Are state and local governments better prepared to weather an economic downturn than in previous cycles? For the most part, yes. With the pace of U.S. gross domestic product (GDP) growth forecasted to slow in the coming years, many local municipalities have continued to bolster financial reserves. In our view, this trend has positive credit implications for issuers of general obligation bonds.
A recent review of the fund balances for a representative basket of cities, counties, and school districts shows why. In all three segments, a greater percentage of municipalities have higher reserves relative to annual expenditures, with a smaller share having lower reserves, when comparing fiscal 2017 (ended July) to fiscal 2012. In 2017, 68% of cities and 67% of counties had reserves more than 25% of their expenditures, which is much improved from the 2012 levels of 59% and 62%, respectively.
Source: Lord Abbett. Data cover the fiscal years ended July 31, 2012, and July 31, 2017 (latest available data).
Sales, Property Taxes Boost Revenues Growing reserves are a direct result of increased sales tax receipts, personal income tax receipts, and strong assessed valuation growth. With U.S. economic activity accelerating in the wake of tax legislation enacted in 2018, sales tax receipts have been growing at a healthy 3-5% nationwide and this trend is expected to continue in 2019. This is especially good news for municipalities that are heavily reliant on sales tax revenue, such as many cities in Arizona and Florida.
Another positive factor from a credit perspective, at least on the state level, is the mid-2018 Supreme Court ruling in South Dakota v. Wayfair, which effectively gives states a basis for taxing e-commerce sales originating from companies based in their state. Considering e-commerce accounted for 9.0% of all retail sales in the United States in 2017 (up from 5.8% in 2013), this ruling takes significant pressure off sales tax-reliant municipalities who would not have been able to collect those levies had the ruling gone the other way.
Rising property values in many areas of the United States have also helped. Home prices continue to move higher, rising 5.2% nationally for the year ended November 2018, according to S&P CoreLogic Case-Shiller. However, the growth has not been equally distributed. Interestingly, the trend of rising prices in cities seems to have reversed in the past year, likely due to the $10,000 limit on deductions of state and local property taxes (SALT) under the 2018 tax bill, which reduced the attractiveness of living in a big, high-tax city. The S&P CoreLogic Case-Shiller 20-city composite index of residential real estate prices was up just 4.7% over the same 12-month period. Moreover, growth in home prices nationally was slightly under the three-year average of 5.8%, suggesting a possible pullback in the near-term. Mortgage rates have retreated from decade highs of nearly 5% reached in November 2018, but are still low compared to historical norms.
Because local municipalities can levy higher or lower property taxes to generate consistent revenue despite constantly-changing assessed valuations, a slight slowdown in home prices means very little to the bottom line for local governments. In fact, property tax revenue for U.S. municipalities is forecasted to grow 2-3% in 2019 (compared to a compounded annual rate of 1.9% since 2013), according to a report from the National League of Cities.
Stress Points: Infrastructure and Pensions But local muni-bond issuers do face some fiscal headwinds. Two particular points of stress are uncertainty over infrastructure spending and rising pension costs. It appears one of the reasons that local governments have been borrowing so little in 2019 so far is a lack of guidance regarding a possible infrastructure spending plan from the federal government. Right now, it is unclear whether infrastructure legislation will even be passed by the U.S. Congress, to say nothing of how much funding it would provide, where the money would be directed, and how it would be paid for. What is certain is that multi-decade low jobless rates, new tariffs on steel and aluminum, and slowly rising interest rates likely will greatly increase the labor, material and financing costs of any large infrastructure project.
Fortunately, municipalities can be more proactive in addressing the issue of pension costs. Pension plan contributions are forecasted to rise by 8% in 2019, and combined with a 4% forecasted growth in 2020, a leading 56-plan benchmark of local municipality pension plans is expected to meet its “tread-water” requirement for the first time since inception, according to Moody’s.* To boost pension contributions, state and local governments must implement structural increases in revenue available for pension contributions. New Jersey took action last year by passing legislation to irrevocably dedicate state lottery revenue for pension contributions for the next 30 years. Other changes made by major issuers include the state of Connecticut lowering its assumed rate of return to 6.9% from 8.0%, while offsetting the near-term balance sheet damage by extending the amortization period of its current unfunded liability.
Finally, there is one other important issue which intertwines the fiscal health of states and local governments. As school districts rely on state aid for up to 80% of their revenue (according to the National Center for Education Statistics), it’s important to keep in mind the fiscal health of the states when thinking about local municipalities. In 2019, state aid is forecasted to grow between 2-4%, in keeping with its range over the last decade. The median state budget reserve increased to 7.9% in fiscal 2019 from 7.3% in the previous year. While at the beginning of 2018, S&P had nine states on negative outlook; as of March 2019, there were none—the first time that has been the case since the 2007–09 recession. (As of April 17, 2019, S&P had 49 stable, and one positive, outlooks on U.S. states). Now this is a double-edged sword, seeing as most of the previous negative outlooks were removed because of rating downgrades, but the lack of any negative outlooks at this time bodes well for the future of state aid.
Summing Up: Municipalities Are Better Prepared
While a prolonged period of U.S. economic weakness could have an adverse impact on state and local government finances, all in all, we believe municipalities are better prepared to weather an economic downturn than they were before the last recession. We will continue to pursue attractive valuation opportunities among state and local government issuers.
*The “tread water” indicator, developed by Moody’s, measures the annual government contribution required to prevent reported net pension liabilities from growing, under reported assumptions.
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.
This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.
References to specific securities and issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The securities referenced may or may not be held in portfolios managed by Lord Abbett and, if such securities are held, no representation is being made that such securities will continue to be held. 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.
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. Investments in Puerto Rico and other U.S. 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.
A general obligation (GO) bond is a municipal bond backed by the credit and taxing power of the issuing jurisdiction rather than the revenue from a given project.
Gross Domestic Product (GDP): The monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.
The credit quality of the securities in a portfolio are 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 principle 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 this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
The Second Quarter 2019 edition offers insights from our analysts on key topics for municipal bond investors, along with essential market information.
Listen to a replay of our May 1 webinar with Dan Solender, lead Portfolio Manager for municipal bonds, Eric Friedland, Director of Municipal Bond Research, Kari Gauster, Research Analyst, and Erik Britt, moderator.
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