Author’s Note: Municipal bonds have been on my radar for some time, even though my focus has been on stocks and corporate bonds. I have attended the Massachusetts Investor Conference for the past four years, as a way to learn about state government, including financial reporting practices and recent financial performance.
While I still have more homework to do, I am offering here a summary (including some personal impressions) of this year’s Massachusetts Investor Conference (which was held on Dec. 9). I am relying primarily on my observations from the conference (and past efforts to learn about the finances of the Commonwealth). My comments here might benefit from additional research, but I am assuming that this post will still provide useful information to readers.
The Massachusetts economy. Dr. Michael Goodman of UMass Dartmouth provided a brief overview of the Massachusetts economy. He said that the Commonwealth has had a robust economic recovery. It is outperforming most other states in key measures, such as GDP and employment growth. Consumers are spending once again. The state has seen above average growth in sales tax receipts, including taxes on auto sales, which were up 11% in fiscal 2015. Massachusetts has now recovered all of the job lost in both the 2008 recession and the 2001 dot-com bubble (which had a proportionately great impact on the state because of its large presence in the technology sector). Massachusetts has grown at a faster pace than the U.S. in the last three quarters. (Although the state got slammed in the first quarter from the harsh winter weather, its economy apparently did not suffer.)
Yet, despite a positive picture overall, there have been pockets of weakness and concern. Employment conditions are still difficult for the young, poorly educated and long-term unemployed. While the economic recovery within the greater Boston area has been strong, it has been much less so outside of Boston, especially in the western part of the state. (For example, unemployment rates are very low in Cambridge (3.1%) and Boston (4.3%), but still high in Springfield (8.3%) and Lawrence (9.0%). A surprisingly high percentage – about one-third – of residents are participating in MassHealth, the state’s subsidized health care plan.
Perhaps the greatest risk to the outlook for the Massachusetts economy comes from the increasingly uncertain prospects for the U.S. and global economies.
The Commonwealth also must address its increasingly uncompetitive position in the cost of energy. With the closing of two regional nuclear power plants – Vermont Yankee and Pilgrim -and the push to close coal-fired power plants, the state risks becoming overly reliant on natural gas-fired generation. Yet, with limited pipeline capacity, the cost of natural gas in the region has soared during the winter months. Renewables are part of the solution, but Massachusetts and its neighbors must come up with a comprehensive plan to address this issue.
State revenue has generally been coming in as forecast, but the state has had to scramble recently to close a surprise funding gap, which has been characterized by some as structural. Given the wealth of its citizens, Massachusetts has the capacity to close any likely budget shortfall, even in tough times, provided that the legislature can muster the political will to do so.
State Treasurer and Receiver General Deborah B. Goldberg walked to the podium on crutches and chided Governor Baker who apparently had a similar injury earlier this year for being freed from his crutches ahead of her. She welcomed attendees, highlighted the Conference agenda and affirmed the Commonwealth’s intention to maintain transparency with bond investors. She sees her role as ensuring that Massachusetts has the financial flexibility to promote economic stability for its citizens and businesses. She also spoke about a pilot effort from the Office of Economic Empowerment to teach kindergarten students about saving for college and retirement.
Governor Charles D. Baker provided some observations on the past year. He spoke about the importance (and difficulty especially under time constraints) of putting together a talented (and bipartisan) team and highlighted his appointment of Stephanie Pollock, a liberal transit and equity “firebrand,” as secretary of MassDOT.
Gov. Baker also spoke about efforts to address the operating problems of the state’s public transportation system that led to last winter’s shutdowns. He noted the MBTA’s past focus on building “shiny new things” at the expense of maintaining existing infrastructure. He spoke of two efforts completed over the past year: the rebuilding of the third rail on the Orange and Red line subway systems to ensure reliability and buying a couple of “gigantic” rail-based snow plows. The MBTA will spend $83.7 million over the next five years to enhance its winter resiliency. As a general principle, the Baker administration will focus more on fixing rather than replacing or upgrading existing infrastructure. A commission appointed by Gov. Baker issued a series of recommendations last April, including the establishment of a Fiscal and Management Control Board to enhance the transparency and public accountability of the MBTA.
