Anyone following Municipal bonds has been subject to a barrage of bad news lately. Seems like each week we hear another story of state funding issues (New Jersey, Connecticut and Illinois come to mind). Wilshire Consulting recently issued a report which analyzed U.S. states’ pension plan funding ratios and the results look worrisome (Reuter's article). Despite a strong equity market state pension funding ratios fell 4% to 69% last year. It is the second consecutive year the funded ratio dropped by 4% and the first year since 2010 that the aggregate funded ratio is below 70%. Despite the many negative headlines on municipal debt, low historical default rates make munis an attractive tax-advantaged option. Still investors should be concerned with headline risk related to credit quality and may consider swapping local government GO (general obligation) bonds with outsized pension obligations for revenue bonds, given the stronger relative security and credit profile in addition to a lower level of spread volatility and downgrade risk.
Although limited data exists on defaults (Based on Moody’s rated debt, the cumulative 10yr default rate for municipal issuers from 1970-2015 is very low at 0.15%), we have learned from the recent major bankruptcies (including Detroit, Vallejo,CA, Jefferson County,AL, San Bernadino,CA and Stockton,CA) that strong precedence exists for the special revenue pledge likely being considered “secured” in a Chapter 9 Bankruptcy. From these cases revenue generating bonds have been treated favorably and allowed debt service to be paid throughout the legal process. The legal issues raised during bankruptcy can be complicated and may vary from case to case but in general recent defaults have shown that pledged revenues from a revenue generating enterprise have been considered bankruptcy remote.
Revenue bonds are backed by dedicated revenue streams. The majority of revenue projects include toll roads, airports, mass transit systems and utilities such as water & sewer, gas and public power. Revenue bonds issuers also include not-for-profit hospitals and health care systems, both single family home mortgage and multifamily housing revenue bonds, higher education facilities revenue bonds, student loan revenue bonds, resource recovery revenue bonds, and pollution control and environmental facilities revenue bonds. Additionally, Revenue bonds have limited pension and OPEB (Other post-employment benefits) obligations. As such, revenue bonds have advantages over state GO bonds with large pension obligations. Interestingly with such advantages, I would expect Revenue bonds to trade rich to GO debt but of late we have seen better value in Revenue bonds. Currently AA Revenue bonds offer higher yields with less volatility1. Looking at exhibit 1, we see that for the better part of the year Rev and GO bonds yielded similar levels with Revenue bonds offering slightly higher yields. However starting early May GO debt has rallied more than Revenue bonds and now Revenue bonds offer roughly a 10 basis point advantage over GO debt. Similarly, looking at exhibit 2, we see that annualized volatility of GO and Revenue bonds have been nearly identical for the majority of the year but in May GO volatility has risen relative to Revenue bonds. Taken together we see higher yields with less volatility creating an attractive opportunity for Revenue bonds.
In summary, the advantages of Revenue bonds include limited pension and OPEB obligations with a dedicated revenue stream. Moreover historical precedence illustrates that revenue bonds are considered bankruptcy remote. With such credit advantages and limited pension obligations we feel like Revenue bonds offer some value relative to GO debt with bloated pension obligations. Additionally, in our opinion the yield advantage along with less volatility make Revenue bonds attractive.