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Fixed-Income Insights

Comments by the Senate Majority Leader are attention-getting, but are really just going to create controversy rather than lead to changes in any laws.

Everyone’s getting frustrated by the virus-related lockdowns and the resultant economic challenges, and that may include Senate Majority Leader Mitch McConnell, who late last week caused a furor in the halls of state governments by suggesting that the states should file for bankruptcy rather than seek more aid from the federal government during this COVID-19 pandemic crisis.

We’ve been getting some questions from clients about Senator McConnell's comments, so we thought it would be worthwhile to respond.

Defaults a Long Way Off
First, it’s important to point out that the states are far from bankruptcy, even if a sovereign state in a federalist system could declare such.* Many claim that the Constitution would need to be changed and that the Supreme Court would need to be involved. Even with the drawn-out legal process that would be required, the states certainly have a long way to go before they would be in a situation where they would need to consider defaulting on their existing debt. The credit rating agencies currently have all states rated as investment grade, with Illinois the only state rated less than A-.

Certainly, if this virus-related slowdown goes on for a long time, states will have to cut discretionary programs that would hurt economic growth and people in need. This means that the states could definitely benefit from federal government support through direct financial aid and borrowing, but not a single state as of this writing is anywhere near a default on its existing bonds in our view.  

Aid Still On the Table
Nor are Senator McConnell’s remarks reflective of an unwillingness of Congress to help states through the current economic crisis. Both parties of Congress and the President have stated many times their support for increasing financial aid to states and local governments during this time of economic shock. As we noted in an earlier piece, there is a considerable amount of federal assistance forthcoming and more being discussed.

 

Figure 1. The CARES Act Provides $280 Billion of Direct Stimulus for Municipal Bond Issuers

Source: National Conference of State Legislatures.Covid-19 2020 Stimulus bill: What it Means for States, 2020

 

Moreover, the Republicans say they are focused upon opening up the economy as soon as possible to get the economic rebuild started. Putting states into bad financial condition without federal support will not do that and would actually have the opposite impact by slowing down the recovery. It’s seems to us extremely unlikely in an election year that the President would allow that to happen. Many of the states that are having issues and huge healthcare expenses are battleground states like Michigan.

Underfunded Pensions the Underlying Story
For Senator McConnell it’s not about defaulting on municipal bonds anyway. It’s about underfunded pension debt. In his own words,

“We’re not interested in solving their pension problems for them. We’re not going to let them take advantage of this pandemic to solve a lot of problems that they created themselves [with] bad decisions in the past.”

In short, McConnell doesn't want the states to use federal emergency COVID-19 related funds to bail out state pensions. There are only a few states that have major pension issues and they include Illinois and New Jersey as well as McConnell’s home state of Kentucky. It’s highly unlikely that he would want to put his own state into bankruptcy.

The Puerto Rico Example
In fact, in my opinion, the chance of encouraging states to dodge their fiscal responsibilities is beyond small. Case in point: the Commonwealth of Puerto Rico.

Puerto Rico has been in default for several years now and has been effectively locked out of the capital markets for funding. They are surviving on the U.S. government’s financial support following Hurricane Maria in 2017 and on money diverted from not paying interest on their bonds while they are paying enormous amounts of money to lawyers and consultants. It is unlikely that the federal government would want to put multiple states and local governments into that position.

Not providing funding to states also would impact more than pension funding; it could put government programs focused upon things like health, unemployment benefits, education, welfare, elderly, and transportation into jeopardy. To say that would be a problem on Election Day would be an understatement.

States and Government Assistance
There is no denying that the states need money because they aren't getting enough tax revenues during this virus slowdown, and they would all benefit from federal government assistance. Prior to March, most states were running surpluses on their budgets and were putting extra money in reserve funds, but things have quickly changed.

Even states that are fully funded on their pensions and had large rainy day funds are still going to run into financial issues if this virus slowdown continues for a while.

We view the Senate Majority Leader’s comments, while troublesome, as mostly an overly aggressive negotiating tactic, because we are unfortunately in a situation where the government needs to provide more financing to state and local governments than anybody previously wanted.

 

*It is not entirely clear that Congress has the ability to allow states to declare bankruptcy. Each state has a different legal set up, and most local governments can't declare bankruptcy either.

 

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. High-yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Lower-rated investments may be subject to greater price volatility than higher-rated investments. A portion of the income derived from a municipal bond may be subject to the alternative minimum tax. Any capital gains realized may be subject to taxation. Federal, state, and local taxes may apply. There is a risk that a bond issued as tax-exempt may be reclassified by the IRS as taxable, creating taxable rather than tax-exempt income. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Investments in Puerto Rico and other territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

The information provided is for general informational purposes only. References to any specific securities, sectors or investment themes are for illustrative purposes only and should not be considered an individualized recommendation or personalized investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. Past performance is not a reliable indicator of future results.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity.  If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment, idea, strategy, product or service may be appropriate for your circumstances.

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