The general obligation sector of the municipal bond market is making a distinction between credits with solid and weak pension funding ratios. This past week, Fidelity Capital Markets and JP Morgan published insightful articles on GO credit spreads and underlying drivers of spread weakness. The chart below from Fidelity (Index of State 10yr GO Spreads to MMD) shows how spreads (or bond yields) have materially widened since the beginning of 2015 for credits with pension liabilities greater than 125% of governmental revenues. Although the general obligation sector of the municipal market is just beginning to recognize pension credit risk, SNWAM has been actively managing pension credit risk for some time.
Taking a step down, JP Morgan drills into one of the drivers of pension risk. Specifically, JPM plots pension funding ratio versus the ratio of annuitants to active employees (Exhibit 14: Scatterplot…). The ratio of annuitants to active employees is important because it indicates that weak or weakening defined benefit plan demographics drive higher required pension costs. Higher required pension costs, in turn, accelerate expenditure growth, which left unabated can create structural imbalances. Prolonged structural imbalances can lead to reduced balance sheet strength and credit downgrades.
Confirmation bias notwithstanding, the two reports affirm the findings of the SNWAM’s State of the States Study published earlier in the year, and the second chart identifies some of the worst offenders, including IL, AK, MI and CT. We continue to forego exposure or underweight exposure to such names and credits within these states.
Sources: Fidelity Capital Markets, JP Morgan “U.S. Fixed Income Markets Weekly” 09/15/2015, and SNWAM Research