Immediately upon assuming office, Gov. Baker worked collaboratively with the legislature to eliminate a large budget deficit for fiscal 2015 and potentially for fiscal 2016. The government had to dip into its “rainy day” stabilization fund temporarily to address the problem, but it has returned the money and anticipates no such drawdown in fiscal 2016. Under Gov. Baker’s direction, the legislature will not raise the Commonwealth’s cap on borrowing.
The Baker administration has also initiated a concerted effort, spearheaded by Lt. Gov. Karen Polito, to address issues of concern to local governments. It is a big supporter of the Chapter 90 program which provides $300 million in annual funds to upgrade local roads and bridges. This year, it created a Community Compact Cabinet to advise the governor on issues of importance to local governments and established of a new office, the Senior Commissioner for the Division of Local Services within the Mass. Dept. of Revenue, which will be responsible for all activities of the Division of Local Services and serve as the key contact point on local issues for the Secretary of Administration and Finance.
In light of the planned closures of existing power plants and the high winter cost of natural gas, the governor will work with the legislature on developing a comprehensive energy policy in the first half of 2016. The Commonwealth needs to ensure that it can remain competitive on energy costs while at the same time finding ways to reduce its carbon footprint.
While the Commonwealth will continue to face many challenges over the next few years, the Baker administration’s primary goal is to preserve and enhance the state’s world class infrastructure and strong competitive position, exemplified by its exceptional educational system and leadership in technology.
A Discussion of State Reserve Funds. This discussion was centered on a report entitled Building State Rainy Day Funds, produced by the Pew Charitable Trusts, an independent, non-profit global research and public policy organization. This and other related reports from the Trusts offer a look at how states manage their reserve funds and identifies best practices.
The need for better management of state reserve funds was demonstrated within the first year of the Great Recession when budget shortfalls outstripped savings by nearly 2-to-1. Relatively few states assess the volatility of their tax revenues. The report urges all states to do so. The amount in state stabilization funds should be linked directly to that volatility assessment, either to overall tax revenue volatility, the volatility of specific (but important) taxes or to economic volatility. Reserve funds should be increased in good times, with any extraordinary and unexpected windfall from certain taxes, like capital gains. The Pew Trusts also argue that those states who have not already developed clear and specific policies about the utilization of Reserve Funds should do so as soon as possible.
The need for such an assessment has been demonstrated by the slow recovery in tax revenues that most states have experienced since the onset of the recession. Twenty-seven states are collecting less today than they were before the recession. Revenues are still down 7%-10% in seven states. Massachusetts suffered a steep 14% plunge in tax revenues in 2009, but revenues have since recovered quickly. In the 2015 calendar third quarter, they were up nearly 7% year-over-year.
Even for those states that follow best practices, however, those rainy day funds may not prove to be sufficient. The Trust estimates that the average rainy day fund would cover 20.5 days of operating expenses, down from 41.3 in 2007. Massachusetts’ stabilization fund would cover 11 days of expenses in 2015, down from 45.9 in 2007.
Furthermore, state tax revenues do not usually move in lock-step with economic performance. They can vary as to both timing and magnitude compared with the state’s economy.
Accordingly, states may have to tap other tools, such as tax increases, spending cuts, additional borrowings and others, to meet budget shortfalls. Rob Ross of the Massachusetts Office for Administration & Finance pointed out that Federal reimbursement has been an increasingly important part of state revenues, especially during the last two periods of decline (from the dot-com bust and the 2008 financial crisis)
Paul Mansour, head of municipal credit research for Conning & Co. emphasized the relatively strong powers that states have to address budget shortfalls (through the tools listed in the previous paragraph). Rainy day funds are a first line of defense. Ideally, they should be sufficient to give a state time to assess and respond to deteriorating economic conditions without having to take more extreme and potentially far-reaching measures.
Mass. Pension & OPEB Practices. Commonwealth Retirement System includes the Massachusetts State Employees’ Retirement System (MSERS), the Massachusetts Teachers’ Retirement System (MTRS) and the Boston Teachers Retirement System. In total, the CRS has about 184,700 active participants and 124,600 retirees or roughly 1.5 active participants per retiree.
