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In The News

MTAM Research

March 30, 2023

1st Quarter 2023 Review and Outlook

January 17, 2023

Credit Comment on the State of California's Latest Budget Proposal

January 9, 2023

Municipal Bond Market - Credit Outlook for 2023

December 28, 2022

4th Quarter 2022 Review and Outlook

September 30, 2022

3rd Quarter 2022 Review and Outlook

June 24, 2022

State of the States - Midyear 2022

January 14, 2022

Credit Comment on the State of California's Latest Budget Proposal

January 7, 2022

Municipal Bond Market - Credit Outlook for 2022

December 20, 2021

4th Quarter 2021 Review and Outlook

October 4, 2021

3rd Quarter 2021 Review and Outlook

July 9, 2021

State of the States - Midyear 2021

July 6, 2021

2nd Quarter 2021 Review and Outlook

April 22, 2021

By the Mile

March 30, 2021

1st Quarter 2021 Review and Outlook

March 18, 2021

Impact of the Federal Stimulus on State and Local Governments

March 12, 2021

The Wayfair Windfall

February 3, 2021

Credit Comment on the State of California's Latest Budget Proposal

January 7, 2021

Municipal Bond Market Credit Outlook for 2021

December 31, 2020

4th Quarter 2020 Review and Outlook

October 15, 2020

An Update on the State of the States

September 30, 2020

3rd Quarter 2020 Review and Outlook

July 6, 2020

State of the States Midyear 2020

July 1, 2020

2nd Quarter 2020 Review and Outlook

March 31, 2020

1st Quarter 2020 Review and Outlook

February 3, 2020

The Coronavirus and its Current Impact on U.S. Municipalities

January 21, 2020

Credit Comment on the State of California's Latest Budget Proposal

January 10, 2020

Municipal Bond Market – Credit Outlook for 2020

December 27, 2019

4th Quarter 2019 Review and Outlook

November 4, 2019

Increasing Financial Pressure on U.S. Cities

October 1, 2019

3rd Quarter 2019 Review and Outlook

August 19, 2019

Cyberattacks in the U.S. Public Finance Sector

July 30, 2019

Update on Late State Budgets

July 1, 2019

2nd Quarter 2019 Review and Outlook

June 20, 2019

State of the States - Midyear 2019

May 14, 2019

The Opioid Predicament

April 5, 2019

New York City's Congestion-Pricing

April 1, 2019

1st Quarter 2019 Review and Outlook

March 8, 2019

The Impact of an Aging U.S. Population on States

January 25, 2019

Planned PG&E Bankruptcy and its Impact on California

January 24, 2019

Credit Comment on the State of California's Latest Budget Proposal

January 18, 2019

Municipal Bond Market – Credit Outlook for 2019

January 11, 2019

Impact of the Federal Government Shutdown on Municipal Bond Credits

December 27, 2018

4th Quarter 2018 Review and Outlook

November 5, 2018

Mid-Term Elections 2018

September 27, 2018

3rd Quarter 2018 Review and Outlook

September 24, 2018

State 'Rainy Day' Funds: Who's Prepared for the Next Recession?

August 2, 2018

California Fires

July 6, 2018

U.S. Supreme Court's Ruling on Union Fees

June 29, 2018

Onset of the Internet Sales Tax and the Impact on U.S. Municipalities

June 26, 2018

2nd Quarter 2018 Review and Outlook

June 22, 2018

State of the States - Midyear 2018

May 29, 2018

Sports Betting Ruling is a Win for U.S. States

May 17, 2018

Most States Have Room to Increase Their Debt

April 11, 2018

The State of Connecticut, the City of Hartford, and the Contract Assistance Agreement

March 28, 2018

1st Quarter 2018 Review and Outlook

March 21, 2018

New Tariffs and the Impact on U.S. States and Local Governments

March 12, 2018

Higher Education: Remain Cautious with Small, Private Universities and Expect Additional Mergers

