Tag Archives: Municipal bonds

Debt, dope and casinos: Chicago is circling the drain, by Simon Black

All that’s left for Chicago is the bankruptcy filing. From Simon Black at sovereignman.com:

While the federal government is slowly careening toward permanent, fiscal disaster, many state governments (which don’t have the power of the printing press) are already staring into the abyss…

Take Illinois, for example. It’s the most broke state in the US with nearly $250 billion in debt. And it only brings in enough in taxes each year to cover 92% of its expenses… so the problem is getting worse.

Good thing Rahm “you never want a serious crisis to go to waste” Emmanuel is the current Mayor of Chicago. You may remember, the above quote was from Rahm’s days as Obama’s Chief of Staff, as told to the Wall Street Journalduring the depths of the Great Financial Crisis…

What followed was the greatest monetary experiment known to man.

Now Rahm has another crisis on his hands – Chicago’s woefully underfunded pensions. And he’s reaching into his old bag of tricks.

Governments can only kick the can down the road for so long. Eventually, they’ve got to make some tough decisions – like who they’re going to default on. Despite the promises made by certain political representatives, it’s impossible for everyone to have everything…

And today, Rahm must choose…

Either Chicago defaults on the pension promises it’s made to city workers or it defaults on its massive debt. It’s simple arithmetic.

Rahm, it seems, has chosen the latter.

Continue reading

The Dirty Dozen Sectors of Global Debt, by Jonathan Rochford

This is a very good survey of the diciest corners of the international credit markets, the ones most likely to start the global credit crisis that nobody will see coming. From Jonathan Rochford at narrowroadcapital.com:

When considering where the global credit cycle is at, it’s often easy to form a view based on a handful of recent articles, statistics and anecdotes. The most memorable of these tend to be either very positive or negative otherwise they wouldn’t be published or would be quickly forgotten. A better way to assess where the global credit cycle is at is to look for pockets of dodgy debt. If these pockets are few, credit is early in the cycle with good returns likely to lie ahead. If these pockets are numerous, that’s a clear indication that credit is late cycle. This article is a run through of sectors where I’m seeing lax credit standards and increasing risk levels, where the proverbial frog is well on the way to being boiled alive.

Global High Yield Debt

Last month I detailed how the US high yield debt market is larger and riskier than it was before the financial crisis. The same problematic characteristics, increasing leverage ratios and a high proportion of covenant lite debt, also apply to European and Asian high yield debt. Even in Australia, where lenders typically hold the whip hand over borrowers, covenants are slipping in leveraged loans. The nascent Australian high yield bond market includes quite a few turnaround stories where starting interest coverage ratios are close to or below 1.00.

Defined Benefit Plans and Entitlement Claims

For many governments, deficits in defined benefit plans and entitlement claims exceed their explicit debt obligations. The chart below from the seminal Citi GPS report uses somewhat dated statistics, but makes it easy to see that the liabilities accrued for promises to citizens outweigh the explicit debt across almost all of Europe.

In the US, S&P 500 companies are close to $400 billion underfunded on their pension plans. This doesn’t seem enormous compared to their annual earnings of just under $1 trillion, but the deficits aren’t evenly spread with older companies such as GE, Lockheed Martin, Boeing and GM carrying disproportionate burdens.

Latest forecasts have US Medicare on track to be insolvent in 2026. At the State government level Illinois ($236 billon) and New Jersey ($232 billion) both have enormous liabilities, mostly pension and healthcare obligations. If you want to understand how pension and entitlement liabilities have grown so large, my 2017 article on the Dallas Police and Fire Pension fiasco and John Mauldin’s recent article “the Pension Train has no Seatbelts” are both worth your time.

To continue reading: The Dirty Dozen Sectors of Global Debt

Neither a Borrower Nor a Lender Be, by Robert Gore

In a debt deflation, you do not want to be in debt. Income and liquidity with which to service your debt shrinks. Deflation increases the real burden of repayment, the opposite of inflation, which devalues the means of repayment and thus works in favor of the debtor.

You do not want to be a creditor, either. There are two risk components of interest rates: rate risk, the risk that rates in general rise, and credit risk, the risk that the borrower does not repay. While interest rates for the most creditworthy borrowers may stay low, for any borrowers for which there is even a hint of doubt about ability to repay, the risk premium over perceived riskless debt rates widens and the interest rate skyrockets. Widening risk premiums and skyrocketing interest rates adversely affect the price of the underlying debt, inflicting losses on creditors. If the borrower defaults, the loss can be the entire investment.

