MuniLand – Finding Value and Protecting Downside Risk

At times the fixed income markets present attractive risk/reward opportunities for those who are patient and focused. This year’s higher than normal equity and interest rate volatility, and the subsequent rally in bond prices across all fixed income sectors, has produced an outlier: the State of New Jersey.  

As we’ve written about countless times in these notes over the years, oversized pension liabilities are one of the biggest long-term financial problems state and local governments are facing. New Jersey has historically been weak on this front. However, over the last year, New Jersey has welcomed two positive credit events that impact its large pension liability. The first came in late 2015 when the U.S. Supreme Court declined to hear a petition from the state’s unions on forgone pension payments or low annual required contributions (ARC). New Jersey has failed to make full ARC payments for a number of years, which is the main reason for its poor pension funding ratios. However, the state has implemented a plan to increase payments every year for the next ten years in order to reach 100% of its ARC. The ARC plan, in conjunction with having the highest employee pension contributions in the nation, helps mitigate downside risk of lower pension funding ratios. The second credit positive happened in June when the New Jersey Supreme Court ruled on cost-of-living adjustments (COLA) for retired government workers. The court upheld a 2011 law freezing COLA increases, which dramatically reduced the state’s pension liability. If the COLA law was found unconstitutional, NJ pension liability was estimated to increase by 33%. This court case was similar to one heard recently in Illinois, but the outcome was different because New Jersey’s constitution does not include the same “shall not be diminished or impaired” language. Combined, the two decisions materially increased the state’s near term budget and management flexibility, and confirmed the state’s sovereign powers. 

We do not believe the market is pricing in these recent positive credit events. In the chart below, we compare short maturity State of New Jersey COPs (blue and red lines) to Bank of America and JP Morgan corporate bonds with comparable ratings and maturities. The chart shows that New Jersey provides an absolute yield pick-up of about 75bps. Adjusted for a 25% marginal tax rate, the tax equivalent yield is about 150bps (red line) over comparable corporate bonds. The additional yield from the municipal bond is material in this low interest rate environment. Furthermore, municipal bonds have historically traded with a lower beta (or volatility) profile than corporate bonds, so the Sharpe Ratio, or return adjusted for volatility, is also higher.

At SNWAM, we talk a lot about poor pension funding ratios and how the municipal market underprices their associated risk. Our base case credit outlook for New Jersey is conservative and includes credit deterioration from low pension funding ratios. However, the state’s strengths include high wealth levels, a diversified economy, low employment volatility, good revenue diversity and low revenue volatility, as well as material sovereign state powers to increase taxes and manage expenses. Recently, those powers were twice upheld by the U.S. Supreme Court and the New Jersey Supreme Court. The results are positive credit factors that offset the state’s credit negative factors and support an “A-“ to “BBB+” credit rating for next 18 to 24 months for NJ General Obligation bonds. The additional compensation in short maturity bonds on both an absolute basis and tax equivalent basis when compared to other municipal and corporate bonds presents a very attractive risk/reward opportunity. Even if the bond market turns volatile, the additional interest income from the short bonds more than offsets the potential downside price risk from credit spread widening.

 Source: Bloomberg, Moody’s, S&P