Minute in the Market

Bond Market Liquidity: Not as Scary as the Headlines Suggest

Given the elevated level of market volatility in the last few weeks, we thought now would be an opportune time to update our clients on our thinking around a popular topic surrounding the bond markets: liquidity. See our thoughts below. In short, since our founding 13 years ago, we’ve been through a number of market cycles and have seen incredible changes in the structure of the U.S. financial markets. While the flavor of this recent bout of market volatility is different from those of the past, the substance is not, and we continue to feel confident on our ability to add value to our client portfolios throughout market cycles, no matter what new “challenge” the market may throw our way. 

Is Liquidity in the U.S. Bond Market Really Gone?
When the popular financial press picks up a news story, particularly one that involves a potential threat to investors, we can reasonably expect to become inundated with headlines and articles on that topic for months on end. Such is the case these days with the topic of liquidity, or lack thereof, in the U.S. bond market. The stories started in October of 2014, when U.S. Treasury Bonds experienced the bond market equivalent of a “flash crash,” as yields fell and prices rose sharply in a period of just minutes. This volatile, once-in-three-billion-years event (statistically it was a 7 standard deviation yield change), coupled with major bond investors such as Blackrock and PIMCO publically sounding the alarm on market liquidity, have caused many investors to question how well their portfolio is protected from a less liquid market environment. In this piece, we explore why this has become a hot topic, what liquidity actually means, whether liquidity has actually fallen, how our clients are meaningfully insulated from such illiquidity and the opportunities that may arise from this new market environment. 

Why Is Liquidity Such a Hot Topic?
The events of 2008 spurred congressional leaders and regulators to enact rules and regulations aimed at preventing the risky behavior from banks and brokers that led to the bankruptcy of Lehman Brothers and a near collapse of the financial markets. Washington’s answer to the problem has been to limit the amount of risk-taking banks and brokers can engage in. Regulations such as Dodd-Frank http://www.sifma.org/issues/regulatory-reform/dodd-frank-rulemaking/overview/, Liquidity Coverage Ratio Requirements http://www.occ.gov/news-issuances/bulletins/2014/bulletin-2014-51.html and stricter Basel Capital Requirements http://www.federalreserve.gov/bankinforeg/basel/USImplementation.htm have made it prohibitively expensive for banks and brokers to participate in the financial markets in the way they once had. As such, broker-dealers have reduced their bond inventory significantly since the financial crisis. This is particularly true in the corporate and municipal markets, but to a lesser extent in the Treasury markets as well. 

How Is Liquidity Measured?
In very simple terms, liquidity can be thought of in the following ways:

  • The time it takes to transact a given security
  • The price variance of the transaction from the market price

Put another way by Fed Governor Kevin Warsh in 2007, “An asset’s liquidity is defined by its ability to be transformed into another asset without loss of value.”
These definitions of liquidity can be measured by statistics such as average daily trading volume and the bid-ask spread (the difference between the price at which an investor can purchase a bond and where they can sell it). 

Has Liquidity Actually Diminished? 
Based on the definition above, no.

Average trading costs have been declining, and we can’t find any statistical evidence to support the notion that trading is taking longer today than its pre-crisis average. As the bond market has grown in recent years, trading volumes have grown right along with it. This is particularly true for corporate bonds.

Trading volumes of corporate bonds 2006-present:

 In the Treasury market, average daily trading volume has declined by 1.3% annually since 2008, but this is likely due to the Federal Reserve becoming a dominant player in the market. Through their three quantitative easing programs, the Fed has accumulated nearly $2.5 trillion of Treasury bonds, which they do not actively trade. 

In the municipal market, average daily trading volumes have declined by 10% annually since 2008, but we don’t see any noticeable difference in bid-ask spreads today versus seven years ago. In fact, we would argue that liquidity has remained stable in recent quarters despite the decline in volumes. We keep close watch on the number of brokers who are submitting bids for the bonds we are selling, and haven’t seen a noticeable change.  

