Coyote" moment after two more hikes. Municipal market
yields are quite attractive now in our view. Given our outlook, we suggest
you start buying when you can—not when you "have to."
Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak
Top Of Page
State 'Rainy Day' Funds:
Who's Prepared for the Next Recession?
Monday, September 24, 2018
The nine years that have passed since the
end of the last recession seem to have given many U.S. states enough time
to save for the next one. Twenty-three state governments have sufficient
reserves to weather the budget shortfalls that would come with a moderate
economic contraction, up from 16 last year,
according to Moody's Analytics. Another 10 states have most of what they
would need, according to Moody's.
The savings have left states in a much
better position than they were a decade ago, when the housing-market bust
and financial crisis left them reeling from deep budget deficits. That may
leave them exerting less of a drag during the next recession by lessening
the need to cut spending deeply and eliminate government jobs.
However, a troubling number of states are
still not ready. While the number of well-prepared states has grown, so has
the number of those that are not. Seventeen do not have the savings for a
moderate recession, up from fifteen a year ago.
Louisiana, North Dakota, and Oklahoma
were rated the least prepared for the second year in a row, though their
finances have shown some improvement. Arkansas, Michigan, Mississippi, New
Hampshire, Kansas, Wisconsin, Pennsylvania, Illinois, Arizona, Missouri,
Virginia, Kentucky, Montana, and New Jersey also performed poorly in stress
tests.
On average, a state would need to have
reserves sufficient to cover about 11 percent of its budget in order to
withstand the next recession without raising taxes or cutting spending.
Standard
& Poor's
For the first time since the financial
crisis, no state government appears likely to have its bonds downgraded
anytime soon by S&P Global Ratings. S&P recently removed the
negative outlook from New Mexico's grade, a step that indicates it no
longer thinks the state's standing could be cut over the next two years.
That followed similar changes to Mississippi and Louisiana and pushed
states passed a bond-market milestone of sorts: none of them have a
negative outlook on their ratings from S&P for the first time since
2008.
The shift reflects the financial gains
that state governments are reaping from the swift pace of the nation's
economic expansion, stoked in part by a tax-collection boost this year as
residents shifted some income into 2017 before limits on local deductions
kicked in. All but a handful of states saw revenue outpace their
projections during the 2018 fiscal year, allowing them to increase their
savings, pay down debt, or cover delayed expenses, according to the
National Association of State Budget Officers.
Some of the pressure has been eased by
declining unemployment, which has reduced spending on the Medicaid health
program for low-income residents. At the same time, last year's federal
corporate tax cut further stimulated the economy, helping produce the faster-than-expected
revenue gains. That provided an immediate jolt, immediate fiscal relief to
states that have been under pressure since the start of this recovery.
But states should not anticipate that the
recent gains will be part of a long-lasting trend. S&P expects the
economy's growth to slow to about 1.8 percent in 2020, assuming the
second-longest expansion on record is not derailed. That compares with 4.2
percent growth in the second quarter. Even the baseline forecast means
there could be renewed pressure.
More
Detail
States increased their cumulative rainy
day funds for a seventh straight year to a record $54.7 billion in fiscal
year 2017, enough to run government operations for a median of 20.5 days,
according to Pew Charitable Trusts. The National Association of State
Budget Officers expects that 2017 figure to be surpassed when final fiscal
2018 data becomes available. Most states ended their fiscal years on June
30, but Texas does not close its fiscal year until August 31 while Alabama
and Michigan end theirs on September 30.
NASBO Executive Director John Hicks said
that deposits made to rainy days funds from budget
surpluses will likely bring the total to more than $58 billion for fiscal
2018. Two of the three states that Pew reported to have nothing in their
rainy day accounts at the end of fiscal 2017 – Kansas and Montana –
recently created rainy day funds. That leaves New Jersey as the only state
with the dubious distinction of not having any money stashed away to
weather an economic downturn.
One example of the upturn is Oklahoma,
which announced it would deposit $381.6 million into its rainy day fund,
its first deposit in four years. The fund previously had $93 million.
Rebuilding rainy days
funds has been a very slow process for many states since the end of the
Great Recession in June 2009. Nationally, total state tax revenue recovered
in mid-2013 from its plunge during the recession but has rebounded more
slowly than after the three previous downturns, Pew said. But only 34
states were taking in more revenue at the end of fiscal 2017 on an
inflation-adjusted basis than they did for the Great Recession.
Rainy days funds are important factor in
determining credit ratings. Well-managed states administer rainy day funds
in a way that reinforces structural balance, or a budget that is
financially sustainable over several years. This means that policymakers
make deposits into reserves during times of economic expansion and revenue
growth, while they make withdrawals during times of distress when revenue
falls.
Rainy day funds have heightened
importance in states with the greatest revenue volatility. The
boom-and-bust cycles of the oil and gas sector have given Alaska, North
Dakota, and Wyoming the highest revenue volatility.
Severance tax was the most volatile
revenue source in eight of the nine states where it accounted for enough
revenue over the past decade to be considered a major tax. Broad-based
personal income tax and statewide sales taxes were found to be less
volatile. Forty-one states levy broad-based income taxes and 45 have
statewide sales taxes.
Kentucky and South Dakota have the lowest
revenue volatility. Both states rely on relatively stable tax streams for
over half of their revenue — sales
for South Dakota and sales and personal income for Kentucky. In 18 of the
22 states where the corporate income is a major tax, it was the most
volatile source of revenue.
Conclusion
Rainy day funds are especially important
to pay attention to amid projections that another U.S. recession is likely
in the next year or two. They can also signal improvement in credit
quality: states like California, New York, Washington, and Ohio have
boosted their total balances from pre-recession levels, a good sign for
investors owning the debt. Outgoing California Governor Jerry Brown has
made the rainy day fund a priority during his tenure. Doing so has paid off
as S&P pointed to the creation of the rainy day fund in 2015, when it
lifted the state's credit rating to the highest level since 1999.
Top Of Page
California Fires
Thursday, August 2, 2018
California appears to be on track for a
fire season nearly as devastating as last year's — the worst fire season in the state's
history. So far this year, Cal Fire has battled nearly 3,800 wildfires that
have burned more than 292,000 acres, a sharp increase from previous years
and far above average for this time of year, according to the state's fire
agency.
Though natural disasters wreak havoc
causing property damage and loss of life, the hit to local economies — and their bonds — tends to be ameliorated by money from
the states, the federal government, and insurance companies.
Natural disasters have become
increasingly acute and chronic, which is presenting operational and
financial challenges to some U.S. state and local governments. The federal
government's role in disaster response is critical in mitigating natural
disaster risk for ratings on state and local governments.
The federal government approved $130 billion
in aid for natural disasters last year, a considerable 0.7% of the
country's $19.7 trillion economy. That said, financial support from the
federal government is not guaranteed. Additionally, proposals by current
and past administrations have been presented to address the burden of
disaster recovery assistance on the federal budget. And although we do not
currently anticipate this, a pullback in the level of federal government
aid would be viewed as a negative credit factor for state and local governments.
Rating actions directly linked to natural
disasters have historically been limited, a notable anomaly being Hurricane
Katrina and subsequent downgrades of the State of Louisiana and affected
areas. However, the damage to vital infrastructure and widespread
repopulation that was seen during Katrina has become more commonplace, most
recently with Hurricanes Harvey, Maria, and Irma last year.
State governments' exposure to
environmental risk is limited thanks in large part to the sovereign powers
bestowed on states under the U.S. government framework along with ample
economic resources that ensure fiscal flexibility and resilience to event
risks and systemic challenges. Local government ratings, by contrast, are
more vulnerable, particularly governments that encompass a small geographic
territory or feature a concentrated revenue base. In response, local
governments are incorporating environmental risk mitigation and adaptation
strategies within long-term financial and capital plans more broadly than
in the past.
Local governments have history on their
side in terms of showing financial resilience and prioritizing spending
where needed, which in concert with federal and state recovery aid can
mitigate credit risk to natural disasters.
Case in point, the recent volcanic
eruption in Hawaii County, known as the Big Island, has had a limited
credit impact, citing preliminary tourism figures. The numbers represent
particularly good news for Hawaii County because it suggests the volcanic
activity at Kilauea will have a manageable effect on the county's financial
health. Total air-travel visitors to Hawaii rose 8% in May, compared with
the same period a year earlier, with increases for Honolulu, Kauai, and
Maui and just a 1.6% drop for the Big Island. Cruise ship visitors to
Hawaii County fell 67%, but these kinds of visitors have historically made
up just 3% of total visitors to the islands.
The volcano on Hawaii County started
erupting on May 3rd and has destroyed at least 657 homes. There has been an
estimated $372 million in private property damage from the eruption, which
means a projected $5 million possible loss in property tax collection. The
damaged property represents only 1.2% of the county's 2018 full value.
County officials also expect the cost of the eruption response was $3
million in May and an additional $2 million in both June and July.
Hawaii County has the tools to address
any fiscal issues that come, including the ability to hike property tax
revenue with a simple majority vote of its council to make up the lava
losses. In addition, the state has given the county $12 million for
disaster efforts and more reimbursement from the Federal Emergency
Management Agency is expected.
Carr Fire
The Carr Fire
in far Northern California has destroyed hundreds of structures and spurred
California fire officials to order evacuations in what is a roughly
300-square-mile-area encompassing the western half of Redding and all of
Shasta Lake. While it is too early to know what the extent of physical and
economic damage will ultimately be, the recent history of municipal
obligors in areas that experienced fire damage suggests to us that credit
deterioration is unlikely. We will continue to monitor the situation.
We have found that federal and state
programs and fiscal backstops have helped local communities respond to
immediate disaster conditions and recover over the long term. For example,
the California Department of Forestry and Fire Protection coordinates
emergency response to fire events and the state chose to backfill $53
million in lost property tax revenue associated with fires in 2017 as part
of its fiscal 2019 budget.
With federal and state aid and insurance
payouts estimated in the billions, investors, analysts, and government
finance officials all expect that homes and businesses will be rebuilt, and
that the impact on local government bottom lines will not be as devastating
as the fires' wrath.
Given the nature of the structural
damage, the rebuild will likely take years to complete, and because of high
property values in the affected areas and the availability of insurance
proceeds, we expect most home and business owners to rebuild. As that
process gets underway, Californians will be aided by state laws designed to
ease the burdens they face, including property tax reductions. However,
while providing support to residents, these incentives could create
pressure for local governments.
State law provides for property value
reassessments and corresponding property tax adjustments. The state also
has a Special Fund for Economic Uncertainties that can backfill property
tax losses to local governments impacted by reassessments. The Department
of Finance can allocate funds from the special fund if authorizing
legislation is enacted. Since that involves the state budget process,
several months could pass before local governments see such relief.
Though local governments could experience
a short-term crunch, the rebuild will likely result in a boost to sales tax
and assessed value further along in the rebuild.
California Governor Jerry Brown has
declared a state of emergency in several areas of the state, a move that
triggers federal funding. He also sent the National Guard into one area to
help extinguish the fires. Firefighting costs, covered by the California
Department of Forest and Fire Protection are at $114.7 million for 2018-19,
which began on July 1, according to Cal Fire. Last year's fires cost an
estimated $505 million. Brown allocated money in the 2018 budget to cover
the cost of last year's fires and a reserve fund to cover this year's. The
state also has an estimated $8 billion surplus in this year's budget.
Brown also announced that the state has
secured a presidential declaration providing direct federal assistance to
further support the communities impacted by the Carr
Fire, following an emergency proclamation issued for Shasta County. The
Governor has issued emergency proclamations for Riverside and Mariposa
counties this week due to fires.
Conclusion
The Carr Fire
is the largest of nearly a dozen fires burning throughout California. While
it is too early to know what the extent of physical and economic damage
will ultimately be, the recent history of municipal obligors in areas that
experienced fire damage suggests to us that credit deterioration is unlikely.
Municipal budgets are most vulnerable to
the loss of property taxes when houses burn. The tax assessor's offices in
the areas devastated last year were busy reassessing property values in
areas where people lost their homes, to reflect the decreased value. But it
takes several months after fires are extinguished to assess the reduction
in property taxes. Insurance companies and federal agencies come to the aid
of homeowners in areas declared a natural disaster. California also has
always approved legislation to provide funding to municipalities that take
a hit to their tax base in a natural disaster.
Past history, including the rash of fires
that devastated regions in northern and southern California last fall,
demonstrated that federal and state programs and fiscal backstops have
helped local communities respond to immediate disaster conditions and
recover over the long term.
Top Of Page
U.S. Supreme Court's Ruling
on Union Fees
Friday, July 6, 2018
Last week's U.S. Supreme Court's ruling
regarding the funding of public sector collective bargaining activities is
likely to have a modest impact on state and local government finances. The
ruling for the plaintiff in Janus vs. AFSCME Council 31 eliminates the
requirement that non-union public sector employees pay "agency
fees" to contribute to the cost of collective bargaining and related
activities. It reverses a 40-year-old Supreme Court decision that allowed
public sector unions to require such fees.
No financial issue has dominated U.S.
states and cities in recent years as much as the massive shortfalls in
their workers' retirement funds, which have triggered battles between
politicians and unions from New Jersey to California and helped push
Detroit into a record-setting bankruptcy. The Supreme Court's decision may
have given governments a bit more of an upper hand. The Court ruled 5-to-4
that government employees have a constitutional right not to pay union
fees, dealing a potentially heavy blow to the economic clout of the labor
movement through a decision that affects 5 million workers. That may leave
unions with a weaker voice in benefit and pay negotiations and curtail
their power at the polls.
State and city pension funds were
negatively impacted by the credit market crisis a decade ago, when stock
prices plunged. That has left them with $1.8 trillion less than they need
to cover all the promised benefits, putting pressure on governments and
workers to set aside more money to make up the difference.
Such unfunded obligations contributed to
bankruptcies in Detroit and Puerto Rico that left bondholders and
pensioners battling in court. In New Jersey, former Republican Governor
Chris Christie fought with the state's labor unions over their benefits for
years, even as his failure to make full annual pension payments caused the
pension system to fall deeper behind. Illinois's bonds have been downgraded
to one level above junk because of retirement system debt that stood at
$137 billion by last June.
Union opposition to pension changes has
been a major force in Illinois. In 2013, Illinois lawmakers approved a
restructuring of the pension system, seeking to cut cost-of-living
adjustments and raise the retirement age for some workers. But unions sued,
and the state's supreme court sided with unions, saying it illegally cut
benefits protected by the Illinois constitution.
While the legal obstacles have not
changed, the Supreme Court decision could chip away at the resources that
unions can bring to such fights. That could help states and local
governments seeking to lower salaries and reduce benefits.
Twenty-eight states have adopted
right-to-work laws. The Janus ruling essentially creates the same framework
for the other 22 states and the District of Columbia for public-sector
employees. States with right-to-work laws that limit collective bargaining
powers can still confront labor-related spending pressures.
