The Bond Ratings Game

By Corry Buckwalter Berkooz

There are some economic trends that municipalities don't want to be a part of — bankruptcy is an obvious one. Less evident is following the downward spiral of the municipal bond ratings of places such as Detroit; Stockton, California; Chicago; and Jefferson County, Alabama.

These economically distressed communities, and others like them, take a triple hit in hard times. First their finances dip — sometimes to the point of bankruptcy. Then their municipal bond ratings drop. Finally, their access to bond funding shrinks. Infrastructure projects become much more expensive, exacerbating the vicious cycle.

The practice of municipal borrowing is as old as the streets and foundations that cities are built on, but the first records of municipal bond issues in the U.S appeared in the early 1800s. It wasn't until the 1970s that loan defaults began to occur and the U.S. Bankruptcy Code was revised to allow for municipal bankruptcies.

Today more and more distressed cities and counties are taking advantage of the opportunity to file for bankruptcy protection under Chapter 9. While the default rate is less than one percent, and most municipal bonds are still viewed as solid investments, the bond ratings system does steer the process of infrastructure development.

To understand their potential impacts, municipal ratings need to be seen in context. There are steps that cities can take to improve their ratings, or at least maintain their good numbers for as long as possible.

Infrastructure engine

Because they are tax exempt, municipal bonds have been a decades-long strategy for states and local municipalities seeking to finance infrastructure construction and public capital improvements. Between 2003 and 2012, tax-exempt municipal bonds funded more than $1.65 trillion in infrastructure projects in the U.S., including the construction of hospitals, schools, public power utilities, airports, affordable housing, water and sewer facilities, and public transit and roads, according to a 2013 report from the National Association of Counties. In 2012, more than 6,600 tax-exempt bonds funded around $179 billion in infrastructure expenditures.

Taken as a whole, municipal bonds are relatively secure, according to most market analysts. "As of August 2013, less than 40 of the 7,500 municipalities rated by Moody's were classified as 'junk' bonds, while Assured Guaranty, a muni bond insurance firm, expects to take losses on fewer than 12 of the roughly 11,000 municipal bonds that it covers," according to a September 2013 article at municipalbonds.com.

An October 2013 report by the National League of Cities made a similar point, concluding that municipal bonds are still a good investment and are likely to keep selling well. The report says that 72 percent of city finance officers claim their cities were in better financial shape in 2013 than in 2012 and that despite a downturn in property taxes, general fund revenues showed a small uptick in 2013.

Yet Wall Street was jolted by the largest bankruptcy in U.S. history in Detroit last year. Investors panicked and municipal bonds experienced their worst annual performance since 2008, according to a Los Angeles Times editorial from January. Furthermore, expected interest rate increases are anticipated to be the greatest menace to municipal bond prices in 2014.

Despite market fluctuations, municipal bonds remain a critical aspect of funding projects nationwide. But how exactly do these infrastructure powerhouses work for cities, states, and counties?

Linking ratings and funding

A quick definition may be in order. Municipal bonds, also known as municipal securities, act as a promise by the issuers (usually state or local governments) to repay money borrowed, plus interest, according to a fixed schedule. Generally, municipal bonds are repaid, or mature, one to 40 years after they are issued.

"The municipal market is complex and diverse," says Lisa Washburn, managing director at Municipal Market Advisors, or MMA, an East Coast-based independent research company. "There are 55,000 unique issuers, all operating under their own state laws and tax structures that can offer different security pledges."

Most planning or infrastructure projects are funded through general obligation — or GO — bonds, which are securities to which the municipality commits its "full-faith-and-credit and taxing power." In the past, market analysts considered general obligation bonds the safest for investors, although that may be changing in a more distressed economy.

In contrast, revenue bonds do not require this public backing or commitment and are considered riskier investments. Since municipal bonds are held longer, on average, than other assets in the bond markets, they fluctuate more in reaction to interest rates.

Required for the sale of any major issue, a rating is simply an alphabetic or numeric symbol that shows a relative demonstration of credit quality. The three main rating agencies for municipal securities are Moody's Investment Services, Standard and Poor's, and Fitch. The highest rating for each one is AAA. The lowest grade for Moody's is Baa3 and S&P is BBB-.