March 5, 2018

Higher Oil Prices and the Impact on the Top Energy-Producing States

February 26, 2018

President Trump's Infrastructure Plan

February 5, 2018

The Legalization of Cannabis in California

January 30, 2018

Amazon's HQ2

January 22, 2018

Credit Comment on California's Latest Budget Proposal

January 8, 2018

Municipal Bond Market – Credit Outlook for 2018

December 27, 2017

4th Quarter 2017 Review and Outlook

November 8, 2017

Municipal Bond Market – Proposed Tax Reform 2017

October 19, 2017

Chicago's New Securitization

September 29, 2017

3rd Quarter 2017 Review and Outlook

September 12, 2017

Impact of Hurricane Irma on the State of Florida

August 28, 2017

Impact of Hurricane Harvey on Southeast Texas

August 16, 2017

State of the States - Midyear 2017

July 20, 2017

Growing Cybersecurity Risks at U.S. Public Power Electric Utilities

June 29, 2017

2nd Quarter 2017 Review and Outlook

May 22, 2017

Challenges Facing the Transportation Sector

April 27, 2017

The Impact of New York State's "Free Tuition"

April 12, 2017

Bank Liquidity Rules Could Boost Demand for Municipal Bonds

April 4, 2017

U.S. States Forecast Sluggish Tax Revenue Growth as 2018 Budgets Established

March 30, 2017

1st Quarter 2017 Review and Outlook

January 26, 2017

Trump's Transportation Infrastructure Plan

January 18, 2017

Trump and the Municipal Bond Tax-Exemption

January 14, 2017

Credit Comment on California's Latest Budget Proposal

January 10, 2017

Municipal Bond Market – Credit Outlook for 2017

December 30, 2016

4th Quarter 2016 Review and Outlook

December 9, 2016

The Repeal and Replacement of Obamacare

November 17, 2016

The Coming Showdown for Sanctuary Cities?

October 27, 2016

Municipal Bond Market - Tax Reform Forecast Post-2016 Election

October 24, 2016

U.S. Cities' Finance Officers Remain Cautiously Optimistic

September 30, 2016

3rd Quarter 2016 Review and Outlook

September 9, 2016

U.S. States Not Having Much Luck with Gambling

August 25, 2016

The Zika Virus and its Impact on the Miami-Dade County Region

June 29, 2016

2nd Quarter 2016 Review and Outlook

June 20, 2016

Philadelphia Hits Soda Industry With Historic Tax

June 13, 2016

State of the States - Midyear 2016

May 3, 2016

Comment on Puerto Rico's Default

April 18, 2016

Colorado's Challenge: Financial Caps and Debt Limitations

March 31, 2016

1st Quarter 2016 Review and Outlook

March 29, 2016

California and the Minimum Wage Hike

February 23, 2016

Flint (Michigan) and the Credit Implications

January 19, 2016

Credit Comment on California's Latest Budget Proposal

January 7, 2016

Municipal Bond Market – Credit Outlook for 2016

December 30, 2015

4th Quarter 2015 Review and Outlook

November 19, 2015

Are Some U.S. Universities' Endowments 'Too Large'?

October 8, 2015

For Financially-Strapped Municipalities, New Prisons May Not Be The Answer

September 29, 2015

3rd Quarter 2015 Review and Outlook

August 25, 2015

Credit Update on the Not-for-Profit Healthcare Sector

June 30, 2015

2nd Quarter 2015 Review and Outlook

June 19, 2015

State of the States - Midyear 2015

April 30, 2015

U.S. Transportation: State Highway Funding Crisis

April 24, 2015

MTAM Recommendation: Remain Cautious with Small, Private Universities

April 13, 2015

Pension Obligation Bonds - A Credit Neutral At Best

March 30, 2015

1st Quarter 2015 Review and Outlook

March 6, 2015

The Impact of the Supreme Court's Decision on Obamacare

March 3, 2015

After the Labor Slowdown:
West Coast Ports are Challenged, but Remain Very Competitive

January 23, 2015

Qualified Public Infrastructure Bonds: A Public-Private Partnership Proposal

January 5, 2015

Municipal Bond Market – Credit Outlook for 2015

December 30, 2014

4th Quarter 2014 Review and Outlook

November 12, 2014

Investor Lessons from the Detroit Bankruptcy Exit Plan

November 6, 2014

Lower Oil Prices and the Impact on the Top Energy-Producing States

November 3, 2014

Municipal Bond Market - Tax Reform Forecast Post-2014 Election

October 30, 2014

Ebola and the Not-for-Profit Healthcare Sector

October 23, 2014

What are Green Bonds?

