VTEB - Q4 2023 Credit Commentary - Munis Close Out The Year Strong - Performance And Credit Quality

2024-01-17 20:15:00 ET

Summary

• Moody’s and Kroll continue to rate the US bonds Aaa/AAA, noting significant strengths and resources, while Fitch and S&P both rate the US AA+.
• We spotlight state ratings on a regular basis because the health of a state affects municipalities and agencies throughout the state.
• According to the Pew report, released in October of 2023, all state pensions have reached the breakeven level.

By Patricia Healy, CFA

This title belies the volatility of the quarter and the past year, which we highlighted in our previous quarterlies. In Q4, Congress averted another government shutdown.

However, the congressional dysfunction leading up to the temporary extension again affected the US government’s credit rating, this time through a downgrade of its outlook to negative by Moody’s.

Currently, a similar snafu may be averted, as a stopgap spending bill has been proposed so Congress has more time to hammer out details of major spending bills. However, the next deadline for shutdown in the event of no budget is coming right up, on January 19 ^th .

Dual wars and military attacks around the globe by rogue actors – and retaliation for those acts – contributed to the volatility, causing changes in supply chains; but just as surely, they further improved prospects for the military manufacturing and other staples sectors.

The Fed’s inflation fighting, with 11 hikes in two years, along with technological improvements in many sectors of the economy and the moderating of employment pressures, brought inflation down, helping bond yields to moderate – although short rates are still higher than long-term rates.

See John Mousseau’s Rollercoaster in Bonds – The Tale of Two Bond Markets for a discussion of rates and the bond market’s performance over the year and dramatic movements during the quarter.

In this commentary we will discuss Moody’s shifting the US’s outlook to negative, state rating changes, pension funding, budgeting in the face of the runoff of federal pandemic funds, predominantly positive rating changes, and expectations of muni credit strength.

United States Aaa Rating Outlook Revised to Negative by Moody’s

Moody’s and Kroll continue to rate the US bonds Aaa/AAA, noting significant strengths and resources, while Fitch and S&P both rate the US AA+. However, in November, after maintaining a stable rating with cautionary comments about the country’s credit quality in Q3, Moody’s changed its outlook on US credit quality to negative from stable.

The agency said that the downside risks to the US's fiscal strength have increased and may no longer be fully offset by the sovereign's unique credit strengths.

In the context of higher interest rates, without effective fiscal policy measures to reduce government spending or revenue increases, Moody's expects that US fiscal deficits will remain very large, significantly weakening debt affordability.

Continued political polarization within US Congress raises the risk that successive governments will not be able to reach consensus on a fiscal plan to slow the decline in debt affordability.

The US’s Aaa rating reflects exceptional economic strength and access to liquidity – in addition to institutional and governance strength that is also very high, supported in particular by monetary and macroeconomic policy effectiveness.

Federal agencies, including Fannie Mae and Freddie Mac, received negative outlooks on their Aaa ratings because those ratings are based on US governmental support.

Systemically important banks and insurance companies that received a notch upgrade to their ratings because of expected governmental support also had their outlooks changed to negative.

These include subsidiaries and branches of BofA ( BAC ), JPM ( JPM ), Wells ( WFC ), and Citi ( C ). (Note that bank holding companies, which are rated lower, are not directly benefited by government support and did not have their outlooks changed.)

Other entities that are solely dependent on the federal government, like the Tennessee Valley Authority and Bonneville Power Authority, also had their outlooks changed.

Refunded municipal issues that are secured by Treasurys in an escrow account and rated Aaa had their outlooks changed to negative, as well.

State Ratings

Because states are sovereign entities, state ratings in the US are not limited by the rating of the country – this is sometimes called a sovereign ceiling. While changes in funding for federal programs may affect states, they have their own taxing authorities and control over budgeting.

The ability of municipalities to raise revenue is dictated by state and local limits, not by the federal government. Moody’s did specifically point out that Maryland and Virginia have stronger ties to federal government-derived GDP and employment than peers, while Florida’s expansive, highly developed coastlines magnify its dependence on periodic federal disaster relief.

Moody’s affirmed the Aaa ratings and stable outlooks on these three states because credit deterioration that caused a one-notch downgrade in the US sovereign rating would be unlikely to cause a reduction in employment or federal disaster relief and the ratings of these states.

We spotlight state ratings on a regular basis because the health of a state affects municipalities and agencies throughout the state. Education and healthcare are the largest spending items for states.

Fitch upgraded the State of Illinois’ general-obligation rating to A- from BBB+ on November 7, reflecting the state’s ability to execute on significant planned reserve contributions and to maintain improvements in budget management, including normalizing accounts payable (for years the state had a large bills backlog), thereby improving the state’s overall operating profile.

This follows an S&P upgrade to A- in February and a Moody’s upgrade to A3 in March of this year. All rating agencies note the progress Illinois has made in improving its pension funded level. It was, however, the lowest funded at 44% in 2021, per Pew Charitable Trust.

Pennsylvania was upgraded to AA from AA- by Fitch on November 27, based on recent use of a surplus to build up reserves and the expectation that the state will maintain higher reserve levels in the future.

The rating also recognizes the state’s low long-term liability profile and budget flexibility, although in a historically contentious decision-making environment. S&P rates Pennsylvania A+ with a positive outlook, and Moody’s rates it Aa3 with a positive outlook.

Ohio now has triple A ratings across the board. The state issuer rating was upgraded by both Moody’s and S&P in early December to Aaa/AAA.

Both agencies noted demonstrated commitment to active budget management and building and maintaining reserves through economic cycles, as well as frequent and significant state-supported economic diversification efforts, which have resulted in positive business development and expansion across the state's traditionally heavy-manufacturing base.

