by Mike Demas.
In recent months, market participants have seen heightened levels of political uncertainty creep into the U.S. municipal bond market. Concerns are largely attributed to the increasingly polarized dynamic between governors (the executive branch) and state legislatures and the impact on local governments.
While the disruption has yet to materially impact investment performance, investors are responding by paying closer attention to political environments at the state and local levels.
What is political risk?
Political risk has come to designate a component of the more widely recognized concept of country risk. It takes the latter’s definition of a country’s ability and willingness to service its financial obligations and applies it to local government in the form of states and municipalities. Under this designation, political risk is a function of a state or municipality’s willingness, less its ability, to service its debt.
Why is political risk a growing issue?
The longstanding gridlock at federal government level has trickled down the political food chain to impact investment and budgetary decisions at the state and local level. Add to that the natural tension between federal and local issues due to increasing federal mandates and decreasing levels of federal financial resources. The result is a situation where it’s hard to differentiate between willingness and ability to make full and timely payment on outstanding debt.
Recent examples include issues in Illinois and, earlier this year, Puerto Rico, with the latter seen as a classic case of the local administration’s unwillingness to pay its debts. States also vary in terms of their level of involvement in the budgetary affairs of their municipalities. Examples include the bankruptcies of three California municipalities – Orange County (1994), Stockton (2012) and San Bernadino (2012) – with no remedial action by the State of California.
Against this backdrop, politicians are generally becoming more reluctant to raise taxes, even for infrastructure projects, and the growing pension burden continues to put an ever-greater strain on local authorities’ finances.
Why is political risk a problem?
Political risk perpetuates a cycle that results in negative outcomes both for investors and the states and municipalities that depend on their funds for infrastructure and service maintenance and improvement.
For municipalities, failure to pass budgets or legislation often delays funding for critical operational and human services. Lack of financial transparency creates a loss of institutional creditability and ultimate loss of market access to funding. Partisan political agendas prolong inaction and lead to unexpected outcomes. Based on any or all of these, the marketplace will extract a cost for perceived preventable actions.
Political obstruction or inaction leads to a series of negative outcomes for all parties.
What is the outlook?
The good news is that thus far (with only a few notable exceptions e.g. Chicago Public Schools) political risk hasn’t hurt absolute investment returns. In other cases, such as the State of Illinois, the massive decline in tax-exempt rates to new historical lows, as well as overall tightening in credit spreads, has obscured any potential loss from underperforming credits. Extremely tight supply conditions in municipal bond markets have further served to dampen any negative effect to-date.
Investors with foresight still have ample opportunity to re-position their portfolios to mitigate the impact of political risk without giving up much yield.
But that’s no reason for complacency!
In the wider market, there remains a belief that the combination of low interest rates and tight credit spreads will end badly. Investors may suffer a ‘double whammy’ when both rates and spreads start to reverse.
Buyers can afford to be ‘choosier’ when the market is going down and may finally steer clear of tainted credits. But market access may become a real concern for distressed issuers and could become a self-fulfilling credit factor.
How can investors mitigate political risk?
Political risk is not a new phenomenon but there has been a significant increase in the number of high-profile entities impacted by political uncertainty. As a result, investors need to be more vigilant than ever before in managing their municipal bond portfolios, looking beyond the traditional indicators of value to potential political risk factors that could impact their holdings.
To protect themselves against future disruptions in the municipal bond markets, investors need to be aware of the political factors at play that could affect their holdings, along with the usual pricing required to value portfolios.
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