At least one demographic is yet to trumpet the end of the recession: local governments.
Despite signals everywhere that the economy may be emerging from the doldrums, Phil Villaluz, municipal strategist at Advisors Asset Management, thinks it’s still time to play it safe.
Investing in local government general obligation debt on the premise that the recession has ended is a mistake, he said. He believes local government tax revenue is in for a rough year or more, even if the recession is over. The reason: local governments’ finances famously trail the broader economy at a lag of a year to a year and a half.
Meanwhile, Villaluz suggests keeping money in bonds secured by vital services people use in any economy — sewer systems, water systems, toll roads, and public transportation networks.
The revenue streams produced by essential services can insulate investors from the squeeze plaguing local governments’ budgets, according to Villaluz.
The economy in the third quarter grew for the first time in more than a year, the Commerce Department announced last week. The Standard & Poor’s 500 index is up 16% for the year, oil is above $80 a barrel, and the yield on the 10-year Treasury note has rocketed up more than 130 basis points since the beginning of 2009.
Not much is budding for local governments, though.
Local governments collected just $108.56 billion in taxes in the second quarter, according to the Census Bureau, down from $111.64 billion in the second quarter last year. That was the first annual decline since 2000.
Property tax receipts plummeted 14.5%, the sharpest drop since at least the late 1980s.
If history is any indication, Villaluz warns investors in local government debt to gird for more pain and turbulence even if the economic recovery is for real.
The reason is that property tax receipts are slow to recognize that a recession is over. More than 70% of local government tax revenue comes from property taxes, whereas states collect most of their revenue from income and sales taxes.
The twist in local government finance is that property tax rates are assessed on old property valuations.
When property values bounce back up, the tax assessor does not know it until after the next revaluations. That means property taxes can continue shriveling even with an economy back on track.
“You’re going to have lingering effects of that downturn translate into weaker tax revenues for those underlying municipalities,” said Villaluz, who has 18 years of experience in investing, his latest stint at Merrill Lynch & Co. “They’re going to be slow to catch up to that rebound.”
Villaluz champions essential-service revenue bonds as the solution. Many of these issuers are integral to their communities, freely set their own rates, and face little or no competition. He looks for essential-service providers in developed communities with strong debt-service coverage ratios, unrestricted cash reserves, and manageable debt burdens.
Villaluz offered a handful of examples in California — the California Department of Water Resources’ power supply and water supply revenue bonds, the Los Angeles Department of Water and Power, the Bay Area Toll Authority, and Bay Area Rapid Transit.
“It’s these types of what I would say not-so-sexy credits out there that have become a focal point and have become very interesting to bond investors,” Villaluz said.
The best deals in this space are in longer-term debt, he said.
He estimates yields on double-A water or sewer bonds at around 4.63% with terms longer than 22 years, compared with 4.66% for local general obligation credits at that maturity.
That means investors can gain almost as much yield for what Villaluz considers less volatility and more safety.
The advantage diminishes on short-term debt. He estimates yields on water and sewer bonds in the seven-to-12-year range at around 3.3%, compared with 3.68% for local GO credits.