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Investors will agree that the recent market volatility raises the allure of municipal bonds. Part I of this series looked at the massive scope and attractiveness of municipal bonds. Part II focuses on the relative strength of issuers.
All men are created equal, but states are not equal when they borrow money. Risk remains critical in all investments. Except for that small sub-section of munis that fails to gain a rating, bonds begin with ratings, which give these instruments an immediate stamp of approval. Some states do a better job at getting the federal government to share the cost of major projects, which lightens the burden on state and local taxpayers. Impressive infrastructure projects always draw a great deal of funding.
Where Does the Revenue Come From?
Risk relates closely to defaults. While municipal bond issue default are rare, the major reason is the inability to generate revenue. Municipal bonds are funded by various kinds of taxes. States and localities collect income taxes, property taxes and excise taxes. The easiest way to fund municipal bonds is by the revenue related directly to the project. An excellent example is the New Jersey Turnpike. Will the project itself, Turnpike widening, continue to generate revenue to pay back its investors? Before we look more closely at the Turnpike, consider how serious this matter is. In New York City, the price of a one way ride on the subway is $2.75; the cost of driving on the Turnpike from New York City to Exit 11 is $6.65. New York City residents do not really have a subway alternative. Going to Exit 11 or a nearby job using the Turnpike might yield a strange alternative – taking a train, a bus and walking. With rare exceptions, good alternatives do not exist.
The New Jersey Turnpike is one of the busiest toll roads in the US. For 2016, the last year for which statistics are available, they took in $1.8 billion in revenue, $1.6 billion from tolls. For 2015, revenue exceeded projections. Much of the revenue is used for construction and maintenance. In terms of risk, the Authority makes a strong case: plenty of traffic, no major alternatives, revenue rising, even faster than projected.
Commuters and long-distance travelers know that New Jersey’s two major roads – the Turnpike and the Garden State Parkway — form an X running north/south. The Parkway starts west of New York City and slants eastward going along the shore. The Turnpike starts eastward (closer to New York City) and slants westward toward Philadelphia. The roads cross at exit 11 on the Turnpike. Muni watchers will take note that the Turnpike generates almost three times as much revenue as the Parkway. The reasons require a careful risk assessment for municipal projects. The Parkway is most useful for going to the beach (including Atlantic City) and for local travel. The Turnpike is better for Boston – New York – Philadelphia – Washington travel by car. The truck lanes, which also permit cars to use them, appeal to freight carriers. For years, they have been widening the Turnpike, adding lanes. Heading south from New York, there are six lanes, doubling the original highway. An outer strip of six lanes (three north and three south) accommodate trucks. This outer strip has been extended to exit 6, which brings the wider highway close to a Philadelphia link. (Here is a Myth Buster tip: the truck lanes have slightly less traffic than the cars-only lanes and trucks are less likely to swerve in and out of lanes.)
The Turnpike’s revenue potential ties to its role in business not leisure. There is an analogy in airplane travel. The airlines that cater to vacationers – Jet Blue and Caribbean – carry higher risk than airlines that cater to business travelers – American and Delta.
The Parkway’s lower revenue also highlights Atlantic City’s slump. There is a very good highway for travel to Atlantic City, but the attraction lacks interest. Alternatives in nearby states cut the bottom out from under the beach-gambling resort. Bonds issued by Long Branch, New Jersey for sewer construction carry a reasonable coupon rate of 4.75%. When the revenue dried for Atlantic City, it created a credit risk tsunami. This is an example of politicians lacking success when they dabble in profit-making businesses.
Will the Federal Dog Hunt?
In addition to generating revenue related directly to the project such as Turnpike travel or travel through O’Hare Airport (discussed in January), federal money may defray a huge portion of the total project cost. Some states and projects do a great job of finding federal funds. With its nearly unlimited taxing power, the federal government can lighten the burden on states and cities. Amtrak offers an interesting case. The national railroad only covers its costs in the northeast, specifically Boston to Washington. For the rest of the country, billions are spent so that the US can have the privilege of a nationwide railroad, or, more specifically, national rails on which passengers and freight can travel. The massive $2.5 billion Crescent Corridor undertaking, a freight rail network that loops from New Orleans to New Jersey with 11 other states in between, ranks among the largest construction projects in the country. Naturally, the federal government bears most of the cost for 300 new miles of track and a dozen new intermodal terminals in this upgrade. Passenger service is close to zero in many of these places, confirming that the federal government buys into the idea of great national projects.
Consider this example. A bridge more than 100 years old in northern New Jersey serves one of the busiest stretches of Amtrak service and needs to be replaced. The project needs $1.8 billion. Amtrak, NJ Transit and the Port Authority of New York and New Jersey are fully behind the project. Washington yawns. This is a case where selling the sizzle not the steak has only led to the full cost resting on municipal investors.
Here is yet another example. Arizona boasts America’s longest aqueduct, 236 miles. It was built several decades ago by the federal government at a total cost of $4.5 billion. The state of Arizona owes about $2.3 billion to Washington. However, the federal government did the heavy lifting in the early stages when the project carried more risk.
This second entry of the series reveals that municipal bonds are a world unto themselves. Coupon rates and yields rise and fall differently from stocks and while generally seen as lacking the spectacle of corporate shares, bonds perform very handily. The next installment will delve into additional insights into this thriving block of every strong investment portfolio.
Michael McTague, Ph.D. is Executive Vice President at Able Global Partners in New York, a private equity firm.