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Fixed-Income Insights

For lower credit-rated cities, financial oversight and assistance from states can represent a fiscal lifeline. What, though, are the implications for muni investors?

[Note: This article is from the latest edition of The Muni Quarterly.]

Municipal bonds have the reputation of being safe investments. Unsurprisingly, the data back it up: According to Moody’s Investors Service, the five-year U.S. municipal default rate has been 0.15% since 2007, which is significantly lower than the global corporate default rate of 6.92%.1 What may be surprising about this data set, however, is that cities represent only 8% of the total number of municipal defaults. There are several reasons why cities represent such a low percentage of defaults.

First, contrary to popular belief, the municipal market primarily consists not of general obligation (GO) bonds issued by state and city governments but, rather, of revenue bonds issued by entities in sectors ranging from utilities to higher education to transportation. Therefore, one reason why city GO bonds represent a small portion of municipal defaults is because they represent a relatively small component of the municipal market.

Another reason why cities tend to be very creditworthy is due to inherent credit strengths. Almost every city in the United States is rated investment grade because most outstanding debt is backed by the strong pledge to raise local taxes as high as necessary to pay its obligations. Even among lower-rated cities, defaults are relatively uncommon, because these issuers have proven to be very resilient, given their significant ability to impose austerity measures.

State Aid
Lower-rated cities also often have constructive relationships with state governments. States can help cities on the lower rungs avoid further credit deterioration through financial and operational oversight and the opportunity for cheaper financing. In the past few months, there have been several examples that illustrate the power of strong state support and how it has helped maintain or improve the credit quality of lower-rated cities.

One example of strong state oversight is found in Pennsylvania. The commonwealth’s Financial Recovery Act (Act 47) provides for the assignment of a coordinator who analyzes the finances of stressed cities and recommends changes. Scranton (the seventh-largest city in Pennsylvania), for example, has been a recent beneficiary of Act 47, when Standard & Poor’s Financial Services (S&P) upgraded, in 2017, the city’s credit rating, from ‘BB’ to ‘BB+.’ S&P cited Scranton’s improved budget flexibility and liquidity, a development largely made possible by state oversight.2 With time, full fiscal recovery is very possible. Pittsburgh (Pennsylvania’s second-largest city) is one example. The city was rated below investment grade in the mid-2000s; since then, state oversight has helped the city improve its rating, to ‘A1’ by Moody’s and ‘A+’ by S&P.

States also can help lower-rated cities garner cheaper financing. In New Jersey, for example, the Municipal Qualified Bond Act (MQBA) allows the state to withhold state aid payable to a lower-rated city and essentially pay that city’s debt-service obligations directly to bondholders. Such state “intercept” enhancement allows debt issued by a participating city to take on the credit rating of the higher-rated state, which lowers borrowing costs for the city. In addition, this enhancement helps maintain a lower-rated city’s market access. One beneficiary of this legislation has been Atlantic City, which has been issuing debt through the MQBA for years now.

Extraordinary Measures
States typically provide their local municipalities significant annual funding; but in rare cases, extraordinary state aid also may be available. In 2017, the state government of Connecticut provided the city of Hartford with extraordinary state aid in amounts adequate for the state’s capital city to avoid immediate bankruptcy. Earlier this year, the state went a step further by guaranteeing the payment of all of the city’s outstanding GO debt. This level of support was unprecedented, and illustrates the extremes that some states may go through to prevent local municipalities from declaring bankruptcy.  

Some states have extended levels of support sufficient to prevent fiscally stressed cities from reaching the breaking point, when expenditures are so burdensome that filing for bankruptcy begins to make sense. However, not all states are as bondholder-friendly. One example would be the state of Michigan. The city of Detroit’s decision to file for bankruptcy was primarily driven by changing economic dynamics and fiscal mismanagement; however, to a lesser extent, the filing also was driven by the state’s decision to not fully support or bail out the city.

Summing Up
Understanding the potential level of state support is important; but, ultimately, when analyzing the debt of lower-rated cities, we focus primarily on the city’s credit fundamentals, as we understand that states typically do not have legal obligations to bail out their cities. For our products that do invest in lower-rated cities, we are constantly assessing and reassessing the value of the holding and the credit of the city. That being said, given the historically low default rates among not just U.S. cities but municipal bonds in general, we continue to view the municipal market to be a generally safe place to be for those seeking tax-exempt yield.

 

1”U.S. Municipal Bond Defaults and Recoveries, 1970-2016,” Moody’s Investors Service, June 27, 2017.
2Paul Burton, “Scranton, Pa., Gets Upgrade from S&P,” The Bond Buyer, August 4, 2017.

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THE MUNI QUARTERLY

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The Second Quarter 2018 edition offers insights from our analysts on key topics for municipal bond investors, along with essential market information.

First Quarter 2018 edition

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