Sequestration - What It Means for the Municipal Bond Market
By Michael Taylor
November 13, 2012
If Congress fails to quickly reach an agreement on deficit reductions, automatic cuts to federal discretionary spending (sequestration) are scheduled to take effect January 2, 2013. On September 14, the U.S. Office of Management and Budget (OMB) released its report detailing how it would implement sequestration, as required by the Budget Control Act of 2011 (Act). Designed to impact defense and non-defense (domestic) program budgets equally, most agencies are subject to cuts between 7% and 11% over the next decade. The exception is Medicare which is subject to a 2% cut.
Given the broad reach of sequestration and implications for the economy, pressure to avoid the cuts is likely to intensify after the November elections. Therefore, we believe it is quite possible that sequestration will be avoided or, at worst, reversed shortly after implementation. In addition, since sequestration will take time to impact governmental and non-profit entities, the credit implications are likely to be somewhat muted. However, we thought it may be helpful to outline what sequestration may mean for the various sectors of the municipal market if implemented as currently proposed.
Sequestration, with over $109 billion in annual cuts through 2021, would touch every federal agency, national defense and virtually all sectors of municipal finance. Should lawmakers fail to agree upon a comprehensive deficit reduction package deep enough to avoid the Act’s triggers, decreased federal spending is expected to have the following effect on the municipal market:
State and Local Governments: Decreased federal spending may drive austerity at the state level, given that federal grants constitute between 28% and 35% of state government revenues1. This would negatively impact program spending and may impact other revenue sources (state income tax, state-shared sales tax, etc.) should significant sequestration-driven job losses occur. For example, the Center for Strategic and Budgetary Assessments estimates that as many as 108,000 Department of Defense civilians could lose their jobs immediately after sequestration goes into effect2. Areas with elevated civilian defense contracting could experience revenue losses and an immediate uptick in unemployment. Fortunately, many state and local governments have experienced a rebound in revenues and employment since the Great Recession, providing some cushion to deal with potential cuts.
Healthcare: While Medicare was relatively unscathed with a comparatively low 2% ($11 billion) reduction in annual funding, the healthcare sector will see a negative impact. The National Institutes of Health's 8% budget reduction ($2.5 billion annually) would impact some hospitals, universities and other institutions. Further, according to the American Medical Association, 766,000 healthcare and related jobs would be eliminated by 2021 if sequestration goes into effect. We do not anticipate that sequestration, on its own, would drive credit rating downgrades. However, a 2% cut, if enacted, would be another factor suppressing revenue growth in an industry that is already struggling with lower volumes tied to weak economic growth and shifts in insurance coverage.
Education: Education grants to states and local school districts would decline and many higher education programs would be affected by 8.2% and 7.6% cuts to domestic discretionary and mandatory spending programs. While the Pell Grant is protected, other federal financial aid programs would be reduced and student loan origination fees would increase3. Higher education credits would likely see some rating downgrades driven by sequestration, especially among weaker public institutions in struggling states that have seen large appropriation cuts. Others in the sector have encountered a reduced ability to raise tuition and are struggling with demand in certain graduate areas. However, many maintain strong reputations, good demand and stable balance sheets that should allow them to weather any potential cuts.
Highways and Airports: Transfers to the Federal Transportation Trust Fund are expected to be reduced 7.6% ($471 million), which includes grant awards used by some state highway officials to back grant anticipation revenue bonds. With the FAA and TSA facing potentially significant cuts, airport managers have expressed concerns that airfield projects may be delayed and their revenues negatively impacted. We expect the reduction in funds would reduce coverage levels modestly, but bondholders would not be impaired.
Housing: Sequestration would result in an 8.2% ($1.3 billion) cut to housing programs for low income families and individuals. HUD estimates housing programs, such as rental assistance and public housing, would be most impacted. However, given that a majority of housing bonds are backed by a federal agency guarantee, we expect bondholders would remain largely unaffected.
Build America Bonds (BABs): Payments authorized for BABs would be cut 7.6%, totaling $255 million in interest subsidy payments for the approximately $200 billion in bonds outstanding. Categorized as non-discretionary, the interest subsidy level is to be reduced from 35% to 32.34%. While we believe the subsidy reduction should have minimal credit implications, the substantial reputational damage these cuts would have on the program is potentially long lasting. Further, some BABs allow the issuer to call the bonds if Congress implements tax changes. Should spreads widen, there may be attractive investment opportunities in the secondary market as the elevated perceived risks of these credits may be unwarranted.
In summary, sequestration has the potential to materially impact a large segment of the municipal market, in addition to the broader economy. Given the wide reach, we believe there is a strong likelihood that Congress forges a political compromise and sequestration is either avoided, or is retroactively reversed shortly after implementation. Political pressure will likely intensify following the November elections as affected parties begin to heavily lobby Congress to find a more palatable, non-sequestration alternative.
The views expressed are as of 11/7/12, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
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