If We Are Wrong and Liquidity Is Actually Lower, Are SNW Separately Managed Bond Portfolios Protected?
In a recent report, the ratings agency Standard and Poor’s attempted to classify the risk of low liquidity to different segments of the fixed income markets. Interestingly enough, it is the pooled investment products such as bond mutual funds and ETFs that carry the most structural liquidity risk. The reason is that these products promise instant liquidity in an investment sector that doesn’t trade on an exchange.  

While separately managed bond accounts aren’t listed on the chart, we’d place them in the lower left hand side of the matrix, with low structural liquidity risks and high capacity to absorb a shock. The reason? We have the ability to hold bonds all the way to maturity. We are likely to transact less in our client portfolios during volatile market environments, which helps insulate our clients from the high trading costs that can occur in less liquid markets. 

Do These Trends Create Opportunity?
In one word, yes. We continue to maintain an investment philosophy that centers on taking risk only when we are being properly compensated to do so. This risk compensation, which is generally measured in credit spreads (the difference in yield between a given bond and a risk-free bond), has declined markedly in the last few years across most sectors of municipal and corporate bond markets. In that vein, our portfolios are positioned very conservatively, with a number of very high quality, low-risk bonds. These are the types of bonds that generally receive fair pricing regardless of the market environment and can be sold quickly to purchase bonds that are being punished due to herd behavior. 
This type of herd event presented itself in the municipal market in late-2010, when banking analyst Meredith Whitney, on the news program 60-minutes http://www.cbsnews.com/news/state-budgets-the-day-of-reckoning/, predicted billions of dollars of municipal bond defaults during 2011. A massive market sell-off occurred, as retail investors rushed to sell their munis in fear of default. We believe that events like 2010 can provide opportunities for us to find solid credits at attractive valuations. While mutual fund managers are forced sellers because of mass redemptions, we are able to be selective buyers.
We stand ready to take advantage of similar volatility. So, when the newspapers are printing those worrisome stories and the anchors on CNBC are saying sell everything, know that we’ll be in the market looking for attractively priced bonds that will provide benefits for years to come.          

Sources: Bloomberg, CBS News, Citigroup, Federal Reserve, Market Axess, OCC, SIFMA, S&P, Trace, US Treasury

The State of the States in Fiscal Year 2014: Déjà Vu

Twenty-seven of the states that SNW Asset Management follows most closely have now filed audited Comprehensive Annual Financial Reports (CAFRs) for fiscal year 2014. Below is our take on the financial performance of these states during the past fiscal year.
We draw our conclusions based on each state CAFR’s Statement of Net Position and Statement of Activities, footnotes detailing bonded indebtedness, liabilities for pensions and OPEBs, inter-fund transfers, and, when necessary, separate CAFRs published for large pension and OPEB plans. This methodology includes closely-governed component units included in the CAFRs, the operations of which can fairly be treated as part of the operations of the states themselves. This methodology allows us to compare state finances in a consistent manner and adds to our confidence in the accuracy of our findings.
We also apply a number of internally-derived metrics to measure (1) the operational performance of the states and (2) the total of bonded debt and other debt-like liabilities to which the states and, therefore, their tax- and rate-paying public are exposed. The most important of the non-bond liabilities are unfunded pensions and “Other Post Employment Benefits” (OPEBs).

