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Municipal Bonds

Voters decide measures affecting state revenues

Municipal Credit Research Team
Experienced sector specialists represent one of the industry’s largest credit research teams dedicated to municipal investing.
vote sign

While credit quality remains solid, new inflationary pressures spurred many states to consider ballot measures related to revenues and financial management in the November election. Voters across several states weighed in on initiatives impacting taxes and reserves, while others approved additional budgetary flexibility and legalized recreational marijuana.

Highlights

 

Credit Report

States pass various revenue measures

Credit quality for state and local governments remains solid. Through the first half of 2022, total tax revenue collections were 13.6% higher when compared to the first half of 2021. Tax revenues across all categories are up and
governments are still benefitting from federal stimulus funding granted in the American Rescue Plan Act (ARPA), which can be used for a broad spectrum of expenditures.

So far, an estimated $110 billion of the total $350 billion allocated has been spent, and approximately $30 billion of ARPA funds have been obligated. Governments have until 2024 to obligate the funds and until 2026 to spend their allocation. Municipalities that apply these funds to onetime expenses rather than use them for revenue replacement will face less cliff risk as the funds are spent down.

Although revenue growth and ARPA funding are both stabilizing budgets now, new inflationary pressures spurred many states to consider ballot measures related to revenues and financial management in the November election. Voters across several states weighed in on initiatives impacting taxes and reserves, while others approved additional budgetary flexibility and legalized recreational marijuana.

Voters in California rejected an amendment to raise the tax on personal incomes above $2 million by 1.75% to fund zero-emission vehicle projects and wildfire prevention programs. In Massachusetts, a proposal imposing a new 4% tax on incomes over $1 million passed narrowly. In contrast, Colorado voters approved a reduction in the state income tax from 4.55% to 4.40%. Maryland and Missouri voters approved measures legalizing marijuana, while voters in Arkansas, North Dakota and South Dakota rejected similar proposals. In South Carolina, voters approved a constitutional amendment incrementally increasing the general fund reserve fund balance target to 7% of revenues. Voters in New Mexico and Idaho approved measures to increase education funding.

New inflationary pressures spurred many states to consider ballot measures related to revenues and financial management.

 

Illinois and Tennessee voters approve opposite right-to-work measures 

Illinois voters approved a constitutional amendment guaranteeing employees’ right to unionize and collectively bargain in the November election. The Workers’ Rights Amendment confirmed a fundamental right to organize and affirmed the state may not pass any future law that interferes with, or diminishes, employees’ ability to negotiate wages, hours, conditions of employment and workplace safety.

The amendment essentially prevents future lawmakers from ever making Illinois a right-towork state. Illinois Governor JB Pritzker, who easily won re-election, and numerous union groups supported the change. Proponents argued that stronger protections for workers’ rights would support higher compensation and better benefits for all unionized employees. Detractors asserted the future cost of more expensive union contracts would ultimately increase property taxes, pushing businesses and residents across state lines. Many states constitutionally protect collective bargaining rights, but approval of the measure makes Illinois the only state to constitutionally prohibit future right-to-work laws.

In contrast, Tennessee voters approved an opposite measure. The recently passed right-to-work amendment makes it unlawful to deny employment based on a person’s membership in, or refusal to join, any labor union or employee organization. Tennessee was already a right-to-work state, but voter approval of the amendment elevates the provision to the constitution, rather than just state code. Labor unions strongly opposed the plan, while some business leaders asserted it will make the state more business friendly. 

The impact of these amendments will take years to assess, although drawing a direct line between future labor costs or tax increases and these constitutional amendments is unlikely to be definitive.

Electric power sees increasing demand and costs

The electric power industry faces challenges, as states, market regulators and investors balance the impact of extreme drought and hotter temperatures driven by climate change; higher fuel prices driven by Russia’s war in Ukraine; and the transition away from fossil fuels toward carbon-neutral power sources. All these factors threaten the delivery of reliable power, particularly in the western states. This summer was a particular challenge.

Earlier this year, there were significant concerns that California might see rolling blackouts as it did in 2020, which was the first time in 19 years. California has seen significant retirement of fossil fuel generation, and the state’s hydro production was projected to be down approximately 50% because of the mega drought in the Southwest. At the same time, summer temperatures have risen an average of 3 degrees Fahrenheit since 1896. Labor Day weekend presented an enormous strain on the system, as an extreme heat wave led to higher power consumption, particularly in the evening when solar power production declines but power usage remains high.

Despite hitting record power demand, the state ultimately avoided large scale rolling blackouts, thanks to calls for conservation and other demand response programs, as well as imports of power from other markets. California will continue to face challenges as demand is expected to increase with the widespread adoption of electric vehicles and because the state seeks to decarbonize the grid by 2045.

PREPA litigation could have broader implications for the municipal market.

While the power market faces record heat and drought, Russia’s war in Ukraine and higher demand for natural gas have caused power prices to rise considerably. Residential retail prices for electricity rose 14.3% over the 12 months through August 2022, according to the Energy Information Administration (EIA). Net generation has been flat, but natural gas consumption has continued to rise (up 9%), while coal consumption has dropped (down 14%), reflecting continued coal retirements and natural gas’ better pairing capabilities with intermittent solar and wind power.

While prices for natural gas as well as for electricity have risen, municipal electric utilities are generally able to pass these costs through to customers. Many utilities have power cost adjustments included in their rate structures, so costs are passed along automatically. In addition, municipal utilities generally have adequate liquidity that allows them to absorb a temporary spike in fuel costs before those costs are reflected in rates.