MTAM expects the Supreme Court decision
will lower public union revenues, membership, and bargaining power in the
22 states that can no longer allow mandatory fees. These developments could
change how state and local governments set employee wages and pensions,
resulting in a positive long-term impact on government finances.
However, state and local governments
remain limited in their ability to control labor spending. Any change to a
state or local government's expenditure flexibility that arises from the
decision is likely to be incremental.
Top Of Page
Onset of the Internet Sales
Tax and the Impact on U.S. Municipalities
Friday, June 29, 2018
The U.S. Supreme Court freed states and
local governments to start collecting billions of dollars in sales taxes
from internet retailers that do not currently charge tax to their
customers. Broader taxing power will let state and local governments collect
an extra $8 billion to $23 billion a year, according to various estimates.
Only five states -- Alaska, Delaware, Montana, New Hampshire, and Oregon – do not have a sales tax.
Siding with states and traditional
retailers on a 5-4 vote last Thursday, the Court overturned a 1992 ruling
that had made much of the internet a tax-free zone. That decision had
shielded retailers from tax-collection duties if they did not have a
physical presence in a state. Writing for the Court, Justice Anthony
Kennedy said the 1992 ruling, which involved catalog sales, was obsolete in
the e-commerce era.
The Court upheld a South Dakota law that
requires retailers with more than $100,000 in sales or 200 transactions
annually in the state to pay a 4.5 percent tax on purchases. Traditional
retailers have been waiting for this day for more than two decades as this
ruling clears the way for a fair and level playing field where all
retailers compete under the same sales tax rules whether they sell
merchandise online, in-store or both.
The measure was opposed by Wayfair,
Overstock, and Newegg. They said small sellers would be hit with heavy
costs of complying with rules for thousands of products in thousands of
taxing jurisdictions. Sixteen states already have laws that will let them
require tax collection by internet retailers in the coming months, and more
could follow quickly.
Internet retailers say they are
especially worried tax collectors will try to impose years of retroactive
liability, which the laws of many states allow. South Dakota and its allies
say those concerns are overblown for practical and legal reasons.
Justice Kennedy did not directly decide
whether states could try to collect taxes retroactively, but he said the
issue was not a reason to keep the physical-presence rule. He said the
Court had other legal tools to ensure that sales taxes do not become an
"undue burden" on small businesses and startups. He wrote that
"each year, the physical presence rule becomes further removed from
economic reality and results in significant revenue losses to the
states."
Justices Clarence Thomas, Neil Gorsuch,
Ruth Bader Ginsburg and Samuel Alito joined Kennedy in the majority. In
dissent, Chief Justice John Roberts said the Court should have left it to
Congress to change the physical-presence rule. Congress could still
intervene. Amazon and Overstock are among the companies that say they
support a nationwide law that would relieve retailers from dealing with a
patchwork of state tax laws.
The 1992 ruling, Quill v. North Dakota,
turned on the so-called dormant commerce clause, a judge-created legal
doctrine that says states cannot unduly burden interstate commerce unless
authorized by Congress. The Trump administration backed South Dakota in the
case, urging that Quill be overturned or at least limited to catalog sales.
South Dakota urged the Court to let sales taxes be imposed on companies
with an "economic presence" in a state -- a test South Dakota
said its law would pass.
The Supreme Court ruling gave U.S. states
– and
their bondholders -- another big win. The decision comes weeks after the
justices allowed states to legalize gambling on individual sporting events,
permitting another opportunity for them to raise revenue. The ruling is a
win for localities that have struggled with slow tax revenue growth even
amidst the second-longest economic expansion on record, and have seen their
tax bases erode as more consumers shop online.
MTAM believes the decision will have a
positive impact nationwide, though it will vary in each state. In terms of
their tax structures, it should certainly assist the states in moving into
more modern tax structures than they have now, which are fundamentally
based on an industrial economy that we have not seen in decades.
An expanded sales tax would give the
biggest benefit to California and its local governments, which could have
seen between $1 billion and $1.7 billion in additional revenue from the
expanded tax collection authority on out-of-state sales in 2017, according
to a U.S. Government Accountability Office report.
Six states -- Texas, Washington, Florida,
South Dakota, Nevada, and Tennessee -- get more than half their revenue
from sales taxes. Texas could generate $1.2 billion, or 1 percent of its
taxes, from online retailers. Sales tax reliance by local governments is
highest in Louisiana, Arkansas, Oklahoma, and Alabama.
The decision will also be a boost to
municipal bonds backed by sales-tax revenue because it will expand the base
of items that are taxed.
Conclusion
MTAM believes the U.S. Supreme Court's
decision allowing states to require out-of-state online retailers to
collect sales tax will stem state tax erosion in a changing economic
environment. In 2017, e-commerce grew 15.9 percent, while retail sales
without e-commerce grew only 3.4 percent, continuing a long-term trend. We
expect most states that impose retail sales tax to enact new legislation
that require at least large out-of-state online retailers to collect sales
tax at time of sale. This should provide a welcome incremental addition to
state coffers.
We anticipate local governments that levy
sales and use taxes will benefit similarly, broadening a revenue source
integral to operations for many municipalities. The ability to capitalize
on an expanded base should help support some of their growing operational
obligations, such as infrastructure and pensions.
Nevertheless, we do not anticipate any
immediate rating changes because of the Court's decision. It will take time
to pass implementing legislation, and the additional revenue will represent
a relatively small portion of overall state and local revenues.
E-commerce retail sales comprised only
8.9 percent of national retail sales in 2017, and sales taxes are generally
not a majority of states' general fund revenue. Many states already receive
a portion of online retail sales tax through aggressive state legislation
that expanded what constituted a "nexus" requiring out-of-state
retailers to collect tax, or report retail sales, if there was presence in
a state. In addition, many major online retailers already collect sales
taxes, either as a matter of policy or because they had a physical presence
in many states. Amazon in particular, which accounts for over 40 percent of
online retail sales, already remits sales taxes to all states imposing
them. (Amazon, however, does not currently collect sales tax for most
third-party sales, which represent half of its total sales.)
At the same time, states struggling with
rising health care and pension costs will welcome the additional tax
revenue, which in effect represents revenue otherwise lost from brick and
mortar stores. It may also help local retail malls avoid a competitive
disadvantage, potentially supporting local government assessed values and
downtown commercial cores.
Top Of Page
2nd Quarter 2018 Review and
Outlook
Tuesday, June 26, 2018
Municipal bond investors earned positive
returns during the second quarter as longer-maturity bonds reached yield
levels that generated solid interest from both domestic and overseas
buyers. A solid technical backdrop for tax-free bonds enticed investors to
re-engage in municipals, as supply remained unusually low during the
quarter. The march to higher yields hit a number of speed bumps during the
quarter as the U.S. Treasury market saw demand spike as emerging market
economies began to feel the pain of the ongoing tightening cycle of the
Federal Reserve. Also supporting the U.S. bond market were nascent fears that
Italy may ultimately decide to leave the European union. This bears close
watching in the coming months as it could immediately put the brakes on any
further rate hikes by our central bank.
Not to be outdone by Italy, the municipal
market has its own potential break-up to contend with, as an initiative to
separate the State of California into three states has qualified for the
November 2018 ballot. If approved by California voters and the U.S.
Congress, the arrangement would hit the municipal market hard. This is due
to the fact that California, which has over $74 billion of long-term debt
outstanding, is the largest U.S. seller of bonds financing state and local
government operations. Under billionaire Tim Draper's measure, California's
debt would be distributed among the three states based on the population—and
investors will not get a say in that.
In 2014, the Silicon Valley
political-eccentric Draper sponsored a ballot initiative to divide
California into six states. The effort failed, considered by many to be
politically impractical and legally untenable. As a result, Draper has
scaled back his ambitions.
According to Draper, the most populous
U.S. state and the world's 5th-largest economy is "nearly
ungovernable" under the current system. The measure calls for three
smaller state governments: Northern California, encompassing San Francisco
and 39 other counties; California, covering Los Angeles and five other
counties; and Southern California, accounting for areas including Fresno
and San Diego.
MTAM believes that a California split is
a long-shot, to say the least. Even if voters decide Draper's idea is a
good one, there has not been a break-up of a state since the Civil War.
Government law experts say a plan would probably require an act of Congress—and
it is unlikely that Republicans in Washington would welcome the idea of
potentially adding more solidly blue states. Nonetheless, it cannot be
understated that the potential for a seismic reaction by investors is
possible should this initiative pass. As we move closer towards November,
"poll watching" could ignite some volatility should the
initiative gain traction with voters. MTAM has always stressed the
importance of highly diversified portfolios, and given the potential
disruptions to markets from overseas (Italy, emerging economies) and within
our borders (California), we would strongly suggest advisors and individual
investors follow our lead. Whether clients of MTAM have national or state
specific portfolios with us, they see the great lengths we go to when
investing in tax-free bonds to diversify their portfolios.
The potential for some amount of economic
disruption is likely as the trade wars heat up between America, Europe, and
China. This combined with the Federal Reserve's ongoing quest to slow the
U.S. economy signals to us that municipal bonds have the potential to
pleasantly surprise investors with generous returns in the second half of
2018.
Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak
Top Of Page
State of the States - Midyear
2018
Friday, June 22, 2018
Fiscal 2019 will mark the ninth
consecutive year of modest state spending and revenue growth, according to
governors' budget proposals, as well as enacted budgets for some biennial budget
states. Compared with this time last year, state fiscal conditions show
signs of improvement and greater stability. General fund revenue
collections have been on the upswing in fiscal 2018, giving governors more
flexibility in their spending plans for fiscal 2019 compared with this time
last year. The vast majority of states are meeting or exceeding their
original revenue projections for fiscal 2018, following two straight years
where at least half of states missed their targets. As a result, far fewer
states have had to make mid-year spending reductions in fiscal 2018
compared with the last couple of years. States also continue to prioritize
their rainy day funds, with most states recommending increases in their
reserve balances in fiscal 2019. While conditions have improved overall,
states continue to face long-term budget challenges as spending demands for
fixed costs such as pension contributions and health care are expected to
grow faster than revenues over the long term. States are also assessing the
impacts of the new federal tax law on their revenues, and it remains
uncertain how much of the revenue acceleration states are seeing in fiscal
2018 will continue into fiscal 2019 and beyond.
State general fund budgets are expected
to increase 3.2 percent in fiscal 2019 (without adjusting for inflation),
totaling $861.8 billion, according to governors' recommended budgets, in
line with the average annual growth rate proposed by governors since the
Great Recession. This represents an improvement over this time last year,
when states were dealing with the impacts of lackluster revenue growth for
multiple years, causing governors to propose extremely cautious budgets
with a total general fund spending increase of just 1.0 percent for fiscal
2018. Overall, 42 states plan for general fund spending increases in fiscal
2019, including 35 states with planned increases of 2 percent or more. By
comparison, this time last year, governors' spending plans for fiscal 2018
called for increases in just 35 states, and only 24 states were expecting
growth of more than 2 percent. Governors' recommended spending changes by
program area for fiscal 2019 reflect an improved fiscal environment
relative to last year. For the upcoming fiscal year, governors called for
general fund spending increases across all program areas totaling $26.5
billion (compared with enacted fiscal 2018 appropriation levels). While a
modest increase, this figure represents a return to relative stability when
compared with this time last year, when governors called for general fund
spending increases of just $8.7 billion across all programs. K-12 education
would once again receive the largest spending boost, not surprising given
that it is the largest category of state general fund spending. Medicaid,
the second largest component of state general fund spending, would also see
a sizeable bump in general fund spending.
Improved revenue conditions in states
this fiscal year led to significantly fewer states making mid-year budget
reductions compared with the last couple of years. Nine states reported
making net mid-year budget cuts totaling $830 million in fiscal 2018,
compared with this time last year, when 23 states reported mid-year cuts
totaling $4.9 billion in fiscal 2017 – which
was later reduced to 22 states making $3.5 billion in cuts when states
reported on final fiscal 2017 spending changes. Overall, 19 states
increased their fiscal 2018 budgets in the mid-year, resulting in a net
spending increase of $1.6 billion across all program areas, compared with
original enacted budgets. Overall, estimated general fund spending in
fiscal 2018 increased 3.4 percent –
higher than what was originally recommended and what states enacted, due to
a combination of mid-year spending increases in fiscal 2018 and actual spending
coming in lower than previously estimated for fiscal 2017. In the
aggregate, estimated general fund spending in fiscal 2018 is slightly above
the inflation-adjusted spending 50-state total in fiscal 2008, the
pre-Great Recession peak one decade ago. Budget situations continue to vary
by state. Twenty-seven states report general fund spending levels in fiscal
2018 that are lower than their fiscal 2008 levels, after adjusting for
inflation –
including 11 states with spending levels more than 10 percent below their
pre-recession peak levels. At the same time, nine states have
inflation-adjusted general fund spending amounts more than 10 percent above
their fiscal 2008 levels.
Most states have seen improved revenue
conditions in fiscal 2018 following the slowdown experienced in tax
collections in fiscal 2016 and fiscal 2017. Total state general fund
revenues grew an estimated 4.9 percent in fiscal 2018, after growing 2.3
percent in fiscal 2017. This improvement reflects continued job growth, a
stronger performance of the stock market in calendar year 2017, and a
modest recovery in some energy-producing states following steep oil and gas
price declines. Fiscal 2018 revenues in a few states were also bolstered by
enacted tax increases. The federal tax changes under the Tax Cuts and Jobs
Act (TCJA) have implications for state revenue collections as well, and
states are still working to better understand the new federal law's effects
on their revenues. Note that the total estimated revenue growth rate is
driven in part by faster growth in several large states – in fact, five out of the six most
populated states in the country reported estimated general fund revenue
growth above 6 percent for fiscal 2018. The median revenue growth rate for
fiscal 2018 is much lower, at 2.7 percent, with a majority of states
estimating revenue growth below 3 percent. At the time of data collection
for this survey, 39 states were meeting or exceeding their original
budgeted revenue projections – with
24 states coming in higher and 15 states on target. Based on updated
general fund revenue information from states, the number of states
exceeding their budget targets seems likely to rise further before the end
of the fiscal year, which is June 30 for 46 out of the 50 states. General fund
sales and personal income tax collections were both significantly exceeding
original budget targets in the aggregate for fiscal 2018, by 2.1 percent
and 0.9 percent, respectively. Among the states that have revised their
fiscal 2018 revenue estimates since releasing their governors'
recommendations for fiscal 2019, the vast majority made upward revisions
for the current fiscal year. Compared with fiscal 2017 levels, sales and
use tax collections are estimated to grow 3.6 percent (median rate of 3.7
percent), personal income tax collections by 7.0 percent (median of 4.8
percent), and corporate income tax collections by 3.2 percent (median of
2.8 percent) in fiscal 2018.