A government's bond rating determines the lifetime cost of projects because the bond rating sets the interest rate that a locality will pay on money it borrows to pay for those projects. The higher the bond rating the lower the interest rate, and vice versa. A low bond rating means that a ratings agency determined the locality has a greater likelihood of default, and the required interest rate will be higher.

However, "the ratings agencies don't always move in lockstep," says Washburn. She notes that Moody's and Fitch have generally been less optimistic about municipal credit quality, whereas S&P has been more positive and has been raising a number of ratings recently. "We have seen both positive and negative changes on an issuer's rating, which makes it harder for non-credit professionals to understand if credit is improving or weakening," says Washburn.

One example is the $1.8 billion sewer bond deal in Jefferson County, Alabama, in November 2013. Barron's reported that Fitch issued a junk rating — questioning the program's potential to generate sufficient income — while S&P rated the notes as investment grade because the county had hired a county manager for the first time.

An MMA newsletter published in November noted that "new money issuance has held to roughly 1997 levels in the last two years, finally beginning to improve (up about nine percent) in 2013." The agency reports a projected increase of another 15 percent in 2014, which could fund $25 billion in additional infrastructure projects nationwide.

Still, there are numerous pockets of economically distressed municipalities with lower ratings, often in post-manufacturing zones. Are their depressed ratings hurting other cities and their ability to borrow?

Detroit: domino or island?

With $18.5 billion in debt and liabilities, and under pressure from the state, Michigan's largest city declared bankruptcy on July 18, 2013. U.S. Bankruptcy Court judge Steven W. Rhodes accepted Detroit's petition, enabling it to seek protection under Chapter 9 of the U.S. bankruptcy code in November. Detroit may now cut public pension benefits. Meanwhile, Moody's has given Detroit a junk grade rating since January 2009.

Right in step with Detroit's bankruptcy declaration, Chicago announced the next day that its rating would drop three levels to A3, four steps above junk grade with an overall debt of $18.7 billion, according to a recent Bloomberg article. Additionally, Illinois has the lowest credit rating for a state in the U.S. — a BBB rating from S&P — because of the state's $97 billion pension liability.

The question of how much Detroit's bankruptcy will affect other distressed municipalities, from Flint to Vallejo, is highly debated. Many analysts are downplaying the impact of Detroit's bankruptcy regionally and nationally.

"We need to put it in context," says Washburn. "All states have their own laws that govern entry into Chapter 9 and the ability to reform pensions, and the impact of court decisions may not easily transfer."

Even struggling Michigan communities are not necessarily borrowing for operations, as Detroit did. That "may make Detroit a more isolated case," says Bill Anderson, a staffer at Southeast Michigan Council of Governments, a nonprofit research organization that assists local governments.

"If anything will shake the financial market," says Anderson, it may be the way in which the Detroit emergency manager consolidated all forms of debt into one category, treating all equally. "They are taking bonds created in full-faith-and-credit and treating them like pension funds, which are created in limited faith, so that AAA bonds are treated the same as CCC junk bonds." This tactic could damage the rating system over the long haul, he adds.

Lisa Washburn agrees. "GO bonds have historically been considered the strongest tax-backed pledge and were given a ratings and pricing benefit as a result," she says. "Detroit has proposed treating the GOs as unsecured in bankruptcy and on parity with other general fund obligations, including those with lesser security pledges that are lower rated. If this treatment is upheld, it could impact current rating practices and have a negative impact on pricing for affected municipalities."

A lot depends on the strengths of the nearby communities.

Saginaw County, Michigan (pop. 198,353), located in the north central part of the state, includes both highly rated municipalities and lesser ones, according to Robert Belleman, controller and chief administrative officer of the county, which has a Moody's rating of AAA. He says the Detroit bankruptcy hasn't impacted his county's finances.

Shortly after Detroit declared bankruptcy, "we had $62 million for a pension obligation and went to price it on August 8, 2013," says Belleman. "There were fewer competitive buyers and the excess interest was too high for our original budgeting. We withdrew on the same day and have been monitoring it ever since to see where the interest rates are going."