The normalized cost of the pension programs is $1.59 million annually. The CRS receives strong support from active employees, 92% of which contribute the full 8%-9% plus 2% of their salaries above $30,000 annually. Teachers hired after 2001 are required to contribute 11% of their salaries. Employee contributions were about $1.16 billion in fiscal 2015, so that net normalized cost that must be met by the state is $431 million.
The combined assets of MSERS and MTRS were $48.4 billion, as of Oct. 31, 2015. The combined funded ratio (i.e. net assets divided by the net pension obligation) was 59% as of Jan. 1, 2015. The combined unfunded actuarial accrued liability was $33.4 billion.
The Commonwealth has taken a number of steps in recent years to close the funding shortfall. It added a new (and presumably reduced) benefit tier and raised the minimum retirement age to 60 for employees hired on or after April 2, 2012. It has also raised the pension appropriation from approximately $1.8 billion in fiscal 2015 by 10% per year in fiscal 2016 and 2017 and by 7% per year thereafter until 2035, with a final payment in 2036, specifically to close the gap.
Based upon its Jan. 1 actuarial valuation, the state’s pension administrator has determined that it would be appropriate to extend the 7% increased funding shortfall payment by two years to 2037, with a final payment in 2038. The extension was caused by an increase in the estimated funding shortfall of about $3.5 billion due to lower assumed investment returns (to 7.75% from 8%) and a longer assumed life expectancy for retirees. The actuaries also note that it may be appropriate to lower the assumed rate of investment return again in 2016.
The unfunded liability has increased from a low of $4.8 billion in 2000 to $33.4 billion in 2015. Similarly, the funded ratio of the pension plans peaked at 85.2% in 2000; but it has declined more or less steadily in the ensuing fifteen years to the current level of 59%. Much of the increase in the unfunded liability is due to the decline in the discount rate for future liabilities (which is tied directly to the general decline in interest rates over the past fifteen years). Obviously, the liability will decline if and when interest rates rise, but so too may investment returns. Consequently, it is not easy to predict exactly how the unfunded liability will change in the future.
Nevertheless, the odds are that the liability will remain high and closing the gap may prove to be challenging. The Commonwealth has responded by taking measured steps to limit the growth in benefits, but it is not clear whether it can implement meaningful changes to close the funding shortfall without taking more drastic measures.
At this time, the actuarially-determined unfunded liability is not fully reflected on the Commonwealth’s balance sheet. That will change when new accounting rules issued by the Governmental Accounting Standards Board become effective. Under transitory adoption rules, the Commonwealth will likely show a net pension liability in its fiscal 2015 Comprehensive Annual Financial Report of $23.3 billion (equal to its fiscal 2014 valuation.) In the future, the new GASB rules will require marking the net pension assets and liabilities to market each year. (Under its previous accounting methodology, the Public Employee Retirement Administration (PERAC) used a 5-year smoothing of asset values. Thus, going forward, the net pension liability may be more volatile.)
Massachusetts also provides other post-employment benefits (OPEB), primarily health insurance, to its retirees. As of Jan.1, 2015, its actuarial valuation estimated the unfunded OPEB liability at $15.9 billion, which was an increase of $734 million from the previous year, due to the updated mortality assumptions. Plan assets were $610 million.
Innovations in Massachusetts Credits. This part of the presentation described efforts by the University of Massachusetts Building Authority and MassDevelopment to finance capital projects. It also included a general presentation on new forms of municipal financing by Nathan Harris of Boston-based Appleton Partners.
The University of Massachusetts has a FY15-FY19 capital plan of $3.4 billion, including $1.1 billion for deferred maintenance. The University also receives support from the state budget. Although it invested more than $3.5 billion in capital projects in the 10 years to FY14, it has assessed its deferred maintenance backlog to be about $3.3 billion. In addition, the UMass Board of Trustees has set a debt service cap equal to 8% of annual operating expenses. In fiscal 2015, five of six campuses had debt services ratios below the 8% cap, with the lowest at 5.2%. All campuses are projected to be below the 8% cap in fiscal 2016 and 2017.