October 1, 2014

3rd Quarter 2014 Review and Outlook

September 30, 2014

Impact of Climate Change on Municipal Credits

September 12, 2014

New Jersey's Financial Challenges Continue

August 19, 2014

Atlantic City (NJ): A Lesson in the Merits of Economic Diversification

July 29, 2014

Credit Update on the Higher Education Sector

July 1, 2014

2nd Quarter 2014 Review and Outlook

June 23, 2014

State of the States - Midyear 2014

May 27, 2014

Credit Comment on California's 'Rainy-Day' Reserve Fund Bill

May 4, 2014

Municipal Bond Market - Default Outlook Improves

April 4, 2014

Puerto Rico: Is Statehood the Answer?

April 1, 2014

1st Quarter 2014 Review and Outlook

March 6, 2014

Chicago is Not Detroit

February 27, 2014

The High Cost of Winter Weather

February 4, 2014

Credit Comment on California's Drought

January 22, 2014

Credit Comment on California's Latest Budget Proposal

January 13, 2014

Municipal Bond Market – Tax Reform Forecast for 2014

January 3, 2014

Municipal Bond Market – Credit Outlook for 2014

December 31, 2013

4th Quarter 2013 Review and Outlook

December 4, 2013

Impact of the Detroit Bankruptcy on the Municipal Bond Market – Part 2

November 7, 2013

New Jersey and the Minimum Wage Hike

October 4, 2013

Impact of the Federal Government Shutdown on Municipal Bond Credits

September 30, 2013

3rd Quarter 2013 Review and Outlook

September 16, 2013

North Carolina and the Impact of Tax Reform

Top Of Page 


State of the States - Midyear 2022

Friday, June 24, 2022

At midyear 2022, U.S. states are in a strong fiscal position as they spend surpluses, with slower growth expected.

According to the National Association of State Budget Officers, Governors' budgets for fiscal 2023 call for a 4.2 percent increase in general fund spending compared with estimated levels for fiscal 2022. This follows 13.6 percent spending growth in fiscal 2022, the highest annual increase recorded in more than 40 years. As states spend down their revenue surpluses from fiscal 2021 and fiscal 2022, mostly on one-time expenditures, this has led to larger than usual fluctuations in spending from year to year. Looking at average spending growth for states over three years - fiscal 2021, fiscal 2022 (estimated), and fiscal 2023 (recommended) - the median annual growth rate is 5.3 percent.

State revenues have continued to perform better than was expected earlier in the pandemic, with tax collections coming in ahead of budget projections in nearly all states for both fiscal 2021 and fiscal 2022. After experiencing record annual growth in general fund revenue in fiscal 2021, largely attributable to one-time factors, fiscal 2022 general fund revenue is estimated to grow 3.2 percent, though final collections are likely to come in higher than estimated.

Revenue projections in governors' recommended budgets for fiscal 2023 show slow growth of 1.4 percent after incorporating the forecasted impacts of proposed tax policy changes for fiscal 2023 that would reduce general fund revenue by an estimated $14.1 billion (or 1.3 percent of total general fund revenues). Many states have revised their projections upward since these forecasts were produced, based on more recent collections data. At the same time, state revenue forecasters are watching closely for warning signs about the economy as the Federal Reserve tries to bring inflation under control, the Russia-Ukraine conflict continues to put upward pressure on gas prices, and labor shortages and supply chain issues continue to present challenges for states and businesses.

States continue to strengthen their reserves to guard against this uncertainty and prepare for the next downturn. Rainy day funds in fiscal 2022 are estimated to reach new heights, with 41 states projecting increases. This follows fiscal 2021, when aggregate rainy day fund balances increased 62 percent after nearly all states experienced revenue surpluses. Total balances, meanwhile, have risen sharply over the last couple of years as well, and states are planning to spend down some of these funds according to governors' fiscal 2023 budgets.

Fiscal 2023 Recommended Budgets Call for Moderate Spending Growth Following Largest Annual Increase in Over 40 Years

Governors' budget recommendations call for general fund spending totaling $1.10 trillion in fiscal 2023, a 4.2 percent increase over estimated spending levels for fiscal 2022. This projected spending growth is considerably more modest than the estimated increase reported by states in fiscal 2022, which was largely driven by one­ time expenditures from surplus state funds, as well as federal funds in a few instances. Overall, 36 states are projecting general fund spending increases in fiscal 2023, while 13 states are forecasting declines and one state was unable to report data on fiscal 2023. Fiscal 2023 recommended budgets were introduced in late calendar year 2021 and early 2022, and upward revenue forecast revisions since then may alter these spending plans.