Saginaw County has an advantage in being well-organized and ready to take advantage of opportunities in the municipal bond market when they come up, says Belleman.

Other Michigan communities aren't so lucky. The state's Revised Municipal Finance Public Act 34, adopted in 2001, was amended to allow municipalities to sell pension or OPEB bonds for a two-year period, which Saginaw is hoping to use before it expires in 2014, says Belleman. Yet municipalities must have AAA- or better credit ratings in order to qualify for the amendment provisions.

"A shortfall in this legislation is that municipalities that need help — such as Bay City and Pontiac — with new infrastructure projects, are not eligible to participate because they don't have the proper credit rating," he says.

Leaning on bondholders

Michigan cities are not alone in their struggles. Even sunny Stockton, California (pop. 296,000), has had its share recently.

Stockton is located in an agricultural area 80 miles east of San Francisco. Like Detroit and Jefferson County, Stockton plans to ask bondholders to take less than the principal they are owed in bankruptcy proceedings. Stockton filed Chapter 9 bankruptcy on June 28, 2012, and expects to maintain its pension obligations through tax increases and other measures. 

To exit bankruptcy, Stockton wants to impose a 0.75-cent sales tax increase, which was approved on a November 2013 ballot and is expected to raise $28 million yearly. The city refinanced $55 million worth of water debt in November as well. That move turned the bonds from variable to fixed rates, which made the city's ratings jump up to an AA- rating.

Stockton issued the bonds in 2010 to pay for the Delta Water Supply Project, a $253 million endeavor. Now Franklin Resources Inc., a lead bondholder, is owed $35.1 million. The city is offering Franklin the option of settling with the city or taking control of a park and two golf courses that were pledged as collateral, according to Stockton's website.

The city says that it can pay only $500,000 of the $2.9 million it owes every year on the water bonds.

Tight belts

Evan Williams, AICP, principal planner for Jefferson County, Alabama (pop. 660,009), says the county planning department staff has shrunk from 35 to 12 over the past two years in the wake of cuts made after the county filed for bankruptcy in November 2011. The county seat is the city of Birmingham, which is in rough straits financially.

"The biggest issue of the bankruptcy is the sewer debt," Williams says. "We will have a very limited capacity for expansion and will want to concentrate development in already built areas." Williams believes that sewer rates will soon be "skyrocketing" to pay off the bankruptcy. The initial Jefferson County deal included proposed sewer-rate increases of eight percent annually for three years and three percent in each of the next two years.

For a weakened tax base this is going to be "very tough on many abandoned areas in the city of Birmingham," Williams says. Jefferson County sold $1.78 billion of sewer system debt to pay off $3.1 billion of defaulted debt at around 54 cents on the dollar in November 2013.

Frederick Hamilton, Jefferson County's director of community and economic development, echoes Williams's concerns. "We came out of bankruptcy on December 3, 2013, and two years ago we had $12.5 million pledged to various projects in economic incentives, all of which were cancelled in December 2011."

Yet things may be turning around for the county: While tax abatements were cut by the county attorney in the bankruptcy process, by early December 2013 tax abatements were being renewed, and "people know that we are open for business again," says Hamilton. This can be tough for distressed areas, but there are some measures to keep bond ratings on the up-and-up, according to market analysts.

Bolstering bond ratings

"Some things are not directly controllable by a municipality, like the local economy for the most part," says Lisa Washburn. "But there are things that you can control, such as instituting forward-looking financial planning, including multiyear budgeting, and developing capital improvement plans, demonstrating a willingness to make midyear adjustments, and adhering to a reserve policy to help deal with uncertainties." 

Washburn, a former Moody's analyst, says that the rating agencies look at four key factors:

• finances, including the size of the general fund balance;
• experienced management that understands its resources, has a record of balancing revenues and expenses, and uses levers available to address problems;
• debt, including pension liabilities; and
• the economy, including the size and wealth of the tax base; often, the communities that need the funding can't access it because of their poor ratings and lack of a viable tax base.

