States and Muni Finance
April 5, 2016
David R. Kotok Chairman and Chief Investment Officer
“From a credit perspective, Illinois is considered to be the most troubled state in the Union. The state has a $110 bn pension funding hole, yearly multi-billion-dollar budget deficits, and a political stalemate that has left the state without a 2016 budget. The Institute of Government & Public Affairs at the University of Illinois estimates a $9 bn budget deficit of all funds in FY 2016, which balloons to $14 bn by 2024 if no changes are made. The strong constitutional protections awarded to pensioners in a recent court decision also make restructuring pensions an unlikely scenario barring a constitutional amendment, which requires 3/5th approval by both Houses of the General Assembly as well as voter approval.” Source: Piper Jaffray, http://www.piperjaffray.com
“Payment outflows to beneficiaries don’t stop for financial markets. Making up losses is not politically popular, particularly where there is already underfunding and fiscal stress. New Jersey, to use one example, has explicitly suspended full pension payments in the past few budgets to avoid having to raise revenues and also to provide budget flexibility. However, New Jersey plans have seen the size of investment assets drop from $81 billion in June 2014 to $72 billion in December 2015, according to the Division of Investment monthly reports. At that rate of depletion, without major reform, the state has about 10 years before shifting to a pay-as-you go.” Source: Natalie Cohen, Senior Analyst, Wells Fargo Securities, www.wellsfargoresearch.com
History shows that states eventually pay their bills and that they eventually pay all the principal and interest on their bonds. I’m specifically referencing the state general obligation bond. There is one example of a missed payment during the last century, involving the State of Arkansas. (See “Bond Default Is About Too Much Debt, Too Little Time: Joe Mysak.”) During the Great Depression era that state ran out of cash and did not make payments. The explanation for the cash deficiency seems to be that the state was using its cash to bail out its subordinate jurisdictions. After legal tests, Arkansas ultimately paid what was owed and cured the default on its general obligation bonds.
Will this history of zero defaults by any of the sovereign 50 US states continue, or are we headed into a political climate that will lead to a state’s reneging on its obligations? Will politics overwhelm the legal obligation to pay? These and many questions like them come to us frequently from clients, consultants, and readers. We believe they are fair game for discussion.
The rating agencies believe that as well. Thus there is a huge distinction between the highest-grade state credits, which are properly rated AAA by the rating agencies, and the lowest-ranked credits, such as those of Illinois and New Jersey. The raters are watching the deterioration of credit quality. They do not see that a default by a state is immediate or imminent. But they do see a reduction in political will to address the credit problem, and they do see a growing unfunded liability of the type described in the two quotes above.
So, what is an investor to do?
One could ignore the warning and buy the higher-yielding but weaker credit instrument. Doing so means the investor is relying on the history of all states eventually paying all they owe. The investor would also be relying on the legal structure that does not permit a state to bankrupt and avoid payment. Many mutual funds and managers are following that approach. We can see this by examining the holdings in those funds and by directly confronting their managers. We will leave it to readers to do that research for themselves.
The other choice is to avoid the risk. Simply say “No.” Don’t chase the higher yield attached to the weaker state credit. Pass on the temptation and stay with a better-quality credit standard. That is Cumberland’s approach. We prefer getting paid with minimal credit risk as opposed to taking on more risk. So our credit standard is higher than that of the benchmark indices, and therefore our managed portfolios have a slightly lower yield than those benchmarks.
The tradeoff of risk versus yield is one that constantly enters the investment allocation debate and does so in a pronounced way when interest rates are very low, as they are today. We favor less risk. Others favor taking more risk. And still others take it but do not make that course clear to the client. Therein lies an issue of integrity and disclosure.
With Cumberland, every client has a separately managed bond account. Every client receives a report on his or her individually selected bonds, and every client can see the credit rating of each and every bond. Full transparency is coupled with a strong bias toward higher credit quality. We want our clients to get paid, and we want them to see how they are positioned and why. We also want our clients to enjoy safety and comfort, which is why we do not take custody of clients’ accounts, and we are not brokers selling bonds to our clients. Our role is that of a fee-for-service adviser only. Our job is to analyze the credits and effect the buy-sell-hold decision on each bond every day for each separately managed account.
In this election cycle there will be lots of focus on national issues. It is very unlikely that any of the presidential candidates will speak to state and local government debt and the funding issues in some of the states. The reason is simple: the topic does not have broad political resonance. But the topic is a critical one. Almost $4 trillion of municipal debt is issued by the states and the other 90,000 subordinate political jurisdictions within them or among and between them. The highest-grade credits among that $4 trillion in debt have a superb payment history. They pay.
At Cumberland, we continue to believe that the higher-credit-quality, tax-free municipal bond with a yield of about 4% and a credit standard of AA to AAA is one of the cheapest debt securities in the world. We own them, and we buy them for our clients.