The state of Illinois once again did not pass its budget and expectations are a continuation of credit downgrades may affect their municipal bonds. Our portfolio management team discusses the challenges facing Illinois, the differences between Illinois and Puerto Rico municipal bonds, other states that may be under the same pressure as Illinois and finally, how Alpine is managing these situations and our portfolios.
The state of Illinois once again did not balance their budget and has been downgraded by some of their credit rating services. Puerto Rico’s restructuring of its debts is still on investors’ minds. Do you think Illinois is the next Puerto Rico?
Mark: At this juncture we do not foresee the state of Illinois heading into bankruptcy in the near future. However, we do believe that if the Governor of Illinois and state lawmakers do not end the political wrangling by the end of June, there’s a strong chance that at least one rating agency downgrades the state’s general obligation bonds to below investment grade, which will place additional budgetary pressures on the state as investors demand higher and higher yields for new debt issuance.
How does Illinois’ debt and liability metrics compare to Puerto Rico’s?
Mark: Puerto Rico has more than double the debt of Illinois at approximately $74 billion versus the state’s $33.5 billion, despite having a population of only 3.4 million; that is about one quarter the size of Illinois’ population. Therefore, the territory has a debt per capita of about $21,700, which increases to over $36,000 per capita when including the island’s unfunded pension liabilities. Illinois compares very favorably to these debt metrics, with a debt per capita of about $2,600 or about eight times smaller than Puerto Rico’s, and a debt per capita of about $12,800 when adding in its very large unfunded pension liabilities, which is a burden per person that is about three times smaller than in the case of Puerto Rico. Despite this favorable comparison, we would note that Illinois’ debt and unfunded pension liabilities are still some of the highest of all 50 states, and the state is now tied with Kentucky, having the lowest pension funded ratio in the nation at 37.6%. Although again, Puerto Rico’s funded pension ratio is significantly worse at only 1.6%.
When looking at Illinois’ socio-economic metrics, how does that compare to Puerto Rico’s?
Mark: The average income in Puerto Rico is about one third of the U.S. average per capita income at 37.9%, with about half the population living below the poverty line. This compares very poorly to Illinois, which has an above average per capita income at 105% of the national average, and a 10.9% poverty rate. Further, Illinois has an economy with a gross state product of over $700 billion in 2016 or an economy about eight times larger than Puerto Rico’s. Another major distinction between the two economies is that throughout the last eightyear economic expansion, the Illinois economy has generally grown by 1% to 2% annually, whereas the Island’s economy during the same period contracted 1% to 2% annually, except for 2012 when Puerto Rico grew just slightly. Illinois has a very diverse economic base with Chicago, the third largest city in the US, as its economic hub. The state has many industries contributing to its economy with no one industry creating a concentration risk for the state, but the state has slightly lagged the nation during the last decade in job creation.
Conversely, Puerto Rico’s largest economic sector, which is manufacturing at 46%, has been in decline since 2006 when the federal government ended 10 years of very important tax incentives, that had encouraged primarily pharmaceutical companies to manufacture its products on the island. Another serious concern for Puerto Rico’s economy is its recent acceleration of population loss, which is now approximately 2% annually. The island has lost 11% of its population over the last dozen years, and the losses are accelerating in the last few years. Concerning Illinois, between 2010 and 2016, the state had flat population growth, with 2015 and 2016 both losing a very small amount of population, which was not typical for the nation as a whole.
The process in these special situations seems pretty long, could you share the process of a potential default and the key hurdles that need to be cleared to avoid a bankruptcy, or to go into bankruptcy?
Jonathan: While we think a downgrade to below investment grade is likely in the case of Illinois, we see the potential for default as unlikely and bankruptcy as a very high hurdle to clear. The state’s general obligation (GO) benefits from statutory mechanisms that include an irrevocable and continuing appropriation for all GO debt service, and a continuing authority in direction to the state’s treasurer and comptroller to make transfers of any and all revenues to pay those debt services. What this means is, funds are set aside for debt payments, even though for the past two years the state did not balance its budget they continued to fund for these debt services. As for bankruptcy, we see this as an unlikely scenario given that states have no bankruptcy restructuring ability, like the local municipalities have with Chapter 9. It may be tempting to draw generalizations with Puerto Rico, but remember Puerto Rico is a territory. Illinois would have to ask congress for broad restructuring ability, and we see this as unlikely to be asked or granted given the constitutional quagmire it could present, given the state sovereignty granted under the U.S. constitution. According to some bankruptcy experts, given the dual sovereign nature of the federal and state governments in the U.S., congress cannot unilaterally subject a state to those federal bankruptcy codes.
What other states are under financial stress and what are their situations?
Jonathan: There is no debate that unfunded pension liabilities have become an increasing concern at the state level nationwide since 2001. States that we’re keeping a close eye on other than Illinois are Connecticut, Kentucky, New Jersey and Pennsylvania. These states have low pension funding levels - in the case of Connecticut, Kentucky, and New Jersey funding levels are below 50%. In some cases like Kentucky and New Jersey, this is made worse by annual appropriations less than 50% of what they should be in order to meet future obligations. In addition to pension concerns, these states also struggle with structural budget deficits, and in some cases have a history of late budget passages, one of the key reasons for the recent struggles in Illinois. All these troubles could enable credit spreads to further widen in the future. For these reasons, we’re advocating to stay underweight in these names at this point.
Do you invest in some of these financially stressed municipalities, and if so, how do you make your investment decision and portfolio allocation?
Jonathan: I think it’s important to note that the states mentioned are under fiscal stress and without structural changes to their pension funding and the like may see further deterioration in their bond prices. We don’t feel that the default scenario or even a multi-notch downgrade from rating agencies should be expected in the near term. Given some of the volatilities that may present themselves with regard to these names, we tend to steer clear in the ultra-short strategy and in the high yield strategy we look for revenue back credits within these states, as well as general obligation notes that we feel may be mispriced given some of the regional associations.
For investors, how should they review these types of credits and what are their options?
Jonathan: The market is extremely fluid with regard to these names and individual investors may be better served to stay away. With the volatility and risk presented, active management is very important. The ability to diversify away some of these risks and maintain underweight exposure gives actively managed mutual fund strategies an advantage over both buying bonds individually as well as index based passive strategies. Here at Alpine Funds, we believe our experience and focus on credit and portfolio construction set us apart, and may work to our client’s benefit.
Article by Jonathan Mondillo and Mark Taylor, portfolio managers, Alpine Municipal Bond strategies
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