Welcome to the lunar Year of the Horse. We promise to keep the equine references to a minimum, even though this weekend’s Superbowl certainly didn’t go well for a certain herd of Broncos.
On Wednesday, the FOMC held its last meeting under the reins of Chairman Ben Bernanke and voted to continue to reduce its bond purchase program by another $10 billion. So far, the Fed is enjoying having its cake and eating it too, since its tapering efforts are being met by declining, not rising, interest rates. Since last week, global investors have been stampeding out of emerging markets’ currencies and stock markets, from Turkey all the way to Argentina. Even the U.S. equities market has been dragged down in the process, turning in its worst January performance in several years, with the DJIA already down 5% this year.
For now, the fixed-income markets are reaping the benefits of this latest flight to safety.
The risk, of course, is that the current emerging markets selloff could turn into a full-fledged panic and derail the nascent U.S. economic recovery.
For now, the fixed-income markets are reaping the benefits of this latest flight to safety. The yield on 10-year Treasuries has broken out of its recent range and re-tested a three-month low at around 2.64%.
After outperforming taxables for much of the month of January, municipals started to lose momentum relative to Treasuries over the last few days. Most of the underperformance was concentrated in the intermediate maturities which, as we pointed out in our last column, have been in overbought territory for a while. Five-year and 10-year muni ratios rose to 74% and 96%, respectively, after getting as low as 65% and 90% around January 24th. The long end of the curve held up better but still saw 30-year ratios rise to 107% from 104% just over a week ago.
One credit that has been in full gallop is the State of Illinois. In his State of the State address on Thursday, Governor Pat Quinn offered an upbeat assessment of the Land of Lincoln’s fiscal and economic progress under his administration, while conveniently glossing over its numerous remaining fiscal challenges. Yvette Shields from The Bond Buyer summed it best: “Quinn was keen to talk up accomplishments, capped by the pension overhaul legislation passed in December (…) But he provided little indication about how he plans to tackle ongoing challenges that threaten Illinois’ fiscal foundation.”
Investors have indeed reacted quite positively to the State’s pension reform efforts, driving the spread on Illinois G.O.s on Illinois G.O.s to 120 basis points in the 10-year range (a 50 basis point tightening), according to Municipal Market Data. Year-to-date through January 13, 2014, the S&P Illinois G.O. Index is up 3.12%, outperforming the S&P National AMT-Free Muni Index by a full percentage point.
Investors have indeed reacted quite positively to the State’s pension reform efforts ..
All this will be welcome news for the State when it comes to market this week with a $1 billion G.O. issue. In its investor presentation for the new deal, the State has provided more details about the potential impact of Public Act 98-0599, as the pension reform legislation is called, on future pension funding needs.
Under PA 98-0599, the three major pension funds – the State Employees’ Retirement System (SERS), the State Universities Retirement System (SURS) and the Teachers’ Retirement System (TRS) – are projected to reach full funding status by 2039, compared to their current funding ratios of 44%, 36% and 43%, respectively. The projected reduction in pension contributions, first estimated at $160 billion, has been scaled back to $145 billion.
Of course, PA 98-0599 still has to withstand the expected legal challenges from the State’s public employee unions. A broad coalition of Illinois public employee unions, called We Are One, did file suit against the State on Tuesday, seeking to overturn the state’s pension system overhaul before it takes effect in June. The coalition’s complaint is the largest of the four lawsuits filed to date against pension reform, in terms of the number of unions and plaintiffs represented.
Assuming pension reform is upheld in court, not an assured outcome by any means, the next fiscal hurdle for Illinois to overcome will be the expiration of the income tax surcharge on December 31, 2014, halfway through the next fiscal year. Not anxious to make himself a political target this early in an election year, the Governor has been notably silent on this subject. Instead, State officials have been quietly pointing out that failure to renew the income tax surcharge would reduce individual tax revenues by $1.717 billion and corporate tax revenues by $325 million in FY2015. The statutory tax rate rollback would also turn the General Fund surplus of $924 million in FY2013 into a $1.9 billion deficit in FY2015. Under this scenario, the State’s infamous unpaid bill backlog would also grow from $6.3 billion in FY2013 to $7.5 billion by FY2015.
We suspect the income tax surcharge issue will become headline fodder once the primary season kicks off in earnest, starting with the first candidate debate in March. Opinions on this issue will likely be divided along party lines: all the Republican candidates except one (Dan Rutherford) have come out against extending the surcharge.
At this point, we see no reason to doubt that the tax surcharge will ultimately be extended, if only because there are few other revenue options available to the State. However, in an election year, this process could still go down to the wire. Given Illinois paper’s recent outperformance, investors may want to brace themselves for some more volatility going into the summer. In other words, hold on to your saddle as the ride could become a bit bumpier.
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