According to governors' budgets for
fiscal 2019, states predict that general fund revenue collections will
increase modestly, with total revenues growing 2.1 percent and 40 states
forecasting positive revenue growth. The median growth rate for fiscal 2019
is higher, at 2.8 percent. Similar to the spending side, 27 states forecast
revenues to increase between 2 and 5 percent compared with estimated fiscal
2018 budgets, with seven states forecasting growth above 5 percent, six
states predicting growth between 0 and 2 percent, and the remaining 10
states forecasting revenue declines. Sales and use tax collections (31
percent of total general fund revenues) are forecasted to grow by a median
rate of 3.5 percent in fiscal 2019 (total growth of 2.3 percent). Personal
income taxes (45 percent of general fund revenues) are projected to grow at
a median rate of 4.2 percent (total growth of 2.9 percent). Corporate
income taxes, the third largest component of general fund revenues at 6
percent, are estimated to grow at a 5.0 percent median rate in fiscal 2019
(total growth of 8.4 percent). Large fluctuations in revenue collections in
some states can skew 50-state total growth rates, while a median growth
rate – the
"middle" percentile when states' revenue growth rates are ranked
lowest to highest – tends
to be more representative of the "average" state. While total
general fund revenue growth is expected to slow in fiscal 2019 relative to
fiscal 2018, the median growth rates for the two years are nearly
identical, and both fairly modest. Significant uncertainty surrounds these
revenue forecasts, however, as states continue to analyze and predict the
effects of federal tax changes under Tax Cuts and Jobs Act (TCJA) – including both the impacts related to
how a state conforms with the federal code as well as behavioral responses
by taxpayers to shift the timing of income. Most governors' budgets came
out before states were able to incorporate the effects of the TCJA into
their revenue forecasts. The federal tax changes have already affected
state revenue collections for the current fiscal year – states saw a significant uptick in their
December personal income tax collections, believed to be largely driven by
high-income taxpayers making advance payments to take advantage of expiring
tax breaks. While some expected April tax collections to be lower as a
result, preliminary data available indicate that states saw strong growth
in their collections in April too. States are still working to untangle and
better understand these trends and the impacts of the federal tax law on
their revenues, and it remains to be seen how much of the revenue increase
this fiscal year will carry into fiscal 2019 and subsequent years.
Fiscal 2019 revenue projections in this
survey incorporate the mostly modest tax proposals included in governors'
recommended budgets. Governors in 14 states recommended net increases in
taxes and fees in fiscal 2019, while 12 states recommended decreases,
resulting in a net increase of $2.8 billion, including general fund and
other state fund revenues. The revenue proposals with the largest dollar
impact include packages of tax increases recommended by the governors of
New Jersey and Oklahoma. Additionally, 16 states provided information on
revenue measures, which would result in a net revenue increase of $3.0
billion. Most of this impact comes from the proposed drawdown from Alaska's
Permanent Fund account, along with a recommendation to move New Jersey's
energy sales tax revenues on budget. These measures usually enhance general
fund revenue but do not affect taxpayer liability. Some of the personal and
corporate income tax changes proposed during 2018 legislative sessions were
prompted by or in direct response to the new federal tax law passed in
December 2017. States have reacted to the Tax Cuts and Jobs Act in a
variety of ways, depending on how their tax code conforms to federal law,
political priorities, and other factors. Governors' revenue proposals
responding to federal tax changes included actions to cut state tax rates,
decouple from the federal tax code to prevent state revenue increases (or
decreases), expand family tax credits, create options for taxpayers to
mitigate the impact of the cap on state and local tax deductibility, and
other provisions. Due to the deadlines for submitting proposed budgets,
governors in many states made or endorsed later recommendations in reaction
to the federal tax law changes.
Rainy day fund balances – budget stabilization funds and/ or
reserve accounts set aside to respond to unforeseen circumstances – are a crucial tool that states rely on
during fiscal downturns and to address shortfalls. States have made
building up their reserves a priority in the years following the Great
Recession, when rainy day fund balances fell to $21.0 billion in fiscal
2010 (or just $10.7 billion when excluding Alaska). Significant progress
has been made since then – from
fiscal 2011 to fiscal 2018, the median rainy day fund balance grew from 1.9
percent as a share of general fund expenditures to 5.8 percent, surpassing
the pre-recession peak of 4.9 percent. The median balance is projected to
rise to 6.2 percent in fiscal 2019, as governors continued to prioritize
rainy day funds in their budgets, with 28 states recommending increases in
their rainy day fund balances and only three states projecting declines. Rainy
day fund levels, as a share of expenditures, vary across states. This
variation is related to differing fiscal conditions, rainy day fund
structures, policy decisions, revenue volatility levels and other factors.
Three states –
Georgia, Oklahoma and Wisconsin – were
not able to report on their rainy day fund balance levels for fiscal 2018
and/or fiscal 2019. Excluding these three states, rainy day fund balances
are expected to total $52.0 billion in fiscal 2017, $53.6 billion in fiscal
2018, and $58.1 billion in fiscal 2019. Total balances include both general
fund ending balances and the amounts in states' rainy day funds. Total
balances reflect the surplus funds and reserves that states may use to
respond to unforeseen circumstances and to help smooth revenue volatility,
though in some states, part of the ending balance may already be reserved
for expenditure in a subsequent year. Total balances are estimated at $78.0
billion in fiscal 2018 (excluding Oklahoma), little changed from fiscal
2017, and they are projected to dip somewhat to $74.6 billion in fiscal
2019 (excluding Oklahoma and Wisconsin).
The median growth rate for Medicaid
spending from all fund sources is estimated at 5.2 percent for fiscal 2018.
Looking just at spending from state fund sources, the median growth rate is
4.5 percent, while spending from federal funds has an estimated median
growth rate of 5.9 percent for fiscal 2018. Looking ahead, Medicaid
spending growth is forecasted to slow considerably in fiscal 2019, based on
governors' budgets. The median growth rate for total Medicaid spending is
projected at 1.9 percent for the upcoming fiscal year. State fund spending
is projected to grow by 1.5 percent (median), while federal fund spending
is expected to increase by a median of 2.3 percent. Given large swings in
some states that can substantially influence total Medicaid spending growth
rates, examining the median percentage change often better reflects
underlying trends, though timing issues can still skew the data. While
Medicaid spending growth shows signs of slowing in the short term, the
long-term growth projections for the program are expected to be closer to
historical growth levels, about 5.5 percent per year, according to the
Congressional Budget Office (CBO). The Medicaid program continues to pose
long-term spending pressures for states as they monitor the impacts on their
budgets of rising prescription drug costs, the growing elderly and disabled
population, changes in federal laws and regulations, and costs associated
with the opioid epidemic. States reported on continued cost containment and
delivery service reform efforts, with states passing or considering
policies to cut drug costs, enhance program integrity, and expand managed
care. At the same time, with budget conditions fairly stable in most
states, a number of states reported increasing provider payments and expanding
Medicaid benefits, while fewer states reported restricting payments or
benefits. States that expanded Medicaid also reported on their expenditures
for the new adult eligibility group (including both "newly
eligible" and "not newly eligible") by fund source. As
states have begun to pick up a larger share of the cost, Medicaid expansion
spending from state funds is estimated to increase $3.6 billion in fiscal
2018. Most states are planning for increases in state fund spending on
Medicaid expansion in fiscal 2019 as well, though 50-state total spending
from state funds is projected to decrease.
Conclusion
Overall, state fiscal conditions show
signs of improvement compared to this time last year by a number of
measures. General fund revenue growth accelerated in fiscal 2018, the vast
majority of states are seeing tax collections come in on target or above
budget projections, and relatively few states have had to make mid-year
budget cuts in fiscal 2018. In this more stable environment, most governors
recommended modest general fund spending increases in their budget
proposals for fiscal 2019. Last spring, states were also facing tremendous
federal uncertainty regarding future federal funding levels, health care
and Medicaid financing, and the prospects for tax reform. Much of this
uncertainty has been eliminated or significantly reduced – at least for the time being – after Congress reached agreement on a
two-year spending framework, made no changes to Medicaid's federal/state
sharing arrangement, and enacted the largest set of changes to the federal
tax code in more than 30 years. States are now trying to untangle the
complicated effects of the recent federal tax changes on their revenues,
and it remains to be seen how much of the revenue uptick states are experiencing
in fiscal 2018 will continue into fiscal 2019 and beyond. While budget
conditions vary by state, all states to some extent are facing long-term
spending pressures in areas ranging from health care and pensions to
adequately funding K-12 education and infrastructure. States are also
working to prepare for the next downturn by strengthening their reserve
funds.
Top Of Page
Sports Betting Ruling is a
Win for U.S. States
Tuesday, May 29, 2018
The Supreme Court of the U.S.' ruling
last Monday overturned a 1992 federal law -- the Professional and Amateur
Sports Protection Act (PASPA) -- that banned states from allowing sports
betting. Many states are likely to welcome this new revenue source as years
of slow economic growth have resulted in slim or negative operating
margins. MTAM does not believe the ruling alone is likely to result in any
rating upgrades, but the potential for an additional increment of revenue
is welcome and has the potential to somewhat ease negative pressure on
credit quality. This new opportunity for states may result in 2018 being
the single largest year for gaming expansion.
New Jersey had challenged the law's
constitutionality, saying that PASPA violates states' right to modify or
repeal existing state laws, which is protected by the 10th Amendment. Since
oral arguments in December, it was widely expected the law would be
overturned. Under PASPA, sports betting was prohibited in all states except
Delaware, Montana, Nevada, and Oregon, which already had existing laws
allowing it. Across the country, states have hedged their bets by enacting
or introducing legislation to begin expanding sports gambling as soon as
the case is decided.
States most likely to expand gambling to
include sports betting are those with existing off-track betting (OTB)
facilities and casinos. While a number of states have existing tribal
casinos, adding sports betting at those facilities may require amendments
to existing gaming compacts. Some examples of states with existing sports
gambling legislation include the following:
-- Connecticut enacted a law (PA 17-209)
last year increasing OTB facilities by six and allowed development of
regulations for sports betting should it become legal.
-- Mississippi passed HB 967 last year,
allowing for sports betting should it become legal.
-- New Jersey already has enacted a law
to expand sports betting and petitioned the Supreme Court to hear the case.
-- New York had allowed for implementing sports
betting when legal as early as 2013 at commercial casinos under the Upstate
New York Gaming Economic Development Act.
-- Pennsylvania's 2017 gaming expansion
(Act 42) cleared the way for sports betting should it become legal.
-- The governor of Rhode Island's
proposed fiscal 2019 budget included a provision to legalize wagering on
sporting events and expects $23.5 million in revenue for the year.
-- The West Virginia Sports Lottery and
Wagering Act became law in March, making it the first state to allow sports
gaming in 2018.
Nearly 15 other states have proposed
legislation to expand sports gambling. While some legislation would
authorize the expansion at existing gaming facilities through statutory
changes, some may require a voter referendum.
States are looking to bring in additional
tax revenue from legalizing a market that has reached $150 billion.
However, legalized sports gaming will not add to state coffers unless
operators and players participate. MTAM believes that Pennsylvania's $10
million initial operator license fee, 34% state tax on gross gaming revenue
(GGR) and 2% GGR local share assessment are likely to deter certain
operators' interest and could incentivize them to outsource sports betting
operations. By contrast, West Virginia's 10% GGR tax rate and much lower
licensing fees are expected to generate greater operator interest.
Casino operators could grow sports
betting to a wider range of locations. However, the growth will depend on
several local factors. Setting competitive tax rates will be required to
draw participants from existing illegal or informal wagering pools and
could limit the growth of some markets. Higher tax structures, such as
Pennsylvania's, or those with a handle-based integrity fee, which charges
approximately 1% on each wager and pays it to the sports league, will limit
margins for casino operators and could lower their ability to be
competitive in those markets.
The impact of this expansion on casino
operators will be small. We expect casino operators to set up sports books,
or partner with companies such as William Hill, to offer betting at their
facilities or, if permitted, online. The revenue effect will be small and
we expect sports books to be offered as amenities to drive higher
visitation, rather than raise revenue.
We do not expect the growth of other
markets to have a negative impact on casino operators in Las Vegas. We do
not anticipate sports books in regional markets will materially compete
with Las Vegas during marquis sporting events, such as the NCAA Final Four
or the NFL Super Bowl, as Las Vegas has firmly established its
attractiveness as a leisure destination.
Top Of Page
Most States Have Room to
Increase Their Debt
Thursday, May 17, 2018
Despite elevated credit pressures in
fiscal 2017, state debt levels for the most part stayed constant. Although
we anticipate more positive credit conditions heading into fiscal 2019, we
think it is unlikely that there will be a significant uptick in debt levels.
In our view, this speaks to the highly managed nature of state debt, in
contrast to the cyclical nature of tax revenues and decades of inadequate
pension funding.
Overall debt levels remain sustainable,
with few exceptions. While affordability studies and debt management
policies seek to curb debt issuance, they do not necessarily result in
restraint.
Total state tax-supported debt increased
0.1% to $492.4 billion in fiscal 2017, following two years of modest
declines (0.4% in 2016 and 1% in 2015), indicating that even as economic
indicators have improved, states have not been willing to take on more
debt. Median debt ratios in comparison with population, personal income,
and gross state product also remained the same or fell slightly, suggesting
that slow economic growth alone has not limited bonding capacity.
The reticence to borrow persisted despite
anticipation that the Federal Reserve would continue to raise interest
rates, giving them a strong incentive to capture low interest rates while
they still could to finance roads, bridges and other public works. The
prolonged weakness in states issuing new debt is linked to slower growth in
state revenues and an environment that makes issuing new debt difficult.
The slow growth in debt has caused a slowdown in state infrastructure
spending, with these projects now largely financed by current spending.
The average net-tax supported debt among
states was $1,477 per capita, with 31 states under that figure. Connecticut
had the highest in net tax-supported debt per capita at $6,544. Nebraska
had the lowest -- just $20.
While most states exercised fiscal
restraint, Illinois, the lowest rated U.S. state, bucked the trend last year
by increasing its debt 16%. That was not because it was investing in
infrastructure, though: Illinois sold $6 billion in bonds to pay off a
backlog of bills left from a long-running standoff over the budget. That
boosted Illinois' net tax-supported debt per-capita to $2,919, the sixth
highest in the country.
General obligation debt continues to
comprise the largest share of state debt outstanding at 52.2% of all debt
issued in 2017. Appropriation and lease debt remains the second largest
share of state debt outstanding at 19.7%. Special tax debt is third
largest, accounting for 13.4% of net-tax supported debt.
