Like real estate, when it comes to municipal bonds it’s all about location, location, location. Three municipal bond experts took a deep dive on munis from several different locales on Friday morning, and the news was, in general, not reassuring, though each saw glimmers of hope as well.
At the Morningstar Investment Conference, Rob Amadeo of Western Asset Management, Joseph Deane of PIMCO and John Miller of Nuveen spoke on munis for Puerto Rico, Detroit and Chicago, but also looked at the bigger picture for municipal debt in light of moves to reduce the federal deficit, which might well have negative trickle-down effects on local governments.
As for Puerto Rico, Deane said that at PIMCO, where he heads municipal bond portfolio management, “we don’t own anything on the island.” Calling the Puerto Rican debt “a very, very difficult situation,” he pointed out that this “small island in the Caribbean” is the third largest debt issuer in the United States — after California and New York — which he said was “unsustainable.” He further warned of a human capital problem on Puerto Rico: “there’s been a big brain drain over the last few years” from the island as its economy has stumbled while its debt burden has risen.
Amodeo, head of municipal bonds for Western Asset, agreed that the Puerto Rican economy is a “mess,” and that in the short term liquidity is a major problem — especially since half of all sales taxes on the island are not collected — but that “we own Puerto Rico” because the government has taken steps to collect that extra revenue. Specifically, Western likes the island’s COFINA (Puerto Rico Sales Tax Financing Corp.) bonds because “you can buy a single A bond that’s bringing in $1.3 billion” in revenue while the island’s total debt service is “only $700 million — and politicians can’t get their hands on” that revenue. Miller, co-head of fixed income at Nuveen, agreed that “COFINA are the best bonds.”
Miller then addressed the closer-to-home muni bond issues facing Illinois and Chicago in particular. The city’s economy, he said, is “large, diverse and growing,” but Chicago’s unfunded pension obligations pose a serious problem that can be solved by one of two politically untenable ways: raising taxes or cutting pension benefits. Mayor Rahm Emanuel, he said, “won’t do either of those.” Thus Chicago’s ratings downgrade to AA1, he said, with “more downgrades possible” which in turn could have a negative effect on the city’s economy, though “we haven’t seen it yet.”
As for the investing side of Chicago’s muni problems, Miller said, “we like Assured Guaranty (AGO), which insures Chicago GOs and other credits” like those issued by the Chicago Transit Authority. As for other opportunities and dangers in munis, Amodeo said “we’re cautious on some of the toll road” bonds, since drivers mull “the cost of your time versus paying the toll.” In general, he said, Western also avoids general obligation (GO) debt. He explains that local governments might have more flexibility with their GO debt, but the “pension issue is more severe on the local level than the state” and that “locals rely on property tax receipts, which have been lackluster.” Moreover, as the federal government looks for ways to balance its budget, it will “share less with the states, which will share less with the locals.”
Deane said that PIMCO believes that “higher grade, shorter and more conservative” issues “will be a win” over the next year. However, “over the next three, five to eight years, he warned, “the biggest issue will be unfunded pension liabilities,” particularly as the “accounting rules on unfunded liabilities” are changing. If you have “a 7% funded ratio, like a certain island in the Caribbean,” that will be a major problem, along with “health care funding for pensioners.” Finally, Deane called Detroit “a microcosm of Puerto Rico,” in response to an attendee’s question, and predicted it was a near certainty that “GO holders of Detroit will be getting a haircut.”
Miller had the last word, suggesting that now more than ever, research into a bond issuer’s real creditworthiness was important, and suggested that the ratings agencies could not be relied on. “Remember,” he said, “that Detroit and Puerto Rico were A rated, while Chicago was AA until recently.”
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