WASHINGTON - Aging infrastructure, rapidly growing pension obligations, and weakening tax revenues are putting a strain on the credit quality of local governments and their bonds, McDonnell Investment Management LLC concludes in a research report.
The Oak Brook, Ill.-based fixed-income asset management firm looked at fiscal 2007 data from more than 350 cities of all sizes and found that the annual amount of money that must be set aside by U.S. cities to meet future pension fund obligations has nearly tripled over five years, rising to a median of $3.397 million in 2007 from a median of $1.282 million in 2003.
In addition, the study also found that the median average age for plant and capital equipment in these cities has increased by about 10% over the same period, to 12 years in 2007 from 10.7 years in 2003.
These demands are being exacerbated by the national economic downturn, which has resulted in a slowdown in tax collections, the revenues that cities use to prop up their budgets, said Richard Ciccarone, managing director and chief research officer at McDonnell.
"You're getting into more and more nondiscretionary dollars that will be set aside before the budget is even calculated for a single year because of the demands that are coming in from fixed liabilities," Ciccarone said in an interview.
In addition to data on debt service, the firm also looked at pension contributions and other post-employment benefit liabilities for which data has only recently been reported, he said.
"Then add to that the average age of plant and equipment to reflect the fact that there's deferred maintenance, that really is a liability that's going to have to be dealt with over time," Ciccarone said.
He said McDonnell found that the liabilities will eat up a "bigger and bigger portion" of the nondiscretionary budgets of state and local governments, which could put a strain on their credit quality.
"There are a lot of cities out there that have huge burdens," Ciccarone said.
And investors need to be aware of those burdens, coupled with the likely upgrades of many cities from rating agencies in the coming months, when considering the quality of municipal bonds, he added.
"We believe that the current move to recalibrate the existing municipal bond ratings structure should be undertaken with great care, if at all," Ciccarone said in a statement introducing the study.
McDonnell also said that because issuers have been going to market without bond insurance, investors should be aware that the burden of analyzing credit quality will fall more clearly on the investment manager and on third-party research providers.
The study found that even as credit quality is declining, the share of the new-issue municipal bond market covered by insurance has continued to fall, "reaching levels not seen since 1988, with just 21% of the new-issue market being sold with insurance so far this year, compared to 48% for the same period in 2007, and an average of 42% for the last 20 years."
"The decline in new-issue insurance shifts the credit burden and underlines again the importance of research for investors in this market," Ciccarone said. "With thousands of outstanding issues, and hundreds of new issues coming out every year, most investors simply don't have the resources to do the kind of in-depth analysis needed to get an understanding of the potential credit risk. Given current market conditions, we don't expect new issuance bond insurance to return to previous levels any time soon."
Ciccarone said that while there are still plenty of solid municipal issuers, investors need to be aware of the growing demands being placed on those issuers when considering munis.
"In some ways, muni bonds are still a safe haven," he said. "But we need to make sure that we don't look at them blindly. It's really a call to arms to do research."
