The constructive development of upgrades to downgrades continues. S&P reported on Might 8th that upgrades outpaced downgrades by 2.39 to 1 in Q1 2019, which compares to 2.09 to 1 for all of 2018. In our monitoring of score businesses’ actions, this development seems to have continued in Q2. Please seek advice from our Q1 commentary for a more detailed discussion of upgrades to downgrades and extra development info: http://www.cumber.com/cumberland-advisors-market-commentary-q1-2019-credit-commentary/ .
While the credit high quality of municipal bonds continues to enhance, the performance of the municipal market has additionally improved on technical elements, squeezed by excessive demand and low provide, and decrease long-term rates. John Mousseau discusses this development in a current piece: http://www.cumber.com/cumberland-advisors-market-commentary-2q2019-review-total-return-taxfree-municipal-bond-the-big-squeeze/ .
Bond markets have priced in two or three further price cuts; nevertheless, we expect the Fed will keep on with being data-dependent (see What Does Knowledge Dependent Imply? commentary by Bob Eisenbeis: http://www.cumber.com/the-june-2019-fomc/ ; and though there’s current combined financial knowledge, progress continues in the US. There will not be as many fee cuts because the market anticipates; so a scarcity of action by the Fed might trigger the curve to steepen; and municipal yields, which had declined relative to Treasuries yields, might creep to greater levels.
Municipal bond credit score high quality is larger on common than corporate bond credit quality is. Corporate scores have a tendency to vary quicker than municipal scores do, probably as a result of there’s extra frequent and well timed reporting by corporates (firms file quarterly and municipalities yearly). Moreover, as corporations’ prospects decline or enhance, there’s a lag between once they conduct layoffs or resume hiring and when these actions have an effect on municipalities. Now, there are indicators that corporate credit score quality could also be turning and should presage a turnover in municipal credit high quality.
Within the nearby chart, Moody’s Scores Distribution by Sector, exhibits that municipal bonds usually have larger scores than corporate bonds. The chart has the newest revealed knowledge and we anticipate when Moody’s publishes the 2018 chart it’s going to show municipal scores skewed greater in credit high quality and corporate bond scores skewed lower.
S&P International, in its June 27 report “Trade Tensions Cloud the Outlook,” notes that downgrades, defaults, and destructive scores bias are up barely. In contrast to state governments, which have not increased bonded debt levels, firms have elevated leverage; and some are experiencing declining margins, which have led to downgrades and could result in more. For example, Oracle was downgraded by S&P to A+ from AA on persevering with elevated leverage because of a large improve in share buybacks. And IBM was downgraded by Moody’s to A2 with its acquisition of Pink Hat, which is predicted to be strategically constructive however represents increased leverage. Low interest rates and modifications from the Tax Cuts and Jobs Act are serving to to spur firms to extend leverage.
Taxable municipal bonds is usually a good various to corporate bonds, and we utilize them at Cumberland Advisors in our taxable bond strategies. We anticipate a continued provide of taxable municipal bonds to be out there, because there are specific tasks financed by hospitals, airports, universities, and different issuers that aren’t eligible for tax-exempt financing. Moreover, issuers can avoid the price of jumping by means of compliance hoops required for tax-exempt financing; and with the current low degree of charges, the distinction in yield just isn’t that nice. The expected 2019 quantity of taxable municipals is $45 billion, based on a Citibank estimate. This figure compares with tax-exempt quantity of between $330 billion to $385 billion for 2019, in response to a wide range of estimates. Though municipalities can not problem tax-exempt advanced-refunding bonds to refinance present tax-exempt bonds, they will situation tax-exempt bonds to refinance Construct America Bonds (BABs) that are taxable. Morgan Stanley Analysis in a June 10threport titled Mid-Yr Provide Examine-Up anticipates that $16 billion of BABs might be refunded in 2019 and somewhat offsetting that reduction in taxable provide is the expectation of $eight billion issuance of taxable municipal bonds to refund tax-exempt municipal bonds.
Seven states began the yr and not using a finalized price range, pointing up disconnects between factions of the federal government and probably signaling governance weak spot. Nearly all of disconnects this yr revolved round instructional and environmental considerations. By the way, the seven states have mechanisms in place to continue to function (continuing resolution or persevering with appropriation), whether by passing an interim price range or by having a regulation that requires the prior yr’s price range levels to be used till a price range is passed. Both options might give legislators and governors aid from impending deadlines. In a report commenting on late state budgets, Moody’s notes that late budgets can mirror governance weak spot and that some states are notorious for late budgets. Massachusetts is a type of states, and this yr it put an interim finances in place by way of October, whereas the fiscal yr began July 1. As of July 5th 5 states nonetheless had not handed a price range based on the National Association of State Finances Officers (NASBO). In addition to Massachusetts, the states are New Hampshire, North Carolina, Ohio, and Oregon.
