A Troubled U.S. State Budget Process Puts Muni Investors on Alert

A Troubled U.S. State Budget Process Puts Muni Investors on Alert
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A Troubled U.S. State Budget Process Puts Muni Investors on Alert

Outcomes from the most recent state budget season, which concluded for most U.S. states on 30 June, underscore the need for caution among municipal bond investors: 10 states started the new fiscal year without a signed budget, and 23 made midyear budget cuts in fiscal 2017, the most since 2010 (according to the National Association of State Budget Officers).

Mounting political risk since the beginning of the year, along with the oft-cited higher pension costs and slowing tax collections, amid a backdrop of tepid nominal growth and soft inflation, all contributed to these outcomes. But political risk, which is inherent to municipal bond investing, has grown more acute since the November federal election as the new administration and Congress consider policies that could further exacerbate the budget process in some states next fiscal year.

We believe credit dispersion in municipals may grow and bouts of credit spread widening may be more common across issuers unable to adjust to these realities. For investors, proactive assessment of credit risk will be critical in a market that too many investors think of as solely a duration call.

Are investors mispricing risk?

We’ve observed various recent instances of what we view as mispriced credit risk in the general obligation (GO) segment of the municipal market. GO debt typically trades rich relative to similarly rated essential service revenue bonds, based in part on the perception that a pledge of the “full faith and credit” or taxing authority of the issuer could support a GO claim without limitation. But not all GOs are created equal, and investors may overestimate GO credit quality and, consequently, misprice risk in the form of required credit spreads.

The unfolding of recent fiscal crises (in Detroit and Puerto Rico, for example) has demonstrated that multiple claims often compete for limited resources, and the positioning of creditors in the payment waterfall may not go as expected. For instance, GO bondholders may find their priority subordinate to essential services (which may be subjectively defined) or perceived priority claims of officials and politicians (like retirement obligations).

Credit pitfall versus credit opportunity

In recent years, the market has witnessed several large borrowers experience “super-downgrades” (multiple notch downgrades by rating agencies). While investors may be quick to draw comparisons between rapidly deteriorating credits and those with real solvency and liquidity concerns (such as Puerto Rico and Detroit), municipal defaults still remain relatively rare. However, credit risk in the form of spread widening and/or credit downgrades can affect income-oriented investors constrained by ratings, or simply fearful they may be holding the next GO headed toward bankruptcy. These investors may prematurely sell without first evaluating the full distribution of potential outcomes and assigning probabilities to each scenario. This strategy of careful assessment of an evolving situation, along with a proactive approach to credit surveillance, can help avoid an unnecessary monetization of losses. Successfully differentiating between a hopeless fiscal crisis and one that offers the debtor a way out can be a significant driver of alpha and is among the primary goals of our municipal credit research.

Illinois offers a key case in point. While its long budget impasse created a number of challenges, our portfolio positioning continued to reflect our view that these issues did not materially increase the state’s probability of default. Although Illinois has high balance sheet leverage emanating from one of the lowest-funded pension systems in the nation, it has better funded these contributions in recent years. Macro conditions in the state also remain relatively sound: The economy is well-diversified, and income taxes – despite a 32% headline increase – are still reasonable for the region.

In short, knowing the difference between a manageable – if painful – credit hurdle and an impending default can be the difference between incurring a loss and generating alpha.

U.S. readers can find more PIMCO insights on the municipal bond markets in “Munis in Focus.”

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Sean McCarthy is PIMCO’s head of municipal credit research and a regular contributor to the PIMCO Blog.

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Disclosures

Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Income from municipal bonds for U.S. tax payers is exempt from federal tax, but may be subject to state and local taxes and at times the alternative minimum tax. All investments contain risk and may lose value. Investors should consult their investment professional prior to making an investment decision.