Fiscal performance. As was the case in FY 2013, state operations were generally sound in FY 2014. Twenty-four of the 27 states, including 5 of the states that are especially important to SNW’s clients, operated on a breakeven basis or better. The states of Connecticut, Massachusetts and New Jersey were significant exceptions, as each incurred operating deficits of $1 billion or more, measured on a total funds basis. The 27 states also improved their liquidity; the aggregate of readily available cash and investments increased by 9.7% to more than $455 billion, and the ratio of readily available cash and investments to total expenditures improved to an average of 28. Finally, if we look at the ratio of the accumulated net assets of each state to its total expenditures, most of the states again performed well. In 22 states, including Idaho, Colorado, Oregon and Washington, the ratio was 34% or better, often much better. California and Massachusetts posted weaker numbers, 11.5% and 9.7%, respectively. And, unfortunately, 6 years after the trough of the last recession, Connecticut, Illinois and New Jersey have negative net assets ranging between $10.2 billion in Connecticut and $3.25 billion in Illinois. This is why SNW remains cautious with respect to California and Massachusetts, and attempts to minimize exposure to Connecticut, Illinois and New Jersey. That having been said, our basic conclusion is that most, but certainly not all, of the states that we follow closely reported very solid operating performance in FY 2014.

Debt metrics. Now comes the more somber news. Last year, our comment on FY 2013 was that the states did well operationally, but frittered away an opportunity to use their improved liquidity and generally stronger financial positions to begin to address, and perhaps gain control of, their bonded indebtedness and their unfunded liabilities for pensions and OPEBs. In FY 2014, our take is almost exactly the same, only with a greater degree of concern because unfunded pension liabilities increased by a surprisingly large amount. For our group of 27 states, the problem generally does not lie with bonded debt outstanding, which rose by only 1.7% to $800.2 billion, nor with OPEBs, which rose by 2.2% to $502.9 billion. The problem lies with unfunded pension liabilities, which for reasons we do not yet fully understand (and which we will leave for a subsequent written comment), grew by 14.2% to $754.2 billion. That is a huge increase, which is particularly disappointing given that we are 5-6 years into economic recovery and also riding a huge rally in the equity markets, a staple of pension fund investing. Unfunded pension liabilities are now 94% of bonded debt outstanding for our group of 27 states. In 14 of the 27, including California and Colorado, unfunded pension liabilities exceed bonded debt outstanding. 

Since bankruptcy court decisions in Detroit, Michigan and Stockton, California treating pensioners’ claims far more generously than bondholders’ claims, owners of municipal bonds must now confront the possibility that they own obligations that will be systematically subordinated to pensioners’ claims if and when troubled municipalities file for bankruptcy. This possibility has not yet been priced into municipal bonds. At the very least, it is now prudent to add unfunded pension liabilities to outstanding bonded debt when assessing municipal credits. 

 SNW Asset Management has done exactly this for a number of years now, and when we calculate the numbers for FY 2014 we find ourselves very comfortable with the states that we hold in our client portfolios. Our preferred metric for establishing credit comfort is the ratio of outstanding bonded debt plus unfunded pension liabilities to aggregate personal income (API). API is a readily available statistic that allows us to gauge the ability of the tax- and rate-paying public within each state to make good on debt and debt-like obligations. The average ratio for our 27 states is 14.5%. The ratios for Oregon, Idaho, Washington and Colorado are below the 27-state average at 8.7%, 8.9%, 9.8% and 12.5%, respectively (and a lower ratio is good). Texas and Florida, 2 states in which SNW regularly invests, also score well, with ratios of 6.6% and 6.9%. California and Massachusetts are above the average ratio at 16.3% and 18.7%, respectively. For the record, the ratios for our least favorite credits, Connecticut, New Jersey and Illinois are 23.0%, 24.5% and 25.5%. Now, reasonable people may differ regarding what constitutes a dangerously high reading, but the average is almost certainly materially higher than it was 5 or 10 years ago. It would also be wise to keep in mind that these obligations are in addition to the claims on income imposed by mortgage debt and by the debt of everybody’s favorite relative, Uncle Sam. 

These warning signals have been apparent for some time now, and it is deeply disappointing, morale-breaking really, that the states keep ignoring them. And so, SNW’s opinion about FY 2014 comes down to a retake of FY 2013 – a good year operationally, not a good year in terms of managing “longer-term” liabilities. The great danger is that for several of the 27 states the long-term has now become short-term; and for the rest, too, the long-term is shorter than it used to be.