Top Of Page
The State of Connecticut, the
City of Hartford, and the Contract Assistance Agreement
Wednesday, April 11, 2018
One of the nation's most indebted states
will see what it owes get even larger under a recently signed agreement to
rescue its beleaguered capital from bankruptcy. Last week, the State of
Connecticut cemented its commitment to the City of Hartford's general
obligation bondholders through the contract assistance agreement (CAA) that
provides for the State to assume annual debt service on the City's $550
million in outstanding GO bonds. The CAA alters the security pledge
supporting bond repayment from a City GO commitment to a full faith and
credit pledge of the State.
Hartford, a 123,000-resident city whose
government has struggled to close budget shortfalls and revive its economy,
owes $755 million in principal and interest through 2036. This will add to
the financial burdens on Connecticut, which has been contending with its
own chronic deficits. At $6,505, Connecticut's net tax-supported debt per
capita was the highest of any state, according to a Moody's report last year.
The figure has grown from $5,185 in Moody's 2013 report.
While U.S. states have a history of
stepping in to help distressed cities, it is rare for a state to take on
debt payments for a locality. "Our goal is to use this period of
stability to continue to push for economic growth that will strengthen the
City's financial position down the road," Mayor Luke Bronin said.
As part of the agreement, the City must
provide ongoing financial reports and a rolling three-year fiscal plan to
the state treasurer and secretary of the Office of Policy and Management.
Hartford's fiscal 2019 budget must be approved by the Municipal
Accountability Review Board (MARB), which was created by Connecticut in
2017 to help cities experiencing distress.
If the City has a cumulative unassigned
general fund balance deficit of 1.5% or more than its general fund
revenues, then it would trigger higher levels of oversight. Such scrutiny
from the State also would be triggered by a default or if the City seeks
approval for bankruptcy protection.
The agreement illustrates the lengths
that states will go to in order to prevent municipalities from filing for
bankruptcy -- a rarity in the $3.9 trillion municipal-bond market and
something that can cause higher borrowing costs for other localities
nearby.
Connecticut has a history of stepping in
to help its localities: In 2001, the State established oversight of the
City of Waterbury that lasted five years. Connecticut guaranteed deficit
financing bonds issued by Waterbury in 2002, and put in place a control
board that could cancel union contracts and renegotiate.
Since the recession, more states have
created mechanisms for dealing with municipal distress. In New Jersey,
former New Jersey Governor Chris Christie's administration took control of
gambling hub Atlantic City's finances in 2016, a move that local officials
resisted at the time.
In 2010, Rhode Island's legislature
passed a law that allows the State to appoint a receiver if a locality is
undergoing a fiscal emergency. It also allows for the state revenue
director to make debt payments if an issuer seems unlikely to pay. Still,
the State can charge those costs against any aid due to the locality. Ohio
added designations in 2011 to identify practices that could result in a
declaration of fiscal emergency.
Michigan, known for a longtime state law
that allows for the placement of an emergency manager, passed laws in 2017
that requires municipalities with underfunded pensions to develop action
plans to fix them. Pennsylvania in 2011 passed legislation establishing a
state receivership process to address the fiscal woes of its capital
Harrisburg.
The Connecticut deal also allows
Hartford's debt to be refinanced using the State's full faith and credit
backing. That step is more commonly used by states: In 1975, New York
allowed for the creation of a corporation to issue debt on behalf of New
York City, which was on the brink of bankruptcy at the time. Pennsylvania
also created a similar mechanism for Philadelphia in 1991 when its largest
city was struggling with a financial crisis.
But few, if any, states have taken on the
debt load of their cities to provide relief. And doing so adds to the
financial burden on Connecticut, which is now on the hook for Hartford's
general obligation bond payments through 2036.
"Strong urban centers are vital to
the State's well-being," Denise Nappier,
Connecticut's state treasurer, said. "Declining to help Connecticut's
capital city could have adversely affected the financial health and
vibrancy of surrounding towns, while helping Hartford actually might make a
potential slippery slope less likely."
Mayor Bronin
said he thinks the plan will be beneficial for the State as well. "If
we want Connecticut to be economically competitive, we have to have strong,
vibrant cities that can help drive that economic growth," he said.
MTAM believes the CAA is consistent with
the State's articulated policy goals and appropriations included in the
2018-2019 biennial budget, although we observe the addition, albeit modest,
to the State's already high debt burden from this undertaking. The CAA is
not expected to have a negative impact on the State's ratings at this time.
Once viewed as a challenged but
relatively stable credit, Hartford's financial standing became more
precarious in recent years to the point where bankruptcy and default were
recently considered serious possibilities. In reaction to these risks, the
State's 2018-2019 biennial budget incorporated multiple responses to the
situation, including the newly formed Municipal Accountability Review Board
(MARB). The budget also included two successive, $48 million appropriations
to accommodate expected payment for Hartford's annual debt service in
fiscal years 2018 and 2019 of $40 million. The remaining allocation is
available for other local governments under MARB's oversight. The City of
West Haven is currently the only other municipality in the State under this
supervision.
MARB was created to provide financial
assistance and fiscal oversight for any of the State's distressed municipalities
that apply for it. It classifies municipalities based on financial distress
criteria and assigns them to one of four tiers, with the highest tier
calling for a stronger degree of state oversight and control. The MARB
legislation permits Tier III and IV municipalities to enter into a CAA for
debt service assistance.
We view the reassigned Hartford debt
service requirements as modest within the State's $18 billion annual
budget, with no measurable change to carrying costs. The assumed principal
increases the State's debt burden by only 0.2% of personal income, to 10%.
While we view the increase as negligible, Connecticut's high liability
burden has weighed on its credit for many years and remains a concern. A
more widespread assumption of municipal debt obligations, currently
believed to be an unlikely scenario, would become a credit concern given
the State's high debt load.
We do not anticipate a surge in
municipalities seeking MARB assistance as no other municipality, aside from
West Haven, has reported fiscal stress comparable with Hartford and,
perhaps more importantly, due to the strict conditions that are placed on
local governments under MARB's oversight. These conditions, which are
dependent on a municipality's level of financial stress, are likely to
limit interest in the program.
Depending on the assigned tier,
municipalities under MARB's oversight are required to submit multi-year
financial plans and seek contract and collective bargaining approvals, and
could be subject to revenue increase limitations and other stipulations
that relieve a municipality of its home rule authority. State statute also
provides Connecticut with the authority to compel Tier III (Hartford and
West Haven) and Tier IV municipalities (considered most distressed) to
restructure any GO obligations for which the State has assumed debt service
payments at any time to ease the financial burden on the State. Additional
aid provided to MARB-municipalities does not guaranty that they will
receive the same amount of state revenue sharing in future years and they
could experience cuts in municipal grants, cost sharing allocations, or
PILOT payments.
We consider the State's creation of the
MARB as a positive for local government bondholders and other
municipalities in the State. The MARB legislation outlines financial
distress measures that state officials can monitor to help prevent fiscal
distress and permits oversight and controls, similar to other states with
fiscal oversight boards, and represents a proactive strategy by the State
to assist its local governments.
In response, Moody's last week upgraded
the City of Hartford's general obligation bonds to A2 from Caa3 based on
the contract for financial assistance with the State of Connecticut
effectuated March 27, 2018. The A2 rating on the City of Hartford's GO
bonds reflects the strong legal provisions governing the State's obligation
to make contract assistance payments on the bonds, and the essentiality of
the State's commitment to its capital city. The obligation to make the
payments to Hartford is a full faith and credit obligation of the State,
and the state treasurer is required to make payments from the State's
general fund to Hartford's paying agent without further need for
appropriation. The rating is one notch off the State's GO rating to reflect
the possible risk of payment interruption or reduction should Hartford file
for bankruptcy.
Top Of Page
1st Quarter 2018 Review and
Outlook
Wednesday, March 28, 2018
Many investors in intermediate tax-free
municipal bonds experienced small negative total-returns in their
portfolios during the first quarter of 2018. As we correctly speculated in
our last quarterly commentary, shorter maturity municipal bonds
significantly outperformed during the first quarter, posting essentially
unchanged returns as investors embraced lower duration assets to shelter
their portfolios from rising market interest rates. Bearish sentiment in
regards to the prospects of increased issuance of U.S. Treasury bonds
steadily guided interest rates higher during the quarter, proving too much
of an impediment to municipal yields remaining stable. We suspect the
treasury market has—at a minimum—approached yield
levels where domestic and global institutional demand may act as a speed
bump to even lower bond prices which can be construed as a sign that the
bulk of the sell-off may be behind bond investors.
Growth and employment in the U.S. economy
remained quite healthy during the first quarter, undoubtedly assisted by
the tax cuts recently enacted by Congress. Interestingly enough, the
Federal Reserve continued to "lean against" the benefits of the
tax cuts to the economy by once again electing to raise short-term interest
rates. From a historical perspective, the timing of fiscal policy being stimulative (tax cuts) whilst monetary policy becomes
more restrictive (higher rates) is about as difficult as handicapping the
outcome of the first fight between Muhammad Ali and Joe Frazier. Dubbed the
"fight of the century" in 1971, both gladiators entered the ring
with impeccable records of success as both were undefeated in their careers.
Fiscal stimulus and tighter monetary policy also have robust records of
achieving their desired outcomes of strengthening and slowing the economy.
Miller Tabak Asset Management expects an economic
"draw" during the remainder of 2018 as these two divergent
policies fight it out to see if higher growth or recession gain the upper
hand. However, it is in 2019 where we see a Mike Tyson versus Michael
Spinks outcome for the economy. You may recall that both fighters were also
undefeated in their careers when they met in 1988. The outcome of this
fight was much more pronounced—it ended quickly, and Spinks never fought
again. Much like Michael Spinks, we see the economy hitting the canvas in
2019 as the constant body blows administered by a Mike Tyson-like Federal
Reserve bring the economy to a halt (as our central bank historically
always tightens policy too much).
Moving forward, the correction to higher
yields of longer-dated municipal bonds has us approaching the market with a
bias to marginally extend portfolio duration should the opportunity present
itself to buy top quality municipal issuers at a bargain price. Given our
view that the Federal Reserve will ultimately prevail in slowing the
economy, we are biased towards higher overall portfolio credit quality, as
protecting client capital remains our primary focus. By way of a review,
here are the core disciplines of Miller Tabak
Asset Management to ensure your municipal bond portfolio never hits the
canvas:
- All holdings rated "A3" or higher in
terms of credit quality as judged by our internal proprietary research
- Avoiding riskier sectors of the municipal market,
such as health-care and tobacco bonds
- No bonds purchased will be longer than fifteen
calendar years to maturity
- Any municipal issuer that refuses to disclose
timely economic, financial, and debt updates will immediately be sold
Advisors and clients should visit our
website during the quarter, as we have an extended library of research on a
multitude of topics relevant to municipal bond investors.
Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak
Top Of Page
New Tariffs and the Impact on
U.S. States and Local Governments
Wednesday, March 21, 2018
State and local government budgets and
infrastructure projects could be at risk from the tariffs the Trump
administration recently imposed on steel and aluminum. A shift toward
protectionist trade policies may also have negative implications for most
state economies. The economic and tax revenue implications could force
states and localities to reevaluate the forecasts that underpin their key
budget assumptions. Our overall assumption is that the tariffs will have
enough exemptions to them that their impact should be minor.
There are 11 states that count on exports
for more than 10% of their economic output, leaving them most at risk if
President Trump's steel and aluminum tariffs prompt other countries to
retaliate against U.S. businesses.
Louisiana (21%), Washington (17%), and
South Carolina (15%) rely on exports the most, leaving them the most
exposed. Higher steel and aluminum import prices would affect states where
these imports represent a larger share of total imports, among them
Missouri, Louisiana, Connecticut, and Maryland. Smaller cities reliant on
export-heavy manufacturing have a potential for economic disruption.
And although President Trump's decision
to exempt Canada and Mexico removed most of the negative economic
consequences from the tariff increases, we nevertheless believe that the
specter of a trade war triggered by the tariffs could lead to a small
pickup in inflation, which could cause the Federal Reserve to be more
aggressive in raising interest rates. This could risk a sharper economic
slowdown in 2019 than forecasted.
We could witness slower economic growth
than most states have assumed in their forecasts. Such an outcome could
translate to lower tax revenue growth rates, further squeezing state fiscal
margins, which have already been under pressure in recent years.
Any slowdown in U.S. economic growth
stemming from shifts in trade policy could have a similar dampening effect
on local governments, and trade-related changes would only exacerbate this
for local economies heavily dependent on the export industry.
In the past when the U.S. has turned to
tariffs, it has resulted in trading partners responding by enacting their
own duties on U.S. exports. The proposed tariffs that take effect March 23
prompted retaliatory threats from countries around the globe.
The European Union and China are among
those that have said they would retaliate by placing tariffs on U.S.
products exported to their countries. Mexico and Canada, which comprise 25%
of steel and 45% of aluminum imports to the U.S., were exempted from the
metal tariffs. The Trump administration is considering tariffs on $60
billion in Chinese goods, which could further pressure retaliatory measures
from China.
It is not necessarily the metal tariffs,
but retaliation from trading partners, particularly Europe, Japan, and
China that represent the risk to budgetary forecasts. If the tariffs led to
retaliatory measures the Federal Reserve could raise rates more than most
forecasts assume, which would impact retail sales.
The State of California has a fairly
significant stake in the potential fallout if trading partners decide to
retaliate because logistics and trade are significant economic drivers for
the state. California is also a destination for manufactured goods from
Asia that are then trucked throughout the country.
Slowed U.S. economic growth resulting
from shifts in trade policy would most heavily impact local governments
dependent on the export industry. Seattle, Los Angeles, Chicago, Houston,
and New York together account for 15% of all U.S. exports, according to U.S.
Census Bureau data. The impact on credit quality to those cities could be
less significant because of their economies being diverse. For smaller
cities where export-heavy manufacturing can dwarf other sectors, a shift in
the pace of exports creates greater potential for economic disruption and
credit deterioration.
We also deem the tariffs a credit
negative for the U.S. infrastructure sector because they are likely to
cause steel and aluminum prices to increase, making projects that need
those supplies more costly.
Projects that could see cost increases
include renewable and fossil fuel power plants, pipelines and liquefied
natural gas export facilities, airport terminal construction,
transportation projects, and seaports.
U.S. ports will experience the greatest
impact, because they will be affected on both the expenditure and revenue
side. The Port of New Orleans could be affected the most, because 15% of
its imports are steel. Houston and Los Angeles have comparable volumes of
steel, but steel represents less than 2% of revenues for those ports, so
less of an impact is anticipated.
We are expecting both imports and exports
to remain at current levels or grow with the health of the economy. The
ports are on the front line if any type of expansive trade war develops. We
are not expecting this to initiate a widespread trade war, but the
situation is still developing.
Gulf ports including New Orleans,
Houston, and Mobile, Alabama that are heavily into oil refining and have
the largest share of steel and aluminum imports are probably the most
impacted. If there is retaliation from trading partners, the risk could
spread to other ports.
