March 2011

The Municipal Review

Over the last few months, the normally “dull and boring” municipal bond market has been the subject of intense debate and frequent media speculation, with many questioning the health and soundness of state and local finances. These concerns have been amplified since the November elections when 26 newly elected governors ran campaigns promising lower fiscal deficits. The highly polarized and publicized debate on budget cuts, pension shortfalls and a reduction on public services has led many investors to sell their municipal bond holdings, thereby pushing yields higher.

Most states incurred a deficit in fiscal years 2009 and 2010 and it appears many of these same states are likely to incur a deficit in 2011. Deficits and defaults are not the same – this seems to be lost on many investors and the media alike. What isn’t helpful are the broad brush conclusions that the entire municipal market is in dire straits. In 2010, during an undeniably challenging fiscal environment, the municipal default rate was less than 1/2 percent and nearly in-line with the long-term default rate. While defaults can’t be ruled out, we believe that the level of defaults will not spiral higher. Our municipal investments continue to focus on high quality general obligation bonds and essential service revenue bonds.

Municipal budgets and finances are cyclical in nature and correlated to the overall health and direction of the economy. Approximately 80% of state and local revenues are tied to personal, sales and property taxes. With rising GDP forecasts, many states could see a rebound in revenues. In fact, recent consumer spending figures validate that personal consumption is in fact rebounding. This will result in a corresponding boost to sales tax revenues. As private sector employment expands, states should also begin to see an increase in personal tax receipts. Additionally, private sector hiring should offset job losses within the public sector and stabilizing housing prices should put a floor on property tax receipts.

We believe that there are two fundamental challenges facing municipalities. These are Fiscal Operating Deficits and Unfunded Liabilities. Operating deficits are short-term challenges generally stemming from the weakness in the economy. Unfunded liabilities such as pension and retiree benefits are a long-term problem. For the most part, we believe that both of these challenges do not pose immediate dangers for bondholders. However, there is a clear need for state and local governments to address both of these near-term and long-term imbalances.

Fiscal Operating Deficits

The Great Recession, ending in June 2009, has caused state and local government revenues to drop while at the same time the need for public services has increased. As a result, many states are facing large operating deficits. Contrary to the Federal government, state and local governments are required to balance their budgets each year. Thus, they will have to cut services and funding for various programs and/or raise taxes.

Debt at the state and local government level is not excessive. In the second quarter of 2010, state and local debt outstanding was 16.7% of GDP. According to U.S. Census Bureau data, state and local governments spent less than 5% of their money on debt service at the end of 2009. Almost all state and local debt is used to pay for capital expenditures (roads, bridges, schools, water systems, etc) – not to cover operating deficits.

The good news is that governments are making the difficult budget choices and tax revenues are stabilizing. Ultimately, the situation should improve as the economy improves.

Unfunded Liabilities

Most people recognize that there are substantial long-term concerns related to unfunded pension liabilities and other post-employment benefits. However, the extent and depth of the problem is not widely agreed upon. Estimating the size of the problem is difficult. How much must the government invest today to pay out benefits 30 years from now? What rate of return is appropriate?

Each year, state and local governments are required to set aside money in a trust fund to pay for future pension benefits. This amount has typically averaged 3.8% of their operating budgets. In 2000, state and local pension obligations were fully funded on average, but since then, the nation experienced two recessions and the worst financial crisis ever. Today, it is estimated that these pension benefit programs are 77% funded. While this trend is concerning, experts concur that less than 70% is considered to be a problem, though not a crisis. To once again be fully funded, governments would have to increase the amount of money they set aside from 3.8% to 5-9% of their budgets depending upon the assumed rate of return.

Improvements in pension benefit programs are clearly needed, but the severity of the problem varies widely from state to state and city to city. The good news is that this is a long-term problem and we have time to fix it. Indeed, more than twenty states have already enacted changes including the elimination of defined benefit plans, increased length of service and age requirements and higher employee contributions. Furthermore, pension funding status should improve as the economy grows.

Badgley Phelps Outlook

While we are very concerned and are watching the developments closely, we believe that the best course of action is to remain patient and invested in municipal bonds. There is a significant difference between deficits and defaults. Municipal bond defaults have been extremely rare. The long-term municipal default rate is less than one-third of 1 percent. Most defaults are on non-general obligation bonds to finance construction of housing or hospitals.

While we expect to see some issuers with fiscal problems, we do not think that the level of defaults will spiral higher. There are more than 30,000 municipal issuers – not all of them have strong finances but not all of them are bad. Municipal budgets are cyclical in nature and should improve as the economic recovery and growth continues. Private sector employment is showing signs of improving as are consumer spending and consumption. Within the vast municipal bond market, we will continue to maintain our focus on quality general obligation bonds, essential service revenue bonds and pre-refunded bonds. While we do expect more headline news regarding the smaller local municipalities and lower quality revenue projects, we are vigilantly monitoring the municipal bond market and will continue to provide updates and our thoughts if we shift our current outlook.