“It’s getting late early out here.” —Yogi Berra
Over the last few years, our municipal fixed income research team has communicated a number of consistent themes, two of which are:
1) The aggressive budget cuts following the 2008 financial crisis shored up state and local government financial operations but masked long-term challenges facing government as the economy normalized; and
2) Long-term suboptimal economic growth ultimately leads to financial strains for governments as the natural inflation rate of government services outpaces the growth of the economy and tax base.
State Budget Delays on the Rise
Here we examine the cases of Illinois and Pennsylvania, two states that are in the news today for late budgets. In our opinion, aggressive budget actions necessitated by the financial crisis were not sustainable in the long-run and, combined with pension issues in these states, are key causes for the current deadlocked budget debates. We further believe that the situation in Illinois and Pennsylvania is a harbinger of things to come in the municipal market.
It’s fairly common for state governments to struggle over budget negotiations. Disagreements between state legislators and governors over topics of taxation, pension reform and program funding, however, have escalated to new levels. Seven years after the recession, state budget delays are growing and investor uncertainty and anxiety is increasing. New governors are often looking for political and economic reform measure wins in their first administrations, thus compounding the potential for political gridlock and delay. In particular, Illinois and Pennsylvania face serious financial problems and have yet to pass their state budgets, three months into their respective fiscal years. With both their executive and legislative bodies holding onto their core ideological beliefs, the potential remains for additional delays and economic costs to local governmental agencies and investors alike.
In Illinois, Republican Governor Rauner and the Democratic-controlled legislative body continue to spar over the state budget. Rauner was elected in November 2014 in a blue state and is trying to deliver on the proposed fiscal reform measures that helped get him elected. Serious problems facing the state include the lost revenue from expiration of personal and corporate tax hikes that ended in January 2015, a growing pension liability and unpaid vendor bills. All told, the state faces a budget deficit in excess of $3 billion. On one hand, Rauner seeks broad changes, including property tax freezes, an overhaul of workers compensation rules and term limits for lawmakers. Conversely, the state legislature seeks to fill the budget gap with new revenues (i.e., taxes). The level of political discord has escalated concerns about how state governmental agencies will operate without a budget in place.
Similarly in Pennsylvania, deep divides exist between newly elected Democratic Governor Tom Wolf and the Republican legislative majorities. Wolf wants to boost education spending and raise the sales and personal income tax rates, while the legislature remains opposed to tax hikes. With regard to pension reform, the governor is opposed to a new state pension plan that would resemble many characteristics of private sector 401k plans. As the budget morass continues, many social services agencies and schools remain uncertain about their own finances in the absence of state aid.
Despite these budgets stand-offs, most essential programs governing the health and safety of residents continue to be funded. Additionally, social service programs such as unemployment compensation, senior and disability care, and Medicaid and Medicare services have been funded so far. The concern rests in programs that require legislative approval for funding. School districts, for example, require line-item approval for state aid. In Illinois, Rauner has approved such funding but, in Pennsylvania, similar legislation has not yet been approved.
From a municipal bond credit perspective, state general obligation debt is legally protected even in the face of a budget impasse, but appropriation and local debt that relies on a component of state funding is at greater risk. And, while traditional reasoning may conclude that education funding (K-12) is essential and that state appropriated debt service will approved in separate line items, the political acrimony in many states has put previously logical conclusions in question.
Finding a Silver Lining
When we author an arguably pessimistic commentary, we feel an obligation to inform our readers that there is a third consistent and more optimistic theme. Municipal credit is idiosyncratic and generally has a lower correlation of credit risk across issuers versus the corporate market. In other words, you can have two adjacent issuers with vastly different credit profiles. With more than 50,000 issuers to choose from, it is possible to build a portfolio of stable credits, even in an overall negative environment.
This material is presented solely for informational purposes and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were, or will be, profitable. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Publications and Web sites referenced herein are intended solely for your information and should not be construed as an endorsement by Neuberger Berman. Neuberger Berman is not responsible for the content of these publications or Web sites.
Certain products and services may not be available in all jurisdictions or to all client types. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
A bond’s value may fluctuate based on interest rates, market conditions, credit quality and other factors. You may have a gain or a loss if you sell your bonds prior to maturity. Of course, bonds are subject to the credit risk of the issuer. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the investor’s state of residence. High-yield bonds, also known as “junk bonds,” are considered speculative and carry a greater risk of default than investment-grade bonds. Their market value tends to be more volatile than investment-grade bonds and may fluctuate based on interest rates, market conditions, credit quality, political events, currency devaluation and other factors. High-yield bonds are not suitable for all investors and the risks of these bonds should be weighed against the potential rewards. Neither Neuberger Berman nor its employees provide tax or legal advice. You should contact a tax advisor regarding the suitability of tax-exempt investments in your portfolio.
Neuberger Berman Fixed Income LLC is a Registered Investment Advisor. The “Neuberger Berman” name and logo are registered service marks of Neuberger Berman Group LLC.
©2015 Neuberger Berman Fixed Income LLC. All rights reserved.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.