This quarter was overshadowed by the invasion of Ukraine by Putin. Nonetheless, there were many developments in Muniland. Discussions on improving muni reporting of ESG risks and outcomes continued. Assured Guaranty Municipal (AGM) was upgraded by Moody’s to A1 based on substantial progress of Puerto Rico restructuring, affecting over 25,000 ratings. The State of New Jersey was upgraded — the state’s first upgrade since 2005. There were governors’ budget proposals addressing social issues and even tax reductions, with some states aiming to eliminate income taxes over time. Many states had strong revenue collections, in addition to stimulus funds, providing flexibility. High oil prices have resulted in revenue spikes for states like Alaska and Texas, and are affecting driving habits and increasing the cost of air travel globally. Rating agencies reported that upgrades outpaced downgrades in 2021.
The war in Ukraine highlighted further cyber risk, not just ransomware, but cyberattacks, the potential targeting of our transportation, electric and water utilities, and healthcare — all municipal functions. Most municipalities now have a chief information security officer (CISO), and many states provide oversight and technical assistance to their local governments to help ensure safety of public assets and personal information. Moody’s recently conducted a survey and notes that although there is work being done and there is great attention to cyber risk, preparedness still needs to improve in all sectors, not just municipalities.
The decline in the stock market produced concern that pension funding may decline, and the rise in inflation may reduce benefits.
And the war exacerbated the disruption in supply chains, threatening food and oil supplies, further fueling inflation. Here’s a link to John Mousseau’s commentary “Inflation and the Fed Scare Bonds in the First Quarter,”https://www.cumber.com/market-commentary/inflation-and-fed-scare-bonds-first-quarter.
Municipal credit is expected to continue strong throughout 2022, with the strong uptick in jobs, the release of additional stimulus funds as well as the accumulation of strong reserves, and improved budgeting since the financial crisis. However, inflation, if high and continuing, could increase costs and intensify efforts to combat it, posing a risk that Fed rate rises could lead to a recession, which generally reduces revenues and requires budget cuts.
Munis may not have performed well this quarter because of rising interest rates; however, credit spreads have narrowed after widening out, and US muni bonds and taxable muni bonds are still higher yielding than those of other countries and could entice crossover bond buyers.
Fund Flows and Supply
Municipal mutual funds were already experiencing outflows when the Ukraine invasion occurred, bringing more uncertainty to the market. The ensuing increase in oil prices and inflation expectations resulted in a flight to quality, with an increased demand for Treasurys and outflows from mutual funds.
Mutual funds need to sell and liquidate to meet redemptions — sometimes at the worst time in the market as investors panic. An SMA manager, however, can use the sell-off as an opportunity to potentially buy good credits at depressed prices. Interestingly, muni ETFs have experienced inflows, although the absolute size is small relative to mutual funds and retail holders of munis.
Muni supply may be down from last year. Some issuers are looking at using cash from stimulus and large increases in sales and income taxes to cash fund projects. Bankers and municipal advisors are reportedly encouraging issuers to reduce outstanding debt to save on interest expense. Reducing recurring expenditures with windfalls is preferable to increasing funding to programs with recurring expenses that could require tax increases or cutting spending or dipping into reserves should revenues fall. This focus on reducing leverage portends for less issuance or supply than last year, which may auger for better performance because muni supply and demand may be out of balance with the generally good demand for tax-free income producing munis.
ESG: Environmental, Social and Governance
We at Cumberland know it is important to evaluate municipalities’ exposure to ESG risks, consider the plans to address those risks, and utilize the information to help determine their effect on credit quality. Impact investing or investing for a specific outcome can be subjective and thus have different meanings to different parties. For example, some investors looking to slow climate change would not buy any investment of a company that had exposure to coal, while some investors would invest if the company was trying to transition away from coal. It’s not a one-size-fits-all issue; and over time changing needs and developments, regulations, and objectives change. Investing in Russian companies is now a social risk, but some investors had steered away from Russian companies before the invasion, and this choice behooved them. Investing takes many risks into account; and being diversified, a mantra of investing, can help a manager.
The Municipal Securities Rulemaking Board that regulates municipal underwriters and advisors, in February conducted a survey and a webinar promoting muni reporting of ESG risks. The prospect of ESG reporting sent issuers into a tizzy because of the potential scope of reporting on climate and social risks. As noted above, risks and approaches are evolving; thus reporting could grow. On the issuer side, some reporting can become burdensome, especially for the smaller, less sophisticated issuers. The MSRB does not regulate municipalities but does regulate municipal underwriters and advisors who advise on putting bond offering documents together. Many issuers that offer green or social bonds do report on their progress in attaining a goal.
