Municipal credit quality will continue to be threatened by growing pension liabilities and risks in the years ahead, after speculative ratings nearly doubled and four municipal issuers defaulted in 2015, according to Moody's Investors Service.
"Some municipal governments are confronting higher and growing expenses, but have a more static level of resources to pay them," Al Medioli, Moody's senior vice president and group credit officer, wrote in the rating agency's annual municipal default survey released last week.
"While revenue growth is muted, pension liabilities are increasing rapidly," he continued. "A fundamental issue of too much leverage across many credits is emerging, largely because of pensions."
The report added to growing concern among buyside analysts that pension related risks may outweigh improvements in municipal credit quality since the Great Recession.
"Funding ratios have not improved as much as might have been expected with rising stock and bond prices," John Donaldson, director of fixed income at the Haverford Trust Co., said in an interview on Wednesday. "The changes to actuarial mortality tables have proven to have a larger impact than the substantial improvement in asset values since the bottom in 2008/2009," he added. "Those municipalities with the largest gaps cannot afford to delay funding."
Of the municipal issuers Moody's rates, more than 20 suffered downgrades in excess of four notches last year, which resulted in an increase among local governments with speculative ratings to 0.8% at year-end 2015 compared to 0.4% at year-end 2011.
School districts rated by Moody's now have 19 issuers in speculative grade territory versus 10 in 2014. The recoveries for the few Moody's-rated local governments that have defaulted or filed for bankruptcy have trended lower as well, the survey says.
The good news is this has occurred in the midst of an overall improving credit quality landscape. Most municipal credits have stabilized since the Great Recession – "albeit at lower levels of resilience," Medioli said in the survey.
"Most municipal governments adapted to the recession by making significant budget adjustments, tapping reserves, or other hard decisions as necessary," he said. "Tax bases and fund balance reserves have broadly recovered to pre-recession levels, and in some cases strongly so."
That doesn't remove the risk in the municipal market, Medioli said.
For instance, the Penn Hills, Pa., School District and Griggs County, N.D., were among municipalities that received multi-notch downgrades – both to B3. Penn Hills was issued a negative outlook and Griggs County a developing outlook. The Lindenhurst, Ill., Park District was dropped to B2 with a positive outlook.
The four entities that defaulted last year included Dowling College in Long Island, N.Y.; Cook County, Ill., single family mortgage revenue bonds; the Puerto Rico Public Finance Corp., and Cardinal, Ohio, Local School District.
Dowling, which had $57 million in total debt outstanding, was rated Ca by Moody's when it decided to close its doors earlier this month after 48 years due to the financial pressures that led to its downgrades.
The existing Ca ratings and negative outlook on the Series 1996 and 2002 bonds continue to reflect Moody's expectation of modest recovery based on Dowling's very limited unrestricted cash and investments through fiscal 2015.
Weak market performance of many pension trust funds has been compounding the situation, which will cause annual pension contributions to rise, adding to budgetary pressure, the Moody's survey said.
"The combination of deferred maintenance and other costs, an uneven recovery, and growing balance sheet leverage from pensions has fostered a 'new normal' of fragile budgetary balance and rising fixed cost charges," the report said.
"We believe pensions are among the biggest risks for many municipalities," David Litvack, managing director and head of tax-exempt research at U.S. Trust, Bank of America Private Wealth Management.
"Some governments do not contribute enough to their pensions, and even when governments do pay the full actuarially-required contributions, their pensions can still become underfunded if the investments fail to meet aggressive return assumptions," Litvack said.
Recent reports on pensions have presented similar views.
The Manhattan Institute for Policy Research said in a March report that funding deterioration, higher risk profiles, unreasonably high rate-of-return assumptions and even social activism have contributed to a $1 trillion shortfall in public pension plans that is rooted in poor governance.
The shortfall jeopardizes retirement security, according to the think tank.
In Chicago, the municipal employees' and laborers' pension funds further eroded over the last year with another $3 billion of unfunded liabilities being dumped on to the city's pension tab, according to new 2015 actuarial reports released this month.
The funds' worsening conditions and bleak prospects mean they are both headed toward insolvency in the next decade.
These and other concerns are what fuels the volatility in the municipal market over pensions, sources said.
"The threat is that municipalities remain complacent," John Mousseau, director of fixed income at Cumberland Advisors said in an interview on Wednesday.
"The pension itself isn't in default until a payment is missed – that won't stop the rating agencies from downgrading severely if they get close to pay as you go," Mousseau said. "The issue is that political infighting reinforces the inertia that is now happening on reaching solutions," he added.
Medioli of Moody's said despite some improvements in overall credit quality in the municipal sector as whole, the rating agency sees "no sign the long-term forces pressuring the public sector have abated."
