Why Some Investors Are Rethinking State GOs

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PHOENIX – Investors should be rethinking what they think they know about states' general obligation debt after a turn for the worse in their credit, some analysts and portfolio managers said.

State credit ratings and outlooks took a beating in 2016, as the three largest rating agencies expressed concern about revenue loss, pension liabilities, and other difficult-to-solve problems that governments are wrestling with in many states. But while the rating agencies continue to consider the sector strong overall and large state GO deals continue to be very well-received by investors that had frequently been starved for supply, there is also a sense among some market participants that the landscape has shifted.

Since the beginning of the third quarter of 2016, Moody's Investors Service upgraded Hawaii to Aa1 from Aa2, but downgraded Alaska to Aa2 from Aa1 and New Mexico to Aa1 with a negative outlook from Aaa. The agency also took a negative review action on Mississippi. All told Moody's has negative outlooks on 11 states.

Since October, S&P Global Ratings has downgraded New Mexico, Illinois, and New Jersey. On Wednesday S&P cut its outlook to negative on a 10th state, Connecticut. Fitch Ratings has three states on negative outlook and a fourth on rating watch negative

While some credit struggles, such as those in Alaska, are very specifically tied to the sluggish energy industry, others are more systemic and affecting many states.

"A few states are struggling to balance their budgets for the current and/or next fiscal year, and some are drawing upon reserves to close budget gaps," Moody's said in a late October report. "State debt levels remain mostly static, while pension liabilities have begun to rise again due to poor investment returns."

Marilyn Cohen, chief executive officer at Los Angeles-based Envision Capital Management, said she believes the rules about state and locality GOs have changed from those she learned earlier in her career.

"There's been a big tectonic shift," Cohen said. "No longer are general obligation bonds the holy grail like we were taught."

Cohen said she believes that many states are going to see their debt ratings continue to slide if they do not alter their behaviors, and that years of deferring dealing with pension costs are going to catch up with more and more GO issuers.

"The chickens have come home to roost," said Cohen. "It's not going to get better with the states and cities and counties conducting business as usual. Finally the rating agencies are not going to stand for it.

"2016 will look like a party," she added. "2017 will look like a funeral."

Cohen said that recent major issuer GO defaults have largely been dismissed by the public as just very peculiar confluences of events, such as the long-term systemic problems in Puerto Rico or the collapse of the traditional automobile manufacturing that powered Detroit. And while she said she agrees that it's hard to envision a U.S. state choosing not to make a GO payment, she said the negative trend in place is enough that she no longer advises GO-heavy portfolios and instead looks to some high-quality revenue bonds and other instruments instead.

"It's somewhat unthinkable that a state wouldn't pay," she said. "But do you want your customers to hold bonds that are on the slippery slope? You don't want a whole portfolio of them, and you don't want 50% of your portfolio in them."

Tom Schuette, a partner and co-head of investment research and strategy at Gurtin Municipal Bond Management was less dire, but agreed that investors should be thinking seriously about the state debt they hold.

"Pensions and Medicaid are consuming more and more of overall state spending, while revenue trends have stagnated and relatively broad-based anti-tax sentiment make material revenue increases difficult to stomach for many elected officials," Schuette said. "We think investors do generally need to be more cautious and understand what they own and closely monitor the fiscal decisions states are making. States that are unwilling to make difficult choices now could end up looking a lot like Illinois or New Jersey in the not too distant future."

Schuette said his firm believes this is a sector that many have treated with a "broad brush" in the past, assuming that all states were safe and the sector's strength guaranteed quality. Now, he said, investors need to be doing their homework as states may be facing similar broad challenges, though each is dealing with their unique fiscal outlooks differently. Even strong highly-rated states have concerns, he added.

"Investors should be concerned that even healthy states will ultimately push their problems downhill," he said. "So investors need to be aware of the knock-on effects of increasingly tight state budgets. Even very solid states are contending with a crowding out effect where pensions, Medicaid and other fixed costs are clearly competing with higher education, K-12 and local aid for resources. That will have consequences for local governments that are ill-positioned to withstand such cuts."

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