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What Brexit Means for the Municipal Bond Market
On Thursday, Britain voters shocked the world by deciding to exit the European Union in a vote that became known as "Brexit," a combination of Britain and exit. The result, which prompted Prime Minister David Cameron to say he will step down in the coming months, has implications for global financial markets, which in turn can affect the U.S. municipal market.
Even before the results of the vote were in, the uncertainty of the outcome was affecting markets everywhere. Global stocks and some corporate bonds had slumped while demand for traditionally safer assets like U.S. Treasuries and municipal bonds had “soared,” according to Ivan Gulich, senior vice president of the financial firm Loop Capital Markets.
This increased demand for municipal bonds has driven down interest rates, which is good for governments looking to borrow money. For example, the interest rate on a 30-year Treasury bond is currently lower than it was even in the wake of the Lehman Brothers' 2008 bankruptcy that roiled the corporate market and drove demand toward government securities.
“What was initially seen as an issue for Europe has rattled markets around the world,” wrote Gulich this week in an analysis.
The Takeaway: The vote to leave could spur more uncertainty for the U.S. financial market. Guy LeBas, an analyst at Janney Montgomery Scott, said financial markets could see the same volatility and losses we endured in January and February of this year. If that happens, institutional investors like pension plans, which primarily depend on investment earnings, could be hurt. But U.S. government issuers might benefit if uncertainty boosts demand for bonds and thus keeps interest rates down.
Pensions Could Get Better ... or Worse
The average funded status of public pension plans dipped slightly in 2015 and could continue in that direction if plans consistently fail to meet their desired investment rate of return, according to a new report.
The report, released by the Boston College’s Center for Retirement Research, found that the average pension plan in 2015 had about 72 percent of the assets on hand to pay its total liabilities. That’s down from 74 percent the year before. The decrease can largely be attributed to mediocre stock market returns in fiscal 2015, causing most plans to miss their target rate of return of 7 or 8 percent.
The decline comes even as governments are getting better about paying their pension bills. On average, they paid 90 percent of their pension contributions in 2015 -- up from about 86 percent the year before.
The Takeaway: If plans continue to miss their marks, the center predicts that pensions' health could continue to decline to about 71 percent funded by 2020. On the other hand, if market conditions improve, then pensions' funded status could improve to nearly 78 percent. “What happens from here on out depends very much on investment performance,” the report concluded.
Litigation Ensnares Puerto Rico
Puerto Rico continues to be bogged down by creditors fighting over money owed as it hurdles toward an expected $2 billion default on July 1.
Earlier this week, the government released documents from their creditor negotiations that shows just how far apart Puerto Rico and its lenders are in deciding how to restructure the island’s debt. Puerto Rico, which has been in recession for the past decade, owes more than $70 billion and has already defaulted twice on debt payments over the past year.
The government’s offer to the creditor groups, who combine to hold more than $15 billion in Puerto Rico’s debt, has improved from its initial proposal of guaranteeing about 50 cents or so on the dollar. But they’re still about 15 cents off from what the creditors want.
Also this week, some of Puerto Rico’s many other creditors sued the island for its so-called debt moratorium law, which was passed earlier this year. That law allows the territory to suspend its debt payments while it restructures what it owes. It's essentially a work-around Chapter 9 bankruptcy, which protects municipalities from being sued while restructuring debt. Puerto Rico can’t legally file for Chapter 9, but Congress is expected to vote next month on a bill that would offer it some restructuring protection while installing a control board to take over the government’s finances.
The Takeaway: The events show just how chaotic things can get without an established route to restructure debt. The process has Puerto Rico fighting simultaneous battles with different creditor groups -- all of whom are trying to score the best deal for themselves.
“With no clear legal mechanism currently in place to address the commonwealth’s $72 billion debt,” said Ted Hampton of Moody’s Investors Service, "additional lawsuits are likely to delay resolution of cumulative credit claims while further delaying Puerto Rico’s economic recovery.”