June 2014 Municipal Market Credit Review- “Is Chicago/Illinois the Next Detroit/Greece?”
The month of June saw the return of municipal new issue supply, but is this just short-lived? The market did a good job of digesting close to a two times increase in issuance. This support came from mutual fund inflows and good seasonal demand technicals for reinvestment. The question now is whether this is a short-term spike in supply, or the beginning of a return to normal issuance levels.
During this surge of supply, we saw the return of several Chicago and Illinois issuers, which have refocused the credit world on their problems. We will use this month’s credit review to look at these pension burdened issuers, understanding that decisions they make in the next six months are very important to their fiscal stability going forward. Are we looking at the next Greece and Detroit all rolled into one? Or are we witnessing the beginnings of a credit turnaround?
June 2014 Municipal Market Review:
During the month of June supply has finally made its way to the market, causing munis to slightly underperform the Treasury market. We have been waiting for supply to return; now the question is whether this is just a short-term phenomenon or is the market back? More specifically:
- Issuance over the last four weeks has been closer to $8 billion a week, versus the previous month’s average of $5 billion a week.
- Municipal rates increased marginally, due to this increase in supply. Muni yields increased roughly 5 to 10 bps over the month, while treasuries increased roughly 2 to 9 bps,
Municipal valuations still appear high, even after this slight back off.
- At these yield levels it does not take much of a backup in rates to create negative returns over a 12 month horizon. For example break even yield increases by maturity are as follows:
40 bps increase for 5-year bonds
39 bps increase for 15-year bonds
38 bps increase for 30-year bonds
- Puerto Rico jumped back in the news last week by passing legislation allowing its public corporations (ex: electric utilities, water & sewer) to restructure their debt. Although the general obligation bonds were exempt from this restructuring, the increase in the credit default swaps from 521 in mid-June to 1545 last week seems to say the market thinks differently.
Going forward the direction and magnitude of change in municipal yields will be triggered by the direction of the US Treasury market and new issue supply. As you can see above, with the low relative yields we are experiencing, it takes very little to push total returns into negative territory. We all know from driving around town that infrastructure demands are high. Additionally, borrowing costs are low versus historical levels. People think the lack of supply has to do with fiscal austerity, but we ask: Why now? We see the window slowly closing to lock in cheap financing for repairs that are of immediate need. If you combine a return of issuance with a slightly stronger economy it could be a bumpy ride to year-end.
Investment Strategy Review:
We remain defensive, but are beginning to look for opportunity. As last summer showed us, opportunities can be born in under 30 days. Until then, the two types of strategies we continue to recommend are as follows:
- Short-term premium callable cushion bonds. We are focused on bonds callable in 3 to 5 years, with at least a 5% coupon and final maturities from 14 to 18 years. This structure should help minimize market price risk when yields do rise. We feel a realistic yield target for this strategy is 2% to 3%, with some total return downside.
- Floating rate municipal bonds. The income on these bonds will change with a spread as 7-day BMA reset rate changes. The selling price, due to their floating rate mechanism, should stay near par when rates increase. A realistic target yield and total return for this more conservative strategy is from 75 basis points to 1%.
Introduction: Is Chicago the next Detroit, and/or is Illinois the next Greece?
Remember, it took roughly 50 years for the demographic decline in Detroit to overtake its financial resources. A point of confidence in municipal finance is that most times, aside from fraud or mismanagement, a municipality can grow out of its fiscal problems. If it cannot, it takes years of demographic decline to exhaust its resources. Where are Chicago and Illinois on this time line? Furthermore, do they even belong on it?
At this time, both issuers’ credit quality is burdened with the same problems that are causing questions about their future solvency. These burdens are as follows:
- Made big promises to retirees, and have not been willing to save up the money to meet them.
- Have practiced “a spend but not tax” fiscal policy, creating a budget that is out of balance.
- Infrastructure and an education system that is severely underfunded.
The recipe to cure these ailments does not take genetic engineering. It is as simple as demographic growth, tough fiscal decisions going forward, and time. Is Chicago or Illinois capable of this and are they ready to make the tough choices? We have some concerns, and we have some hope.
Chicago- The Concerns:
Current fiscal imbalance and a potential fiscal crisis: Chicago’s budget is now strained, and the increasing costs of pension obligations will make it worse. D-Day for Chicago’s budget could be in 2016. They have changed the statutory formula guiding the police & fire pension contribution amounts, bringing it more in line with actuarial funding methodology. To meet this requirement, the city will need to increase contributions from $480 million to $1.1 billion in 2016. The city needs to begin identifying where it is going to get this revenue now in order to leave enough time to implement and begin collecting it for the 2016 payment.
Tax and debt burdens are high:
- Chicago is ranked 5th highest tax burden amongst large US cities. Chicago taxes are higher than NYC and Los Angeles (according to the Huff Post, 3/3/13). It has also been said that every household in Chicago owes $88,000 for promises the government has made to retirees.