Fitch rates Ohio AAA (upgraded in Sept of 2022), and Kroll Bond Rating Agency rates the state AAA.

That brings the number of states rated AAA by S&P to 16, while Moody’s rates 17 states Aaa. All states are rated A- and above with the upgrades of Illinois’ rating.

California’s outlook on its AA- rating was revised to stable from positive by S&P on Dec. 15, reflecting the state's significant revenue under collections. The agency does note that the state has better liquidity and reserves than in prior periods of revenue volatility.

However, longer-term structural imbalance is nevertheless worsening, absent a meaningful budgetary course correction to reflect a new period of subdued income tax growth, most notably among the state's highest-income earners.

Moody’s, in the 2 ^nd quarter, had assigned a negative outlook on their Aa2 rating of the state’s GO bonds, while Fitch rates the state AA stable.

As we have mentioned in the past, California would be the 5 ^th largest economy in the world based on GDP, and it has tremendous resources – but it also has volatile revenue, given its dependence on a progressive income tax that fluctuates with the economy, in addition to sometimes inflexible budget mandates.

State Pension Funding and Credit Ratings

The chart below depicts Pew Charitable Trust-calculated state pension funding levels for the most recent year available, which is 2021, and current S&P ratings.

According to the Pew report, released in October of 2023, all state pensions have reached the breakeven level. The markets, both stock and bond, had performance challenges in 2022, so funded levels are expected to decline.

Pew estimates the average funded level will decline to 74%, compared with 82% in 2021. Market performance declined, then improved in 2023, so funded levels will have changed again.

In addition to market performance, the levels of interest rates and inflation rates affect the calculation of the present value of pensions and future benefit payments.

The important issue is that a state continually budgets funds to pay into the pension at a level that preserves or increases and does not decrease the funded level.

Pew concludes that states have become better at this and now realize that pensions are a liability that can get out of control quickly if not continually addressed. Ratings agencies’ comments also reflect this sentiment.

Many factors affect credit ratings. This chart shows that states with the lowest-funded pensions also have the lowest ratings. Illinois, New Jersey, Kentucky, and Pennsylvania are the lowest-rated states by S&P; all other states are rated AA- or higher.

POBs and PABs

In addition to committing to a funding schedule, states can issue pension obligation bonds (POBs) and pension acceleration bonds (PABs). Proceeds of POBs are used to add funds to a pension plan.

The interest cost on the bonds and especially the performance of investments purchased with the proceeds largely determine if borrowing to fund the pension is worthwhile.

These financings are not generally viewed positively by credit analysts because of the risk that the market will turn down after the bonds are sold, and because, in addition to the issuer having a pension liability, their overall debt burden increases and there are debt-service payments to be paid on the bonds issued.

PAB proceeds are used to prepay pension payments to pensioners – giving them the present value of the pension benefit. This way, the state reduces future pension obligations, although again there is debt service to be paid on the bonds.

Some pensions allow the pensioner, at their option, to choose to take the present value of the pension instead of being paid over their remaining life. The City of Dallas experienced huge withdrawals years ago from its police and fire retirement fund, and the city experienced downgrades related to it.

The city is still struggling to grow its funded level, with some estimates projecting it to be only 25% funded by 2055. The city is considering using POBs and may put the question to voters. Meanwhile the state is considering a rule to require municipalities to have better-funded pensions by 2050.

Budgeting as Stimulus Funds Wind Down

A tremendous amount of pandemic stimulus funds was bestowed on municipalities, which helped them weather the pandemic as well as build up strong reserves and improve credit quality.

In some cases the funds do not need to be spent until 2026, so municipalities are still reaping the benefits and figuring out how to spend the remaining amounts.

According to S&P, of the $350 billion State and Local Fiscal Recovery Fund, 39% remains unobligated and unspent. Most of the money spent to date was for public health, infrastructure, revenue replacement, and battling negative economic effects.

Most municipalities are in good shape to manage the stimulus wind-down and budget for a slowing economy. Some municipalities that used the stimulus funds for ongoing expenditures rather than one-time items may have greater budgeting challenges, which could damage their credit quality.

Many states over the past few years have also reduced tax rates, which is easier to do than raising taxes; so that may be a challenge as well, depending on the severity of a recession if one evolves.

Long-term challenges, in addition to pension funding, include the changing climate, rising insurance premiums, changing demographics, cyberattacks, and the need to improve infrastructure.

Ratings Upgrades Again Surpassed Downgrades for the Year

Smith’s Research and Gradings tracks aggregate upgrades and downgrades by Moody’s, S&P, and Fitch to get a broad picture of risk level in the market. Smith's tracked 783 ratings upgrades and adjustments during 2023, affecting $530.8 bln in outstanding long-term debt.

The largest number of issues upgraded during 2023 occurred in the GO Bond sector, with 415 upgrades, affecting $246.3 bln in outstanding debt. There were 70 upgrades in the Transportation sector, affecting $89.7 bln in par outstanding, and 47 upgrades in the Lease/Appropriation category, with $82.9 bln in par.

Smith's tracked 53 upgrades in the Lease/Appropriation Bond sector, affecting $56.1 bln. By contrast, there were 341 downgrades and ratings adjustments in 2023, affecting $111.7 bln in outstanding long-term municipal debt.

At Cumberland we take a top-down approach to analysis, so we will be watching the economy, municipal budgeting, and how municipalities are addressing longer-term risks and potential deterioration in certain sectors and credits.

Most of our muni bond holdings are rated in the double A category, which indicates stability. AA-rated credits generally have a wealthy and diverse economic base, strong financial operations, reasonable debt levels, and a manageable pension liability, as well as proactive management.

I wish all our clients and readers a Very Happy New Year.

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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