Muni-Market Deals?

If 2010 was defined by the transition of developed country sovereign debt from interest rate space to credit space, 2011 is shaping up as the year where investors will see the same transition occur in municipal space. What was once unthinkable, that governments in industrial economies could seek debt restructurings, became all too real in 2010, and the same process of understanding the very real credit risks in the municipal space is now underway.

In many ways this process is long overdue after decades of dependence on infrequently updated ratings agency views, supposedly AAA monoline insurance guarantees, and assumptions about potential bailouts. Now, however, with many states and local governments struggling to close large deficits, it's time to acknowledge that defaults could happen, even in large and systemically important municipal issuers.

The bad news, then, is that municipal markets must permanently change to understand and more fairly price the default risk inherent in muni credits. But the good news is that the municipal market has swung too far into default panic, and we believe the real level of defaults that the muni market will experience will be well below what the market currently implies, not to mention some of the more extreme predictions of hundreds of billions of dollars worth of muni defaults. We at PIMCO believe that selective municipals now offer some of the most compelling value in credit markets. Selecting those credits takes an informed, bottom up understanding of each issuer. This requires applying the kind of debt sustainability analysis methodology that our emerging markets and European peripheral sovereign analysts use. Careful credit analysis could reap significant rewards over the next year or two as investors adapt to the transition from rate space to credit space and grow better over time at separating the winners from the losers.

Do Munis Really Have Too Much Debt?The most important factor supporting our bullish call on municipals is that many investors do not yet appreciate how low the total debt stocks, interest costs, and debt rollover requirements are on most major municipal credits, and how these factors can help to keep a lid on the municipal default risk. Granted, we would not simply look to low historical default rates as a reason to expect low forward default rates.

One common refrain from some in the muni optimist camp is that historical municipal default rates have been extremely low, which should provide confidence that municipal credits can find ways to weather fiscal storms when they arise. We, however, would be very cautious around the relevance of historical municipal default statistics. If the last few years have reminded us of anything, it is that historical default patterns can be shattered given different initial conditions, as seen so painfully in investment grade corporate default rates during the crisis, not to mention defaults on structured credits rated AAA by the agencies. It is better, we believe, to look in detail at state and local municipalities' current ability to service their liabilities than to simply rely on their historical default track record.

Even with this more skeptical forward-looking approach, however, we find the vast majority of state and local credits well prepared to continue to service their debt in the years ahead given generally very manageable levels of indebtedness. Using Census Bureau data, the median state had debt of just 7.3% of local GSP (Gross State Product, the state equivalent of GDP) in 2008, with almost half of that representing debts of state affiliated issuers like universities and transportation authorities with their own debt service resources (see Figure 1). Local governments add another roughly 11% of debt as a percentage of GDP, but again a significant portion of this amount comes from quasi-corporate issuers like water or electric utilities with their own revenues for debt service.

Granted, one cannot simply compare these figures to sovereign indebtedness figures and conclude that debt stocks are low. A weak sovereign with debt at 100% of GDP is not necessarily weaker than a state with 10% debt/GSP, because the economy of the state must service not only its own state debts but in effect must also service its pro rata share of the central government's debt. Even adjusting for this consideration, however, many states start with debt levels that are manageable, especially given the long-term nature of most state debt and the relatively low muni interest rate paid on that debt.

The long-term nature of most states' and local municipalities' debt may be critical in helping minimize the number of muni defaults in the years ahead. Different measures of the length of muni debt vary, but data from SIFMA as of December 31, 2010 show the weighted average maturity (WAM) of munis outstanding at 16.2 years, far in excess of most other asset classes (the WAM of U.S. Treasury debt is just under five years). This is not to say that there are no rollover risks in the muni sector, especially given the still outstanding stock of effectively short-term variable rate demand obligations (VRDOs), but we expect the impact of VRDO problems to be limited. VRDOs represent a little more than 10% of the outstanding stock of muni obligations, and a little more than a quarter of those VRDOs will see their backstop bank letters of credit (LOC) expire in 2011. This is hardly an insignificant amount of potential rollover risk, but we expect that the vast majority of the VRDO issuers with expiring bank lines of credit will be able to find replacement LOCs from other bank providers, though likely at a higher commitment fee.

