Last week, Senate majority leader, Mitch McConnell, raised the idea that states should be enabled to file for bankruptcy. Instead of viewing the Senator’s comments as a negotiation tactic over a future aid package, municipal investors logically reacted with fear. The resources and operating flexibility of states does give them the strength to overcome the financial challenges wrought by the pandemic, but not without significant cuts to safety net services and education budgets. While all states are not equal from a credit perspective, we view investors’ fear as unfounded.
During this national crisis, the Federal government has already passed the $2.2 trillion CARES Act (Coronavirus Aid, Relief and Economic Stability Act) and a $484 billion supplemental aid package for small businesses, hospitals, and broader testing. Current estimates place the size of the Federal fiscal deficit at approximately $4 trillion (or nearly 20% of gross domestic product [GDP]), a record in the post-War era. Senator McConnell’s remarks come as Congress has begun grappling over another aid package, this time for states.
Beyond fiscal support, the Federal Reserve (Fed) has initiated a broad range of stimulus measures which include interest rate cuts, quantitative easing, and liquidity support. Included in these Fed programs are provisions allowing the purchase of Corporate bonds, non-recourse lending for the purchase of qualifying Asset-Backed Securities and Commercial Mortgage-Backed Securities, and a $500 billion short-term loan pool for states and large counties and cities.
The strength of these fiscal and Fed responses should come as no surprise. The U.S. economy is experiencing a severe contraction. Estimates for second quarter GDP center around an annualized decline of 40%. While the vast majority of citizens are sheltering-in-place and many businesses are shut-down, unemployment has sky-rocketed and consumer spending has declined at a record rate. State governments have been on the front lines in our national fight against the virus. Promoting the health, safety, and welfare of citizens has been job number one. The medical and economic costs of the crisis have been substantial, and they continue to grow.
In today’s hyper-partisan environment, the politicization of an aid package for states should not come as a surprise. It is difficult to perceive a state aid package during a national crisis as a reward for profligacy, but these times are not normal. The stakes are high. In aggregate for the current fiscal year, state budgets are $1.9 trillion. In the downturn, state revenues have contracted along with national economic activity, leaving budgets strained. The Center on Budget and Policy Priorities has estimated state budget shortfalls of at least $500 billion. States with the weakest finances, such as Illinois, have been among the hardest hit. We have avoided Illinois general obligation bonds for years.
Approximately $170 billion of aid from the enacted relief packages will help mitigate the impact of rising expenses incurred to fight the virus, rather than filling state revenue shortfalls. Just like the Federal government, many states have also pushed back due dates for taxes. In the absence of help, states have levers they can pull to balance their books. Laying off workers, cutting services, pushing service provisioning down to local levels of government, and raising taxes are all viable options. However, these options would only worsen an already-difficult situation, as states would be working directly against Federal stimulus. This raises the question: Should states be able to file for bankruptcy?
The concept of state bankruptcy was last floated in earnest in response to the 2008-09 Global Financial Crisis. It was quickly snuffed out then. Enabling state bankruptcy is complex and would likely require an amendment to the U.S. Constitution. Amending the Constitution requires two-thirds of votes at both the House and the Senate and ratification by three-quarters of states. States enjoy sovereign immunity and cannot be sued for the proper execution of its duties. Consequently, creditors could not sue to put a state into bankruptcy, it would have to be voluntary, if allowed at all. This is in stark contrast to corporate bankruptcy.
Presumably, a state could not oversee its own bankruptcy. However, federal oversight of such a process would infringe upon states’ sovereign rights. As a result, any action such as a Constitutional amendment would likely need to contemplate some ceding of state sovereign power. If a state was allowed to oversee its own bankruptcy process, the Constitution’s Contracts Clause would likely need to be amended. The Contracts Clause specifically prohibits states from unilaterally amending or invalidating their own contracts or obligations. This is the reason why Illinois has had such difficulty in reforming their pension obligations – they are treated as contracts. The opposite is true in New Jersey, where unaccrued pension benefits are not afforded contractual protections. Each state is different.
As mentioned earlier, enabling state bankruptcy would be complex, and we view it as a remote outcome. We also question the benefits that enabling state bankruptcy would provide. The vast majority of state expenses relate to service delivery. Think education, health, and safety. The median state’s debt service is only 4% of revenues. The worst state on this basis is Connecticut at 13%. We intentionally left pension and related retirement obligations for last. In past municipal bankruptcy proceedings, pensioners have typically enjoyed preferential treatment relative to bondholders. In all, it is difficult to see the practical savings of a bankruptcy filing. States can already actively manage their service delivery costs through the labor negotiations and levels of service. With pension benefits often treated as sacrosanct, this leaves debt holders on the hook, but the overall potential savings is meager. The savings would be even lower if one considered that a state would likely face elevated costs when trying to access the bond market. There would surely be consequences to willfully defaulting on your debt.
Today, we face unprecedented challenges as individuals, and as investors. While March’s historic volatility may have subsided, credit risks from the rapid plunge in the economy have taken center stage. Emergency aid is not a substitute for a resumption of normal economic activity, but it helps. Credits that rely on growth to remain solvent, those with narrow revenue streams, weak balance sheets, and those that operate on thin margins all face significant risks.
One irony in the commotion caused by Senator McConnell’s remarks is that we believe that it is a strength to align with states, the vast majority of which are currently on solid financial footing with significant flexibility to weather the crisis. Investors can benefit from these stronger states through several vehicles – State General Obligation or essential appropriation debt, state-supported school debt, bonds issued by land-grant universities, and bonds backed by state dedicated taxes are all good examples. Of course, aligning with the Federal government provides even greater strengths, but a narrower selection of sectors – pre-refunded securities and State Housing Finance Authorities. The vast majority of our recent purchases have been in these areas. We are cognizant that absent an effective treatment, or better yet, a vaccine, this crisis might be prolonged. As a result, we focus our investing in durable credits1 that will be able to withstand a long and deep contraction in the economy.
Opinions, forecasts, and discussions about investment strategies represent the author's views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations.
Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE IM-07883-2020-04-27 Exp. Date 07/31/2020
1 Obligations such as bonds, notes, loans, leases, and other forms of indebtedness, except for cash and cash equivalents, issued by obligors other than the U.S. Government and its agencies, totaled at the level of the ultimate obligor or guarantor of the Obligation.