States of Denial?

February 27th, 2013

by Eric Schaefer

Neither the threat of the fiscal cliff nor the specter of sequestration seems to have diminished investors' appetite for municipal debt. Over the twelve months ending January 2013, the Barclays Capital National Municipal Bond Index returned 4.80% (7.58% on a tax adjusted basis). In contrast, the Barclays Capital U.S. Treasury Index returned just 0.74% (0.83% tax adjusted) over the same period.

One could argue the adverse effects of the fiscal cliff and sequestration, should they occur, will unevenly impact the fifty states. This is a valid point. Maryland (MD), Virginia (VA) and Hawaii (HI) are perhaps three of the most vulnerable states in the event a Congressional impasse forces a furlough of civilian employees and a delay in expenditures. Each has underperformed the national muni index over the past twelve months.

Then, there are several states we anticipate will be sequestration-proof. The ongoing shale gas and shale oil energy boom has created a number of winners among the fifty states. Wyoming (WY), Louisiana (LA), North Dakota (ND) and Colorado (CO) are four states whose fiscal fortunes have been transformed by hydraulic fracturing. North Dakota in particular has benefitted tremendously from the Bakken oil boom. Sparsely populated, the state has seen its population grow 7.2% (versus 4.2% for the nation) over the last five years. Concurrently, employment has surged 20.9% over the same period. So, despite the added costs of building schools, hospitals and the other infrastructure needed to accommodate the state's new residents, investors are betting that, net-net, the incremental taxes and royalties the state stands to collect more than offset the expense. As a result, its debt has become something of a better bet.

To these two subsets, we can add a third: a handful of states where caution and a second look are advised. In the past, we have written extensively on California (CA) and its peculiar and perilous finances. In California Dreamin', dated January 18th, 2013, we argue while Propositions 30 and 39 may help California's fiscal situation in the short-term, over the long-term we expect they will exacerbate its problems. Judging by the rally in California municipals, investors appear to be happy that the budget gap has been closed for however brief a period.

Now there are two other states — Illinois (IL) and Michigan (MI) — where we also question investors' enthusiasm. In the case of Illinois, the legislature has failed to heed Governor Pat Quinn's injunction to tackle the state's chronic pension funding deficit. Using statistics from the state's three major pension plans, we estimate for fiscal year 2012, the actuarial difference between plan assets and liabilities is a staggering $92.9 Billion. To put this into perspective, this deficit equals 13.9% of the state's nominal gross domestic product (GDP) or 160% of its general revenue in 2011. Unfortunately, action has been delayed so long, there is no easy out. The only certainty is that pain will be borne both by taxpayers and state workers. This is a key reason why S&P downgraded the state's debt rating to A– on January 25th.

Across Lake Michigan, the state is poised to assume fiscal control of Detroit. The city has been caught in a downward spiral for some time. Over the last decade, its population has contracted by almost one-quarter while the size of its municipal infrastructure has just gradually declined. The consequence is the city faces perennial budget deficits with no clear path to fiscal sanity. Governor Rick Snyder, fresh from his right-to-work victory, is expected to create a fiscal control board to beleaguered Detroit. While we applaud the action, we wonder if the priorities are correct. Michigan too faces its own pension deficit problem. Given the relative magnitudes, perhaps, the pension problem should be tackled first.

As in the taxable debt markets, municipal bond investors appear to be seeking yield irrespective of the risks. Denying the obvious may work in the short-term; long-term, though, denial is a prescription for grief.

Notes on Sources and Methods:

The Barclays Capital Municipal Bond Index is an unmanaged index consisting of approximately 46,000 different securities. To be included issues must carry an investment grade rating and must have an outstanding par value of at least $7 Million. The same criteria apply to the fifty different state municipal bond indices.

S&P rates municipal debt on a scale of AAA (the highest rating) to BBB (the lowest rating) for investment-grade instruments. Debt rated below BBB is considered to be non-investment grade (or, junk).

Nominal gross domestic product (GDP) is a widely used measure of the total goods and services produced (consumed) by a nation (or, state) over a period of time. Nominal GDP reflects the value of the aggregate goods and services at current price levels.

(Sources: Barclays Capital; Census Bureau; Bureau of Economic Analysis; AIFS estimates.)

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