Our conclusion is that for a number of years now the municipal bond market has become increasingly, but perhaps imperceptibly, more risky. By the end of FY 2014, however, the bankruptcy settlement in Detroit and the pension crises at both the state and local levels in Illinois have brought the risks into plain sight. More than ever before, municipal bondholders must insist that the credit analysis underlying their investments be well informed, thorough and carefully thought out. At SNW, we have made it our business to do just that.

Minute in the Market: Muni Credit - A Look Back and a Look Ahead

Having recently completed the financial review of our municipal holdings for the latest fiscal year, we thought it would be appropriate to share our thoughts on the state of the municipal credit market. Generally, we are pleased with what we saw and are maintaining a constructive outlook on the sector. Most municipalities have been able to dig out of the recession-driven balance sheet stress that plagued them for much of the decade and have emerged with healthy and, in some cases, quite strong financial positions. Of course, there are certain idiosyncratic situations that don’t fit the mold, but for the most part, things are looking up. We have organized our thoughts on a sector level by focusing on credit trends and outlooks. In an attempt to get straight to the point, we are using notes as opposed to long-form prose. Please contact us with any questions, but we hope this piece provides both comfort that we have a handle on the situation and confidence that we’ll be able to spot relative value and any change in trend if one should occur.
 
States/Territory
2014
State revenues continued to increase, but at a slower rate than in previous years. States also continued to defer maintenance and otherwise underspend on infrastructure, and they have so far failed to address growing unfunded liabilities for pensions and OPEBs.

The U.S. Economy’s continued recovery has benefited most states. The economies of some states have also been aided by more localized developments, such as the tech boom in California and the oil boom in Colorado, North Dakota and Texas.

Outlook 2015
Continued economic expansion, job growth, and lower fuel costs will boost income tax and sales tax revenues, but increases in transfers to local governments will consume most of the revenue gains. The current oil bust, if it continues, will hit producers (ND, CO) harder than refiners, processors and petrochemicals (TX).

Transfer payments will grow towards pre-recession levels and perhaps beyond (in nominal terms).
The tech boom will continue, though the continuation of the oil boom/bust is uncertain.
 
Local Municipalities and K-12
2014
Taxable values continue to grow, with some areas exceeding 2007/08 highs (for example the San Francisco Bay Area), but most metro areas are still below highs, but only slightly.
 
State support has been slow to materialize, but well managed, economically diverse and positive demographic areas saw improvement (Dallas/Fort Worth, TX).
 
Bankruptcy proceedings in Detroit and Stockton treated pensioners far more generously than bondholders. Bankruptcy has become a viable option for local muni credits to shed liabilities. 2014 represented a watershed year for GO municipal credit defaults.
 
Outlook 2015
“This isn’t your Daddy’s municipal bond market.” 
 
Bankruptcy priority is advancing pensioner interest above bondholders.
 
A credits’ security pledge has become less important than underlying credit fundamentals.
 
Assessable values will rise and exceed 2007/08 highs. Areas hit hardest by foreclosures will lag, but still see improvement.
 
Hospitals (not-for-profit)
2014
Medicare/aid and the roll-out of the federal insurance mandate have reduced operating margins and spurred consolidation. Large regional players are maintaining positive operating margins. State- or city-run care centers that focus on the uninsured have benefited from increased insurance coverage.
 
A merger and acquisition trend is well underway, and will continue with the risk of thin to negative operating margins due to expensive organization consolidation and management missteps. An example is Swedish Health Services, now part of Providence.

Outlook 2015
Larger players and university health centers are better positioned to manage change, and generally have very strong balance sheets.
 
Merger/acquisitions of smaller, more remote systems into larger metro area organizations will continue, but the most compelling mergers (those most attractive in the long term) may already have occurred.
 
Higher Education
2014
Lack of tuition affordability and reduced state support are placing greater pressure on income statements.
 
Flagship state universities continue to show impressive balance sheet strength and pricing power due to lower tuition costs relative to private institutions.
 
