Despite Illinois's financial troubles, muni market looks strong

July 5, 2017

 
Ed Saracino

Ed Saracino

For two years the Democrat-controlled Illinois state legislature and Republican Governor Bruce Rauner have been unsuccessfully engaged in protracted negotiations to hammer out a budget.

The unprecedented lack of a fiscal spending plan has led to delays in the state's paying its bills, unsettled and growing pension obligations, and damage to the state's credit rating. On June 1 Illinois's debt was cut to one step above "junk" by Moody's Investors Service and S&P Global Ratings, giving it the lowest ranking on record for a U.S. state.

Despite Illinois's troubles, the municipal bond market has proved to be a good investment. Through June 20, the market was up 3.65% for the year.* Overall, situations like the one in Illinois are isolated and haven't created systemic risk for the muni market.

What's Vanguard's exposure?

Illinois continues to be a significant part of the municipal bond universe. The state is among the five-largest issuers in the Bloomberg Barclays Municipal Bond Index as of May 31, 2017. Our positions in the state's general-obligation bonds are in line with the overall market weight and are about 1% across most of our national municipal funds. As investors might expect, the exposure in Vanguard High-Yield Tax-Exempt Fund is slightly greater because the fund seeks to have a larger allocation to bonds offering higher yields.

"Relative to the size of our portfolios, our exposure to the State of Illinois is modest. A key benefit of Vanguard's municipal product offering is diversification, which minimizes the risk of any one issuer," said Ed Saracino, the senior product manager for Vanguard Municipal Bond and Money Market Funds.

Is Illinois another Puerto Rico?

In 2016 Puerto Rico defaulted on its debt, including repayment of its general-obligation bonds. The situation in Illinois does not compare with what the municipal market has witnessed in Puerto Rico.

In fact, Illinois's bond debt is less than half the Caribbean island's, even though the state's population is more than three times as big. Puerto Rico has been in a recession for more than a decade, while Illinois still has a relatively robust economy and is a center for commerce in the Midwest. Last, Illinois's level of wealth is much higher than that of Puerto Rico, which has been plagued by poverty.

Unlike Puerto Rico, Illinois's problems are largely political in that the governor and state lawmakers have been unable to form a working relationship. Aside from the political turmoil, the state does have long-term headwinds as a result of growing pension and health care obligations. For decades, state officials have spent more than they can afford, borrowed to plug budget holes, and delayed pension payments in lieu of enacting true reform. Although Illinois has long-term structural problems that must be addressed if it is to get its financial house in order, the state's immediate financial troubles can be stabilized when a budget deal is reached.

Our muni market strategy

Vanguard's 20-person credit research team and the portfolio managers in Vanguard Fixed Income Group continue to evaluate how new developments will affect the situation in Illinois. We will continue to take a cautious approach with respect to Illinois and other states that face long-term pension challenges. That said, we're also mindful that much of the risk is already reflected in current prices.

Our actively managed, investment-grade national municipal funds are allowed to have as much as 5% of assets invested in below-investment-grade securities. Currently, the Illinois bonds haven't fallen below investment grade. Overall, the funds are not close to the 5% threshold.

To mitigate risks to Vanguard funds, the team will continue to evaluate the amount of risk associated with each issuing municipality, while taking a diversified approach to investing.

* S&P Municipal Bond Index.

Notes:

  • All investing is subject to risk, including possible loss of principal.
  • Diversification does not ensure a profit or protect against a loss.
  • Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
  • Past performance is no guarantee of future returns.
  • The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.