 
Puerto Rico bond reorganization continues

Following the breakdown of mediation in mid-September, Puerto Rico Title III bankruptcy Judge Swain issued a series of orders:

Puerto Rico Electric Power Authority (PREPA) litigation could have broader implications for the municipal market. At issue is the bondholders’ lien on PREPA’s electric system revenue, which secures the bonds. PREPA bonds are technically special revenue bonds – that is, bonds issued by a government for the provision of transportation, utility or other services.

928(b) of the Bankruptcy Code provides that the lien on special revenue continues to apply to revenue acquired by the debtor after the beginning of the bankruptcy case. Despite this, the Oversight Board contends that bondholders do not have a claim on future PREPA revenues, and instead simply have a lien on monies already collected by PREPA.

A decision on this issue is not expected until the spring of 2023. However, the judge may never rule on the special revenue lien question if parties reach a consensually negotiated settlement to adjust PREPA’s obligations ahead of a decision.

Hurricane Ian impacts state/local governments and sectors

Hurricane Ian, a Category 4 storm, made landfall in the Cape Coral/Fort Myers Metropolitan Statistical Area on 28 September. The storm’s slow pace and path through numerous expensive housing markets in southwest Florida magnified damage. Compared to Hurricane Charley, which made landfall in southwest Florida as a Category 4 storm in 2004, Ian was much larger and moved at a slower pace across the state. The final tally of damage from Ian is likely to make it one of the more costly storms in the state’s history.

Local governments and households across Florida will face challenges from substantial unbudgeted cleanup and rebuilding costs. However, long-term credit impacts are likely to be muted for municipal bond issuers since much of this cost will ultimately be covered by the Federal Emergency Management Agency (FEMA), the state and insurance proceeds.

As of 01 November, more than $1.7 billion in federal grants, disaster loans and flood insurance payments had been provided to the state of Florida and to households to help in the recovery after the hurricane. The state received approval for 100% FEMA reimbursement for the first 60 days of the disaster period for debris removal and emergency protective measures.

At this early date, state agencies in Florida estimate that they’ll spend approximately $1.8 billion to fund disaster recovery efforts. The state has sufficient liquidity to fund these upfront costs and cover expenses in advance of FEMA reimbursements. The State Treasury had $52.9 billion in state funds available to cover expenses as of 30 September.

Florida has sufficient liquidity to fund upfront costs and cover expenses in advance of FEMA reimbursements.

The Florida Hurricane Catastrophe Fund is a state trust fund that provides reinsurance coverage for hurricane-related damages to private insurance companies and to Florida Citizens Property Insurance Corporation (CPIC), which is the public, state-run property insurer for residents unable to obtain coverage from the private market. Both the Catastrophe Fund and Citizens Property currently have municipal bond debt outstanding ($3.5 billion and $275 million, respectively) and will have to pay sizable insurance claims in the near term.

Even though the full extent of the monetary damages caused by Hurricane Ian will not be known for some time, there is little concern over the ability of the Catastrophe Fund or Citizens Property to cover its share of claims liabilities. The Catastrophe Fund has about $16 billion of claimspaying resources for the 2022 hurricane season. Citizens Property has reported total claims-paying capacity of $13.6 billion. Based on current modeled losses, these two state entities do not believe assessments on policyholders or financing through the issuance of bond debt will be needed.

In addition to the state and local governments, several other municipal credit sectors were impacted by Hurricane Ian:

Healthcare/senior living. It’s estimated 16 hospitals were evacuated throughout the state due to the storm. A total of 8,000 patients were evacuated from 47 nursing homes and 115 assisted living facilities. The most serious credit impact was felt at Lee Memorial Health System, which experienced severely reduced water pressure at several of its hospitals. Many of the Health System’s patients were evacuated to other hospitals in south Florida. All hospitals quickly regained power and the Health System reported no structural damage to any of its facilities.

No new credit concerns have emerged for Florida higher education institutions.

Typically, FEMA funding and insurance covers much of the business disruption. No other hospital or health system has reported material problems from the hurricane. Many retirement communities were affected by power outages, but they had generators and did not need to evacuate. Only one, Mayflower Retirement Center, reported lasting damage to its facility.

Charter schools. Charter schools in the Fort Myers and Naples areas generally reported minor damage and were closed for a limited time after the storm. Building repairs for charter schools are largely expected to be covered by insurance. A more significant concern is student displacement and loss of enrollment, as was the case with certain charter schools in Texas and Louisiana following Hurricane Harvey in 2017. The state is likely to enact hold-harmless provisions for any enrollment losses due to the hurricane.

Higher education. No new credit concerns have emerged for Florida higher education institutions. The University of Tampa and the University of South Florida were fortunate and emerged with minimal damage. Bethune-Cookman, an HBCU located in Daytona Beach, seems to have sustained the most significant damage from wind and flooding. Florida Gulf Coast University in the southeast area of Fort Myers reopened after a two-week closure.

Figure 1: Muni treasuries table
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Endnotes

Sources

Moody’s State Debt Medians; Moody’s Report: “Federal aid, insurance proceeds and liquidity mitigate Hurricane Ian’s costs”; NYT (via Bloomberg): “How Hurricane Ian Compares to Charley, Another Southwest Florida Storm”; State of Florida Division of Bond Finance: Hurricane Ian Update; Florida Health Care Association

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Investing involves risk; principal loss is possible. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Bond insurance guarantees only the payment of principal and interest on the bond when due, and not the value of the bonds themselves, which will fluctuate with the bond market and the financial success of the issuer and the insurer. No representation is made as to an insurer’s ability to meet their commitments.

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