The third quarter of the year was certainly eventful. The US government almost shut down twice and the US government bond rating was downgraded by Fitch to below AAA, emphasizing governance issues. Fed members continued to signal higher-for-longer rates, raising fears of a recession. Strikes abounded, from screenwriters to actors and from healthcare workers to auto workers. There was another round of bank downgrades, as well as fears of commercial real estate declines hurting regional banks and possibly more banking disruption. Hurricane season was upon us, accompanied by extreme heat in much of the country, Maui wildfires and destruction, smoke covering the US from Canadian wildfires, and more comments from rating agencies reporting on climate risks.
The war in Ukraine continued; and after the quarter ended on October 7th, Hamas rained rockets on Israel and then attacked by land. As we finalize this quarterly commentary, the situation there is escalating; and there is concern about other geopolitical risks, from terrorist attacks around the globe to worry that China may join the party and try and reclaim Taiwan.
There was an initial decline in bond yields as investors headed to the safety of Treasury bonds, but that reversed as the economy continued to chug along – a bright spot in the otherwise negative headlines. Inflation measures are down and there are some signs of slowing; however, earnings season has been better than expected. GDP is reported this week; and personal consumption expenditures (PCE), the Fed’s preferred measure of inflation, is released Friday morning and may shine some light on future Fed action. See Robert Eisenbeis’s commentary on the Fed blackout period: “Before the FOMC Blackout – October 2023,” https://www.cumber.com/market-commentary/fomc-blackout-october-2023.
In this commentary we will discuss the US downgrade, state rating changes, Texas munis, bond insurance, and stronger wording from rating agencies on how climate-related weather risks are growing, with a peek at FEMA’s National Risk Index for US counties.
US Downgraded from AAA
The dysfunction of Congress that we have witnessed included a debt ceiling crisis that extended from January 19 to June 3, requiring extraordinary actions by other arms of the government to keep things running. That was followed by a potential government shutdown in Q3, which was averted when Congress enacted a continuing resolution to keep the government operating past the September 30 fiscal year end to November 17. Hopefully, the House has a speaker by then and can rally support around a rational spending plan.
On Aug. 1, 2023, Fitch downgraded the US long-term foreign currency rating to AA+ from AAA, reflecting the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to AA- and AAA-rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions. Bonds that have Fitch ratings tied to the US were also downgraded – in addition to government agency debt, muni pre-refunded bonds and housing bonds that are secured by government obligations, and ratings dependent on federal grant funding.
More than 10 years ago, on August 5th, 2011, the US lost its S&P AAA rating, based on S&P’s view of the rising public debt burden and their perception of greater policymaking uncertainty. Sound familiar!?
Moody’s recent comments on the US rating sound cautionary regarding governance but they did not lower the US’s Aaa rating. Kroll Bond Rating Agency (KBRA) remained resoundingly AAA stable, based on the US’s unrivaled access to liquidity and the flexibility of its balance sheet. They note that US policymakers choose to run large deficits because they can. Fiscal deficits can be significantly reduced with a few adjustments of the tax code, because the country’s enormous underlying wealth capacity is unmatched, and the US is among the least-taxed populations in comparison to other industrialized counties, by choice. Kroll further notes that deficits are not a positive credit factor and believes that the US deficit could be reduced from a combination of revenue growth and spending rationalization.
State Ratings
State rating actions were limited in the third quarter, with just a few outlook changes. S&P changed to positive the outlooks for Oklahoma’s AA rating in July and for Pennsylvania’s A+ rating in September. Moody’s assigned a positive outlook to Kentucky’s Aa3 rating.
Regarding Oklahoma, S&P notes there is a one-in-three chance they could raise their rating should the state continue to attract development that grows its economy, while also demonstrating a firm commitment to structurally balanced financial performance and sustaining reserves and liquidity at levels that position the state to more readily respond to volatile swings within future budgets, particularly given that a higher proportion of the state's economy and revenue base are tied to cyclical global energy markets compared to the national average.
S&P changed the outlook to positive for Pennsylvania reflecting continued progress toward structural budgetary balance, with positive operating results in five of the past six years, leading to stronger reserves that are better aligned with state policies. The outlook change carries the expectation that forecasted out-year structural imbalances will be addressed, with emphasis on sustainable solutions commensurate with the current rating level. In addition, Pennsylvania's liquidity position is expected to remain stable in the near term.
