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 bonds for essential services (which may be subjectively defined) or perceived priority claims of officials and politicians (like retirement obligations).