Tue, 11 Dec 2012
Pensions and other post-retirement benefits will continue to be a growing concern for municipal governments and muni investors for years to come, says Morningstar municipal credit analyst Rachel Barkley.
Christine Benz: Hi, I'm Christine Benz for Morningstar.
Municipal bonds could be attractive in a higher tax landscape, but investors still need to stay attuned to the risks of the asset class.
Joining me to discuss the muni landscape is Rachel Barkley. She is a municipal credit analyst for Morningstar.
Rachel, thank you so much for being here.
Rachel Barkley: Thank you for having me.
Benz: One thing we've been hearing in advance of the fiscal cliff is that if tax rates do go higher, that could stoke demand for munis. What do you think is the likelihood of that happening?
Barkley: On the surface it make senses that if tax rates go up, you would see municipal bonds become more attractive to investors. Historically, though, we haven't seen that pan out. Looking over the past 20 years, there hasn't been a significant correlation between the relative value of municipal bonds compared to that of Treasuries. Going over the past 20 or so years, we've seen a series of tax increases and decreases, and it hasn't played out in either case.
In the Clinton administration, we saw an era of increasing tax rates, sort of similar to what you may be expecting today if tax rates were to go up next year. And it didn't have a measureable impact on the relative value of munis. On the other hand, with the tax decreases that took place in the Bush era, we also didn't see a measurable impact on the municipal market. On the whole, I'd say that past behavior doesn't necessarily have much to do with potential future behavior.
We would say that there are other factors influencing the municipal market besides the marginal tax rate--from the nominal interest rate to economic events. So, it's really a guessing game.
Benz: So, in the case of the Clinton tax hikes, for example, there was the big dotcom bubble going on, where investors didn't have a lot of interest in bonds, so a lot of moving parts.
Barkley: Exactly, a lot of moving parts.
Benz: So Rachel, a lot of your work has focused on the creditworthiness of municipalities. You've been taking a hard look at the state of state pension funds. Let's talk about what investors should be looking at when they attempt to evaluate the creditworthiness of a municipal issuer. What are the key factors they should be trying to get their arms around?
Barkley: Well, when looking at the general fiscal health of the municipality, you should look at four key areas. The first is the economy. You'd look at things like the population area, the tax base, the wealth levels, the employment--because that's really what a government would tap to raise revenues that would be used to repay these bonds.
You also look at finances. What are their reserve levels? You want to look at the revenue diversity, and also stability, and the cost pressures.
Then for a third area, you want to look at their debt levels. This will include everything from their actual debt levels to capital plans, if they're going to need to borrow debt out in the future, and also the long-term liabilities. This is where you would fold in a pension analysis as well as other post-employment benefits, which is postretirement health care. The latter two--pensions and other post-retirement benefits--have been a growing concern for governments recently, and we think that they will remain a growing concern and something that you really want to focus on when you're looking at government credit quality for years to come.
The last area that we look at under this would be management and operating environment, and that's sort of an overarching category. That looks at such items as how effective has the government been? Has there been a lot of turnover of major management? Do they have a lot of controls in place or do they have limitations as to, for instance, what tax rates they can levy--that sort of thing.
Benz: In your recent analysis of state pension systems and the overall health of them, you found a broad disparity. Can you just kind of give us a thumbnail of those results when you went through that research?
Barkley: We look at two main drivers when we look at pensions. One is the funded level, which has been something that historically has been looked at, and that's just assets divided by liabilities, and your ability to make future contributions. For that, we have three main buckets. Anything below a 70% funded ratio we consider to be poor. Above that we consider to be fiscally sound, but as in all cases, there are gradients of being fiscally sound. From 70% to 80% we consider you to be fair. So it's not necessarily a credit negative, but it's not a credit positive either. And above 80%, we consider it to be a good funded ratio.
Now when you talked about disparity, we see a very broad variance in the funded level. There were 21 states, so almost half, that were below our 70% threshold and are considered poor. There were also a few states that were above 90%, and some are over 99%, so they are practically 100% funded.
The other thing that we look at that we think isn't looked at enough in the market is the unfunded liability per capita, and that can also range drastically from over $10,000 per capita to $20 per capita, and that would be relatively what every resident would have to pay to fully fund the state's liability.
Benz: So if one has a very high per capita rate, that is certainly a negative?
Benz: Alaska was one I know that you looked at that was relatively high.
Barkley: Exactly. Alaska isn't completely apples-to-apples compared to other states, because they have a different revenue source, but it is still something that you would have to look at.
Benz: One thing we've seen is that investors seem to have been in risk-on mode, certainly in the muni space, and they seem to be embracing risk. So we've seen a big run-up in some of the high-yield munis, for example. How should investors go about evaluating that trade-off and go about making those credit quality decisions for themselves?
Barkley: Well, it's not a blanket yes or no for the whole investing universe. Every investor should consider their own personal risk tolerance as well as their overall portfolio and investment objectives.
Municipal defaults are rare, but they do happen. So, you need to look at credit risk. Overall, the yield for lower-rated bonds remains above that of higher-rated bonds. So, you should consider your risk tolerance as well as what return objectives you'd like to pursue.
Then on the other hand, most people buy municipal bonds under a buy-and-hold strategy, so they have the idea that they're going to want to hold these bonds until they mature. However, if that's not the case, you want to look out for bonds that possibly could be downgraded or have a decrease in credit quality, because then when you go to trade them, you are probably not going to get the same price that you would if the credit quality had remained high. And just overall municipal bonds tend to be illiquid compared to other asset classes. So, depending on your liquidity needs, you'd also want to consider that.
Benz: Last question for you, Rachel. How hard is it to do this kind of due diligence for yourself as an individual investor? Is it difficult to get your hands on the right information that you need? Let's talk about the challenges for individual investors?
Barkley: Unfortunately, municipal disclosure isn't what we see on the corporate side, and it's very difficult, I would say, for an average individual to do the due diligence you would need to do to get a full understanding of a bond's credit quality by yourself.
For instance, some of the items that you'd have to look at you might not even know about and are in various different places. The other thing is a lot of the items that you'd rely on don't get to one of the key metrics that you need to look at when you look at bonds, and that's price. We look at the true value of a bond being the intersection of the price and the credit quality, and if you don't look at both of those items, then you don't understand the true value of what you're investing in.
Benz: And that's a potential pitfall if you're relying just on credit quality ratings from one of the major agencies, for example. They're looking at creditworthiness
Benz: Not price at all.
Barkley: Right. They don't have anything to say about price, and while credit quality does reflect the probability of you being repaid your principal as well as you receiving your interest payments, bonds can still be undervalued or overvalued no matter what the credit rating is.
Benz: Rachel, thank you much for this helpful overview of what is a very complicated space.
Barkley: Thank you. I appreciate it.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.