By , Stephen O'Connell, Head of US Fixed Income Research, Citi Investment Management, and Hilary Sutton, US Fixed Income Research Analyst, Citi Investment Management
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Predictions of a pension-induced munis crisis have been circulating for years. Here's why we think they're still wrong.
Is a devastating crisis about to erupt in the US municipal bond market? Various commentators over recent months have suggested that it might be. The gloomy narrative goes something like this: Several US states have big shortfalls in their pension funds. As ever more of their baby boomer employees retire, those states will have no choice but to take difficult decisions. The greatest potential victims will be investors in municipal bonds issued by the states in question. The pessimists predict that the impending wave of defaults on ‘munis’ could be the worst since the Great Depression.
At first glance, the figures may indeed look concerning. Across the fifty states of the US, the total unfunded pension liability stood at just under $1.4 trillion at the end of 2016. The present value of the median state’s pension assets was 71.1% of future obligations, which was 3.4 percentage points worse than the previous year. However, we would point out that 37% of the total unfunded liability is concentrated in just three states: New Jersey, Illinois, and California1. What’s more, despite the sizeable holes in those and other states’ various pension schemes, none of them are anywhere close to insolvency.
While we do not believe a pension crisis is imminent, however, there is also no room for complacency. The pension-funding shortfall demands action. However, there are various obstacles on the path to pension reform. In certain states, for example, constitutional protections limit modifications to the pension benefits of both existing employees and retirees. Assigning new employees to defined contribution plans – where shortfall risk is borne by the employee rather than the state – could help to address the situation. But labor unions may well oppose such measures. In such cases, we believe that switching to hybrid schemes – where the shortfall risk is shared between the states and their employees - may offer a way forward.
We also see various other possibilities for states to prevent their pension liabilities from growing further, especially where pensions lack constitutional protection. For example, the minimum retirement age for new employees could be raised, along with the years of service required to receive full benefits. Cost of living adjustments – which see pensions increase with rising inflation – could potentially be reduced or eliminated. We note with interest the recent landmark ruling in a Rhode Island court case that determined that the state was not contractually bound to pay benefits and might be able to reduce certain retirees’ benefits. In order to make up some of their pension shortfalls, states could also raise taxes and cut spending elsewhere.
Our view, therefore, is that state pension problems are neither as generalized nor as insoluble as the doomsayers suggest. We do not expect an imminent wave of contagious state defaults crippling the munis market, a prediction that has been doing the rounds for more than a decade. Instead, we see many attractive possibilities for income-seeking investors in this sector. Citi Investment Management’s investment process is designed to take advantage of inefficiencies through active portfolio management, allowing us to select securities that may offer reasonable risk/reward while avoiding those that do not. You can read more on the Private Bank’s positive case for munis in our Make your cash work harder theme in Outlook 2019.
1Bloomberg as of 31 Dec 2018
Depending on your state of residency, some bond interest may be exempt from state and local taxes; however, interest may be subject to the federal alternative minimum tax.
Fixed-income securities, such as municipals, present issuer default risk. Municipal securities will be affected by tax, legislative, regulatory, demographic or political changes, as well as changes impacting a state's financial, economic, or other conditions. Municipal investments may be highly impacted by events tied to the overall municipal securities markets, which can be very volatile.
Certain sectors of the municipal bond market have special risks that can impact such sectors more significantly than the market as a whole. For example: Investing significantly in municipal obligations backed by revenues of similar types of industries or projects may make them more susceptible to developments affecting those industries and projects. Because they invest primarily in securities issued by municipalities, they can be more vulnerable to state specific issues.
Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer's credit rating, or creditworthiness, causes a bond's price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made.