Ballot proposals in several states could affect state municipal CEFs.
Astute municipal investors have been paying attention to the U.S. presidential election rhetoric around taxes. Regardless of which candidate wins, there are bound to be significant changes to the tax laws as Washington attempts to shore up the nation's fiscal deficit.
But, while much focus is on the presidential election and the year-end, so-called "Fiscal Cliff," investors in state municipal bonds have other concerns. Voters in many states will be weighing in on ballot proposals that could change the credit quality of their state and local governments. Recently, two of Morningstar's municipal credit analysts, Rachel Barkley and Candice Lee, highlighted ballot initiatives in four states: Arizona, Florida, Michigan, and Illinois. While there aren't any Illinois-focused closed-end funds, or CEFs, we thought this was a great opportunity to publicly tie into the work that the municipal credit team is doing and to highlight the CEFs that could be affected should the state ballot measures pass.
Arizona has two propositions on the ballot. As Barkley and Lee write: "Proposition 117, a legislatively referred ballot measure, seeks to limit the growth in annual local property valuations. It would cap the annual increase of assessed property value to 5% over the previous year's value, with the aim of preventing spikes in property assessment values that would lead to increased taxes paid by homeowners. Proposition 117 would also eliminate the current two-tier property tax system in Arizona. For taxes levied for debt service and special districts such as fire safety and flood control, properties are assessed at full market value, which can grow without limitation; for the operation and maintenance of cities, counties, and school districts, properties are assessed at a secondary limited property value, which can grow by 10% annually. If passed, Proposition 117 would adversely affect the revenue-raising ability of local governments in Arizona, which have already endured strained budgets as property tax revenue declined after the housing crash.
"Via Proposition 204, voters will decide whether to make permanent a statewide sales tax that is estimated to generate roughly $1 billion of revenue in its first year, with the lion's share mandated to fund primary and higher education. The temporary sales tax was originally advocated by Gov. Jan Brewer in Proposition 100 as a means to alleviate the state's ongoing budget deficits. However, the governor opposes making the sales tax permanent, and Secretary of State Ken Bennett even tried to exclude Proposition 204 from the ballot despite it having garnered more than 290,000 signatures. Passage of Proposition 204 would limit the state's financial flexibility, but at the local level would be a boon to school districts and institutions of higher education."
There are currently five Arizona-focused CEFs, though the four from Nuveen are in the process of consolidating into one fund, pending shareholder approval. As with all state municipal CEFs, the total assets in the funds are relatively small and the value traded on a daily basis is also quite meager. (We caution investors to use limit orders when purchasing or selling shares.) Assuming shareholders approve the measures, the Nuveen Arizona Dividend Advantage Municipal funds (NXE, NKR, and NFZ) will merge into Nuveen Arizona Premium Income Municipal NAZ, probably in early December.
There is only one CEF focused on Florida, and our municipal credit analysts view the state's finances as sound for now. As they write: "Amendment 3 is one of 11 proposed amendments to the state constitution included on Florida's November general election ballot. Commonly referred to as the state revenue limitation amendment or the 'smart cap,' the amendment would revise the state's existing revenue limitation from one based on personal income growth to a new formula incorporating inflation and population growth. Any revenue collected in excess of the cap would be required to be deposited into the state's budget stabilization fund until the fund equals 10% of general fund revenue. Additional revenue would then be used to reduce school district property tax rates or be returned to taxpayers. Once in place, this cap would require a supermajority vote of the legislature to be adjusted. The revenue growth limit includes debt service revenue used to pay bonds after the beginning of fiscal 2013.
"Morningstar notes that the current financial condition of the state is sound, highlighted by its proactive budgetary management in recent years and maintenance of healthy fund balance levels despite significant revenue volatility. However, if passed, Amendment 3 could constrain the state's financial flexibility. We will monitor the status of this amendment and the state's ability to manage its financial health. If passed, the new revenue cap would not take effect until fiscal 2015, allowing the state time to plan for any potential impact."
Michigan voters have two proposals on the ballot sheet, which Barkley and Lee explore: "Proposal 2 is a voter-initiated constitutional amendment ballot measure that seeks to grant both public and private employees the constitutional right to collective bargaining through labor unions. This would shift power to employees and, at the governmental level, could impose limitations on financial flexibility vis-a-vis wage setting and hiring and firing procedures.
Proposal 5 is another voter-initiated measure that potentially limits the state's revenue-generating capacity. If passed, it will introduce a constitutional amendment that requires a two thirds supermajority vote in both the House and the Senate in order for the state to enact new or additional taxes, expand the tax base, or increase tax rates. Proposal 5 would therefore make it very difficult for the state to address growing expenditure needs through expanded revenue; it would more likely need to make expenditure cuts or otherwise accumulate budget deficits or employ deficit financing, which would both be credit negatives."
When considering or reconsidering your CEF investments, the checklist doesn't typically include looking at how a state municipal CEF may be affected by changing laws at the state and local level. Once every four years, though, the checklist needs to be updated. Our municipal credit analysts have provided an overview that is useful for three groups of state municipal CEF shareholders. As always, caveat emptor--especially heading into elections.
Morningstar credit analysts Rachel Barkley and Candice Lee contributed to this article and originally prepared the ballot proposal information for their article featured in the Morningstar Analyst Research Center.