Based on current estimates (or governors' budget recommendations in some cases), general fund spending is on track to total $1.05 trillion in fiscal 2022, a 13.6 percent increase over fiscal 2021 levels. This is the fastest annual growth rate since fiscal 1981, driven by a number of variables, including: states spending down surplus funds from fiscal 2021 (and fiscal 2022) on onetime investments; a shift from a reliance on federal funds to general funds in certain areas; a lower baseline in fiscal 2021, when some states made budget cuts in anticipation of revenue shortfalls; and the inclusion of federal COVID-19 funds in expenditure amounts for a few states. Inflation is likely also a driver behind the increase. Adjusted for inflation, general fund spending in fiscal 2022 is estimated to grow 7.0 percent.

Recommended Budgets for Fiscal 2023 Call for Net Increases in Nearly All Program Areas, at Similar Levels to Proposals One Year Earlier

Recommended budgets for fiscal 2023 call for $74.8 billion in increases over fiscal 2022 enacted appropriation levels. All program areas would see net increases in general fund appropriations according to governors' budget recommendations for fiscal 2023 except transportation, a program area that is primarily funded by special fund sources outside of the general fund. The "All Other" category would receive the largest net increase, closely followed by the projected increase in Medicaid, as governors' budgets planned the end of the enhanced Federal Medical Assistance Percentage (FMAP) tied to the Public Health Emergency in fiscal 2023. K-12 education, higher education, public assistance, and corrections would see increases as well. Appropriation increases for fiscal 2023 also reflect a shift from reliance on federal funds for certain expenditures to a greater reliance on general funds, especially for Medicaid.

Governors' budgets for fiscal 2023, in terms of spending changes by program area and the overall scale of net increases, resemble proposals one year ago for fiscal 2022 in many ways, when governors proposed $70.5 billion in net appropriation increases. Enacted budgets for fiscal 2022 ended up being considerably larger than what governors proposed, thanks to upward revisions in revenue projections. It is possible that this could happen to some extent again for fiscal 2023 enacted budgets, as revenue collections have been running ahead of the forecasts used in governors' budgets for most states.

Due to Strong Fiscal Conditions, States Report Minimal Use of Budget Cuts and Other Balancing Actions

In order to manage their budgets, particularly in an economic downturn, states employ a variety of strategies and tools, including spending reductions (across-the­ board or targeted), revenue changes, personnel actions, efficiency savings, and one time measures. Given strong fiscal conditions currently in most states, budget management strategies were fairly minimal and targeted.

In fiscal 2023 recommended budgets, only five states reported making targeted spending cuts and one state reported making across-the-board cuts. In contrast, one year earlier, governors recommended targeted cuts in 17 states and across-the-board cuts in three states. The use of personnel actions was minimal as well in fiscal 2023, with only three states continuing hiring freezes and none imposing furloughs. Similarly low use of various budget balancing tools was reported for the middle of fiscal 2022 as well.

Regarding mid-year budget actions, states also reported on spending changes considered or adopted in the middle of fiscal 2022 in quantitative terms. Overall, 22 states reported net mid-year increases in general fund spending for fiscal 2022, while seven states reported decreases compared with their enacted budgets. Among the seven states that reported net mid-year cuts, none reported these cuts were made in response to a revenue shortfall. Rather, states with decreases reported the reductions were attributed to lower spending needs or in areas where federal assistance was able to be used in place of general funds. For the states that reported net mid-year increases in general fund spending, these included supplemental appropriations for fiscal 2022 to address additional spending needs, including disaster assistance and (OVID-related expenses, as well as one-time expenditures using surplus funds for capital construction, paying off debt, rainy day fund deposits, and supplemental pension payments.

49 States Report Collections Outperforming Budget Projections in Fiscal 2022

General fund collections for fiscal 2022 from all revenue sources were exceeding original projections used to adopt budgets in 49 out of 50 states at the time of data collection. This marks the second consecutive year when virtually all states saw tax collections outperform budget forecasts. Additionally, 33 states reported collections were coming in above their most recent official forecasts for fiscal 2022, while 11 states said they were on target and the remaining states were unable to report; no states said they were coming in lower than their most recent forecasts. Just as with fiscal 2021, state revenues in fiscal 2022 have been helped by the economic impacts of federal stimulus. Additionally, recent employment and wage growth, increased consumption, a strong stock market performance in 2021, and rising inflation are likely helping to drive these revenue gains.

