Which muni bonds are at risk? The ones from states with outsized pension debts.
Rent strikes. Moratoriums on foreclosures. A collapse in the tax revenues that support municipal bonds.
The suppliers of capital—landlords, banks, bondholders—are about to experience some unpleasantnes. This report will look at prospects for the third group, savers who lend money to states and municipalities. To give away the ending: Tax-exempt bonds are dangerous.
So far into the 2020 recession, distress in the muni bond market is scarcely discernible. There was a moment of panic in March, but it was quickly over when the Federal Reserve stepped in to bid up the short-term paper of states and cities. Municipal bonds are currently fetching high prices, an average 12% premium over par value in the Vanguard Tax-Exempt Bond index fund.
Those prices won’t last if investors wake up to the sickly state of state and local balance sheets. Government balance sheets, already unattractive before the pandemic, are truly frightening now.
It’s not just the funded debt, represented by the bonds in your tax-exempt fund, that weighs down on taxpayers. It’s the far larger amount owed to retirees. Teachers, police officers and firefighters must be paid, now and when they retire. When tax revenue is meager, those workers stand in line ahead of coupon-clippers.
That’s what happened in Detroit when it went bankrupt seven years ago. Bonds theoretically backed by a claim on tax revenue did not, in the end, have anything like a secured interest. The bonds were replaced with cash equal to 20% of par plus a promise of future payouts keyed to a revival of the city’s economy. In return for having $7 billion of debt erased in the bankruptcy, the city extracted from pensioners a give-up of cost-of-living adjustments.
A similar outcome is likely in Puerto Rico, where a pending settlement has holders of general obligation bonds getting a small amount of cash plus some new IOUs. The new IOUs will start out with perhaps a 30% haircut to par value. Once issued, they are likely to trade at a substantial discount to that depleted par.
States and cities were, at least until the virus came along, paying their bills. Cash flow was adequate. Indeed, as Moody’s notes in a somewhat optimistic review of their finances post-Covid, many of them had set aside rainy-day funds.
But look at the liability side of the balance sheets. Visible state and local debt adds up, in the latest U.S. Census Bureau accounting (based on fiscal 2017 data), to $3 trillion. Then there’s the hidden debt, in the form of pension promises.
Measuring pension debt is a complicated affair, and the rules give governments great leeway in fudging the numbers. States and cities discount future payments using their hoped-for returns on investments, nowadays typically in the neighborhood of 7%. At that rate, the dollar that California will be obliged to pay a retiree a decade hence has a present value of 50 cents.
Bad accounting, says Joshua Rauh, a Stanford University economist on a crusade to make taxpayers more conscious of pension costs. The pensioner is promised not whatever 50 cents grows to in the stock market but a dollar certain. And so, he says, the future payment should be discounted at the low rate on risk-free Treasury bonds. The lower the discount rate, the higher the present value of a future obligation.
Using wishful-thinking discount rates, state and local pension plans in California calculated that pension rights that had accrued as of 2017 came to a combined $1.1 trillion. Subtracting what was on hand in investment funds, government officials confessed to a shortfall of $309 billion.
Rauh redid the math, using Treasury rates. He arrived at $1.8 trillion for the 2017 value of future promises. In his computer the shortfall tripled to $991 billion.
Even that scary number isn’t high enough, given today’s bond market. I adjusted Rauh’s numbers for the 1.7-percentage-point decline in Treasury yields since the date of his analysis. California’s pension hole widens to $1.3 trillion.
New York is more responsible than most states about funding pensions, but its generosity takes a toll. (See Through New York, a watchdog for taxpayers, lists numerous retirees collecting more than $300,000 a year.) For 2017 the state plus its cities admitted to a $77 billion shortage. I’m estimating that using Rauh’s approach and applying today’s low interest rates would demonstrate a $410 billion hole.
For the whole country, I size up state and local pension obligations as exceeding pension assets by $5.3 trillion.
Big debts. Compared to what? Let’s compare them to the population of private-sector workers whose taxes will pay them off. Give California, New York, Illinois and the other providers of rich pensions the benefit of the doubt: Use February employment, when the economy was at full strength.
In California the combined burden of funded and pension debt comes to $118,000 per worker outside government. That’s about double what an average salary is in that prosperous state.
Put it this way: If California’s tax collectors confiscated two years of people’s earnings they would have just enough to pay off obligations accumulated to date.
Would California, could California, appropriate most or all of workers’ pay? Of course not. Productive citizens would move out. (They’re doing that already, when the top income tax rate is a mere 13%.) More probable: a Detroit-style restructuring of finances, in which pensioners give up a little something and bondholders give up a lot of principal.
Bankruptcy for states? That was suggested recently by Senate Majority Leader Mitch McConnell, in response to a plea from Illinois for a federal handout to help with its pension debt. There has been some federal aid to the states, and there will be more, but nothing like $5.3 trillion. Nor should there be. Why should taxpayers in Tennessee (burden per worker: $22,500) chip in for the lavish pensions awarded in Illinois ($108,100)?
As to the relative sacrifices to be asked of bondholders rather than pensioners: You can predict that most of the giving back will be by the former group. It’s politics. Bondholders don’t look deserving, not alongside firefighters and teachers.
If you have any doubt about how this is going to shake out, listen to the pronouncements from two people who have thought about the matter, neither of them the sort to be found at a down-with-capitalism rally.
Writing in City Journal, a publication of the conservative Manhattan Institute, Nicole Gelinas declares:
The longer Congress hesitates on additional aid, the more likely it is that New York would have to make the hardest decision of all: defaulting on its $7.5 billion worth of annual debt payments. If the choice is between maintaining basic public services and infrastructure or keeping current on debt payments, the answer is obvious.
The other comment worth citing is from Joshua Rauh, the Stanford economist with the gloomy view of pension funding. In a recent edition of Fox Business, he says: So what will happen if states don’t get bailout money? Their creditors might just have to take a hit, including the individuals who own over $3 trillion worth of municipal bonds.
Do you own any tax-exempt bonds from sickly states? Sell while you can still get a good price.
See Through New York is a service of the Empire Center for Public Policy that tracks government spending. Its eye-opening list of pension payouts can be found here.
This story about pension trouble appeared in Forbes Magazine 37 years ago. We could run the same article today by just making all the numbers bigger.
Conning evaluates state finances on behalf of investing clients, such as managers of insurance company portfolios. You can get its June 2019 State of the States report by going here.
The most recent survey of state and local pension funds by the U.S. Census Bureau can be accessed here.
— to www.forbes.com