Risk premiums have already widened significantly on the debt of natural resources companies and for emerging market governments and companies. They are nowhere near the levels reached in the last financial crisis, so it is not too late to sell, because they will probably attain and surpass those levels.

Turning to other debt, there is no better candidate for sale than municipal bonds. Such debt is an investor favorite because most municipal interest is either tax-advantaged or tax free. Historically, default rates on municipals have been low. However, if the stock market knows what it is talking about and the economy is heading into a recession or worse, state and local governments’ income, property, and sales tax collections will be reduced, just as they were during the last crisis. The demand for services, particularly the social safety net and policing—crime increases during economic downturns—will increase. Revenues down and spending up means that the ability of governments to pay their debts deteriorates.

There’s another consideration. A significant portion of governments’ pension and medical liabilities are unfunded. Estimates of the aggregate state and local shortfall range from $1 to $4 trillion. With a shrinking economy, governments will have less money to either make current payments into pension and medical funds or make up for past shortfalls. Not only that, but those funds’ investment returns are plummeting. Low interest rates have been a problem, but now they must contend with falling equity markets, too. Diminishing revenues, increased demand for government services, huge unfunded liabilities which are only going to get bigger—selling municipal bonds is as close to a no-brainer investment decision as the financial markets are ever going to hand you.

The case for selling corporate bonds is almost as compelling. There are a few triple A, gold-plated corporate credits that can probably survive anything short of the destruction of the planet. They will be in such demand that the interest they pay will be minimal. The vast majority of corporations will be operating in a shrinking economy, and that means shrinking revenues, profits, and ability to service their debt.

The dirty secret of the latest bull market is the games companies have been playing with their own stock. Stock bulls constantly point to cash on corporate balance sheets and rising earnings per share as reasons to buy. What they don’t point out is that many corporations, in the name of “shareholder friendliness” have either been spending the bulk of their profits, or all of their profits and going into debt, to buy their own shares and pay dividends. That balance sheet cash is borrowed and the rising earnings per share are because the share count, the denominator in earnings per share, has shrunk. In many cases gross revenues and total profits have been stagnant or declining.

The low interest currently being paid on most investment-grade (BBB or better) municipal and corporate bonds offers little compensation for their rising credit risk, making the decision to sell that much easier. While the credit rating agencies have their gradations for the creditworthiness of various bonds, the market often applies a simpler test: is a bond going to pay or not? If it decides payment is in doubt, the market quickly and substantially marks down the price of the questionable bond, leaving holders no way out without hitting fire sale bids and sustaining painful losses.

This analysis applies to municipal and corporate bonds only. The day will come when markets question the creditworthiness of US government bonds and debt securities with US government guarantees (they certainly should), but we’re not there yet. For the time being, the US government’s debt and guarantees are regarded as the benchmark of creditworthiness and that will probably continue for a while. We will know things are changing when interest rates on government debt show a sustained increased in the face of economic contraction and deflation.

During the last financial crisis and recession, many municipal and corporate bonds were subject to precipitous drops. Even as the crisis unfolded, most investors found it inconceivable that stalwart industrial and financial companies would go bankrupt or require government rescues, but they did. This time the window for selling corporate and municipal bonds is still open, but once the herd realizes that financial turmoil and economic contraction will impair the ability to pay across broad swaths of the bond market, it will snap shut.


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She Said That? 6/20/15

From Moody’s municipal credit analyst Rachel Cortez:

Help me understand why Chicago is different than Puerto Rico?

The Wall Street Journal, “Chicago Isn’t Moody’s Kind of Town,” 6/19/15

Ms. Cortez asked her question during a February 2014 meeting attended by Chicago Mayor Rahm Emanuel. Ratings agencies have traditionally accepted municipalities’ rates-of-return assumptions on  their pension funds in evaluating the unfunded liabilities of those funds. The returns assumed for many funds, including Chicago’s, are unavailable for safe investments in today’s markets, and in fact are high by a wide margin. By using more realistic return assumptions, Moody’s increased its estimate of Chicago’s unfunded liability and downgraded the city’s debt to below investment grade, or junk. Pensions are the hair in the hot dog of municipal debt. They have crippled or bankrupted several municipalities and will do so to scores more. Moody’s concern is justified, especially after it and the other ratings agencies failed to see the housing debacle coming until way after it arrived. What has Moody’s gotten for its new-found probity? Chicago has dropped it from rating its bond deals, and other municipalities are considering doing the same.