State Revenue Growth Projected to Slow in Fiscal 2023

Governors' budgets for fiscal 2023 are based on general fund revenues totaling $1.07 trillion, which would represent modest growth of 1.4 percent compared with fiscal 2022 levels. This slow growth rate is from a high baseline, as it follows record high growth in fiscal 2021 and moderate growth estimated in fiscal 2022. Based on the strong performance of recent revenue collections, many states have revised their fiscal 2023 forecasts upward compared with the projections used in governors' recommendations. Among the states able to report more current projections for fiscal 2023, all reported upward revisions compared with the estimates used in governors' budgets. That said, there are also some downside risks to fiscal 2023 revenue forecasts that states are mindful of, including the steep rise in gas prices due to the Russia-Ukraine conflict, the impacts of high inflation, and the potential for a recession.

States reported fiscal 2022 general fund revenue estimates totaling $1.05 trillion, representing a 3.2 percent increase compared with fiscal 2021 levels. This data was mostly collected before states had data on April tax collections, which significantly outperformed forecasts in most states, and final fiscal 2022 collections are likely to exceed the estimates.

State revenues performed considerably better in fiscal 2021 than was expected earlier in the pandemic, due in large part to federal stimulus that pumped additional money into the economy. States reported fiscal 2021 general fund revenues totaling $1.02 trillion, representing a sharp 16.5 percent increase over fiscal 2020 actual collections. Several one-time factors contributed to this increase, including a low baseline in fiscal 2020, the impact of the tax deadline shift on when revenues in some states were recognized, and the inclusion of federal funds, borrowing and other sources in at least a few states.

As referenced above, the annual percentage changes in general fund revenue in fiscal 2021 and fiscal 2022 were 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 (most states end their fiscal year on June 30), while the other 31 states did not defer the delayed revenue, either because they recognized receipts on an accrual basis, they do not collect an income tax, or follow a different fiscal year. Deferring states were much more likely to report large, double-digit percentage increases in fiscal 2021, followed by slower growth or decreases again in fiscal 2022. Comparing the median general fund growth rates for fiscal 2021 and fiscal 2022 for states that deferred revenues to those that did not defer can help illuminate this. The median growth rates for all 50 states were 5.6 percent in fiscal 2021 and 0.9 percent in fiscal 2022. For the 31 states that did not defer revenues due to the deadline change, median growth was 12.2 percent in fiscal 2021 and 2.5 percent in fiscal 2022. For those states that deferred revenue, median growth was 20.6 percent in fiscal 2021 and -2.3 percent in fiscal 2022.

General Fund Revenue Estimates Have Improved Over Course of Pandemic

State revenues performed considerably better than was expected earlier in the pandemic for several reasons. First, federal stimulus measures put a lot of additional money into the economy and directly boosted personal income. Second, personal income taxes were not as impacted as expected due to the recession disproportionately affecting low-income workers while high-income earners have been relatively insulated. Third, the pandemic's effects on economic activity largely curtailed consumption of services that most states do not tax, while consumption of goods, which are taxed, was less affected. Fourth, increased online sales tax collections following the U.S. Supreme Court decision in Wayfair v. South Dakota has mitigated sales tax losses.

This trajectory of continued improvement in revenue forecasts is evident, as eighteen months ago, state revenue estimates predicted that general fund revenue would record an annual decline of 3.5 percent in fiscal 2021. Meanwhile, states reported final actual collections for fiscal 2021 that recorded a 16.5 percent increase over prior-year levels. This large swing speaks to the many difficulties of and tremendous uncertainty surrounding state revenue forecasts during the pandemic. Most states saw general fund collections come in above their pre-COVID forecasts as well. Examining general fund revenue for fiscal 2020 and fiscal 2021 combined, aggregate collections came in 3.2 percent above states' (mostly) pre-COVID forecasts. Fiscal 2022 revenue estimates have seen significant improvement as well based on governors' budget proposals, which predated passage of the American Rescue Plan Act.

