Muniland and Pensions
February 15, 2011
David R. Kotok
“In December, projections by Meredith Whitney, the banking analyst, about possible municipal defaults began to rattle the $2.86 trillion municipal-debt market. Investors withdrew $1.2 billion from U.S. municipal-bond mutual funds, the 13th-straight outflow, Lipper U.S. Fund Flows said about the week ending Feb. 10. About $24.8 billion has been redeemed since the week ended Nov. 17, including a record $4 billion in the week ended Jan. 19, the most since Lipper started compiling data in 1992.”
Source: Bloomberg, Feb. 14.
Panic-driven mutual fund redemptions continue to depress the prices of high-grade Munis. To us, this means the buying opportunity for well-selected issues is intact. Remember, this is an idiosyncratic securities sector. Broad-brush painting of “all Munis are going to default” is specious.
Forced selling by mutual funds depresses the pricing references that are used by the pricing series. Most Munis do not trade every day. Hence, the drop of a few prices lowers the estimated prices of all Munis. This perception issue has created a misunderstanding in the market and resulted in exacerbation of the selloff.
Think about it this way. Let us examine the case of a single mutual fund that must sell to meet redemptions. The fund manager needs the cash at once. He sells his liquid and highest-credit-quality names, which allows him to get cash as once. These same bonds are used to price the entire universe of Munis. The next day all Muni reference prices are lower, even though most of them did not trade. Since the mutual fund holds many bonds, its share price reflects the new pricing, and hence is lower. That alarms more shareholders and another round of selling triggers a downward spiral. This has been going on for 13 weeks.
Some say the cause of the selling is the opacity in the unfunded pension systems of the states. Maybe so. Moreover, maybe that is part of the hype. We think the pension issue is clear. One only needs to do the homework.
In a state like Delaware, the pension system is nearly fully funded. The credit rating of the state is AAA. There is no pension issue in Delaware. The same is true for many states.
There are 218 separate state pension plans among the 50 states. There are 2,332 local pension systems. Thank you, Natalie Cohen of Wells Fargo for the data. Natalie notes the differences by illustrating Indiana. The Indiana Public Employee Retirement Fund is about 94% funded. The Indiana teacher plan is only 43% funded. In NJ, which was just down-graded by a rating agency, Natalie reports the public fund is 56% funded, the local fund is 71% funded, and the teachers’ plan is 64% funded. As we have been saying for months, broad brushing Muniland does not work. One must drill deeply into the data.
Estimating the present value of an unfunded pension obligation is imprecise. It takes a lot of assumptions and falls into the murky realm of actuarial science. Moody’s offers that “a 100 basis point movement in the discount rate results is an inverse movement in the obligation of approximately 8-12%.” Current rules allow much flexibility to states and local government in making assumption choices.
That is about to change. The Government Accounting Standards Board (GASB) is issuing new rules on accounting and reporting liabilities for pensions and other post-employment benefits. These are in draft form now. The rating agencies are combining the actual bonded indebtedness of states or local governments with the unfunded liability estimates. That is why NJ was recently downgraded.
In addition, there is legislation at work to force pension disclosure to be more consistent and transparent. Public Employee Pension Transparency Act or H.R.6484 is under discussion in the House of Representatives. It will require timely information on al governmental pension funds and it will impose penalties for failures to disclose. Rating agencies are endorsing such legislation. So do we. The effect will be to improve funding and force clarity. We expect this to become law in this congressional session.
At Cumberland, we already look at the unfunded obligations and the assumptions. We are glad to see this issue being addressed by states and local governments and by the rating agencies. It has been a long time coming.
One group that objects strenuously is the public employee unions. They are now the largest organized labor faction in the US, and they are trying to preserve the status quo. There is where the political rubber hits the road. We expect this to be a state-by-state fight. We saw the first salvo fired in Illinois as the retirement age was extended. Major changes proposed by NJ Governor Christie currently are stymied in the state’s legislature. Watch what happens as the NJ budget fight gets down to the last minute.
In our view, these issues will get resolved because they must get resolved. State and local governments cannot continue to fund promises they cannot afford. The tide has changed. We expect nearly all of them to alter their budgets, and we expect austerity to be imposed. The notion of electing default or bankruptcy as an option seems politically dead to us.
We continue to buy well-selected Munis at tax-free yields in excess of the taxable yield references. We are witnessing a generational opportunity and want to seize it.
David R. Kotok, Chairman and Chief Investment Officer