It could stall what has been a very good
year for the twin ports of Los Angeles and Long Beach, both of which have
seen an increase in port traffic this year. The Los Angeles port processed
725,000 twenty-foot equivalent units in February, the busiest February in
the port's history – and a
16% jump over last February's number, while the Long Beach port processed
661,790 TEUs, a 32.8% increase over last February, according to officials
from each port. Steel represents only 2% of the Los Angeles port's
business, but officials are concerned about the impact on Asia, because
that is where the bulk of the port's cargo comes from.
In addition, the smaller economies of the
Upper Midwest and the Southwest border states would be the most negatively
affected state economies if the U.S. withdraws from the North American Free
Trade Agreement (NAFTA), due to the states' high exposure to export trade
with Canada and Mexico. Withdrawal would negatively impact employment and
growth in these states, which would mean lower tax revenue, likely leading
to constrained budgetary flexibility and higher unemployment. The entire
U.S. economy would be less affected by withdrawal as exports of goods and
services accounted for only 12% of U.S. GDP in 2016. Exports to Canada and
Mexico accounted for 18% of all U.S. exported goods in 2016 or 1.4% of GDP.
Top Of Page
Higher Education: Remain
Cautious with Small, Private Universities and Expect Additional Mergers
Monday, March 12, 2018
The credit outlook for U.S. colleges and
universities is stable
in 2018, though the gap is widening between larger, stronger universities
and some of their smaller counterparts.
Operating revenue pressures will likely
intensify for small, tuition-dependent schools in demographically declining
areas or highly competitive regions. Barring those outliers, operating
performance is expected to remain strong sectorwide,
which coupled with steady student demand and enrollment and solid financial
resources, supports a stable sector outlook.
Operating revenue also stands to be
affected by the recently passed tax reform legislation, with annual
charitable gift revenue and both state and federal funding to feel those
effects most acutely. Most vulnerable are institutions already facing
revenue pressures related to enrollment, tuition dependency, or those with
limited liquidity profiles lacking material foundations or endowments.
Nonetheless, the majority of U.S.
colleges and universities enjoy ample financial flexibility and have been
proactive in minimizing the volatility of investment returns and increasing
the overall liquidity of their total holdings. Well-positioned institutions
retain meaningful balance sheet resources, solid demand, and increasing
tuition revenue while keeping leverage in check. Most colleges are also
effectively balancing the desire to maximize long-term investment returns
and the need for capital investments against the need for sufficient
working capital and liquidity.
This being said, some U.S. colleges and
universities will continue to shutter, merge, or sell assets in 2018 as
enrollments decline and states cut aid, which could lead to a small number
of bond defaults. States with rising fixed costs and slow revenue growth
will look to cut discretionary spending. Of 22 states with mid-year budget
cuts in fiscal 2017, 17 cut an aggregate of $344 million out of their
higher-education budgets.
Smaller, tuition-dependent private
colleges that serve a more localized area, and public universities without
strong national demand in fiscally-challenged states, will have a more
difficult time. As several states add tuition-free programs at community
colleges and state universities, the enrollment declines at these schools
will likely be exacerbated.
The number of high school graduates are
expected to decline by 2% by the 2022-2023 academic year. The Northeast and
Midwest, which have the highest concentration of smaller, less-competitive
4-year private institutions, are projected to have a high school graduate
decline of more than 2% while the South and West will see growth.
There has been a surge in mergers among
colleges and universities since the recession, with bigger schools snapping
up smaller rivals to extend their geographic reach or competitive
advantage. But there have been few mergers between small private schools,
which have been squeezed by heightened competition because the number of
high-school graduates has shrunk and some students have shunned taking on
costly loans to cover tuition.
There have been at least 55 merger and
acquisition transactions among colleges and universities from 2010 and
2017. A 'mergers of equals' has been rare.
Public university systems in Georgia and
Wisconsin plan to consolidate campuses within their systems or have already
done so. Last year, Boston University said it would acquire the much
smaller Wheelock College, with just over 1,000 students.
When you combine two entities, once you
get past a year or a year and a half of implementation, you may see the
power of the two institutions having been merged together under one
university. If done effectively and efficiently, the financial and credit
profile could improve dramatically. Merged entities can benefit from
increased enrollment, size, and programmatic diversity. As such, we expect
the pace of mergers to increase.
Top Of Page
Higher Oil Prices and the
Impact on the Top Energy-Producing States
Monday, March 5, 2018
In November 2014, MTAM released a special
report entitled 'Lower
Oil Prices and the Impact on the Top Energy-Producing States'.
Consistent with our long-held view, outsized budget reserves in most of the
oil-producing states appears to have provided an effective fiscal cushion
as they transitioned to lower oil prices. Since then, oil prices have
rebounded and we decided to revisit the topic.
The rising price of oil and crude oil
production increases are improving the economic and financial stability in
most oil-producing states. However, the natural resource states' revenue
growth prospects remain constrained and, for some, financial resiliency has
become weaker.
The U.S. oil industry's rise has
benefitted Alaska, Louisiana, New Mexico, North Dakota, Oklahoma, and Texas
(natural resource states). Economic growth and tax revenues tied to higher
prices and production have risen. However, financial operations for many
could remain tight as the fallout from successive one-time actions,
including substantial reserve use, applied in recent budgets in response to
the multi-year price and production downturn continue to challenge them. In
addition, the recent oil bust could temper these states' expectations of a
long-term turnaround in the industry.
The U.S. oil industry's recovery is
underpinned by strong production growth. It grew by 11% in 2017 on the
expansion of shale companies' production after organization retrenchments
necessitated by the late-2014 price plunge that bottomed at $26.21/barrel (bbl; West Texas Intermediate [WTI]) in February 2016.
Prices have been rising as well. An
OPEC/Russia agreement to limit production and growing global demand have
pushed oil prices up beginning in 2017 from $52.33/bbl
to $59.64/bbl by year's end. The 2017
acceleration boosted U.S. rig counts to 930 at the end of the year; up 36%
from January 2017, but still far below the 1,904 rigs in service in September
2014.
Forecast
The U.S. Energy Information
Administration (EIA) forecasts a 1 million bbl/day
increase in U.S. oil production in 2018 from 2017. The EIA expects a 2018
average of 10.3 million bbl/day in production,
rising to 10.8 million bbl/day in 2019. Growth
regions identified by the EIA include the Permian region in Texas and New
Mexico and the federal Gulf of Mexico. Production in Alaska is expected to
remain flat in both 2018 and 2019. The forecast for the WTI price is
$50.00/bbl for 2018 and $52.50/bbl for 2019; the long-term forecast is a subdued
$55.00/bbl, reflecting the high level of market
uncertainty and lower global production costs that are unlikely to result
in a sustained period of materially higher prices.
Many factors could have an impact on
these expectations, including deteriorating compliance within the
OPEC/Russia production cuts, and U.S. producers' response to recent price
increases.
Throughout 2017, there was a confluence
of developments supporting higher oil prices, and MTAM believes that is
likely to continue this year. These include the continuation of OPEC
production cuts, ongoing supply disruptions, globally synchronized growth
portending solid demand, reported declines in crude inventory levels, and a
weakening U.S. dollar.
The energy-industry states will likely
see continued economic growth this year as the price of oil rebounds. That
promises a much-welcome boost to governments that saw revenue disappear
after oil prices began collapsing four years ago, triggering downgrades to
some states' bonds.
Conclusion
Oil prices, which slipped to as little as
$26 a barrel two years ago, have since more than doubled to $63, just shy
of the more than three-year high hit last month.
All major oil-producing states are likely
to see their economies expand in 2018, with Texas poised to lead with 4%
growth, according to data from IHS Markit. These
states rely on energy production as a key driver of their economies and for
taxes levied directly on the industry.
Stabilizing economic performance combined
with a range of fiscal adjustments implemented in the energy-producing
states has brought about an easing of the negative pressure on the credit
quality they were experiencing. The higher prices have not resulted in any
rating upgrades for the states yet. Still, municipal bond investors have
responded to the recent rise in the price of oil by demanding less
compensation on at least two oil-producing states' debt, signaling that
credit risk may be abating.
Top Of Page
President Trump's
Infrastructure Plan
Monday, February 26, 2018
The Trump Administration last week
released the long-awaited details of its plans to fix the nation's broken
and crumbling infrastructure. President Trump's "Legislative Outline
for Rebuilding Infrastructure in America" framework is aimed at
shaking up the federal government's role in infrastructure investment. The
administration's infrastructure proposal, part of its fiscal year 2019
budget request, faces an uncertain path through Congress.
The plan unveiled three new programs and
other changes intended to provide $200 billion in federal funding which,
combined with state and local funds and private capital, could lead to $1.5
trillion of new infrastructure investment. The plan also pledges to
dramatically shorten the time it takes to obtain permits, and outlines a
host of other features that could revamp state and local governments'
infrastructure investment decisions while opening the door to the private sector.
The Trump administration's infrastructure
proposal would significantly expand private activity bond (PAB) usage and
speed the approval process. Both developments would be a credit positive
for infrastructure projects. However, the proposal's effects on overall
infrastructure development would be small as the proposal lags the need in
the U.S. by trillions of dollars. In addition, there are political risks to
implementation with uncertainties including legislative support and
potential opposition from states.
The proposal would make PABs applicable
to a broader array of infrastructure projects and would also increase the
amount of PABs that could be issued by raising state volume caps. An
expansion of PABs would give project finance a bigger set of funding
options and could mean more private investment in infrastructure, both of
which would help address the aging infrastructure in the U.S.
The infrastructure proposal includes $200
billion in federal funding over 10 years, largely repurposed from existing transportation
programs. States and locals are asked to provide up to an 80% match for
competitive grants and loans for $120 billion of this total. In contrast,
most current federal funding operates on a 80%
federal to 20% state and local match ratio. In the proposed plan, $50
billion will go directly to governors for rural infrastructure, while $10
billion will be for federally owned infrastructure, and $20 billion will
fund expansion of existing federal loan programs and private activity
bonds. The $200 billion represents limited increased federal funding over
the next decade with much of it reallocated from existing transportation
programs including Amtrak and the Federal Transit Administration's Capital
Investment Grants (New Starts).
Many states have implemented
transportation funding increases in recent years at a time of federal
inaction. This will limit their willingness to pursue the additional
revenue increases required by the proposal. Since 2013, 26 states and the
District of Columbia have implemented transportation funding changes
according to the National Conference of State Legislatures. Often, the
additional funding has been directed to specific initiatives with a heavy
focus on maintenance of existing facilities. We anticipate these states in
particular will be challenged to meet the proposed 80% match requirements
for new projects.
The new cap on the SALT deduction
implemented with the December 2017 Tax Cuts & Jobs Act (H.R. 1) further
limits state and local governments' flexibility to generate the funding
called for in the administration's plan. Taxpayers in 19 states and the
District of Columbia had average SALT deductions exceeding the $10,000 cap
imposed by H.R. 1, according to the Government Finance Officers Association
(GFOA). The average deduction exceeded $9,000 in another 12 states in the
GFOA analysis, which was based on 2015 Internal Revenue Service data. Tepid
growth in state tax collections, which makes meeting operating spending
demands for education and health care an ongoing challenge, further
complicates states' ability to dedicate funding to a new federal
transportation program.
The problem for U.S. infrastructure has
never been a shortage of private capital, but rather how it is paid for.
Even if policymakers reject the overall plan and its role for private
capital, we see an inevitable need for Americans to accept paying more to
use the nation's infrastructure. At its very essence, the plan forces into
the political debate a conversation about who will support new
infrastructure because massive federal funding is no longer on the table.
And if the gap cannot be bridged by local and state governments alone or
through additional direct federal spending or programs, the private sector
will inevitably have to be involved in the solution.
The proposal did not include a solution
for the Highway Trust Fund (HTF). The HTF collects federal fuel tax of 18.4
cents per gallon on gasoline and 24.4 cents per gallon of diesel fuel and
other excise taxes. The Congressional Budget Office estimates the HTF will
become insolvent under current law by 2020, threatening a primary source of
existing federal support for infrastructure. The HTF provides $40 billion
in highway spending and $10 billion in transit spending to states annually.
The Federal Highway Administration reports that since fiscal year 2008,
trust fund spending has outpaced revenues, requiring $140 billion in
congressional transfers from other funds, mainly the treasury's general
fund.
Conclusion
The Trump administration's infrastructure
proposal relies heavily on funding from state and local governments. MTAM
believes that providing funding from tax revenues could be challenging for
some state and local governments as many have already raised revenues in
recent years to fund infrastructure investments, and general revenue growth
has been slow. While opening the door to the private sector, the plan
includes limited additional federal funding and lacks a long-term solution
for the federal highway trust fund, which serves as the primary source of
existing federal infrastructure funding. Highway trust fund insolvency
remains a significant long-term federal infrastructure issue.
Top Of Page
The Legalization of Cannabis
in California
Monday, February 5, 2018
As acceptance for cannabis legalization
expands, the widely varied regulation and tax structures at the state and
local levels have led to a measurable - and in some cases substantial -
revenue boost. Tax provisions have been central to nonmedical legalization,
as a way to gain public support and discourage consumption, similar to
other vice taxes. Cannabis is now legal in some form in 30 states where 64%
of Americans reside.
The benefits of cannabis legalization as
a harm-reduction strategy appear likely to supplement gains from new
revenues. States may see decreased public safety costs, including reduced
arrests, prosecutions, and jail-time. Public health costs may also be
positively impacted, notably by a potential decline in opioid abuse.
Negative outcomes may become more
apparent over time, but appear likely to be less consequential than impacts
from other legal substances, such as alcohol or tobacco.
Taxes are most significant in states that
have legalized nonmedical cannabis, a market that appears likely to dwarf
the medical cannabis market based on the broader pool of potential
consumers. The low end of cannabis taxation stands at 10%-20%, while the
higher end - due to multiple state and local taxes - can reach as high as
50%.
In California, the retail sale of
nonmedical cannabis began on January 1, 2018 following California voters'
approval of the Control, Regulate and Tax Adult Use of Marijuana Act
(Proposition 64) in November 2016. In addition, residents of seven
California cities voted to impose local taxes on cannabis in the November'
2017 elections. With retail sales beginning on January 1, the newly
approved measures will add to the already substantial tax burden on legal
cannabis, potentially undermining California's fledgling legalization
initiative.
Voters in the cities of Cotati,
Farmersville, Modesto, Pacifica, Palm Springs, Rio Dell, and Woodlake
approved cannabis measures, joining local governments across the State that
adopted local taxes in prior elections. In total, 67 of California's 540
cities and counties have adopted local cannabis taxes to date, contributing
to combined state and local tax rates that could be as high as 45%. Taxes
include a 15% state excise tax, state cultivation taxes of $9.25 per ounce
for cannabis flowers ($2.75 per ounce for leaves), and state and local
sales taxes ranging from 7.75% to 9.75%. By comparison, Oregon taxes
nonmedical cannabis at 20% and Alaskan taxes range from 10% to 20%.