Smaller liberal arts colleges are becoming less competitive based on tuition, and declining net tuition revenue is pressuring balance sheets. Endowment pressure and risk taking are increasing as investment revenue is used to fill shortfalls in operating revenues and to fund student aid (thereby increasing affordability).
 
Outlook 2015
Tuition affordability will continue to weigh on the sector, and state support of public institutions is unlikely to return to pre-recession levels.
 
Expect credit downgrades of small private liberal arts institutions.
Endowments’ investment performance should accelerate balance sheet improvements.
 
Airports
2014
Airports benefit from enplanement growth, which leads to higher passenger volumes and more ancillary fees (parking and concession fees) and Passenger Facility Charges (PFCs). The driver of enplanements is improved economic conditions. In addition, higher global wealth levels are benefiting international hubs as flying becomes an option for more people.
 
The sector weathered airline bankruptcies and consolidations well because landing fees and terminal leases are generally not material components of airlines’ cost structures (fuel and labor being the material components). Balance sheet ratios are trending positive, but high debt loads due to increasing demand for expansion of facilities continue to pressure debt service coverage.
 
In many cases, PFCs subsidize operating margins and debt service coverage, but there are no anticipated changes to the PFCs from the max rate of $4.50 per passenger. Ancillary charges represent nearly half of airport revenues in some locations.
 
“International” hubs maintain their strategic importance. “Origination & Departure” airports with strong local economies (SEATAC) show credit strength. Destination airports (Las Vegas) continue to improve with the overall economy.

Outlook 2015
Moody’s sees enplanements accelerating from 2% to 3% to 4% in 2015 on continued economic growth, and has upgraded the sector from stable to positive.
 
The airline industry has consolidated into traditional carriers (American Airlines and Delta) and discount carriers. This new dynamic has and will continue to concentrate single carrier operational risk. For example, DFW is predominately (+75%) American, and ATL is predominately Delta.
 
Parking revenue bonds are becoming an important source of financing for infrastructure improvements.
 
“Crowding skies” issues will benefit from GPS technology and force large metro airports (NYC) to specialize as domestic or international hubs.
 
Toll Roads & Transportation – GARVEEs
2014
Toll road defaults were the 2014 story. Indiana Toll Road exited bankruptcy. It was privatized in 2006, but since it never realized projected pro forma revenues due to the economic downturn, the system is again up for sale. The Foothill/East Transportation Corridor in CA also restructured its debt due to limited rate-raising ability and insufficient volumes. Both of these cases demonstrate how overly optimistic vehicle travel projections and poor revenue estimates can be the downfall of a toll road credit.
 
NJ and PA Turnpikes continue to be a source of persistent revenue transfers for states with unbalanced budgets. However, the NJ Turnpike has significant revenue capacity (it raised tolls 50% in 2013) and ample liquidity to support the transfers.
 
Free cash flows can be prodigious for systems with: (1) limited competition from non-tolled freeways, (2) electronic toll payment systems and (3) conservative budget practices.
 
GARVEEs (Grant Anticipation Revenue Vehicles) are threatened by the Highway User Revenue Trust Fund deficit. There is little action on a replacement for the gasoline tax (last updated in the early 1990s) to support the Trust Fund. However, Congress has taken annual appropriation action to support the fund.
 
Outlook 2015
The outlook for 2015 is upbeat due to increased vehicle miles driven. This is a significant milestone because it represents a reversal of the recent trend.
 
Look for states and local authorities to lease toll roads and transportation assets as a mechanism to fund pension and OPEB liabilities.
 
Because Congress shows no sign of increasing funding for the Highway Trust Fund, annual last-minute appropriation “fixes” are likely to continue. States and local taxing authorities will step up to fill the funding gap with new sales or fuel taxes.
 
Seaports
2014
Seaports continue to benefit from improvements in the U.S. economy. The top 10 ports by volume have monster balance sheets, a sticky business model and significant pricing power. Operating margins are strong and coverage ratios are sufficient to withstand economic downturns.
 
