Municipal Credit Update: Characteristics to Cautiously Consider

Municipal bonds remain a key sector for bank portfolio managers. It’s not uncommon for banks with assets under a billion dollars to dedicate thirty percent or more of their portfolio to municipals. Clearly, pre-and post-purchase credit analysis of municipal holdings continues to be critical. Although municipal bonds generally experience very low default rates, certain types of municipalities and bond structures create apprehension. Some credit risks we suggest monitoring include bonds secured by appropriated funds issued for non-essential purposes, rural hospital bonds, and higher education bonds.

Appropriation Bonds

Municipal bonds secured by appropriated funds are at risk of sufficient money not being appropriated for bond payments. Certificates of Participation (COPs) or lease bond structures are often subject to annual appropriation, although other bond structures could be as well.

For appropriation bonds, ability and willingness to budget the necessary funds each year is of paramount importance. The issuer’s ability to pay can be analyzed with the general credit strength of the issuer while the nature of the project being funded provides insight into the issuer’s willingness to set aside necessary funds. Municipalities have strong incentives to budget for projects that are essential in nature while unnecessary projects may be cut when times are hard. Also, rated municipalities who access the credit markets fairly often are inclined to maintain a good rating which provides even more motivation to appropriate funds for all obligations.

Platte County, MO recently demonstrated unwillingness to appropriate funds for a revenue bond issue which funded a shopping center. The shopping center has not been generating sufficient revenues to cover the debt service payments, and appropriated revenues from the County are pledged as a supplemental revenue stream. According to S&P, Platte County has the ability to pay the debt service, but is reluctant to pay.

Rural Hospitals

Triggered by growing healthcare expenses, many insurance companies are encouraging low-cost providers or are cutting reimbursement rates which can pressure hospital profit margins. Rural hospitals tend to treat a greater proportion of uninsured or underinsured patients and also rely more heavily on government reimbursements than other hospitals, both of which pose additional financial challenges and constrain the ability of rural hospitals to meet shifting industry demands.

Healthcare bonds historically have had some of the highest default rates among municipal bonds. The credit quality of bonds issued by rural hospitals hinges on hospital liquidity and margins as well as the bond’s structure.

Higher Education

Rising student loan levels has created a political conversation about the essentiality of a college degree and whether or not the federal and state governments should be subsidizing higher education. Declines in governmental support may be detrimental to certain colleges, particularly those already experiencing declining enrollment.

The 2016-2017 budget impasse in Illinois created a delay and decline in state aid payments. The Center for Tax and Budget Accountability reports that higher education in Illinois suffered a 68% reduction in appropriations during just one year of the impasse. Some colleges were forced to lay off a significant number of employees while other colleges weren’t sure they would be able to maintain operations without state funding toward the end of the impasse. This highlights the risk of a widespread reduction in governmental support of higher education.

It is important to note that many municipalities meeting the characteristics described previously are well-positioned to endure evolving risks. For this reason, municipal bond investors should consider the financial condition of the issuer and any additional credit enrichments in addition to broad subsector risks.

The Baker Group is one of the nation’s largest independently owned securities firms specializing in investment portfolio management for community financial institutions.

Since 1979, we’ve helped our clients improve decision-making, manage interest rate risk, and maximize investment portfolio performance. Our proven approach of total resource integration utilizes software and products developed by Baker’s Software Solutions* combined with the firm’s investment experience and advice.

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For More Information
Dana Sparkman

Dana Sparkman, CFA

Senior Vice President/Municipal Analyst
The Baker Group LP

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