Wendy Wipperman, currently the assistant vice president at the Texas Association of School Boards, known as First Public LLC, stresses the importance of the municipality's debt condition. In a 2010 report for the Texas Association of County Auditors that she authored (as a consultant for her former employer, Crews and Associates), she stated that a municipality needs to pay attention to its "current debt-service burden, as measured by debt-to-market value, debt per capita, and debt as a percentage of operating expenditures. ... Debt is considered high when debt-service payments represent 15 percent to 20 percent of the combined operating and debt-service fund expenditures. A high debt burden can impede an issuer's ability to finance future capital projects and raise taxes if necessary." 

On the federal front

Two federal proposals should be interesting to track in 2014. On the one hand, to the possible detriment of the tax-exempt status of municipal bonds, the fiscal 2014 budget proposal, sanctioned by the Obama administration, includes capping the tax deduction for municipal bonds at 28 percent.

According to a June 2013 study by the U.S. Conference of Mayors and the National League of Cities, "Jobs Impact of Proposal to Limit the Municipal Bond Market," the reduction or elimination of the tax deduction would raise the financing cost of critical infrastructure projects. Many projects would be dropped as a result, and job growth would be adversely affected.

Had the tax deduction been capped at 28 percent in 2012, economic activity in U.S. municipalities would have been almost $25 billion lower, according to the report.

In a sector-by-sector analysis, the report estimates that some of the exemption proposals put 892,000 jobs and $71 billion of annual Gross Domestic Product at risk. In the proposed restriction, which caps the exemption at 28 percent, the projected loss is 311,000 jobs and $24 billion in GDP.

On the other hand, for municipalities that can't float bonds because of their low ratings, there may be alternatives through new legislation. In November 2013, a bipartisan coalition of 10 U.S. senators introduced legislation to establish a new infrastructure financing authority that would help states and localities to leverage private funds to build and maintain infrastructure.

Called the Building and Renewing Infrastructure for Development and Growth in Employment Act, or BRIDGE Act, the legislation would provide an additional financing tool for municipalities for projects of at least $50 million, and be of "national or regional significance to qualify," according to the proposed legislation. Rural projects would be limited to $10 million in cost, and a total of five percent of the authority's overall funding would be spent on projects in rural areas. 

The BRIDGE Act aims to create an independent, nonpartisan financing authority to work with existing U.S. infrastructure funding. The agency would provide loans and loan guarantees to help states and localities fund the most economically viable road, bridge, rail, port, water, sewer, and other infrastructure projects. Initially, the authority would receive seed funding of up to $10 billion, meant to trigger private investment and make possible up to $300 billion in total project investment.

On December 3, 2013, Jefferson County, Alabama, came out of its bankruptcy status, so while the cycle of a fiscal downturn clearly isn't forever, the system of bond ratings affecting infrastructure development is not disappearing anytime soon. Municipalities may want to keep a close eye on federal developments in bonds to make sure much needed infrastructure projects can remain at the forefront of their local agendas.

Corry Buckwalter Berkooz is a writer and planner in Ann Arbor, Michigan.

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Resources

Images: Top — The musical group La Bottine Souriante performs in the Diego Rivera court of the Detroit Institute of Arts in 2013. A group of philanthropic foundations is raising funds to help the bankrupt city of Detroit, in the hope of persuading the city not to sell art treasures from the DIA. Photo Fabrizio Costantini/The New York Times. Bottom — Detroit's bankruptcy raises a lot of questions, one of which is what will happen to the art owned by the city and housed at the Detroit Institute of Arts. This painting alone,The Wedding Dance by Pieter Bruegel the Elder, is valued at $100 million to $200 million. Photo Reuters/Joshua Lott. Illustration by Christopher Neimann.

The Fundamentals of Municipal Bonds, Judy Wesalo Temel, John Wiley and Sons, 5th ed., 2001.

The Bond Buyer's Municipal Marketplace, called "the red book," an industry-wide directory.

National Association of Counties report, "Protecting Bonds to Save Infrastructure and Jobs"

Municipal bond news and updates: http://muninetguide.com/category/municipal-finance/municipal-bonds/

Research on issuers, articles, and education: http://municipalbonds.com

Municipal Bonds for America Coalition: a nonpartisan organization formed to preserve tax-exempt bonds: www.munibondsforamerica.org