Governors in 30 States Recommend Net Tax Reductions in Fiscal 2023

According to governors' budgets, governors in 30 states are proposing net decreases in taxes and fees while just three are proposing net increases, resulting in a projected net revenue decline in fiscal 2023 of $15.0 billion for all state funds. Looking only at the impact on general fund revenue, these changes would reduce revenue on net by $14.1 billion, representing 1.3 percent of forecasted general fund revenues in fiscal 2023 governors' budgets. It is worth noting that, if enacted, a $15.0 billion reduction in revenues from proposed tax changes would be the largest decline on record. Measured as a share of general fund revenue, the percentage decrease would be similar to the reductions recorded in the late 1990s and early 2000s.

The scale and scope of tax reductions proposed by governors for fiscal 2023 reflect strong fiscal conditions. They also mark a departure from one year ago, when governors proposed revenue actions that would have resulted in a net increase in revenue of $6.5 billion. Proposed tax cuts in governors' fiscal 2023 budgets ranged from targeted, one-time tax relief measures to permanent, broad-based rate reductions - often phased-in over a series of years.

State Balance Levels Remain High After Steep Increase in Fiscal 2021

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. As they coped with weakening revenue projections and increased spending demands early in the pandemic, some states turned to their rainy day funds, other reserves, and prior-year balances as a tool to help manage their budgets, resulting in declines in both rainy day funds and total balances in fiscal 2020.

Due to revenues exceeding budget projections as well as other one-time factors, states reported substantial increases in balance levels in fiscal 2021, with both rainy day funds and total balances reaching new record levels. At the end of fiscal 2021, rainy day fund balances totaled $124.5 billion or 13.5 percent as a share of general fund expenditures, while total balances (including rainy day funds) reached $234.7 billion or 25.4 percent of spending. According to current estimates for fiscal 2022, these year-end balances as a share of general fund spending are expected to come down slightly - which is a reflection on rising spending levels as opposed to declining balance levels. In dollar terms, both rainy day funds and total balances are estimated to continue growing in fiscal 2022. While balance levels vary by state, growth has been widespread, with 28 states reporting rainy day fund balances greater than 10 percent of their general fund spending and 47 states reporting total balances greater than 10 percent in fiscal 2022. In governors' budgets, most states are planning to spend down some of their cash balances - largely on one-time investments, with 34 states forecasting total balance declines; meanwhile, a majority of states (37) plan to maintain or increase their rainy day fund balances in fiscal 2023.

Medicaid Spending Growth Projected to Slow in Fiscal 2023 with Expected Expiration of Enhanced Federal Match

Medicaid spending figures reported for fiscal 2021 through fiscal 2023 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 11.1 percent in fiscal 2022 compared with fiscal 2021 levels (median growth of 10.6 percent). Looking only at state fund sources, spending is estimated to increase 11.3 percent in fiscal 2022 after an increase of 2.9 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 11.0 percent for fiscal 2022 after increasing 13.8 percent in fiscal 2021.

Looking ahead, Medicaid spending is forecasted to grow at a much slower rate in fiscal 2023 based on governors' proposed budgets. Total Medicaid spending is projected to grow 2.8 percent for fiscal 2023. Spending from state fund sources is projected to grow 15.6 percent, while federal fund spending is expected to decline 3.6 percent in fiscal 2023. Almost all states assumed in governors' budgets that the increased FMAP would no longer be available during fiscal 2023, with the majority of states assuming an end date of either March 31, 2022 or June 30, 2022. However, the increased FMAP, which is tied to the public health emergency, now remains in effect until at least September 30, 2022.

States also reported on Medicaid expansion expenditures. As of May 2021, 38 states and the District of Columbia have adopted Medicaid expansion. One additional state that has not yet adopted expansion included spending projections from the governor's budget for fiscal 2023, while one expansion state was unable to provide data. In fiscal 2021, 35 states reported total spending for Medicaid expansion of $119.9 billion, $13.6 billion in state funds, and $106.3 billion in federal funds. In fiscal 2022, 37 states are estimated to spend $139.0 billion in all funds, $15.9 billion in state funds, and $123.0 billion in federal funds. In 38 recommended budgets for fiscal 2023, projected spending for Medicaid expansion totaled $142.8 billion, with $16.4 billion in state funds, and $126.4 billion in federal funds. The median state share for Medicaid expansion on a fiscal year basis is 10 percent for all three fiscal years (fiscal 2021, fiscal 2022 and fiscal 2023).