High taxes increase prices in legal
markets, and have the effect of reinforcing price advantages to
long-established black market cannabis. Taken together, state and local tax
burdens put California at the high end of the tax range for states that
have legalized nonmedical cannabis.
In Colorado and Washington, revenues,
though initially short of expectations, have ultimately exceeded estimates
measurably. Monthly growth rates have slowed more recently, suggesting some
maturation of the legal cannabis market.
California's high cannabis taxes may
encourage black market sales and limit potential local government revenues
from this new market. The State's black market will also benefit from its
long history as a supplier to states where nonmedical cannabis remains
illegal.
California became only the latest of the
states to contend with black market staying power. Colorado, Washington,
and Oregon each lowered their cannabis taxes following legalization to
address black market competition. Proposition 64 and most local tax
measures included provisions that could permit reductions in tax rates over
time. However, future tax cuts may be politically challenging to implement.
Federal restrictions pose an additional
and ongoing risk to revenues in states that have legalized medical and
nonmedical cannabis. The risk of intervention has risen under the current
presidential administration following the U.S. attorney general's call for
increased enforcement of drug laws that continue to classify cannabis
alongside heroin and LSD. Rising popular support for cannabis legalization
nationally may mitigate such risks over the longer term.
In the mean time,
California is searching for a solution to the lack of access to banking for
the State's cannabis businesses. As the State closes its first month of
legal recreational cannabis sales, the governor, state treasurer, attorney
general, and the legislature are all working on the issue.
"We are contending with a multi-billion dollar cannabis industry that needs banking
services, and a private banking industry that is stymied by federal law in
meeting the needs of the new industry," said Treasurer John Chiang.
Federally insured and regulated banks
have refused to handle transactions from cannabis businesses, because the
federal government still considers marijuana an illegal drug, one facing
increasing hostility under the Trump administration.
The lack of access to banking means that
cannabis businesses keep a great deal of cash on hand making them targets
for robberies.
The state attorney general's office and
treasurer's office are both moving forward on dual, separate feasibility
studies to create a state bank to provide the industry with banking
services. The state attorney general's office study will look at the
legalities while the treasurer's study would look at operations. The
studies will consider the costs, benefits, risk, and legal and regulatory
issues.
That would include considering whether an
online bank or a bricks-and-mortar institution would be a better solution
and potential alternatives for capital and whether bonds might be part of
that.
In separate efforts, California Governor
Jerry Brown has proposed a correspondent bank, which would act as a
wholesaler for a network of smaller banks. And, state Senator Bob
Hertzberg, D-Van Nuys, introduced a bill that would give a new state
charter to financial institutions that are not federally insured to issue
certified checks and handle payroll for cannabis workers licensed by the
State.
U.S. Attorney General Jeff Sessions
rescinded a trio of Obama-era memos on January 4 that stipulated a policy
of non-interference with cannabis-friendly states. The moves means federal prosecutors across the country now have to
decide how to enforce federal laws regulating cannabis possession,
distribution, and cultivation of the drug in states where it is legal.
Top Of Page
Amazon's HQ2
Tuesday, January 30, 2018
Amazon recently announced that it has
narrowed its choices of potential second headquarters sites to 20
communities. The company expects to select a site by the end of 2018 that
it says could eventually encompass $5 billion in real estate investment and
50,000 mostly high-paying jobs (over the next 10 to 15 years). Aside from
Toronto, the remaining 19 cities are domestically-based, with nearly half
on the East Coast.
While the city that Amazon chooses for
its second headquarters will likely experience an improvement in credit
quality, the incentive packages that some cities may have to offer could
offset the revenue gains. In evaluating the credit effects of Amazon's site
decision, we expect to examine the potential positive economic and revenue
effects of the investment against the cost of any incentives.
The scale of the proposed real estate
investment and addition of high-paying jobs would have mostly positive
local economic and governmental revenue effects, which would be most
noticeable in communities that are relatively small or have lower per
capita effective buying incomes.
Amazon wants the city that lands its
second headquarters to have a "stable and business-friendly
environment." To corporate America, that means no surprise tax
increases, please. Some cities may forego increased tax revenues, expecting
to capture trickle-down economic benefits.
But eight of the 20 finalists have high
debt and pension-fund bills, a potential red flag that they may come
looking for extra revenue in the years ahead. Atlanta, Austin, Chicago,
Dallas, Indianapolis, Los Angeles, Philadelphia, and Pittsburgh are among
the cities with more than 250,000 residents that spend the greatest share
of their budgets on debt, pensions, and retiree medical benefits.
Among the other 12 finalists, Columbus
and Denver can boast relatively low debt and pension burdens.
The 20 finalists have various levels of
fiscal health. Using the fixed-cost ratio as a determinant for the level of
financial flexibility, several cities on the list struggle under the weight
of debt service and legacy retirement costs, including the population
centers of Los Angeles and Philadelphia. Each of these cities has
fixed-cost ratios above 25%. Yet Philadelphia appears more stressed with a
poverty rate in excess of 26% vs. 18% for Los Angeles.
Many studies have been conducted on the
economic benefits outweighing the costs of tax incentives necessary to lure
a desired new corporate citizen. In looking at the issues facing Seattle --
such as increased traffic, rents, home prices and homelessness -- this
windfall may come at a price.
Amazon is the fourth-largest employer in
the Seattle area, but does not even enter the top-10 largest customers for
Seattle Light and Power, despite the large sums the utility spent on
Amazon's current location. Spending by the utility to facilitate the
build-out of almost 8.1 million square feet of office space is just one
form of subsidization that a new host city should keep in mind. Seattle
Light spent upwards of $210 million to build out a new substation in the
Denny Triangle portion of Seattle.
With few options to outgrow fiscal woes,
some cities -- and even states -- may resort to an all-out, high-risk
financial proposition to land Amazon HQ2. One example is Newark (NJ), which
has offered $2 billion in local tax incentives and another $5 billion in
state tax breaks, as the state searches for new revenue sources.
Top Of Page
Credit Comment on
California's Latest Budget Proposal
Monday, January 22, 2018
The State of California is enjoying its
highest credit ratings (Aa3/AA-/AA-) since the turn of the century,
primarily due to a record-setting stock rally, a resurgent real estate
market, and a Silicon Valley boom that swept away once crippling budget
deficits. Yet Governor Jerry Brown's latest annual spending plan is focused
on risks ahead. The governor has proposed a fiscally-restrained budget with
a large rainy day fund pointing to uncertainty in State revenues and the
potential fallout from the federal tax overhaul enacted last month.
Governor Brown, who took office seven
years ago, has overseen a financial turnaround for the most-populous U.S.
state that has been lauded by Wall Street. After revenue rebounded, in part
because of tax increases, the governor used some of the windfall to pay off
debt and add to the savings account that can be tapped the next time the
economy stumbles.
California's revenue is volatile because
it draws a large share of taxes from wealthy residents whose incomes are
tied closely to the stock market, which saddled the State with huge budget
deficits after the Internet and real estate bubbles burst. The top 1% of
earners accounted for nearly half of the State's personal income tax
collections in 2015. Voters in November 2016 approved a 12-year extension
of higher tax rates on the wealthy, deepening the reliance on their
fortunes.
There is some volatility and some risk
that California has that other states do not. In periods of economic
growth, the State is going to outperform; in periods of recession, the
State is going to underperform. State officials' ability to mitigate those
swings is going to be manifested through their budgeting practices.
Recent
Financial and Economic Results
California tax revenues came in $85
million below estimates in November, but were ahead by $588 million on the
$40.5 billion year-to-date forecast, according to the California Department
of Finance.
Both personal income tax revenues and
sales use tax receipts came in below expectations for the month, though
corporation tax revenues came in ahead of projections. Personal income tax
revenues were $86 million below the month's forecast of $4.9 billion. Sales
and use tax receipts came in $48 million below the month's forecast of $2
billion. Corporation tax revenues came in $88 million above projects, which
were expected to be a negative $108 million.
Economic indicators were positive.
California real gross domestic product rose by 2.1% in the second quarter,
compared with only 0.6% growth in the first quarter. U.S. real GDP rose
3.1% in the second quarter.
California's seasonally adjusted
unemployment rate fell by 0.2% to 4.9% in October. While this rate equaled
the pre-recession low from March to December 2006, it remained 0.2% higher
than the 4.7% in May and June of this year, according to the Department of
Finance.
California housing permits jumped to
their highest level since March 2007 with 141,000 permits issued in October
2017 on a seasonally adjusted annualized basis. Multifamily housing permits
led the gains, rising 127% to 79,000 units, while single-family housing
permits rose 4.9% to 62,000 units. Through the first ten months of 2017,
California housing permits averaged 112,000 units, 11.4% above last year's
year average.
2018-19
Budget Details
On January 10th, 2018, Governor Brown
unveiled his $131.7 billion general fund ($190 billion all-funds) budget
proposal for fiscal 2019 (the final of his governor's tenure). The proposal
is favorable from a credit perspective. It recommends materially increasing
budget reserves, seeking to preserve for more difficult economic conditions
some of the fiscal gains the State has achieved during the past seven
years.
Governor Brown, who took office in 2011
while the State was still reeling from the effects of the recession, has
strove to keep more of a cushion for future downturns, a theme he kept in
his last proposed budget as governor. He boosts the rainy day fund to $13.5
billion with a supplemental transfer of $3.5 billion. The additional
deposit in the coming year would make the rainy day fund fully meet the
constitutional goal of saving 10% of tax revenue.
The governor's proposed budget indicated
that California also plans to slow the pace of general obligation bond
sales. Brown estimated the State would sell $4.1 billion of general
obligation bonds over the 2018 calendar year. Such sales would total $2.5
billion from January through June and $1.6 billion from July through
December. Early last year, Brown had projected the State would sell $5.7
billion in the 2017 calendar year vs. $4 billion projected in 2016, and
$3.6 billion in 2015.
Obstacles ahead include possible federal
setbacks ranging from the effects of the recently enacted tax overhaul --
which will fall heavily on some residents by capping state and local tax
deductions -- to the potential loss of funding for children's health
insurance.
The biggest battle in this year's
California budget process is likely to be about what to do with an
estimated $7.5 billion budget surplus. The governor's budget would direct
$3.5 billion into the rainy day fund in addition to the $1.5 billion
constitutionally required through legislation that created the fund in
2014. Brown's budget would also place $2.3 billion into an operating
reserve fund in addition to the money going into the rainy day fund. The
Legislature's Democratic majorities have signaled that they think some of
the surplus should be used to bolster social programs, particularly those
for the very poor.
Given the uncertainty at the federal
level and the likelihood of more federal cuts to social programs, the
governor could strike "a better balance between putting funds away for
later and boosting state investment now to help more households to make
ends meet and climb the economic ladder, especially in light of our State's
highest-in-the-nation poverty rate," said Chris Hoene,
director of the California Budget & Policy Center, a think tank that
focuses on how the State's budget policies impact poor and middle-class
residents.
The much-outnumbered Republican caucuses
have their own ideas for the surplus. They want $2 billion to be used for
reserves, $2 billion to pay down pension liabilities, and $2 billion to go
to local government to fund housing incentives, homeless shelters, and fix
local streets and roads.
Senator Jeff Stone, R-Riverside County,
supported the governor's plan to bolster the rainy day fund, but suggested
that the level of the surplus gives the State plenty of room to return some
of the money to taxpayers "to mitigate any negative impacts that may
come from the recently adopted federal tax reform legislation."
Brown's budget would also send money to
local governments with $8 billion in flexible funding to help counties as
they continue to deal with the shift that began in 2011 of non-violent offenders
from state prison to county jails. He also would allocate $3 billion for
K-12 schools through local control funding to put more money in the hands
of schools that have higher concentrations of impoverished students and
English learners.
Brown's budget also takes aim at the
State's estimated $67 billion in deferred maintenance. The 2015 and 2016
budgets allocated $960 million to the most critical deferred maintenance
projects such as levees and high-priority state facilities including office
buildings and the Capitol Annex.
This budget takes into account the
passage of Senate Bill 1, the gas tax, which it says will provide $55
billion in new transportation funding over the next 10 years, split equally
between state and local projects.
The governor's spending plan would
allocate $4.6 billion in new transportation funding in fiscal 2018-19
including $2.8 billion to repair neighborhood roads, state highways and
bridges, $556 million for trade and commute corridors, $200 million for
high-priority transportation projects and $721 million for passenger rail
and public transit modernization.
Brown's budget would direct $1.3 billion
to natural resources and housing infrastructure spending presuming that
state bond measures passed by the Legislature last year will be approved by
voters in November. The Legislature approved 15 bills last year to
encourage housing construction to help fill an annual 180,000-unit of homes
that need to be built over the next 10 years to alleviate the housing
crisis. One placed a $4 billion general obligation housing bond measure on
the statewide ballot in November, while the other is expected to bring in
$250 million a year through a $75 fee to most real estate transaction
documents, except on the purchase or sale of property.
The governor's January proposal is an
opening gambit in the long march toward a budget that is to be adopted in
June, before the July 1 beginning of the fiscal year. The governor will
release a revised budget proposal in May using updated revenue figures from
April's income tax filings.
Top Of Page
Municipal Bond Market – Credit Outlook for
2018
Monday, January 8, 2018
Municipal bond issuers will continue to
face several credit challenges in 2018, but MTAM expects that the vast
majority of municipalities will successfully manage through most
difficulties with a combination of spending cuts and revenue enhancement
plans.
Notwithstanding the challenges facing
municipal bond issuers, there are always good opportunities, even for the
very conservative investor. Despite our expectations for moderate levels of
economic growth, we still expect defensive credits like water and sewer
bonds, special tax bonds, and public power bonds to perform better from a
fundamental perspective. These types of bonds tend to have revenue streams
that are less subject to economic volatility, have strong covenants, or are
tied to an "essential service", making debt service payment more
certain. In addition, there is legal precedence that bonds backed by a
dedicated revenue stream may be protected in the case of a municipal
bankruptcy. We prefer bonds that have a clean flow of funds, broad revenue
streams, and high debt service coverage tests.
State
Governments
U.S. states are well positioned to meet
budget forecasts in 2018 so long as the economy continues to grow, though
five states could run into some issues. The credit outlooks for most U.S.
states are stable
and expected to remain so over the next 12 months. Federal action remains
the pre-eminent factor driving state credit ratings this year. Decisions
around Medicaid and tax policy present the most immediate risks while
infrastructure, trade, and other policy areas will affect economies and
budgets over time, all with varying degrees by state.
Nearly one year into the new federal
administration, many areas of policy remain unresolved. Throw in
increasingly contentious state budgeting sessions and policy becomes more
of a challenge for states this year. However, state budget makers are
historically conservative, which should make budget forecasts attainable
for the vast majority of U.S. states.
