Local governments like Detroit, Michigan (2013); Jefferson County, Alabama (2011); Stockton, California (2012); and San Bernardino, California (2012), were few of the major municipalities to file for bankruptcy in recent times. Majority of these local governments filed for Chapter 9 due to the 2008 real estate market crash that significantly deteriorated their property tax revenues for the general funds.
This was perhaps a rude awakening for many municipal debt investors that had originally thought municipal debt to be a relatively safer investment backed by the taxing power of each local government. In this article, we’ll take a closer look at the changes in municipal debt markets and the credit profiles for various muni issuers after the 2007-08 financial crisis, thereby understanding the potential silver lining of the financial collapse on fostering more organic growth in the debt markets with newer policies and regulations.
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Post-Recession Credit Profiles of Muni Issuers
The credit profile of any muni issuer is supported by its financial strength, management of its assets, the stability of its revenue streams and the potential preventative measures to withstand any future downturns in the economy. The overall impact of the financial collapse and the severe weather patterns in the U.S. had a significant impact on the financial strength and revenue streams, which, in turn, negatively impacted the credit profiles for the local governments.
In addition, many municipalities didn’t act quickly enough to deploy their contingency plans to meet their debt coverages and potentially prevent insolvency. For example, in the state of California, officials declared the state to be in a historic drought and urged its residents to conserve water as much as possible.
Although this was a great measure to save water and not run into any significant water shortage challenges, it severely affected the water revenues for the local governments; thus, impacting almost all the enterprise debt covenants. On the other end, municipalities that acted in a timely manner were able to establish and implement Water Rate Increase measures to address the drought impacts.
In the current times, the drought conditions have been lifted and the water revenues have been returning to normal. Water rate increases and the increased water usage have significantly helped revenues for many entities and strengthened their bond covenants. In addition, the property values have also been on the rise, post financial crisis; thus, increasing the general fund revenues for local governmental bodies. This has improved the chances of being able to access the debt markets again.
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Better Financial and Reporting Oversight for Debt Issuances
The recent financial crisis highlighted the need for better reporting on all the debt instruments for municipalities and hold them responsible for not meeting the reporting requirements.
The Securities and Exchange Commission (SEC) has shifted its focus to not only municipalities but also their officials. Although municipal issuers were always subject to antifraud requirements under federal securities laws, the SEC has started enforcing these requirements with legal action against both entities and individuals. In 2016, the SEC announced that it would be bringing enforcement actions against 71 municipal entities and officials for violation of federal securities laws. This entailed both municipalities and underwriters who either omitted or misrepresented information on bond documents and continuing disclosures.
Post-recession, these policies and initiatives have brought some mandatory requirements for local governments to follow the stringent reporting requirements, or else they will not be allowed to access the municipal markets for any new debt issuances. The SEC introduced the Municipal Continuing Disclosure Cooperation (MCDC) initiative to encourage voluntary self-reporting of material misstatements and omissions in municipal bond documents.
This initiative was the key for issuers and underwriters to mend their previous wrongdoings with favorable settlement terms. Mainly, the settlements included issuers or underwriters to implement proper policies and procedures for their continuing disclosures, comply with existing disclosures and material events (e.g., delinquent filings) and disclose these events in the future bond-offering documents and cooperate with any SEC investigations.
Be sure to read this article to remain aware of the due diligence process for evaluating municipal bonds.
Sector Outlook in the Municipal Space
The low-rate environment has served U.S. municipalities well, as 2016 has set some new precedents for muni bond issuance and refunding in recent history.
As seen below, the total dollar amount of municipal debt refunded in 2016 has been the highest in the past two decades.
2017 – YTD
From the above table, it is evident that the supply of municipal debt is likely to lag in 2017 compared to the supply numbers produced in 2016 throughout the U.S. Lack of local government borrowing for infrastructure projects can be touted as one of the main reasons.
The first quarters of 2016 produced $99.9 billion in municipal debt supply (comprised of $38.2 billion in new capital and $61.7 billion in refunding) and $125.6 billion (comprised of $48.8 billion new capital and $76.8 billion in debt refunding transactions) in the second quarter. Comparatively, these numbers are on the decline for 2017; the first quarter, 2017, supply of municipal debt was $91.4 billion ($43.5 billion new capital and $47.8 billion in refunding) and $107.8 billion ($50.8 billion in new capital and $57.0 billion in refunding transactions).
The fact that New York, California & New Jersey – three of the major municipal debt suppliers in the U.S. – have shown significant declines can be a cause of concern going forward. For instance, the tapered supply of municipal debt is likely to put upward pressure on municipal yields. However, as the revenues return to their normal marks, local governments will have better opportunities to access the municipal debt markets and fund their new infrastructure or improvement projects.
Keep our glossary of municipal bond terminologies handy to familiarize with different concepts commonly used by municipal investors.
Looming Issues for Municipal Debt Issuers
The pension burdens and the unfunded liability due to poor investment performances have been the biggest looming concern with almost all the local governments.
Consider the case of California. The majority of the local governments in California go through CalPERS (California Public Employee Retirement System) for their retiree pension system, making it the largest pension fund in the United States.
Now, every local government puts money into their CalPERS portfolio to meet the retiree pension obligations, and CalPERS assigns an assumed return on that portfolio of 7.5% per year, also known as the discount rate. Now if investments in CalPERS’ portfolio doesn’t give a 7.5% return, then the local governments must come up with the difference to meet the monthly retirement obligations. This has been the challenge in the low-rate environment for the majority of the local governments in the United States.
The Bottom Line
Municipal debt markets and its issuers have seen some enormous ups and downs in the recent times and its investors are most vulnerable to these shifts. Furthermore, before considering any municipal debt investments it is imperative to familiarize yourself with the revenue streams backing the debt and the official statement of the issuance to see if it fits your own investment objectives.