Municipal debt, or any investment instrument backed by the tax authority of a local government, was once considered one of the safest investment vehicles that investors would use to diversify their investment portfolios. Although almost every muni debt investor is familiar with the basic risks associated with these investment vehicles, bankruptcy risk was almost unheard of in the municipal debt world.
The common misconception with local government debt was that all the debt issued by the local government was backed by its full tax authority; so, if there is ever a loss in revenue or general fund deficit, the municipality will simply increase the taxes to fill that deficit. Then, Detroit, MI and Stockton, CA happened, delivering a rude awakening for many investors who simply thought local governments can never go bankrupt. For Detroit and Stockton, there was little to no state intervention to help their municipalities and it eventually led to two of the biggest municipal bankruptcies in the history of the United States. However, there have been other examples, like Atlantic City, NJ, where the City has been under major financial strain to meet even its short-term obligations and the state (New Jersey) intervened to provide the much-needed help to prevent bankruptcy.
Recently, investors and municipal debt markets witnessed something quite similar: the State of Connecticut’s intervention into its capital city, Hartford, and its finances to provide much-needed financial relief. This eventually led to a four-notch credit rating boost for Hartford City debt from CCC (junk) to A (investment grade).
In this article, we will take a closer look at the State of Connecticut’s intervention, its short- and long-term impacts, and what it means for other municipality General Obligations (GOs) in a similar situation.
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What Led to the Fiscal Strain?
Hartford, the capital of Connecticut, has been struggling with rising fiscal deficit, heavy pension burdens and a gradual decline in its population. For all local governments in the U.S., one of the main sources of revenue is property taxes; however, in Hartford, over half the City’s properties are exempt from paying taxes because they are held by government entities like the Supreme Court, the University of Connecticut and Trinity College, among others.
In addition, as shown in the graph, the City’s population has been declining, which has a direct correlation with declining economic output by the City, deteriorating consumer spending and decline in sales tax revenues for the City.
Over the years, these fiscal strains have been a challenge for the City to not only access municipal capital markets; they have also prevented economic growth in the City. Credit rating agencies, like S&P and Moody’s, have progressively downgraded the City’s GO debt ratings, which has had a negative outlook on the City’s fiscal conditions.
Check out our article on how Chicago was able to increase a new muni issuance credit rating.
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Intervention From State of Connecticut
Given the fiscal struggle of its capital city, the State of Connecticut decided to take on the City of Hartford’s GO debt portfolio and back it with the State’s full faith and credit. This essentially means that if/when Hartford is unable to meet its obligations, the State will kick in and make those payments, meaning that Connecticut’s full faith and credit will be on the hook for the City’s $540 million GO debt portfolio and will serve as a backstop.
This is a huge intervention by a State to prevent a potential financial insolvency situation by one of its cities. However, under this deal, the City will be under State oversight and need to have its budget, new debt issuance related discussions and labor agreements approved by the newly created Municipal Accountability Review Board.
Impact on Credit Quality
In terms of the City’s credit rating, this deal has served the City in the best possible way since the Hartford GOs are now technically dependent on the full faith and credit of Connecticut. As a result, credit rating agencies, like S&P, were able to increase their credit rating from a junk CCC to an investment grade A rating. This brought much joy to Hartford GO holders and provided the much-needed relief on their investment holdings.
However, it was perhaps at the expense of Connecticut muni debt bondholders, as Connecticut’s rating was decreased by S&P to A from the prior A+ rating. The additional burden of the Hartford GO debt has brought down the State’s solvency and liquidity ratios.
Be sure to check out our previous article depicting how municipal bonds can help you during volatile markets.
Implications for Other GO Debts Issued by U.S. Cities
For other cities, especially in Connecticut, a Hartford-Connecticut type of agreement can certainly serve as a case precedent for both the cities and their GO investors; this simply means that when/if another city in Connecticut faces financial strains on its revenues that affect its ability to meet its financial obligations, investors will know that the State might intervene to provide financial relief and protect their investment like they did for Hartford, CT. In addition, the State might use this as a test case to formulate its future policies and requirements to advise other cities that might be following the similar path of Hartford.
This also serves as an important case for municipal debt markets and its investors to know and realize that state-issued debt and its liquidity & solvency ratios are just as good and applicable to the State’s debt portfolio; these ratios will be altered if the State decides to back up one of its City’s debt portfolios. This can/will ultimately lead to the State’s credit rating taking a hit and its investors suffering the potential consequences.
Be sure to check this article to remain aware of the due diligence process for evaluating municipal bonds.
The Bottom Line
The Hartford-Connecticut agreement serves as a perfect example for investors to realize the unforeseen risks associated with municipal debt instruments and they can be far greater than the basic interest rate risk for investors’ liquidity risk. Although this agreement positively served Hartford and its GO bondholders it might not be the case for other ‘City-State’ agreements to come in the future.
In addition, State debt holders might never have imagined this form of an agreement before purchasing the State debt instruments at an A credit rating, which was downgraded to A-, and those investors suffered the consequences.
In essence, these events show us the critical need for proper portfolio diversification more than ever before.
Disclaimer: The opinions and statements expressed in this article are for informational purposes only and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication and are subject to change without notice. Information has been derived from sources deemed to be reliable, the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professionals and advisors prior to making any investment decisions.