The Commonwealth of Puerto Rico
Puerto Rico has been in default on many of its bonds since 2016. The financial stress resulted from, among other things, changes in tax treatment of companies operating there, population decline, poor governance, and too much debt for the island commonwealth, exacerbated by numerous natural disasters. Earlier this year, many bond issues were restructured, including Puerto Rico general-obligation, Public Building Authority, and Convention Center District bonds. Investors received a combination of cash and securities, including a contingent value certificate, which could increase in value if the commonwealth hits certain revenue targets. The settlement amounted to 60% to 80% recovery.
Insured Puerto Rico bondholders received interest and principal payments in full and on time as promised in financial guaranty contracts. The insured bonds maintained their ratings based on the insurance. Insurance companies are treated as holders of the debt and shared in the settlement, removing uncertainty from their risk profile.
Assured Guaranty
Assured Guaranty Municipal Corp (AGM) was upgraded by Moody’s to A1, and Assured Guaranty Corp (AGC) was upgraded to A2 on March 18th, reflecting a credit profile improved by the resolution of the company’s exposure to the GO bonds of Puerto Rico and by limited expected volatility among its remaining Puerto Rico exposures. Moody’s also noted that demand for financial guaranty insurance has been increasing in the US and Europe. AGM has $6.6 billion in claims-paying resources (CPR), and AGC has $3.1 billion. Both AGM and AGC are rated AA by S&P and AA+ by Kroll. Insurance penetration has been growing, especially since the pandemic, and is expected to increase further with interest rates rising and wider spreads between credits, which make bond insurance more appealing because they can lessen the interest rate paid by the issuer. Assured is the market leader, and the next largest active competitor is Build America Mutual (BAM). BAM is a relative newcomer (2012) with CPR of $1.9 billion a rating of AA by S&P. It insures only US muni bonds and does not have Puerto Rico exposure. National Public Finance Guaranty, currently in runoff, has $3 billion in CPR, is rated Baa1 by Moody’s, and has exposure to Puerto Rico.
Financial guaranty companies take up to 30+-year risk, as they often insure all serial maturities of a bond issue. They manage risk through robust capital levels, diversification, strong underwriting, and surveillance, with the ability to step in and advise an issuer when problems arise. They are regulated by state insurance commissions, and the insured portfolio is stress tested internally and by rating agencies. Although insurance penetration is improving, runoff of the portfolio is greater; and as the book declines, the firm needs to find other ways to increase earnings. To that end, Assured purchased an asset manager and has diversified its insurance offerings over the years as well as purchased insured books of other bond insurers in runoff. The increase in interest rates should also help increase bond insurance penetration and improve premium flexibility. Bond insurance lowers the interest rate an issuer would have to otherwise pay, because there are two repayment streams and usually the insurance enhances the rating of the bonds.
State of New Jersey Upgrades
Moody’s upgraded New Jersey to A2 from A3 based on strong revenue and liquidity and the steps the state has taken to address pension and other liabilities more aggressively. It was the first upgrade since 2005. S&P followed suit, upgrading the state to A- from BBB+ positive. Fitch rates the state’s GO bonds A- positive, while Kroll has an A rating with a positive outlook on the state’s credit quality. New Jersey still has one of the highest unfunded pension liabilities, which keeps it at the lower end of the ratings for US states.
Taxes
Strong revenue growth in 2021 and expected strong revenues in 2022 have led numerous states to reduce individual income and corporate taxes and return some revenue to taxpayers. According to the Tax Foundation, in 2021, 11 states enacted some form of tax reductions; and 2022 seems on pace with, if not ahead of, 2021. One proposal of two in Kentucky has the income tax phasing out completely through broadening the sales tax. In addition to income taxes, states are considering tax holidays for fuel, food, and other items, given inflation. The level of taxes often affects the decisions of people and businesses to locate in a state, but tax revenue is also how the states fund themselves. If there is a slowing in the economy, lower tax revenue could reduce budgetary flexibility.
At Cumberland Advisors we evaluate market forces like supply or bond issuance, demand or fund inflows and outflows, as well as interest rates, inflation, and credit conditions to help in the decision to buy or sell a particular bond and to structure our portfolios. We use a barbell approach in our total-return investing, meaning that we hold both short-term and long-term bonds so that we can more easily adjust our duration (which measures sensitivity to changes in interest rates). The shorter bonds can be sold to take advantage of large outflows from mutual funds, which could reduce prices because the funds must sell bonds to honor redemptions into a market selloff.
Patricia Healy, CFA
Senior Vice President of Research & Portfolio Manager
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