Helping matters is the likelihood of the
broader economy continuing to grow in 2018, which is what MTAM is
projecting. Changes to federal funding could present a challenge without
mandate relief, though states would likely rely on their strong ability to
manage budgets and download fiscal challenges were federal changes to take
place, protecting ratings.
The overall stable outlook for the
sector, however, is not without its outliers. Not surprisingly, Illinois
and New Jersey are once again on MTAM's 'states to watch' list in 2018
along with Connecticut, Kentucky, and Louisiana. Illinois will enter 2018
with an enacted budget for the first time in nearly three years, though
whether the budget will be successfully implemented remains a lingering
question mark. If Illinois reverts back to a pattern of deferring payments
for near-term budget balancing, their credit rating could face more
immediate pressure.
U.S. states continue to keep overall debt
largely in check, though their pension burdens are larger and rising. Our
calculations showed a modest year-over-year increase in median state
long-term liability burdens at 6% of 2016 personal income compared with
5.6% one year earlier. We attributed the entire year-over-year increase to
defined benefit pension liabilities versus bonded debt. Nonetheless, we
still deem the median state liability burden low relative to state
resources.
A different picture emerges when
assessing liability burdens for individual states. We calculated that six
states have liability burdens eclipsing 20% of personal income. Illinois
tops the list with a total liability burden equal to 28% of personal
income, followed by Connecticut, Kentucky, New Jersey, Alaska, and
Massachusetts. By contrast, 38 states carry liability burdens below 10% of personal
income, with Nebraska the lowest at 1.4%.
The disparity in liability burdens is
driven mostly by pension obligations. Many states with elevated pension
burdens provide pensions not only to state retirees but also to local
teachers. Additionally, a history of weak contribution practices has
resulted in actuaries forecasting that pension assets will be depleted for
many states with the highest pension burdens. This requires a more
conservative calculation of pensions under current accounting rules.
Unlike bonded debt, state pension burdens
continued to rise. Factors driving this growth include weaker than expected
asset performance during the most recent reporting period, inadequate
contributions by some governments, long-term demographic trends and the
continued shift by states toward lower discount rates.
Local
Governments
Numerous questions concerning Federal
policy and infrastructure adequacy will not impede the financial resiliency
of U.S. local government ratings in 2018. Our stable outlook for
U.S. local government ratings remains in place for 2018 thanks in large
part to their financial dexterity in uncertain times, both economic and
otherwise.
Local governments have long demonstrated
the ability to close budgetary gaps throughout economic cycles. Also
helping matters are reserve levels, which going into 2018 are well in
excess of what is needed to offset a recessionary revenue decline.
Federal policy uncertainties around
Medicaid, the federal tax system, and international trade could heighten
the risks associated with local government non-property tax revenue.
Depending on the outcome of each of these areas, school districts would be
most at risk as a result of changes to Federal policy since they are most
reliant on state aid. Also worth watching are localities bordering Canada
and Mexico that would be vulnerable to loss of direct revenues resulting
from changes in trade policy.
Infrastructure remains an ongoing concern
and more so in light of Hurricanes Harvey, Irma, and Maria, which caused
widespread damage in parts of Texas, Florida, and much of Puerto Rico and
the Virgin Islands. That said, local government ratings should remain
well-insulated from ongoing rebuilding costs as they are largely shouldered
by the federal government. Local governments will not have to issue much
debt that is not reimbursable by the federal government, so the recent
storms should not affect debt service or long-term liability burdens.
Another area of note in the coming year
is the desire by some local governments to create structures that protect
bondholders from a government's general operating risk. One such structure
is securitization, as evidenced by the recent creation of Chicago's Sales
Tax Securitization Corporation.
Several California issuers along with the
Chicago Board of Education have also issued bonds secured by tax revenues
that lead municipal market participants to analyze the debt without regard
to operations, and increased interest among some other local government
entities is a real possibility in 2018.
Not-for-Profit
Hospitals
Regulatory, political, and competitive
challenges will intensify for U.S. not-for-profit hospitals and healthcare
systems headed in 2018, resulting in a negative credit outlook for the
sector. Growth in Medicare and Medicaid volumes are weakening provider payor mixes at a time when providers are moving from
volume-based to value-based reimbursement in greater numbers.
Profitability will also continue to
weaken gradually for the sector in 2018, although operating performance
should largely be stable, similar to what was seen in 2017. That being
said, growing pressure on salaries and wage expense and continued erosion
in payor mix could adversely affect operating
performance for lower-rated hospitals.
Operating expenses have risen faster than
expected and Affordable Care Act reimbursement cuts and Medicare
sequestration make it difficult for a hospital to be profitable. Tax reform
legislation will also likely raise borrowing costs for all hospitals,
especially smaller and lower-rated hospitals that have fewer financing
options.
The proven operational resilience of
hospitals should prevent steep sector-wide declines in performance in 2018;
however, we do expect further divergence in financial performance depending
on a hospital's size and geography. For many standalone or smaller
hospitals located in low density areas with slow or stagnant population
growth, operating margins have narrowed more quickly or turned negative
already.
There is an expected renewed uninsured
growth as Congressional Republicans are expected to continue undoing
elements of the Affordable Care Act and the tax reform's repeal of the
individual mandate will factor in more uninsured patients.
Republican leadership declared
entitlement reform to be a top legislative priority in 2018. Should there
be significant changes to Medicare and Medicaid, state finances are likely
to quickly come under pressure, with negative downstream effects on
hospitals.
Transportation
An otherwise stable outlook for
U.S. transportation infrastructure in 2018 will be clouded somewhat by
questions surrounding tax reform. Potential changes in tax, trade, and
border policies could affect growth for some transportation segments. While
tax reform will increase costs for capital improvements for U.S.
transportation assets in the near-term and may limit issuer options, it may
deepen the pool by opening up investments to a larger investor base. The
government subsidy will need to grow modestly for projects that already
need some public investment.
Broader questions aside, most major
transportation segments are set for another stable year in 2018 with volume
growth likely to mirror GDP and fuel prices remaining low. Moderate traffic
growth is expected for U.S. toll roads, while some projects nearing capital
plan completion may prompt MTAM to take some positive rating actions.
Our credit outlook is stable for U.S.
ports in 2018, reflecting the expectation of healthy cargo and cruise
growth balanced by a weak pricing environment, and continued overcapacity in
the ocean carrier industry.
We expect loaded container growth to
moderate to 2%-3% in 2018, consistent with growth in GDP and retail sales.
Strong growth in consumer demand for goods and faster growth in exports
will continue to support the sector.
Our stable outlook is also supported by
projected low oil prices, which will alleviate transportation costs
throughout the supply chain. Low oil prices also support the purchasing
power of U.S. consumers, which is the primary driver of demand for import
cargo and cruise travel.
While demand for U.S. ports will remain
healthy in 2018, our outlook is tempered by a still-weak pricing
environment. Many ocean carriers continue to operate at losses, which
reduces seaport operators' flexibility to increase terminal charges or
scale back service and investment levels. Further consolidation among
shipping companies will increase carriers' negotiating leverage over
seaport operators.
The ocean carrier industry has
demonstrated modest success in efforts to reduce supply and improve
profitability, but the continued supply-demand imbalance remains a risk for
ports.
Large infrastructure projects, such as
the expansion of the Panama Canal and the elevation of the Bayonne Bridge
at the Port of New York and New Jersey, support the deployment of larger
cargo ships to ports in North America. As ports continue to improve harbors
and terminals, users can access them more efficiently, which lowers costs
and increases the competitiveness of U.S. routes in carriers' networks.
Although some Caribbean islands were
devastated by hurricanes in 2017 directly before the winter booking season,
we expect that the cruise industry will revise its itineraries away from
the affected ports of call, sparing U.S. ports any significant loss of
traffic.
Our outlook could be revised to positive
if container growth exceeds 4% and ocean carriers exhibit greater financial
stability that supports an improved pricing environment for terminal
operators. The outlook could be revised to negative if container growth
falls below 1% and there is renewed weakness among ocean carriers and a
weaker pricing environment for ports.
MTAM is maintaining our positive outlook
on the U.S. airports sector, reflecting the expectation that continued
economic expansion will lift enplanement growth to 3.7% in 2018.
Enplanement growth -- the increase in the number of passengers using an
airport to depart on a flight -- is a key indicator for the U.S. airport
industry outlook since it generally translates to higher parking and
concession revenues, which account for about half of total airport revenue.
Historically, enplanement growth is highly correlated with the average of
GDP and airline seat growth.
The enplanement growth rate for large
airports may slow in 2018, however, reflecting constrained capacity growth
at primary connecting hubs for legacy carriers like American Airlines and
Delta Airlines. We anticipate small and non-hub airports will see the
strongest enplanement growth in 2018, reflecting the capacity investment in
these markets by low- and ultra-low cost airlines. For example, Long Beach
(City of) CA Airport Enterprise and Colorado Springs (City of) CO Airport
Enterprise both saw 29% enplanement growth from September 2016 to September
2017 thanks to new service from Southwest Airlines and Frontier Airlines,
respectively. All told, the increased net revenue will provide stronger
debt coverage and, in most cases, result in greater liquidity.
Challenges for the sector include parking
revenue declines as passengers continue to use services like Uber and Lyft
to get to and from airports. While data from 2016 did not register a
significant impact, data from fiscal 2017 shows some year-over-year
declines in total parking revenue.
If airlines grow seat capacity at the low
end of our estimate or if GDP growth fails to meet expectations, the
enplanement growth rate for the sector could suffer. We would consider
revising our outlook to stable if enplanement growth drops below the
threshold of 3% and was expected to result in stagnation or weakening of
revenue.
Water
and Sewer
Uncertainties around the regulatory
environment will not deter the stable
outlook for the U.S. water and sewer sector in 2018.
The U.S. Environmental Protection
Agency's (EPA) Lead and Copper Rule (LCR) may roll out revisions in 2018
following numerous stops and starts. Added capital and operating expenses
could be meaningful depending on how significant the changes to LCR are.
That said, any costs would likely be phased in over several years.
Wastewater utilities will continue to face pressure from enhanced nutrient
removal requirements as discharge permits are renewed periodically.
Despite the regulatory uncertainty, water
and sewer municipalities have strong balance sheets that give them
flexibility should capital demands increase. In addition, the latest
medians point to slightly lower capital spending in 2018 and beyond from
recent levels. Over time, however, sustained capital investment increases
will be necessary to address deferred maintenance and preserve service
levels over the long term for water and sewer municipalities.
Also solidifying the sector's stable
outlook in 2018 will be a manageable debt profile, with MTAM projecting
growth in debt to be muted. The likelihood of water and sewer utilities
keeping new debt issuance modest in the coming year will also keep the debt
profile sustainable even if interest rates rise.
Public
Power
MTAM is maintaining a stable outlook on
the U.S. public power sector for 2018, reflecting our expectation of timely
cost recovery and lower capital spending requirements. The willingness and
ability to set retail electricity rates is a fundamental credit strength of
public power utilities, and serves as the key indicator for our sector
outlook.
Fuel and interest cost trends, demand
projections, and the pace of environmental regulation all indicate stable
finances for the sector in 2018. We expect public power utilities will
continue to evaluate their rate structures to ensure adequate recovery and
maintain their competitive positions.
We project the median fixed obligation
charge coverage ratio will be approximately 1.80x in 2018, in line with
2017 levels. Debt leverage in the sector will continue to moderate near
50%, reflecting less debt issued to fund new generation. Instead, public
power utilities are shifting toward using regional energy markets and less
capital-intensive generation.
Competitive customer retail rates will
continue to be supported in 2018 by a combination of low interest rates,
low fuel costs, better plant efficiency, and substantial excess power in
most regions. Excess generation capacity will also keep rates down as
public power utilities turn to regional energy markets for their customers
while running owned generation less often.
While carbon emission policy at the
federal level has slowed, many states and municipalities will maintain the
pace of their existing renewable energy standards, posing challenges to
some public power utilities. The cost of renewables continue
to decline, which mitigates some carbon transition risk. But differing
customer preferences are also affecting procurement decisions and creating
regional differences.
While the sector continues to demonstrate
resilience and adaptability to market challenges, risks from industry
transition driven by technological developments such as energy storage will
remain a near-term focus. Capital investment for protection against
cybersecurity risks, meanwhile, is likely to represent a growing cost.
Our credit outlook could change to
positive if the median fixed obligation charge coverage ratio were to
exceed 2.0x. The outlook could be changed to negative if the ratio were to
fall below 1.50x, or if there were a successful challenge to the
fundamental credit strength of self-regulated cost recovery.
Colleges
and Universities
The credit outlook for U.S. colleges and
universities sector is stable
in 2018, though the gap is widening between larger, stronger universities
and some of their smaller counterparts.
Operating revenue pressures will likely
intensify for small, tuition-dependent schools in demographically declining
areas or highly competitive regions. Barring those outliers, operating
performance is expected to remain strong sectorwide,
which coupled with steady student demand and enrollment and solid financial
resources supports a stable sector outlook.
Operating revenue also stands to be
affected by the recently passed tax reform legislation, with annual
charitable gift revenue and both state and federal funding to feel those
effects most acutely. Most vulnerable are institutions already facing
revenue pressures related to enrollment, tuition dependency, or those with
limited liquidity profiles lacking material foundations or endowments.
Nonetheless, the majority of U.S.
colleges and universities enjoy ample financial flexibility and have been
proactive in minimizing the volatility of investment returns and increasing
the overall liquidity of their total holdings. Well-positioned institutions
retain meaningful balance sheet resources, solid demand, and increasing
tuition revenue while keeping leverage in check. Most colleges are also
effectively balancing the desire to maximize long-term investment returns
and the need for capital investments against the need for sufficient
working capital and liquidity.
Housing
MTAM has revised its outlook for the U.S.
state housing finance agency (HFA) sector to stable from positive, reflecting
the expectation that margin growth will slow in 2018. A combination of
stable single-family loan originations and a gradual shift back to bond
issuance will hold margins near 16% in 2017 and 2018. While HFA margins
remain high, limited growth potential within the sector prompted us to
change our outlook to stable.
HFA origination volume doubled between
2014 and 2016 due to interest rate subsidies and down payment assistance on
mortgage products, high consumer confidence, a growing borrower base and
effective use of the secondary market as an alternative financing tool.
For the next several years, however, a
limited supply of affordable housing on the market will constrain
originations near 2016 levels. First-time homebuyers with low to moderate
income are the primary consumers of HFA mortgage products. In addition to flattening
originations, a gradual move toward bond financing will also temper margin
growth in 2017 and 2018.
The shift will have a positive effect on
loans and bonds outstanding on HFA balance sheets, but will have a neutral
to negative effect on margins. The scale depends on the extent to which
bond financing cannibalizes their high margin secondary market business.
