While renewed concerns about economic growth cloud the outlook for US state and local tax collections, we don’t envision a rash of municipal bond defaults if tax collections are lower than expected. Here’s a recent report from my colleague Guy Davidson.
The municipal bond market has come a long way since predictions of widespread defaults spooked the market early this year. Only a few, small issuers have defaulted or are at risk of doing so soon. So far Jefferson Country, Alabama is the only large bankruptcy. Furthermore, Jefferson County’s bankruptcy has long been expected by market participants, including ourselves.
Consequently, over the past several months, tight supply and improving tax collections have spurred a strong rebound in the municipal bond market.
We estimate that state tax revenues have climbed about 85% of the way back toward the peak reached in September 2008, after their unprecedented collapse in late 2008 and 2009 (Display). While renewed concerns about economic growth have clouded the outlook for tax collections, we don’t envision a rash of defaults if tax collections are lower than expected.
Most state and local governments made progress this summer in addressing their budget shortfalls, and they continue to do so, reducing the risk of defaults. According to The National Association of State Budget Officers, every state except Minnesota passed its budget for fiscal year 2012 on time. The overall improvement in tax revenues, along with varying combinations of spending cuts and/or tax increases, has enabled municipal issuers to handle the imminent end of federal aid that they had received over the last three fiscal years.
Still, the debt crisis in Europe continues to raise questions about the debt burden of state and local governments in the US. But state and local governments unlike most countries’ governments, are almost universally required to pass balanced budgets; this prevents them from accumulating large debt burdens from deficit financing over the years. As a result, by almost every measure, the debt burdens of US states and local governments fare very well when compared with those of many countries.
For example, the debt burdens of the five states with the worst fiscal problems are manageable, since debt service represents only 5% of annual spending, on average. In addition, only a very small share of total state and local debt rolls over in any one year. Most of it is infrastructure-related, and therefore has a long average maturity that mirrors the useful life of a given project.
In short, the debt burden on states is light in comparison with most sovereign governments across the globe. Claims that California is “the next Greece” demonstrate a fundamental misunderstanding of municipal finance in the US, as well as the recent trend of state and local governmental borrowing, in our view (Display).While we expect the volume of defaults in the municipal market to remain low and issuer-specific, the finances of state and local governments will remain under pressure for years to come as the federal government grapples with its own budget deficit. As a result, state and local governments will have to do even more to embrace austerity, particularly with regard to pension and health insurance costs for retired employees. In most cases, such costs are spread across many years, allowing governments the time to make necessary adjustments.
If such adjustments are made, our research shows that annual required pension contributions will not become unaffordable or squeeze out other necessary state payments and services. But if these adjustments are ignored or delayed too long, annual pension contributions will become a far larger burden over time.
Ultimately, this could result in states reducing aid to localities, which would put pressure on them, in turn, to raise taxes or slash spending. The primary source of tax revenues for localities is property taxes: the good news is that despite the sharp decline in housing values, property tax revenue collections have held up relatively well.
In the meantime, we think it’s prudent for municipal bond investors to focus their purchases on revenue bonds. These bonds are backed by dedicated taxes or fees for essential services such as electricity and water, and are largely insulated from the budget battles we expect to see in the years to come.
The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income and Guy Davidson is Director of Municipal Bonds, both at AllianceBernstein.