With interest rates rising – the Federal Reserve could deploy a rate hike of 50 basis points in May – and inflation stubbornly high, these are trying times in the bond market. Advisors known as much and clients are learning that lesson in real time.
Finding bright spots in the bond market isn’t easy these days, particularly in high-quality segments of the fixed income market. That’s not to say there aren’t glimmers of hope. There are and some of those opportunities don’t require investors to take on credit risk.
Some of the green shoots in the fixed income universe today come courtesy of municipal bonds. Not to sugarcoat things, but some municipal bonds carry duration risk and, broadly speaking, these bonds are surprisingly correlated to equities.
Those disclaimers should not be ignored. Nor should some of the good news pertaining to munis, much of which revolves around robust finances at public pension plans.
Pleasant Surprise in Muni Land
There was a time when public pensions were thought to be a potential, future source of havoc in the bond market. Indeed, since that idea was floated more than a decade ago, most of the albeit small number of municipal defaults around the U.S. have been caused by pension bloat.
Lavish benefits, years of underfunding, years of tepid returns by public pension managers and increasing life spans are among the factors conspiring to place burdens on public pension funds. Those scenarios shouldn’t be ignored, but today the fact is public pensions are remarkably well funded and that’s good news for muni investors.
“The good news is that in general, states have the financial resources to make payments to both their pension plans and bondholders,” notes Cooper Howard of Charles Schwab.
While no state’s public retirement system is 100% funded, the gold standard is getting to 80%. Today, nine states – including California and Florida – are between 70% and 80% funded. Another 13, including New York, are above 80%.
“The good news is that in general, states have the financial resources to make payments to both their pension plans and bondholders,” adds Howard.
A decade-plus of a bull market in stocks, low interest and robust private equity returns helped states and municipalities get their pension houses in order to some extent.
For muni investors, these are important points because in many states, including large ones with significant pension obligations, cutting benefits simply because the state is under fiscal duress is next to impossible. It’s been attempted several times in California and every time, a court rules if benefits are cut, those perks must be replaced with something of comparable value, resulting in essentially no savings to the state and its municipalities.
Not Perfect, But an Improvement
The public pension system in the U.S. isn’t perfect as far as muni investors are concerned, but it looks better than it did a decade ago.
“Many municipalities have used the recent strong economic recovery and substantial fiscal aid to help shore up their unfunded pension liabilities. For example, contributions have increased an average of 8% per year. Even some of the plans with the lowest funding have made significant improvements to contributions to get their plans on better footing. Illinois, Kentucky, Pennsylvania, and New Jersey have all increased contributions by an average of 16%,” adds Howard.
Bottom line: At least one risk for muni investors to considers is diminishing today and that’s nothing to scoff at.
Related: Finding Bonds That Aren’t Heavily Correlated to Stocks