Many smaller and particularly unrated VRDO issuers will likely fail to find new LOC providers, though, and will be similarly unable to term out the outstanding VRDOs into long-term debt. The muni market could well see a wave of defaults from these issuers, but the amount of defaulting VRDO issuers is unlikely to exceed several billion dollars. Importantly, it appears as though these defaults would come from systemically unimportant issuers, particularly special purpose issues financing multi-family housing or health care properties, many of which came to market in the go-go issuance years of 2005-07, but which are not core holdings of most muni managers. Their defaults are unlikely to have a significant contagion effect onto the broader muni market, in our view, let alone onto the broader credit markets.

The other often under-appreciated factor supporting credit quality in municipal issuers is the relatively low interest costs most muni issuers carry. Aggregating all interest paid on all municipal debt (including state, local, non-profit, etc.), the median state paid 0.74% of GSP in interest costs in 2008, the last year for which the Census Bureau data is available. The median state paid 2.9% of its revenues in interest, and the median local government paid 4.0%. These numbers are gross interest costs, unlike the net interest burden often quoted for sovereigns. Also, much of the interest paid by muni issuers at the state and local level is on debt specifically tied to quasi-public corporate entities like water and electric utilities, toll bridges and roads, air and sea ports, etc., all of which rely primarily if not exclusively on their own non-tax revenues to fund their operations and service their debts.

Even without these considerations, however, interest costs are still far from becoming an unsustainable burden on state and local government finances. If anything, aggregate interest costs are now well below where they have been in the past for the municipal sector. In the early 1990s, according to data published by the Census Bureau, total municipal interest costs represented 6.2% of total state and local revenues. As we show in Figure 2, the muni sector has enjoyed a significant decline in this ratio, leaving interest costs as much less of a concern today than they were 20 years ago. And even in the higher interest cost environment that existed 20 years ago, defaults only reached just 0.39% at the cyclical peak in 1991.

It is true that the interest burden is not evenly distributed among issuers, and a number of states are seeing interest costs rise to uncomfortably high levels. Massachusetts, for example, is by far the worst among the states, having paid 7.9% of state and local revenues in total state and local interest costs in 2008. But for the foreseeable future no state is likely to have aggregate interest costs high enough to warrant a restructuring simply because the interest bill is unaffordable.

Could Cash Flow Deficits Ignite Defaults?Excessive debt rollover risk appears minimal for most municipal issuers, then, and the interest burden for most municipals is unlikely to kick off a wave of defaults. Another potential threat to the muni default rate, though, is the cash flow deficits that states and local governments are facing in 2011, and the prospect that state and local governments might default simply because they cannot raise the cash to fund operations. With deficits so large, and with capital markets shut to states and local governments trying to borrow to finance those deficits, might muni issuers choose to cease payments to bondholders as part of a broader restructuring?

While this type of default driven by cash flow deficits is likely to play out in a high number of smaller municipalities over the next few years (along the lines of what has occurred with the filing of chapter 9 bankruptcy in Vallejo, California), we believe that deficits are much less problematic than some of the headlines suggest for most municipal issuers. The municipal market suffers from both a blessing and a curse due to its standards of deficit accounting; its highly conservative deficit accounting helps to focus lawmakers on addressing the deficit, but it also inflates the deficit figures well beyond what they would be using traditional deficit accounting for sovereign governments.

The first and most important difference between muni and sovereign deficit reporting is that the reported deficits are "cumulative." For example, when states enacted FY 2011 budgets, most were actually closing two shortfalls "“ (1) the projected gap between FY 2011 revenues and expenditures, and (2) the FY 2010 gap that arose because FY 2010 revenues fell short of FY 2010 appropriations. State budgets rely on a single year of incremental revenue generation and/or expenditure cuts to close projected shortfalls for the upcoming fiscal year as well as shortfalls accumulated in past years. Shortfalls are viewed this way because 49 states have balanced budget requirements (Vermont being the exception). If the U.S. federal government had to report its deficits this way, it would have a deficit not of around $1 trillion this year (the difference between its expenditures and its revenues) but of $9 trillion, representing the deficits accumulated over the last 220 years!