The constraints imposed by the debt service ratios combined with significant long-term capital needs has led the University to explore Public-Private Partnerships (P3). The UMass Building Authority was formed in 2012 to investigate the potential of P3s for capital facility projects that have been approved by the Board of Trustees.
As the name implies, these potential Public-Private Partnerships are joint ventures of the UMass Building Authority and real estate developers. In most cases, a non-profit special purpose entity (SPE) is formed to oversee development and manage the property. However, the real estate developer may create and contribute equity to the SPE, which operates the property for-profit upon completion. In both cases, the proceeds of debt issued by the SPE are paid to the developer to cover the cost of construction. The UMBA, through its participation on the joint venture’s board of directors, is there to ensure that the costs charged by the joint venture to the University and/or its students are reasonable.
P3s represent a form of off-balance sheet financing, but it is not clear whether the rating agencies will treat them as such. UMBA has one project, a new dormitory for UMass Boston, underway. It issued an RFP in March 2015 and received responses from seven developers. It is currently working to determine whether it can get favorable treatment from the rating agencies on this project and also to finalize the details with the potential developer.
MassDevelopment works with various constituencies, including businesses, nonprofits, banks and local communities to stimulate economic growth in the Commonwealth. Its projects promote investment and jobs in Massachusetts.
In the three year period through fiscal 2015, MassDevelopment completed 375 financings for $9.7 billion. Fifty financings representing $4.8 billion of issuance were completed in the public markets. The remainder were done privately, primarily through local banks.
The agency has created the Infrastructure Investment Incentive program (the I-cubed program), which finances public infrastructure improvements that support major private developments. Qualifying projects must demonstrate the ability to raise new state tax revenues (i.e. retail sales tax and employment tax) to a level capable of covering anticipated debt service by 1.5 times. Applicants must show that the project would not achieve its contemplated economic targets without support from MassDevelopment and that they have the means, including financial resources, to complete the project. Priority is given to projects in economic distressed areas.
The Massachusetts Development Finance Agency is the issuer of debt under the I-cubed program, but credit is provided by Commonwealth Contract Assistance, which has the full faith and credit backing of the Commonwealth of Massachusetts. Accordingly, previous issues have received debt ratings equivalent to the Commonwealth’s. A typical issue size is $50 million or less. The program is authorized to issue up to $600 million in bonds.
Bonds issued to date have financed a number of mixed use and retail projects, including Fan Pier in Boston, Assembly Row in Somerville, Chestnut Hill Square in Newton, Boston Landing in Boston and Van Ness Development in Boston. A new financing, $10 million in Special Obligation Bonds (Commonwealth Contract Assistance) Series 2015C, is currently in the market.
Nathan Harris of Applegate Partners covered the broad spectrum of credit innovation in the municipal market, including Green Bonds, Public-Private Partnerships, mini bonds (such the $500 face value bonds issued by the City of Denver in 2014), social impact bonds, crowdfunding and new platforms for funding small projects, like Citizinvestor, Ioby and Neighborly. These innovations may be an effective way for issuers to broaden their investor base, transfer risk, fund small projects and get results fast. Investors are cautioned to make sure that these financings are for essential purposes, with good security provisions and offer potential returns that are commensurate with the risks (including poor liquidity).
A Massachusetts Transportation Update. Brief updates were provided by Anna Tenaglia of MassPort, Thomas Dugan of the MBTA, who discussed MassDOT, and Sue Perez, Asst. Treasurer for Debt Management in the State Treasurer’s Office.
MassPort is a quasi-public authority that operates the states airports, maritime operations and certain real estate. Its debt is rated Aa2/AA.AA. Logan Airport accounts for 85% of its fiscal 2016 operating budget of $667 million. Its primary strategic initiatives include: 1) enabling Logan Airport to meet its expectations for passenger growth; 2) revitalizing maritime operations and 3) developing its properties in East Boston and South Boston. In order to issue new debt, Massport’s Board requires that the underlying projects are core to the authority’s core mission, the terms of the debt comply with applicable laws and regulations, funded projects meet specified parameters and the issuance will leave Massport with financial metrics sufficient to maintain its AA credit ratings, including an annual debt service coverage ratio of 2.0 times and annual operating ratio of 70% or less.