Labor disputes at West Coast ports resulted in delays, but these types of labor disputes are short-term in nature and do not represent a material credit risk.
 
The rise of natural gas and distillate exports will offer little benefit to existing public ports since much of the oil and gas activity is handled through private facilities.
 
Mississippi River barge traffic is an important means of shipping commodities. Infrastructure spending is needed to maintain flood controls and navigation.
 
The Jones Act requires that any goods shipped by water between two U.S. ports must be on a U.S. built, owned and flagged vessel. There are no initiatives to repeal or update the Jones Act.
 
The cruise line industry is increasingly important (for example, Miami-Dade and Port of Baltimore), but more variable than the shipping industry.

Outlook 2015
The outlook for 2015 is the same as 2014. However, major mid-term (next 5 yrs) shifts will occur in the sector.
 
The future of North American (N.A.) ports will depend on the opening of the expanded Panama Canal and the location of a N.A. shipping hub post Panamax. Post Panamax ships are so large and carry so many containers that they will change how shipping is done in N.A.
 
Miami Dade Seaport sits in an interesting position for becoming the N.A. shipping hub post Panamax. It is the largest cruise line hub in N.A. The credit has taken on significant debt to upgrade its facility to accept larger ships. The credit offers nice risk reward characteristics because of higher yield levels relative to other ports.
 
Water and Waste Water
2014
Water and wastewater utilities continue to display strong credit fundamentals. Solid balance sheets, strong revenue capacity, positive operating margins and ample coverage ratios make this sector one of the most stable in muniland.
 
The lesson learned from the City of Detroit bankruptcy settlement is that secured revenue debt (W/WW component unit) may be impaired despite strong operating fundamentals. The Detroit case saw W/WW bondholders lose their call protection through a tender offer that ended up reducing interest payments, but gain a pledge to repay 100% of the principle amount.
 
Aging infrastructure and environmental mandates (sewage overflow) is pressuring operating margins and increasing leverage ratios.
 
Drought conditions in the West (California) and Southeast highlight the need for new infrastructure spending on water conversation efforts as well as increased supply capacity.
 
Outlook 2015
Credit trends will continue in 2015.
 
Debt supply may receive a boost from the Qualified Public Infrastructure Bonds (QPIBs) proposal, but we will have to wait and see if the measure becomes a reality.
 
California ballot initiative Prop 1, the water bill, passed, which calls for $7.12B in GO debt to support water supply infrastructure projects.
 
Electric Utilities
2014
Electricity generation and transmission utilities continue to display strong historical credit fundamentals. Solid balance sheets, strong revenue capacity, positive operating margins and ample coverage ratios make this sector one of the more stable in muniland.
 
Low cost hydro power generators maintain their strong position even in an environment where natural gas is becoming a competitive player.
 
Sustainable electrical producers (green bonds) are still a relatively small portion of the municipal market.

Outlook 2015
The outlook for 2015 is similar to 2014’s credit trends.

However, long-term shifts in the sector are beginning to develop. Decentralized generating capacity (photovoltaic panels) and advancements in energy storage capacity are becoming cheaper and more widely used. This is a long-term fundamental shift that will undermine the monopolistic power of centralized electricity generators. Though the trend has been developing slowly, electricity generation is a sedate industry and management may make mistakes.
Transmission utilities are positioned well for decentralized electrical generation based on photovoltaic power, natural gas and storage environment. The rise of a distributive power system and its associated pricing power is a long term positive for the sector.

