Joseph Krist

Municipal Credit Consultant

2015 OUTLOOK

For many municipal market participants, 2014 turned out to be a good year in the end, although that’s not the way it looked at this time last year. At the  beginning of the year most market participants didn’t expect to see anything more in the way of returns than the average coupon. Weak supply however, was overtaken by basic demand. While Detroit’s bankruptcy dominated the news, the large Puerto Rico bond issue ($3.5 billion of general obligation bonds on March 11) came to market and then traded up. The junk-rated bonds were priced with an 8% coupon to yield 8.727% in 2035 and saw strong demand from investors.

Continued growth in the economy and lower oil prices provide a favorable base for many credits in the near term. Sales tax, utility, and transportation credits based on demand and utilization should broadly benefit. General tax backed credits should also be in better shape as an improved economy supports budgets. There are of course exceptions. The State of Illinois continues to face its ongoing pension deficit problem. Kansas continues to face significant deficit problems as the result of its policy of slashing income taxes through both rate and base reductions. While not a GO issuer, other credits (primarily for highways) supported by dedicated taxes are under pressure from the need to transfer funds to fill the state’s revenue shortfall.

Another transportation credit that will face headwinds is the NY State Thruway Authority. Management is under fire with the resignation of the top two executives under pressure from a looming investigative report and funding issues related to the Tappan Zee replacement project. Another NY transportation issuer facing controversy is the Port Authority of NY/NJ. At the end of December, their Legislatures already adjourned, Governors Cuomo of New York and Christie of New Jersey, vetoed a bill that would have reformed the agency. The governors, who jointly control the bi-state Authority, then released a report of their own calling for changes. Among the proposals was one considering the elimination of service between 1 a.m. and 5 a.m. on the Port Authority Trans-Hudson, known as PATH. The Port Authority chairman, John J. Degnan, who helped write the governors’ report, has since stated that stopping overnight service is one of at least six proposals for improving the finances of the PATH system. Eliminating service would save the authority $10 million from its $330 million budget, according to the governors’ report.

Potential demand could come from investors who removed  $60 billion in assets from the muni space in 2013. The 2014 market did not recover all of those assets as investors returned only $21 billion into muni funds, according to Lipper US Fund Flows data.  In 2015, the amount of maturing debt is set to drop to $176 billion from $282 billion data compiled by Bloomberg show. In a sign of potential new supply from  lawmakers for new projects, U.S. states and localities asked voters in November to approve $44 billion of bonds for schools, water systems, hospitals and roads, more than twice what they sought in 2010. Voters approved more than $37 billion of the measures.

One thing unlikely to change is the tax break for municipal bonds, which has been threatened by proposals advanced in Washington during the past four years. The prospect of taxing muni-bond interest has been raised since 2010 as President Obama and congressional Republicans looked to lower the deficit or pay for cuts to income-tax rates. Representative Paul Ryan of Wisconsin, the new chairman of the tax-writing House Ways and Means Committee, has said that focusing on business taxes may represent the best chance for success, given how far apart Obama and Republicans are over how to approach taxes on individuals. That lessens the odds that Congress may alter the status of municipal bonds.

The tax break, forecast to cost the Treasury about $47 billion this year in foregone revenue, has been targeted along with dozens of other provisions in overhauls that failed to advance during the past four years. Governors, legislators and local officials have lobbied Congress to prevent any such change. More than 100 House Democrats and Republicans in 2013 signed a letter supporting the break. At a hearing on the issue in the Ways and Means Committee that year, lawmakers from both parties said taxing munis would push costs onto local governments and taxpayers.

The improving economy has eased the pressure on Congress to reduce the federal budget deficit in the year ended in September, the deficit was $483.4 billion, about a third of the record $1.4 trillion hit in 2009. One potential negative is that if the economy really is as strong as 5%, then investors could anticipate that yields would rise, then munis would underperform.

A CHRISTMAS PRESENT FOR A.C.

Elsewhere, New Jersey is giving Atlantic City a $40 million short-term loan so the city won’t have to sell notes in the municipal market, according to a published report. The city had originally planned a $140 million bond sale for November, then scaled it back to a smaller note sale, which was delayed because of concerns about the city’s finances in the wake of the casino closures. The city must repay the 0.75% interest loan by March 31, according to an agreement signed by the city and the state, Reuters reported.

WATER AND CALIFORNIA

While we were on hiatus, I had a chance to travel through northern CA on the way to and from Yosemite National Park. Along with a great chance to view the wonder that is Yosemite, the trip afforded the chance to see many real examples of the importance of water and the impact of the drought on many CA industries. The trip takes in some 200 miles of rich agricultural land including fruit orchards, cattle ranches, many varieties of nuts, and much valuable timber land. The dependence on reliable fresh water sources could not have been clearer.

The trip also took in the Don Pedro, Cherry Lake, and Hetch Hetchy water storage facilities. The impact of the drought has been well documented by a variety of studies and statistics. In reality, the problem is easy to see.

The white ring just above the surface of the water in the Hetch Hetchy Reservoir represents the shortfall in water stored versus the amount usually stored here for the City of San Francisco. A similar if not greater ring was visible at Don Pedro Lake. In addition, the area had a distinct lack of snow for the time of year. Given the lack of rain and snow, no improvement is expected and that ring is likely to grow in height. It is just one example of what influenced CA voters to support Proposition 1 in November in such large numbers.

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