A second reason why reported budget deficits are conservative is that spending for upcoming fiscal years is typically projected at current per capita service levels. This tends to exaggerate the level of future spending beyond what legislators actually expect, leading to greater reported deficits. When states report "spending cuts," these cuts are typically relative to projected spending in the upcoming fiscal year, not relative to the previous year's spending. California's official deficit projection, for instance, assumes that all of its recently enacted spending cuts will be reversed, and that spending will revert to 2007 baseline levels despite the fact that legislators have repeatedly approved continuing spending below the 2007 baseline.

Third, budget deficits include both interest and principal payments on debt. This approach differs from sovereign budgets that only include interest payments. As mentioned above, states have a constitutional requirement to balance their budgets, and principal repayment is included in the definition of budget expenditures. The nature of municipal debt also plays a role in why principal payments are included as budget expenditures -- almost all municipal debt is fully amortizing. Generally, annual debt service payments (principal + interest) are level or decreasing with no maturity spikes. As a result, municipal issuers generally do not rely on market access to roll over principal maturities.

Figure 3 illustrates PIMCO's budget deficit calculations for three states that have recently enacted/proposed gap-closing measures for FY 2012 budgets. For the states shown, we have illustrated the impact that accumulated budget shortfalls and the inclusion of principal payments have on reported budget deficits. In the far right column, we have shown enacted or proposed budget solutions. For California and Texas, the proposed solutions reflect significant spending cuts relative to those states' baseline forecasts of expenditures.

Public Pensions "“ How Big a Threat?A decade ago, public pensions were well funded and posed little risk to the long-term solvency of municipal issuers. According to the Center for Retirement Research at Boston College, aggregate state and local pensions enjoyed over 100% funding levels "“ the value of plan assets exceeded the present value of plan liabilities. Today, aggregate public pension plan assets are estimated at less than 80% of aggregate liabilities (according to Alicia H. Munnell, Jean-Pierre Aubry, and Laura Quinby, The Funding of State and Local Pensions: 2009-2013, Center for Retirement Research at Boston College, April 2010.) Pension assets fell with the impact of the two recessions last decade and cutbacks in sponsor contributions. Meanwhile, liabilities have increased with growing public sector employment and attractive public pension benefits.

Much attention has been paid to estimating the true unfunded liability of public pension plans. Estimates range between $700 billion and $3 trillion depending on what interest rate is used to discount the future benefit obligations. In any case, the aggregate unfunded liability is very large with many municipalities choosing to increase pension contributions, implement pension reform for new employees and in some high profile cases, attempt to enact changes to existing member benefits. Many states, including Illinois and California, have implemented reforms for new employees such as raising the retirement age, increasing employee contributions, and eliminating salary spiking. Other states' have attempted to reduce benefits for existing plan members, concluding that the unfunded liability can only be adequately addressed by doing so. In Colorado, Minnesota and South Dakota, attempts to reduce cost-of-living increases for existing plan members were met with lawsuits.

Regardless of the exact size of the aggregate unfunded liability, inaction will threaten the long-term solvency of many issuers. Our concern, however, is whether pension problems pose a threat to the near-term solvency of municipalities. To answer this question, we first considered that aggregate numbers do not tell the full story. For instance, many state pension plans are well funded. New York state pensions, for example, had actuarial funding levels greater than 100% as of March 31, 2009. Second, even states with large unfunded liabilities in absolute dollar terms may be reasonably well funded on a percentage basis, as is the case with California. Therefore, our effort to determine whether pension problems are likely to cause near-term crises focused on the handful of states with large, poorly funded pension plans.

States at the top of this list have pension funding levels below 65%.  Assuming state contribution levels consistent with recent experience and a return on plan assets consistent with PIMCO's New Normal outlook, these states would fully deplete pension assets over the next 10-15 years. In the absence of pension assets, benefits would be paid as they are due on a "pay-as-you-go" basis, accounting for as much as 25% of general fund revenues. Even with considerable fiscal adjustments in other areas, such high burdens would be unmanageable.  This analysis demonstrates the severity of the pension challenges facing several high-profile states. But even for these states, pension problems will not lead to an immediate debt crisis this year (or even in the next five years). That said, "kick-the-can down the road" is clearly no longer a viable solution; if significant changes are not made in the next few years, the problem will likely become untenable in the latter years of this decade.

