Waddell & Reed Advisors Funds Market Perspectives – January 2012
MEREDITH WHITNEY’S LATE 2010 FORECAST FOR TURMOIL in the municipal credit markets and “hundreds of billions of dollars” in defaults certainly had an impact. Two months after the high-profile prediction, and with other pundits joining the chorus, so many jittery investors had bailed out of the muni market that borrowing costs rose to two-year highs in January 2011.
But rather than retreat, the muni market rallied. Measured year-to-date from Jan. 1 through Nov. 30, municipal bonds were up 8.63 percent as measured by the BarCap Municipal TR USD Index. The growth outpaced the broader bond market, which was up 6.67 percent over the same period as measured by the Citi USBIG Index, and equities, as measured by the Standard & Poor’s 500 Index, which were up 1.08 year-to-date.
The performance is at the far end of the spectrum from what Whitney and others predicted.
“I sort of laugh because it is funny if you look back starting with Meredith Whitney in November 2010 as well as many other pundits coming out and predicting the doom in hundreds of billions of dollars in muni defaults,” said Michael Walls, portfolio manager of the Waddell & Reed Advisors Municipal High Income Fund. “Most municipal bond professionals realized that the vast majority of governments would minimize other expenses, but continue paying their debts.”
Certainly, as there are every year, there were municipal defaults in 2011, including a couple that were high profile:
- On Oct. 12, the city council of Harrisburg, Penn., voted to seek bankruptcy protection after wrestling with $310 million in debt related to a trash incinerator project. Prior to the vote, the city had spent a decade battling with funding issues connected to an upgrade of the city’s incinerator.
- On Nov. 9, Jefferson County, Ala., filed for the largest government bankruptcy in U.S. history, with $4.2 billion in debts including more than $3 billion related to a sewer project. Reports noted that the county’s borrowing interest rates jumped in 2008 because of swap agreements in place during the financial crisis.
While both generated headlines, they were not a surprise to Walls and his Fund’s analyst team.
“These credits were distressed and that they got into these positions was no surprise,” Walls said. “These were not overnight scenarios. There were long periods of missteps, mismanagement and many other things that caused these credits to fail.”
Overall, municipal defaults for 2011 are projected around $2 billion. The Distressed Debt Securities Newsletter made some headlines in December predicting $20 billion in defaults using a broad measure that includes issues where no payments have been missed, but where the publisher said there may be defaults in the future. Even using the newsletter’s arguably inflated numbers, the totals would still be a fraction of what some predicted heading into 2011.
The pundits, Walls said, failed to realize that it is extremely difficult for a municipality to file bankruptcy, which is blocked by law in some states. Another major hurdle is that when declaring bankruptcy, a municipality must prove its insolvency in court – an extremely difficult step when they can raise taxes to generate additional revenue. Even if it is able to pass the legal requirements, the end result of a bankruptcy filing is a loss of access to credit markets that are critical to municipal finance because of the seasonality of tax revenues.
“There is only one group that does well in a chapter nine and it is the attorneys,” Walls said.
The process aside, Walls notes that muni doomsayers also did not take into account that many 2010 elections were won by candidates that ran on platforms of austerity and fiscal tightening. Although moves such as layoffs and service reductions may have a negative impact on local communities, from an investor perspective it frees up additional funds that can be used to meet debt payments.
Another factor that some critics may have overlooked is that, in many areas, conditions are showing some improvement.
“If you look at state and local tax receipts, they have consistently gone up throughout 2011, albeit you are not seeing a lot of growth, but it is consistent and we believe that you have seen the bottom,” Walls said.
Revenue from all sources, including taxes and fees, exceeded annual budget projections in 32 states during fiscal 2011, according to the most recent edition of the Fiscal Survey of States, which is published twice annually by The National Governors Association and the National Association of State Budget Officers. Compared against fiscal 2010 levels, personal income tax collections were up 9.7 percent in fiscal 2011, while corporate income tax collections were up 9.4 percent and sales tax collections were up 4.8 percent.¹
The report also notes that states have begun to replenish depleted “rainy day” funds. After peaking at $69 billion, or 11.5 percent of general fund expenditures, in fiscal 2006, reserve fund levels dropped more than half to $30 billion, or 4.6 percent of expenditures, at the end of fiscal 2009. Fiscal 2012 budget projections predict that number to rise to $41 billion in fiscal 2012, equaling 6.2 percent of planned expenditures.
Although, the report cautions that state budgets still remain below pre-recession levels and that there are some unknown issues on the horizon — most notably the economic recovery and potential cost increases related to health care — conditions are improving.
“In 2012, states appear on track for continued, at least moderate, financial improvement highlighted by increasing general fund expenditures, rising tax collections and the slow restoration of state rainy day funds,” reads the report, noting that if current trends continue, state budgets will stay on a “positive, albeit slow moving track.”
¹ Forty-six states begin their fiscal years in July and end them in June. Two operate on an October to September schedule, one is September to August and one is April to March.
The BarCap Municipal TR USD Index is an unmanaged index of securities representing the municipal bond market. The Citigroup USBIG Index is an unmanaged index of securities representing the broad U.S. bond market. The Standard & Poor’s 500 Index is an unmanaged index 500 widely held stocks that is generally considered to represent the U.S. stock market. It is not possible to invest directly in an index.
The opinions expressed in this article are those of the Waddell & Reed Advisors and its fund managers and analysts, and are not meant to predict or project the future performance of any investment product. The opinions are current through January 6, 2012, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed.
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