Final yr nearly no state price range was late – probably due to midterm elections. The State of New Jersey passed its finances on time, for worry of a government shutdown; nevertheless, it did not achieve this and not using a dislocation. The legislature turned down the governor’s proposed “millionaire’s tax,” which some feared would push out some residents. The legislature also rejected additional deposits to the wet day fund; nevertheless, a large cost was budgeted for payments into the pension system. As we’ve noted up to now, New Jersey has one the bottom pension funding levels of all states. For fiscal 2017, the newest yr for which comprehensive knowledge is accessible, the level stood at 35.eight% in response to a June 27 report by Pew Charitable Trusts. This is the second worst degree, just above Kentucky’s 33.9%, and slightly below Illinois’ 38.four%.
Constructive economic progress projections have led to budgets based mostly on continued anticipated income progress and will increase in taxes and costs. Considerably, states have continued to bolster their rainy day funds in fiscal 2019. With the reminiscence of the financial disaster still crystal clear, most finances proposals addressed one-time needs fairly than instituting new packages that have to be funded with devoted levels of increased income. There are headwinds to the constructive progress, similar to a potential enterprise slowdown, attainable reductions in federal assist as our national debt grows, and the demographics of an getting old population, in addition to looming liabilities akin to pension and different post-employment advantages (OPEB) funding wants and infrastructure tasks.
Notably, the level of state internet tax-supported debt has remained primarily flat since 2012 on numerous measures, including as a proportion of GDP, as a proportion of private revenue, and as well as a proportion of debt service to expenditures. The flat degree of internet tax-supported debt is because of fiscal constraints, and it might even be that different fastened long-term liabilities, comparable to pensions and OPEB, which at the moment are required to be reported in monetary statements, are consuming a larger share of state budgets. Ready for a federal infrastructure plan, states delayed tasks which may have also contributed to the flat debt levels. Within the chart under, observe states’ score ranges compared with their debt ranges and the elements of those long run obligations.
State Scores and Actions
Once once more there were no score modifications or development modifications in state scores in the quarter. Although, just after quarter end, Fitch downgraded Vermont to AA+ from AAA on account of lower progress prospects of an getting older population. The Fitch score is now inline with the Aa1 and AA+ scores of Moody’s and S&P, and the development is secure. There were nevertheless different state actions taken that can affect the credit high quality of state related entities or localities. On July 2, College of Alaska was put underneath assessment for a downgrade by Moody’s as a result of the state’s budgeted payments to the university have been decreased by 42%. This discount is one among others proposed by the state to assist scale back a $1.6 billion deficit and achieve extra structural stability. We now have typically noted that when states have some fiscal strain, funds to their businesses and localities are topic to decreased state assist. Alaska depends on oil royalties for a lot of its income, and this revenue has been risky and contributed to the state’s dropping its AAA scores a couple of years in the past and to subsequent downgrades to Aa3 by Moody’s and AA by S&P.
Different examples of states proscribing an area issuers’ flexibility embrace the State of Texas’s SB 2, which if handed would prohibit native governments from growing property taxes by greater than 3.5% annually, down from 8% yearly, without voter approval (there are exceptions for sure districts). Many Texas communities have been raising taxes above this degree, and to the extent that further progress doesn’t occur or reductions in expenditures aren’t carried out, financial cushions might erode.
The State of Florida passed legislation usurping the facility of the Miami Dade Expressway Authority (MDX) to boost rates and construct tasks by changing it with the Larger Miami Expressway Authority (GMX), mandating a toll decrease, and permitting toll will increase only to satisfy the speed covenant, which requires that internet revenues cowl 1.2x debt service, while the newest degree was over 2.0x. The laws is being challenged; and even when the challenge is profitable, it is clear the entity has had its unbiased rate-setting authority compromised.
The Governmental Accounting Requirements Board’s (GASB) Assertion 91 would require municipalities to reveal debt that was bought in its identify as a conduit for an additional entity and the quantity of debt service the municipality is more likely to pay. Typically a municipality issues debt on behalf of one other entity, often in relation to economic improvement. The obligation of the municipality to pay for the debt can vary from no obligation in any respect to partial or full. Typically the underlying borrower can’t or doesn’t pay, and the municipality might lend its help. This info is required to be reported for fiscal years starting after Dec 15, 2020. This degree of disclosure is intended to make government officials and taxpayers aware of potential claims which will arise. It also will increase transparency for buyers.
GASB continues to work on tasks to enhance transparency for taxpayers, issuers, and buyers and is presently accepting comments on proposed reporting for public-private partnerships (P3 or PPP) and concession agreements with personal partners. There continue to be political and practical causes for municipalities to interact in P3, for example to realize economies of scale or a big upfront capital commitment; so the concentrate on these arrangements and the way they’re introduced in monetary reporting is welcome.
At Cumberland Advisors we intently comply with state and municipal credit score developments and associated information gadgets, incorporate them into our views of the financial system and markets, and make use of them in our purchase and promote selections. Nearly all of our municipal bond holdings, both taxable and tax-exempt, have AA scores, usually reflecting numerous financial bases and powerful monetary performance.