Credit Bulletin: New Jersey
At Samson we have a strong bias toward owning bonds from state issuers as we view them as possessing an even more remote potential for default than any other municipal sector. States’ strong fundamental credit characteristics result from their extensive flexibility to raise revenues and cut expenses. Therefore, even lower rated states exhibit a high level of credit quality compared to other sectors. Throughout the recession and during the recovery, many states raised revenues, slashed spending and reduced aid to local governments. While these aid cuts increased budget pressures for recipients, they have allowed states to maintain a degree of structural budget balance. Economic growth since the recession has resulted in aggregate state tax collection growth for 16 straight quarters. This has allowed many states to rebuild reserves that were drawn down in the recession. The State of New Jersey has, to this point, emerged as an exception as structural balance has remained elusive.
The flexibility inherent in the state sector exists in New Jersey and was demonstrated on the revenue side through a sales tax increase in 2007 as well as an increase in income taxes on high income earners in fiscal year 2010. The state monitors revenues on a monthly basis and makes budget adjustments within 30 days of identifying a gap. The governor has the power to make mid-year budget reductions without legislative approval. Notwithstanding these strengths, the specific challenges facing New Jersey include poorly funded pensions, structural imbalance, optimistic budgeting, a somewhat lagging economy and weak liquidity.
We continue to monitor the challenges facing New Jersey, which have resulted in a one notch downgrade last week from Standard and Poor’s to A+ (outlook stable). Moody’s and Fitch maintain negative outlooks on their respective Aa3 and AA- ratings. A negative outlook typically implies a chance of downgrade within the next two years.
New Jersey has seen strong revenue growth on a year over year basis, but it has repeatedly fallen short of its optimistic assumptions. Revenues in 2013 fell short of forecasts and 2014 revenues are on track to fall short again. The state has relied on one time revenues significantly since the recession. For example, the state delayed property tax rebates to residents from fiscal 2013 to the current fiscal year to provide budget relief. This structural budget imbalance is notable as many other states have begun to rely less on one time revenues and are now rebuilding reserve levels. Addressing this structural mismatch between recurring revenues and recurring expenses will be a key driver of the state’s credit quality and ratings going forward. It is also key to rebuilding the state’s liquidity levels, which have fallen below that of other states. Net tax supported debt stands at $35.7 billion according to Moody’s, ranking it fourth among states in per capita debt.
Positively, the state passed pension reform in 2011. This reform represents an improvement to the long term credit prospects of the state, while introducing near term credit pressure. The state has historically set aside less than the amount recommended by actuaries for its annual pension payments. As reported by the state, pensions are 54.2% funded. After reform, the state will increase its contribution each year until it begins setting aside the recommended amounts annually in 2018. The increased contributions will add budget pressure each year and the unfunded liability will increase until the full payments begin. This reform is an example of the state actively addressing these long term pension problems. We continue to monitor implementation of the reform measures as well as adjustments the state makes to its contributions. The state recently received attention for adjusting actuarial assumptions to lower the contributions made through 2018. While the adjustment was relatively modest, further adjustment to its contributions would be a credit negative.
High Income Levels and Slowly Recovering Economy
Wealth levels in New Jersey are a key credit strength as they are among the highest in the nation. Median household income of $71,637 is equal to 135% of national levels. The economy has slowly recovered since the recession, but that recovery has lagged the nation. Unemployment stands at 7.1%, above national levels, but noticeably trending downwards over the past two years. Housing prices rebounded in 2013 and are projected to increase again in 2014. We would also note that a long foreclosure process and large foreclosure backlog have kept price growth lower than other states. Over the past two years, spreads on New Jersey appropriation debt have narrowed despite the stresses mentioned above. This likely reflects a general spread compression across fixed income and a reduction in supply in outstanding New Jersey debt. We believe the market largely anticipated the recent downgrade and that the yield on these appropriation bonds compensates for the limited risks inherent in the name. We will continue to monitor New Jersey as it works to remedy the mismatch between recurring revenues and recurring expenses and to tackle its long term liabilities. Bryan Laing, CFA Credit Research Associate April 10, 2014
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