Summer Portfolio Review Session for Munis

As investors review their muni holdings, it is important to consider the anticipated viability of a local government credit during the next recession. Strong fund balances, revenue, tax-payer, and employment diversification, as well as certain independence from a respective state, would be key indicators of preparedness. In a recently published report, Moody’s noted that “most states have the financial flexibility and reserves to manage a recession." Much of the rating agency’s observations can be supported by the characteristics ascribed to a long-running economic recovery, which have generated good revenue performance in many areas, as well as by efforts to promote fiscal austerity measures in many states. Since the end of the last recession, many states have worked diligently to rebuild reserve balances as a way to prepare for the next downturn.

We also believe that revenue bonds require a careful review, particularly in light of the 1st Circuit Court of Appeals ruling that gives issuers of special revenue bonds the option of not paying debt service in bankruptcy. This decision runs at variance to established precedent in the muni market, yet has moved the rating agencies to assign negative outlooks and even to adjust ratings downward to more reflect the rating of the host government. While we are not of an alarmist nature and do not necessarily agree with some of these credit actions, we do think that spreads on certain structures could widen as the next recession takes hold.

Although default experience has picked up over the past ten years, it remains low and is generally confined to the more speculative sectors such as project finance, conduit housing transactions and various types of senior living facilities. In 2017, most of the Moody’s-rated municipal defaults were related to the Commonwealth of Puerto Rico, with the Puerto Rico defaults elevating default dollar volume for general governments and municipal utilities. Moody’s reports that the five-year municipal default rate since 2008 was 0.18%, versus.09% for the 1970 – 2017 study period. As a comparison, the five-year global corporate default rate was 6.6% since 2008 and 6.7% since 1970.