Massport’s fiscal 2015-2019 capital program totals $1.37 billion and includes a garage in Framingham for express service to Logan, a 2,050 car garage at Logan, a new connector between terminals C and E at Logan, upgrades to terminal E to accommodate the Airbus A380 aircraft and an air rights garage over a section of I-90 in Boston.
MassDOT’s Project Selection Advisory Council (PSAC) was established by law in 2013 to develop a prioritized list of projects across all transportation modes. Its original deadline for completing this task was extended by six months to June 30, 2015 to accommodate the incoming Baker administration. PSAC uses specified selection criteria, such as cost effectiveness, safety and economic impact, to guide its project selections. MassDOT has received over 1,400 comments from the public through its Capital Conversations bulletin board. It will now move forward to complete the project scoring and planning process to finalize its project plans at an upcoming Board meeting on January 20.
The Commonwealth Transportation Fund issues revenue bonds under two programs: the Rail Enhancement Program (REP) and the Accelerated Bridge Program (ABP). It issued its first bonds under REP – the $450 million Series A Bonds – in October 2015. The REP is intended to provide financing for big (and some controversial) projects, such as the green line extension, new orange and red line vehicles, the South Coast rail extension and South Station improvements. CTF expects to issue $1.86 billion of REP-related bonds by fiscal 2020 (including the 2015 Series A Bonds).
ABP Bonds have been issued under two programs: $1.57 billion of CTF bonds issued to date (with a total authorization of $1.88 billion) and $0.7 billion of Grant Anticipation Notes have been issued (with $1.11 billion authorized.) The Commonwealth commenced the ABP program in 2010 to accelerate the improvement of bridges and related infrastructure. Since 2008, 231 structures have been replaced, renovated or preserved, reducing the number of structurally deficient bridges from 543 in 2008 to 408 as of Sept. 2015, which is better than originally planned. The CTF program has achieved Aaa/AAA credit ratings, with debt service coverage of 6.0 times and dedicated revenues from motor fuel taxes, Registry of Motor Vehicles fees and direct payments from the government. The Baker administration currently plans to issue $2.1 billion of CTF bonds over the next five fiscal years, with $800 million planned for fiscal 2016.
The Luncheon Keynote (which I missed) was given by Navjeet Bal, Vice President and General Counsel of Social Finance, a non-profit organization dedicated to driving social progress. Social Finance specializes in designing public-private partnerships. Its offerings are centered on Pay for Success financings (aka Social Impact Bonds) that direct government resources to social programs that deliver proven results.
Final Observations. While Massachusetts is clearly in a stronger position than many states, it will undoubtedly face significant challenges in the years ahead. The Baker administration has addressed some smajor problems in a short time, including the budget shortfalls for fiscal 2015 and fiscal 2016 and the performance problems at the MBTA. Governor Baker has set a firm tone for managing the day-to-day operations of the Commonwealth in a practical manner; but it is evident that the Commonwealth does not yet have sufficient flexibility to cope as effectively as it may need to in a new downside economic scenario. The focus on fixing existing infrastructure before adding “new shiny things” was the right thing to do at the MBTA, but it must be applied to all state agencies and operations. For example, the University of Massachusett’s plan to apply only 1/3 of its Capital Plan over the next four years to deferred maintenance and leave 2/3 of its deferred maintenance needs unaddressed suggests that a reordering of priorities is necessary. The new forms of financing which were described at this Conference may be interesting, but it is probably unlikely that they will make a significant impact on state finances. From my perspective as an analyst, the Conference’s focus on topical issues did provide some relevant information about the current condition of the Commonwealth, but it would be more valuable if Treasury officials provide a detailed review of the financial performance of the Commonwealth and other Commonwealth-related bond issuers, such as MassDOT, the MBTA, the Mass Port Authority and others.
December 10, 2015
Stephen P. Percoco
Lark Research, Inc.
P.O. Box 1543
Linden, New Jersey 07036