- Debt service is a high component of its budget at 12% of general fund expenditures, (Detroit’s is 14%). Issuing additional debt to meet pension requirements will only make things worse.
Chicago- The Hope:
Demographics still slightly positive:
- Although the city is shrinking in size (population), it still remains the major economic engine of the state. This just means people may be moving out of the city, but they still work there, shop there, and hang out there. Roughly 82.2% of the state’s GDP was linked to the city in 2003; in 2013 it is 81.9%.
- Employment growth has been slow over the last four years @ 2.4% (versus US average of 4.7%), and is still only 92% of levels before the economic crisis of 2008.
Taxing flexibility: Chicago has home rule status that provides the city with the ability to raise virtually any tax without voter approval. Chicago currently levies property tax for pension contributions and debt service payments only, and could levy more in the future. The Mayor is now reviewing and contemplating increasing the property tax or phone tax to help meet funding needs by 2016.
Illinois – The Concerns:
Chronic fiscal imbalance. The current budget is not fiscally sustainable and debt levels are high. The state cannot continue to provide the same levels of services, keep taxes at current levels, provide all promised benefits and make the needed investments in education, and infrastructure. It has been this way for years which is why it has such a high balance of unpaid obligations. The state owes $8 billion of past due bills as of 2013. Other budget and debt concerns are as follows:
- $85 billion unfunded pension balance owed with only 53% of the plans on average funded.
- Medicaid enrollment & expenditures have doubled from 2000 to 2011. Rising healthcare costs and an aging population will keep this trend going higher.
- Debt per capita is the highest in the US. Over 60% of the debt outstanding is due to pension bonds that the state has issued instead of making contributions from current revenues.
- It is estimated, that by 2015, 50% of the state’s revenues will be needed to meet just pension and Medicaid obligations.
Poor Management and leadership: The tax rate increases enacted in 2012 were offset by a reduction in American Recovery & Reinvestment Act of 2009 (ARRA) monies. Income tax is not collected on retirement income. Therefore, as the population continues to age, revenues will most likely stagnant or decline unless changes are made. Other issues of concern:
- State does not have an infrastructure plan or source of financing to help aging & deteriorating infrastructure.
- Temporary tax increases are set to roll off in mid-2015:
- Income taxes temporarily increased from 3% to 5% in 2010, and are set to roll back to 3.75% until 2023, and then 3.25% after 2023.
- Corporate taxes temporarily increased from 4.8% to 7% in 2010, and are set to roll back to 5.25% until 2023, and then 4.8% thereafter.
Illinois – The Hope:
1) The recent 2013 budget did make some decisions, but not big ones:
- Cut education spending 3%.
- $1.6 billion in Medicaid program cuts.
- Some consolidating of government services and departments.
- Still avoiding the big decisions, pensions and Medicaid reforms.
2) Tax burden, although high, does have room to expand. Average annual tax burdens has Illinois ranked 10th in the nation at a rate of 10.2%. This is slightly higher than the national average of 9.9 % (according to data from The Tax Foundation published by the USA Today on March 2, 2013).
3) Demographics do not show a decaying municipality. There is growth as follows:
- GDP growth of 3-4% over the last four years, only slightly lower the national average.
- Employment growth is slow, but improving, less than 1% over the last 4 years.
- Population growth of over 3% in the last 10 years.
4) The state is attempting pension reform, but the courts will now decide if it can proceed:
Changes being sought under current legislation are as follows:
- More COLA based increases versus a set rate.
- Extend retirement age requirements.
- Salary calculation for retirement controlled.
There has been some weakening of demographics, such as wealth levels, employment/population growth, but not at a rate that is a concern for both issuers. At this point in time, neither is going through a Detroit like demographic decay. We also are encouraged with their recent actions that show both are trying to implement pension reforms, trying to make the government more efficient, and looking at ways to increase tax revenues. Here is what needs to happen soon to put us positive on each issuer
- The city either increases its property tax, or enacts a new form of revenue.
- Pension reform for 2 of the 4 plans recently passed needs to stand up against legal challenges, and then be extended to the other two plans.
- Pension reform needs to be approved by the courts. This would be a big win because the state law in Illinois appears to protect pension liabilities better than any other state in the USA. It will be hard to make the needed changes and stay within the law. If not approved, there is still the ability to lower benefits on new employees and OPEB’s such as life insurance and healthcare premiums.
- Tax increases set to sunset in May 2015 must be extended. Recent budget talks did not discuss this extension. It appears the state legislature is waiting until after the fall elections. If they wait to vote on it in early 2015, there needs to be only a +50% majority to approve it. If they voted today it would take +66%.
In our view we like Illinois’ prospect better than Chicago’s. The demographics for the state have been better, and there is more flexibility to increase tax revenue. Either way, the next six months will elucidate many of the prospects for both issuers, going forward.