What about Local Municipal Issuers?While municipal budget deficit problems may be better than their headline numbers suggest and pension issues less of an immediate threat than a long-term one, we cannot rule out a meaningful increase in the incidence of default this year, particularly at the local level. Cities and counties will continue to suffer from the lingering impact of the housing crisis on property taxes, reductions in state aid (resulting in part from the June 30, 2011 expiration of federal stimulus funds under the American Recovery and Reinvestment Act), variable rate demand obligation renewal risk, and the expenditure inflexibility arising from unionized labor forces that represent the greatest category of spending for most local governments.

Faced with these challenges, the majority of local issuers will implement some combination of the following: an increase in property tax rates, aggressive spending cuts, and no "backfilling" of spending on state-mandated programs for which they no longer receive state aid. A minority of municipalities will simply be unable or unwilling to take these actions. For some, this will result in defaults and chapter 9 filings such as Vallejo, California's 2008 filing. For others, the state will come to the rescue as did Pennsylvania for its capital, Harrisburg. Actual investor losses may be well below default totals as we believe most issuers will restructure and extend amortization schedules. A modest amount of reserves will also contribute to bondholder recoveries. To the extent there are losses, letter of credit banks and monoline insurers will absorb much of them as suggested by the recent debt relief plan filed by Vallejo, California.

The question of which local municipalities are most likely to default is a difficult one to answer if for no other reason than the sheer number of issuers. The question is best addressed by considering regions of the country that were hardest hit by the economic downturn, suffered the greatest reduction in median home prices, and the largest increase in unemployment levels. The "sand" states of California, Nevada, Arizona, and Florida come to mind. Even in these states, however, the municipal market can survive an uptick in defaults among systemically unimportant issuers.

The greater concern lies in the possibility of a major U.S. city or county default. The municipalities at the top of this list were already experiencing secular declines before the financial crisis of 2008. Detroit, Michigan is a prime example, but one which we think will be relatively isolated given its unique level of distress for a major municipality. As its local economy continues to absorb the domestic auto manufacturing sector's restructuring and cutbacks, the city's population has declined and unemployment rates have risen. Since 1990, Detroit has experienced an 11.4% population decline to about 911,000. The November 2010 unemployment rate of 20.5% was among the highest in the nation.

Indicative of the city's deteriorating fiscal condition, it issued a "fiscal stabilization bond" in 2010 to finance its increasingly negative general fund balance. Without this bond, the general fund balance would have fallen to $341mm or 28.7% of general fund revenues. If Detroit is unable to overcome these challenges, its restructuring would make big headlines and cause a significant disruption in the municipal market. A Detroit default will not, however, precipitate large cities nationwide to file for bankruptcy. Detroit is already rated below investment grade and market participants recognize the idiosyncratic nature of Detroit and a handful of similarly affected cities. Therefore, a systemic crisis resulting from defaults by Detroit or a smaller distressed rust belt city seems unlikely given most investors' understanding of the unique problems in these credits.

Take Exposure Now, Before Others Do Their Credit HomeworkMunicipal credits should enjoy the fruits of low initial stocks of debt, minimal debt rollover risk, and generally manageable cash flow deficits over the course of 2011, and we expect defaults will come in far below some of the more pessimistic forecasts that have been circulating in recent weeks. Many, if not most, states still have considerable heavy lifting to do in righting the fiscal ship, but the recent news out of Illinois and the strong pro-adjustment stance of Governor Brown in California, Governor Christie in New Jersey, and Governor Cuomo in New York indicate that states are making significant progress in addressing their near-term fiscal issues. The state and local pension problems are very real, and large long-term pension concerns will likely depress credit ratings and keep muni credit spreads higher than historical averages.

Over the next few years, however, pension concerns are simply not big enough to drag any major state or municipal government into defaulting on its general obligations. With municipal taxable credit spreads still pricing in meaningful probabilities of default, and with tax exempt yields at similarly stressed levels, we believe investors should look beyond the headline noise and selectively add exposure to municipal credits at current yield and spread levels that do not reflect the true level of default risk. The municipal market will continue to migrate from being a low-risk asset class to a credit asset class. This transition will be painful in some cases, but investors with the right framework for assessing credit risk in municipal credits should be well positioned to win out over time. 

A word about risk: Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax; a strategy concentrating in a single or limited number of states is subject to greater risk of adverse economic conditions and regulatory changes. The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. There is no guarantee that results will be achieved.

This material contains the current opinions of the author and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2011, PIMCO.

No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO.

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