Additionally, states reported changes to their Medicaid programs in fiscal 2022 and recommended changes for fiscal 2023, both to contain costs and enhance their programs. States' most common strategies to contain costs included enhanced program integrity efforts, policies to cut prescription drug costs, changes to managed care capitation rates reflecting decreased utilization, and delivery system changes. The program enhancements states have made or are planning to make reflect the impact of the pandemic, especially increased provider payments for vulnerable providers, expansion of behavioral services, expanding or restoring benefits, and telehealth.

State Budget Outlook: Slower Pace Ahead After Two Years of Robust Growth and Revenue Surpluses

As states prepare to enter fiscal 2023, they continue to be in a strong fiscal position after two consecutive years of robust growth and widespread revenue surpluses. These surplus funds have helped states invest in capital projects, pay down debt, make supplemental pension payments, bolster reserves and provide inflation relief to consumers and taxpayers. States also continue to leverage federal aid from the American Rescue Plan Act to support residents and businesses affected by the pandemic and make strategic one-time investments that will strengthen the resilience of their economies and communities. Meanwhile, states' rainy day fund and total balance levels are at record levels, leaving them with a substantial budgetary cushion as the face some uncertainty about the economic outlook. For now, state revenues are projected to continue increasing, but the pace of growth is expected to slow considerably compared with what states have experienced over the past two years.

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1st Quarter 2023 Review and Outlook

Thursday, March 30, 2023

Municipal bonds started off 2023 on a strong note, as recession concerns and limited new issue supply combined to produce positive returns. Concerns about the stability of the U.S. banking system drove investors into the safety of bonds, causing yields to collapse as the end of the quarter approached. Market expectations for the future of Federal Reserve monetary policy were all over the map with sticky inflation and the banking crisis moving market pricing for short term interest rates higher and lower sometimes to the extreme from one day to the next. In particular, the intraday moves on the two-year U.S. Treasury Note were historic in nature with moves sometimes exceeding 25 basis points in a day.

One cliche often mentioned in financial circles is that nobody ever got rich betting against the U.S. consumer. This thesis will be put to the test in a significant way in the coming months. With regional banks tightening lending standards to preserve capital, and credit card rates exceeding 25% in some cases, consumer spending is set up to be more volatile in both directions moving forward (picture pedaling a bike in the streets of San Francisco). As it stands right now, we believe the market is ahead of itself in predicting any rate cuts from the Federal Reserve in 2023. Inflation is too far away from the central bank's stated goal of 2% to be easing policy. Also, employment metrics still indicate that the job market remains fairly tight, which should keep the Federal Reserve from easing policy for fear of creating a wage-push inflation cycle. However, given all that we mentioned, it would be a great surprise and a huge mistake - for the central bank to continue raising interest rates in this environment. As such, we foresee a market that trades in a fairly narrow range in the coming months, as more clarity is awaited on the health of the U.S. consumer.

As always, in the late stages of a tightening cycle, credit analysis becomes more in focus as recession concerns become elevated. We remain biased to upper-tier municipal issuers that pass our rigorous internal credit standards. Should the economy take a dive, always know that your client portfolios are outfitted with the highest-quality scuba gear known to man.

Regards,
Michael Pietronico
Chief Executive Officer Miller Tabak Asset Management

email Michael Pietronico

millertabakam.com

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Credit Comment on the State of California's Latest Budget Proposal

Tuesday, January 17, 2023

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.

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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.

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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

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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.

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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.

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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 20212022, 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 relocatingaffecting 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.

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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

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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

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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.

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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

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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.

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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

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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.

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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 annuallywhich 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 taxesusing 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 taxesto 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 togetherthe Wayfair decision and the pandemichave 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.

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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.

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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 20152019. 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.

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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

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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.

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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

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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.

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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

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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

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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.

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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.

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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.

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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 120not 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

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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.

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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 yieldswhile historically very loware 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

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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.

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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.

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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

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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.

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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 2015double 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.

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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.

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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

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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.

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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.

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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.

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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.

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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.

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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

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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.

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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 cannot 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

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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.

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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.

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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.

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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.

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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 populationand 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 Congressand 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

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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.

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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.

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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.

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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.

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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 hasat a minimumapproached 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 pronouncedit 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

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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

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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

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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