State of the States: An Opportunity Foregone

Summary
In fiscal year 2013, our sample states continued to rebound from the recession of 2008-09.  Aggregate revenues exceeded aggregate expenditures by greater amounts than in fiscal years 2012 and 2011, and liquidity also continued to improve.  The states’ capitalization metrics also recovered.  Unfortunately, the states’ fiscal successes did not extend to their debt metrics.  Bonded indebtedness was well-controlled, but unfunded pension liabilities rose faster, even with large gains in the equity markets that are favored by pension managers.  Our bottom line for the states’ debt metrics is that they are accelerating faster than growth in all revenue sources.  The result is debt metrics are structurally out of balance with underlying state revenue outlook.  What is most discouraging to us is that so many of our sample states – virtually all of them, in fact – did not use the generally benign financial environment in FY 2013 to begin the process of controlling and ultimately reversing the relentless growth of their non-bond liabilities.  In all, FY 2013 presented a foregone opportunity to reduce the pace of long-term off-balance sheet liabilities growth and to better align future obligations with a sustainable rate of revenue growth.

Methodology
Each year, as part of our credit process, SNW Asset Management examines a sample of the most investable and relevant 29 states plus the Commonwealth of Puerto Rico.  We do this to assess the states’ fiscal performance and exposure to bonded indebtedness and other liabilities including unfunded pension obligations and “other post-employment benefits” (OPEBs). 
Our sample includes the states in which the vast majority of our clientele reside or where debt is offered at attractive levels.  We conduct this  study because we want to track the financial health of the states in which our clients are directly exposed to credit risk, by owning bonds issued either directly by the states or by local governments therein, which are necessarily affected by economic and financial issues facing the state as a whole.  We gauge the financial health of our sample states by looking primarily at three fiscal measures.

  1. Operating Performance: revenue divided by expenses
  2. Liquidity: unrestricted cash & investments divided by total state expenditures
  3. Capitalization Ratio: total net assets reported on the balance sheet divided by total expenditures

We also examine two metrics estimating exposure to longer-term liabilities.

  1. Percent of Personal Income to Bonded Debt + Pension Liability: bonded debt & unfunded pension liabilities divided by state aggregate personal income
  2. Percent of Personal Income to Bonded Debt + Pension Liability + OPEBs: the same as above but adds unfunded OPEBs divided by state aggregate personal income

Only 13 states exceeded the 104.9% average for the sample, indicating that 17 of the 30 states and territory continue to operate at margins that are positive but a bit thin.  However, in general, at SNW we conclude that in terms of fiscal performance, FY 2013 was a solid and successful year for most of our sample states.

The states’ capitalization metric, which is the cumulative result of long periods of financial operations and is less volatile than liquidity metrics, also improved.  Within our sample, capitalization (total net assets divided by expenditures) averaged 69.9%, ranging between 675% for Alaska with its large Permanent Fund and -40.6% for Illinois.  The negative number for Illinois reflects the state’s large negative net asset balance – the result of years of financial mismanagement.  Connecticut and New Jersey also have negative asset balances, only not as big as the one in Illinois.  The chart below shows the comparative capitalization metrics for the states in our sample.

On a positive note, total revenues exceeded total expenditures in the sample, allowing states to continue to rebuild liquidity.  Liquidity is readily available cash and investments divided by total expenditures and ranged between 600% in Alaska (again, buoyed by the large, oil-driven Permanent Fund) and 7.8% in Connecticut.  The following chart displays the liquidity performance of our sample states.

Findings – Debt Results
Unfortunately, the states’ fiscal successes did not extend to their debt metrics.  Bonded indebtedness was well-controlled, rising by only 3% from the prior year, but unfunded pension liabilities rose by more than 6% despite large gains in the equity markets favored by pension managers, and unfunded OPEBs rose by more than 4%.  The OPEB numbers are actually lower by $20 billion, or roughly 4% of the sample’s OPEB total, because Michigan abandoned pay-as-you-go financing in favor of an actuarial approach coupled with an unrealistic 8% assumed rate of investment return which significantly reduced its reported OPEB obligation balance.  OPEBs, in particular, are likely to grow very rapidly in the years ahead because most states do not fund actuarially-required annual contributions (ARCs) at anything close to 100% – 40% or less is the norm.