In the decade since the financial crisis,
HFAs have actively strengthened their risk profiles by diversifying their
loan origination channels, shifting their mortgage insurers to government
providers and mortgage-backed securities and altering the structure of
their variable rate debt. As a result, they are better prepared to face a
future housing and financial crisis of the same magnitude, a strength that
supports the stable sector outlook.
MTAM could change its outlook to positive
if margins climb over 15% with a potential for growth. Operating margins of
10%-15% support a stable outlook, while margins of under 10% could lead to
a negative outlook.
Default
Outlook
Defaults in the U.S. municipal bond
market continue to be rare, with just four in 2016 (most recent official
data available), all related to the Commonwealth of Puerto Rico. The
defaults, which included a Puerto Rico agency, compare with four in 2015,
zero in 2014, and seven the year before. While the majority of bond issuers
remain stable, more are confronting pressure from underfunded pensions,
infrastructure bills, and other expenses.
Total debt affected was $22.6 billion in
2016, by far the highest annual default volume in a 47-year study period.
The number of municipal defaults will more than double in 2017 if the
various Puerto Rico credits now entering court-ordered resolution are
restructured with bondholder losses or otherwise default. An additional
$41.7 billion debt is at risk.
Municipal defaults and bankruptcies have
become more common in the last decade, but are still rare overall. The
five-year municipal default rate since 2007 was 0.15%, compared with 0.07%
for the entire study period. In contrast, the five-year global corporate
default rate was 6.92% since 2007. Competitive enterprises, such as housing
and healthcare, account for most default events since 1970, while general
governments and municipal utilities led in default volume.
Conclusion
Despite uncertain fiscal, economic, and
regulatory pressures, U.S. municipalities will benefit from moderate
economic expansion that will support revenue growth and stability. MTAM
continues to recommend that investors select high-quality municipal issuers
that understand the new financial reality and have made or are making
budget adjustments. Essential service revenue bonds without the budgetary
concerns of state and local governments and limited payrolls can be
attractive, but we stress that an essential service issuer cannot flourish
if the underlying governmental entity is in dire economic circumstances. A
healthy outlook holds for most infrastructure issuers due to fundamental
strengths reflected in the provision of essential public services, adequate
balance sheets, and generally sound governance and fiscal management
practices. In the case of the enterprise sectors comprised of higher
education, health, and housing, credit quality will be maintained primarily
as a function of their ability to increase fees, control costs, and improve
overall operating margins. Sound debt and fiscal management practices,
preservation of adequate liquidity, and strong governance oversight will be
significant determinants of credit quality for issuers during the coming
period of financial adjustment.
Top Of Page
4th Quarter 2017 Review and
Outlook
Wednesday, December 27, 2017
Negative returns were prevalent in the
fourth quarter of 2017 for municipal bond investors as a tidal wave of new
issue supply overwhelmed the market and weakened prices in systematic
fashion. The driving force behind this surge in supply was the tax reform
bill that grabbed everyone's attention once it was divulged that issuers
would no longer be able to "advance refund" their debt in 2018.
Once the word got out about this shocking provision, municipal issuers
worked around the clock to bring any debt to market that they could advance
refund before the year ended. In fact, the month of December broke the
all-time record for municipal debt coming to market — a whopping $55.6 billion. This provision
of the tax reform bill did become law, so the municipal market has said
"sayonara" to advanced refundings and
with that, participants expect about 20% less new issue supply in 2018 and
thereafter.
The future of "private
activity" bonds also came under a cloud during the last quarter as the
House of Representatives initially called for the end of tax-free financing
in this sizeable sector of the market that includes universities,
hospitals, and airports. While it was later learned that the Senate sought
to preserve private activity bond issuance in their version of tax reform,
it was too late to stem the onslaught of issuers who became concerned that
market access may not have been possible in 2018. As a result, the onslaught
of private activity bond deals commenced almost immediately to add to the
overwhelming supply of municipal bonds last quarter. Ultimately, the final
version of tax reform that President Trump signed preserves the tax-exempt
status of private activity bond issuers.
Now that tax reform has been signed into
law, it is important for tax-free bond investors to consider its potential
long-term consequences on the municipal market moving forward:
- The end of advance refundings
→ less supply → positive for prices overall
- Federal deduction for payment of state and local
taxes capped at $10,000.00 → will likely increase demand for in-state bonds →
positive for prices of bonds of high tax states
- Corporate tax rate dropping to 21% →
less demand for municipals from banks and insurance companies →
negative for prices overall
Interestingly enough, the technical
forces of the municipal bond market (less supply) and the United States
treasury market (higher deficits - more supply) are set to diverge in the
coming months which bodes well for potential outperformance of tax-free
bonds. In particular, shorter-term municipal bonds are oversold and
excessively cheap to U.S. Treasuries in our view. We would not be surprised
at all if shorter maturity bonds stage a comeback of sorts in January as
billions of dollars of cash hit individuals' portfolios.
Moving forward, there is a plethora of
unknowns relating to tax reform that will take many months to become more
apparent to municipal market participants. However, what is unambiguously
clear at this time is that market yields are somewhat elevated due to an
excessive amount of supply that will not be repeated anytime soon. This
keeps us here at Miller Tabak Asset Management
quite focused on having your portfolios as fully invested as possible.
"Scarcity" is a word tax-free bond investors are likely to hear
in the coming months. For that reason, a strong buy signal has emerged in
our view.
Happy New Year!
Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak
Top Of Page
Municipal Bond Market – Proposed Tax Reform
2017
Wednesday, November 8, 2017
The House Republicans' "Tax Cuts and
Jobs Act," if enacted, could mean shrinking the tax-exempt municipal
market by at least one-third, and possibly as much as 40 percent, depending
on the direction of interest rates. The important news is contained in the
section "Subtitle G - Bond Reforms." The bill proposes
terminating private activity bonds (PABs), repealing the use of advance refunding
and tax-credit bonds, and prohibiting the sale of tax-exempts for
professional sports stadiums.
We note that the likelihood of the
passage of this proposed legislation into law remains far from certain and
will be subject to potentially key changes as it proceeds through the House
and the rest of Congress.
To appreciate the enormity of the
Republicans' assault on future municipal market supply, you have to go to
the Municipal Securities Rulemaking Board's glossary and look at the
definition of "Private Activity Bond." And there you will find
bonds sold for airports, docks and "certain other
transportation-related facilities; water, sewer and certain other local
utility facilities," single- and multi- family mortgages, blight
redevelopment and student loans. And then: 501(c)3s, which means museums,
hospitals, colleges and universities.
The tax reform proposal by Republicans in
the U.S. House of Representatives could affect some states' and local
jurisdictions' revenues if passed. Nonprofit hospitals could see a key
funding stream evaporate if the tax bill becomes law. Private activity
bonds, which are issued by governmental authorities to help private
organizations pay for facilities and capital improvements, are currently
exempt from taxation in certain circumstances, including when the proceeds
of the bonds go to support qualified 501(c)(3) organizations, like most
hospitals. The Republican proposal eliminates the tax exemption for the
bonds altogether, which could increase the borrowing costs for hospitals
and, in turn, force them to raise the rates for patient care.
The proposal could limit tax raising
flexibility, particularly for the states that charge higher taxes, as it
would substantially reduce the federal tax deduction for state and local
taxes. This would cause an increase in the impact of state and local taxes,
as they would be without an offsetting federal deduction. Residents in
states with comparatively high taxes, such as California, Connecticut,
Massachusetts, New Jersey and New York, would be more affected and may have
less tolerance for higher taxes going forward. The proposed tax cuts for
the higher-income taxpayers most likely to benefit from the current
deduction for state and local taxes, including rate reductions and
elimination of Alternative Minimum Tax, could somewhat offset this effect.
Most states are not in a position to lower taxes in response to the federal
tax increase due to tepid revenue growth and ongoing spending pressures.
If the proposed changes to the deduction
of mortgage interest and the cap on the deduction for property taxes reduce
the incentive to buy houses, assessed property values in areas with high
average home prices could see lowered growth or even decline and reduce the
amount of property tax local governments collect. This change could result
in lower revenue growth prospects for local governments absent tax rate
increases.
A proposed 1.4% excise tax on net income
from the largest private colleges' endowments would be an incremental
financial stress but would likely not have significant near-term credit
effects on colleges or universities. The impact would be narrow. For
example, only 140 endowments had funds in this range according to 'The
Chronicle of Higher Education.' However, it could lower the incentives for
donors to fund endowments and raise the possibility of higher and more
onerous taxes on endowments in the future.
The potential elimination of private
activity bonds and 501(c)3 non-profit bonds would likely lower the interest
in and feasibility of public-private partnerships, which have increasingly
been used to procure transportation projects. Eliminating PABs would raise
airport financing costs and possibly cause a reduction in private
participation in water projects.
Termination of advance refundings would hurt future supply of tax-exempt
bonds. Under current law, governmental bonds are allowed one advance
refunding. Advance refundings help issuers when
interest rates plummet. They can advance refunding their bonds and reap
considerable savings so they are not stuck with the higher coupon bonds.
Sometimes advance refundings are needed to change
covenants in bond documents that become outdated.
The PAB and advance refunding proposals
in the House GOP's "Tax Cuts and Jobs Act" could significantly
shrink the municipal bond market. PABs make up 15 percent to 20 percent of
the municipal market. Advance refundings vary
widely depending on interest rates, but three years ago they represented
half of all new municipal issuances.
The bill also would put new limits on the
federal deductibility of state and local taxes. It would limit the
deductibility of property taxes to $10,000 annually while other state and
local taxes would be deductible only for households with incomes under
$400,000. The mortgage interest deduction, another key component for
households that claim the SALT deduction, would be capped for future
mortgage loans of $500,000. Current mortgages would be grandfathered.
Households would get a larger standard
deduction of $24,000 for families and $12,000 for individuals. Personal
exemptions would be replaced with a $300 credit for adults and a larger
credit tax credit of $1,600 instead of the current $1,000.
Conclusion
MTAM remains bullish on holding and
buying municipal bonds. The proposed tax plan is telling us that investors
may not own enough longer duration tax-free municipal bonds. We believe the
strong returns in the municipal market could be seen as rational given the
tax plan's goal of decreasing future supply. Lately, the longest-dated
municipal bonds have staged their strongest rally in 11 months as the
Republican tax bill promises to sharply cut sales of new tax-exempt bonds.
The efforts in Congress, if successful, also have the potential to increase
demand for debt issued by higher-tax states such as California and New York
by rolling back the ability to deduct local taxes from their federal
income. That will leave residents interested in investments that will
reduce their tax liability. MTAM strongly suggests raising investors
allocation to this asset class, as the potential for a notable decline in
supply could lead to higher prices and lower yields over time.
Regards,
Michael Pietronico
Chief Executive Officer
Miller Tabak Asset Management
mpietronico@millertabak.com
www.millertabakam.com
Follow us on Twitter: @MillerTabak
Top Of Page
Chicago's New Securitization
Thursday, October 19, 2017
Last week, the Chicago City Council
authorized a new bonding tool to refinance as much as $3 billion of debt in
a move that officials say will lower borrowing costs for the junk-rated
City (Ba1/BBB+/BBB-).
Council members approved the creation of
a corporation that is legally and structurally insulated from the City,
whose credit rating has been cut to junk by Moody's partly due to $35.8
billion of pension debt. Mayor Rahm Emanuel said the new authority would
allow the City to "pay less to Wall Street".
The State of Illinois fiscal 2018 budget
plan included a provision allowing municipalities to sell debt secured by
state funds it receives.
About $700 million of the proceeds will
be used to retire existing sales tax bonds and another $2.3 billion will be
used to refund some of the City's outstanding general obligation bonds.
Chicago Chief Financial Officer Carole Brown said she expects the debt to
win a higher rating than the City's, leading to a lower interest rate and
cost savings. Brown wants the corporation to sell the bonds in four
separate deals with the first transaction of an estimated $600 million to
$700 million occurring in late November, depending upon the underwriters'
recommendation.
Brown told aldermen -- some of whom
expressed skepticism and want more time to assess the program's benefits --
that the new credit structure will lower debt service costs without adding
to the City's risk profile. The bankruptcy-remote legal provisions of the
structure, removal of City operating risk, and statutory lien "should
give us a better rating" and in turn "that should give us much
lower rates," Brown said.
The City will assign its sales tax
revenue to the new corporation that will issue bonds backed by the revenue,
insulating the bonds from potential future City distress. Similar
structures used in New York, the District of Columbia, and Philadelphia
have won high-grade ratings.
Brown tried to quell the misgivings of
aldermen who worry that their oversight powers will be diminished. Aldermen
have been stung in the past for rubber stamping Emanuel's and former Mayor
Richard Daley's bond financings and Daley's asset lease deals. That led to
criticism as the public soured on the 2008 parking meter system lease, and
the City's practice of using debt for budget relief made headlines.
The promised savings tamp down the worry
for many aldermen, especially as the City is trying to erase $260 million
of red ink in its next budget that will be unveiled this week. The precise
savings is still unclear as the market may impose some penalty for both the
Chicago and Illinois names. However, it is a new credit, so buyers constrained
by their current holdings can participate in the deals. The lockbox on
revenues is also appealing.
Brown said structuring details on
maturities are still in the works so she cannot say with certainty that
some existing debt will not extend beyond its current maturity but she
stressed that "our intent is to do refunding" for traditional
debt service savings and not for "restructuring" purposes.
Future use adding to the City's debt
burden remains a worry for some aldermen. Brown left the door open during
the hearing to using the program to tap other revenue streams and possibly
to raise new money. The state legislation included in the fiscal 2018
budget packages allows for home rule units to securitize revenue streams
that flow through the state. They include sales taxes, motor fuel revenues,
gambling, and other taxes. Brown also left open the door to consider using
the entity to eventually raise new money at "a lower cost to
taxpayers," but made clear that was not her current recommendation.
Improved spreads seen after the City
announced its intentions could reflect the market's initial view that the
new program will ease some pressure on the City's GO credit and make it
scarcer. But multiple market participants cautioned that the bankruptcy
remote structure is not sure proof until truly tested. Greater interest in
the use of securitization and dedicated revenue structures have grown out
of Detroit and Puerto Rico's bankruptcies, where structures once thought
safe were challenged.
In a potential bankruptcy situation, the
inevitable question will once again arise: if more credits can get to the
front of the line, then who gets left behind? The holders of the original
full faith and credit GO bondholders of course. Brown sought to quell
concerns. To existing GO bondholders, she offered the reminder that a
portion of the sales tax is already tapped to back existing bonds and to
pensioners who could see their position also diminished in a distressed
situation she stressed that bankruptcy is not an option.
"The City doesn't have the ability
to file bankruptcy" under state law and it does not have the
"intention" to seek such approval, she said. The City has also
put in place over the past year new funding streams
