- Pension crisis driving downgrades offers buyers opportunity
- Citi recommends state bonds on cusp of downgrade for value
For a year, Citigroup Inc. has recommended a strategy that has been controversial among its clients: Buy debt issued by the lowest-rated U.S. states to boost returns in a market where tax-exempt yields sank to historic lows.
Though there is “little optimism” that some of the worst-rated states with negative credit outlooks will see their funding of public pensions improve enough to help their bond ratings, Citigroup continues to “cautiously” recommend the debt to investors, according to a new report.
“It’s a controversial topic, but we think it is a compelling buy,” Vikram Rai, head of municipal strategy at Citigroup, said in a phone interview. “There is downgrade risk, but the credit stress is going to unfold slowly. The spread is compelling.”
Citigroup’s report declines to name specific states but some of the lowest rated such as Illinois and New Jersey, have returned 5.148 percent and 6.067 percent this year, respectively, according to S&P Municipal Bond Indices, some of the highest in the market.
The five states with the most underfunded pensions have seen that status worsen, which has led to rating cuts, Citigroup said. Even as Moody’s Investors Service has maintained a negative outlook for many of its lower-rated states facing underfunded pensions and budget stress, those states have continued to see the yields on their bonds decline along with the rest of the municipal market, which has raised their prices despite downside risk, according to Citigroup’s report.
But Citigroup said it still recommends the low-rated states because of the potential yield pickup. Long-dated Baa2 rated state general obligation bonds are trading at a yield of 3.75 percent, Citigroup said. That is a spread of 1.75 percentage points to top-rated 20-year bonds. It may not sound like much but given the low-rate environment it can “boost portfolio returns quite substantially,” Citigroup said in its report.
No state has defaulted since Arkansas during the Great Depression. And states can’t file for bankruptcy.