Our bottom line for the states’ debt metrics is that they are material, growing at an accelerating pace and pressuring the economic resources in some state.  Outstanding bonded indebtedness and unfunded pension liabilities averaged more than 14.8% of aggregate personal income (the annual personal income of each state’s citizenry) in FY 2013, ranging from 3.9% in Tennessee to a staggering 39.9% in Alaska.  These are “hard” liabilities which state and local courts are unlikely to allow to be reduced in any substantial way – short of federal bankruptcy decree.  Adding in unfunded OPEBs, which are “softer” liabilities but liabilities which the states must nonetheless ultimately make good – the sample average rises to more than 19.5% of aggregate personal income. The chart below displays the total of bonded debt plus unfunded pension and OPEB liabilities versus aggregate personal income for each of the states in our sample.

Outstanding bonded indebtedness plus unfunded pension and OPEB liabilities exceed $100 billion in each of 6 states – Ohio ($112 billion), Texas ($137 billion), New Jersey ($175 billion), New York ($231 billion), and California ($324 billion) – and account for 55% of the sample’s total.  These are big numbers.  Ranked against one another, 18 states do better than sample averages of percent personal income (debt + pension + OPEB), meaning that the states which do worse than the sample average do very much worse.  The states which fare worst when liabilities are measured as a percentage of aggregate personal income are, in descending order, New York, South Carolina, Massachusetts, Ohio, New Jersey, Connecticut, Illinois, Hawaii, and Alaska. 
 
Conclusion
What is most discouraging to us is that so many of our sample states – virtually all of them, in fact – did not use the generally benign financial environment in FY 2013 to begin the process of controlling and ultimately reversing the relentless growth of their non-bond liabilities.  Although in most states, pension and OPEB liabilities are issues for the intermediate- to longer-term and are not yet immediate problems, the negative implications are very real, and if not now, when will they ever begin to be addressed?
In terms of SNW Asset Management’s process of constructing portfolios and managing credit risk for our clients, these are the facts as we see them.  The longer-term financial environment for the states and their political subdivisions is one which we think requires intensive, ongoing care in the appraisal, selection, and monitoring of municipal investments for our clients.  We hope that this summary of our municipal credit work and the lessons which we draw from it will reassure our clients that we continue to be diligent in managing their investment assets, always trying to look a little deeper into the credit characteristics of the securities they own, and making it our business to distinguish accurately between better and lesser credits.

Modest and Uncertain Economic Growth

Thisweek’s economic data reaffirms the recent trend of modest and uncertain economic growth.  Initial jobless claims 4-week moving average hit its lowest level in nearly six year at just 308,000.  Looking back, these initial jobless claims levels follow growth periods in 1988, 2000 and 2006.  But unlike those times we continue to see an elevated unemployment rate of 7.3%.  August saw the fourth consecutive month of mild income growth with 0.4% rise which met expectation.  Consumer spending, which represents 70% of the U.S. economy, also met expectation with a rise of 0.3%.  When added together the data would portend job growth, but where are the jobs?  We have rising home values and stock market gains which is good for those American’s with assets.  We have an economy that is seemingly sloughing off increased payroll taxes.  Disposable incomes are up 0.3% after adjusting for inflation.  Vehicle sales are up to levels not seen since 2007 as consumer replace cars and truck that average 11 years old.  These are all good economic signs; however, the labor participation rate continues to fall from a high of 67.3% in 2000 to a current read of 63.2%.   The last time the labor participation rate was this low was 1978.  Personal saving rates on average continue to rise with a 5-year moving average up 5.5% from an absolute low of 2.8%, still far below the 50 year average.  While good in the long run increased personal saving does not help spur near term consumption.  So for every positive economic indicator there seem to be a negative indicator.  The conflicting economic signs indicate the economy is working through structural issues such as long-term unemployed, demographic shifts and elevated household debt levels.  In all, recent data suggest modest near term growth will continue but the longer term outcomes are far from certain.