The National League of Cities (NLC) just released their “City Fiscal Conditions 2014” survey, which is a good barometer of economic conditions. It contains some positive findings. The bi-annual survey reports for the first time in its 29-year history that 80% of local finance officers are better able to meet fiscal needs than in the prior year. The survey also reports that since 2008 more local governments are adding to their municipal workforce rather than reducing it. These are positive indicators of economic growth. Furthermore, property taxes are anticipated to show positive growth – the first positive growth in five years. Sales and income taxes are also expected show positive, but with slower rates of projected growth. The depth of the recession had a serve impact on local governments, and though fund balances are near pre-recession highs, they are still below 2006 levels. Expanding funding balances remain vulnerable to specific risks such as rising services cost, ongoing pension and healthcare cost and long-term infrastructure demands. The question remains: do these individual risks present a systemic credit risk to local government debt in light of recent watershed municipal bankruptcies? S&P Rating Service does not think so. S&P, just a week before the NLC report, updated their general obligation local government rating criteria. According to the revised criteria, S&P raised 41%, maintained 55% and lowered just 4% of their ratings, though some of the upgrades were the result of new data and improved economic conditions. On average, the local government sector moved up the rating scale to “AA-“ from “A”. S&P’s new general obligation rating criteria is heavily weighted towards economic measures (30%) and budget flexibility (30%), while much less weight is given to liquidity (10%) and debt (10%). The final rating component is management character (20%). S&P argues that their new rating criteria reflects the strength and stability of the local government sector as well as the sectors low risk of default throughout history.
At SNWAM, we agree that the local government sector offers credit strength and income stability. An allocation to taxable and tax-exempt municipal bonds is important for capital preservation and income investment objectives. However, SNWAM takes issue with S&P’s argument that historical default rates infer ongoing low rates of default. We can’t rely on historical default rates to protect client portfolios, but must use instead all available information to mitigate any potential risks to our clients’ capital or disruptions to their future source of income.
Sources: National League of Cities, S&P Ratings Service, Bankrate.com, Bloomberg, The Economist, The Guardian, SNWAM Research