Moody’s assigned a positive outlook to Kentucky’s Aa3 rating, based on the expectation that the budget reserve trust fund will remain in line with those of higher-rated peers. The commonwealth's sound financial position, bolstered by demonstrated fiscal discipline, improving economic growth, and stable though high leverage and fixed costs, indicates an improving credit profile. S&P and Fitch upgraded Kentucky last quarter to A+ and AA-, respectively.
Texas Paper Attractive – Texas PSF debt issuance spiked in Q3
Texas is the second largest state in the nation after Alaska, and it has experienced strong population growth and economic development. Texas is large in terms of production, too, and by itself is considered the world’s 9th largest economy, based on 2022 GDP of $1.88 trillion. So, it is no wonder that the state is a large issuer of debt. Texas does not have an income tax, and Texas municipal bonds are considered general market bonds – they can help diversify all portfolios – and don’t have the same in-state demand that munis in high-income-tax states do. Extreme weather events and coastal exposure sometimes make investors require additional yield for Texas paper. A larger than normal supply in the third quarter led to attractive opportunities.
The large supply in July and August was due to a spike in Texas Permanent School Fund (PSF) insured bonds. The influx of population during and after the pandemic greatly increased the need across the state for K-12 and charter school construction and improvements, while inflation raised construction costs. The Texas Permanent School Fund (PSF) guarantee program reached its IRS debt limit cap in November of 2022. The limit was finally increased in May of 2023, and by July and August school districts were ready to issue new debt with the guarantee. School district bonds insured by PSF receive AAA ratings, resulting in lower interest costs for the school district and very good security for bondholders.
The PSF was created by Texas' first constitution in 1845 as a perpetual fund to support the state’s public schools and was seeded with $2 million in 1854. Since that time, the PSF has grown to hold over $51 billion in assets and now distributes nearly $2.2 billion annually to Texas K-12 schools. It is ranked as the world’s 26th largest sovereign wealth fund. PSF’s new guarantee limit is $152.6 billion. The sizeable fund is well diversified and has not had a draw on the guarantee since the program began in 1983. Contributing to this outcome is that borrowers must be creditworthy to receive the guarantee and are subject to state oversight if they begin to have financial issues.
Bond Insurance
Second-quarter statistics, released in the third quarter, show that bond insurance penetration has increased to 9% of par issued, compared with 6% before the pandemic. This remains well below the pre-financial crisis levels of over 50% of the market. Today there are two active muni insurers: Assured Guaranty Municipal (AGM) and Build America Mutual (BAM). AGM is rated AA/A1/AA+ by S&P/Moody’s/Kroll and BAM is rated AA by S&P. Prior to the pandemic, interest rates were extremely low, such that the premium for bond insurance did not bring the yield on insured bonds down enough to make sense or provide enough savings for issuers. It was also a period of improving credit for munis as the economy grew and municipalities instituted better budgeting, increased reserves, improvement in pension funded levels, and generally lower debt levels. Some sectors and even some states had credit issues, but for the most part upgrades exceeded downgrades and the need for bond insurance was low. Higher-for-longer interest rates and a potential recession and credit concerns increase the demand for muni bond insurance.
Rising Extreme Weather Risk and FEMA National Risk Index
We have noticed more comments from rating agencies on the risk of extreme weather events to credit quality. Often, financial resources and wealth of an area, as well as FEMA funding, help preserve credit quality. Many municipalities are working to improve their infrastructure, but what if weather and rising sea levels increase more than financial wherewithal can handle? In addition to the concerns of physical damage, cost of rebuilding and availability of insurance there is population migration away from stressed areas, which is sometimes slow to occur and is generally a negative credit factor. Analysts are keeping an eye on extreme weather events – both the increased risk and potential changes in how ratings agencies assess these risks in determining ratings.
If you are interested in seeing natural hazard risk exposure for your county, you can go to FEMA’s National Risk Index (NRI). The index includes assessments of social vulnerability, community resilience, and expected annual losses.
Map | National Risk Index (fema.gov)
Patricia Healy, CFA
Senior Vice President of Research & Portfolio Manager
Email | Bio
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