Municipal Bond ETF’s Still Have Illinois Bonds

The largest Exchange Traded Funds (ETF’s) in the country are still holding the debt of Illinois. Technically speaking, all 50 states have always had Investment Grade bonds. That is, their bonds are rated at or above Standard & Poor’s BBB rating (Moody’s Baa rating). ETF’s have had plenty of justification for holding on to a slice of every State’s debt, it could be argued. That may be changing for Illinois debt, as it appears to be on the precipice of Junk (below Investment Grade) rating. This will be a unique challenge to Municipal Bond ETF’s and Index Mutual Funds.

Exchange Traded Funds track an index that is typically constructed and or maintained by a third party firm. This is not true for all ETF’s (for instance, Wisdom Tree sometimes use Indexes it creates), but it’s true of many of the most highly capitalized funds for example, tickers SPY and AGG). Hypothetically, it could be argued that there is room to dodge certain obvious bad apples in an Index for many ETF’s: even the largest and most passive ETF’s use statistical sampling to recreate the performance of the underlying Index being used.

The problem for large Municipal Bond ETF’s is uniquely complex. Should Illinois be downgraded, as some have suggested, will these ETF’s stop indexing the state altogether? Will the underlying indexes drop Illinois? Will they keep Illinois but become more specific about which particular bonds are indexed (i.e. Bonds that come with revenue backing versus a General Obligation of the state)?

On June 27th, Bloomberg published an article titled “Illinois Is in a $6 Billion Budget Hole and Flirting With Junk.” In that article, they note that Illinois may very become the first state in United States history to be downgraded to “Junk” status. 1 

Should Illinois start the fiscal year with no budget, S & P Global Ratings  claims it will likely downgrade Illinois. The obvious problem with having no budget while running a $6 Billion deficit is that there is no end in sight to the financial crisis the state faces. There is no credible exit plan for the near future, so to speak.

Junk status would actually deepen the state’s financial hardships. There are $100’s of millions in unpaid costs on servicing existing debt for the state. Funding those payments with subsequent new debt will be even more costly, as borrowing costs will inevitably rise with a downgrade to Junk status. Many states have constitutions mandating either balanced state budgets or limiting deficit spending, but Illinois does not. It’s run a deficit since 2002, leading to the accumulation substantial debt to service.

Since there is neither the ability nor precedent for a state to simply file for bankruptcy, Illinois must find a political means to fiscally navigate out of its current debt troubles.

One issue unique to the ETF industry is that many indexes may not give ETF providers adequate leeway to sample indices without including debt that investors will see as increasingly undesirable. There will be plenties of issues even within Illinois that receive adequately high ratings from agencies, as different securities are issued by separate entities within the state that have discrete funding sources. For instance, the bonds of a well established, highly efficient research hospital may issue revenue-backed debt that is the highest possible rating even as the state’s ratings degrade.

Indexes may face no compelling technical reason to expel Illinois securities from their ranks. Investors may find any Illinois debt unpalatable, however. Should that manifest in net outflows from passive funds still invested in the state, it may result in a need to reposition either underlying indexes or how sampling to track those indexes is done at the fund. As of the time of publishing this, none of the 5 largest Municipal bond ETF’s have disinvested in the state, with the largest fund (Ticker: MUB) allocating 2.53% to Illinois.

ETF’s and Index Mutual Funds have picked an increasing share of the fund universe’s capital in recent years. They aren’t the only available options, however. Investors who do not trust the fundamental viability of Illinois’ finances may end up taking their funds elsewhere.

Actively managed Municipal Bond Mutual Funds may prove an attractive choice for bond fund investors looking to dodge further degrading finances of problem states like Illinois. Funds like T. Rowe Price’s Summit Muni Income fund (ticker: PRINX) may choose to use their broader mandate to avoid areas investors are nervous about. Many fund families offer actively managed fund options.

For Variable Annuity investors, there should be little if any concern. Variable Annuities are tax-deferred investment vehicles by nature. Including Municipal bonds in these portfolios is almost always a sub-optimal choice, as the only way to make many Municipal bonds taxable is to include them in a tax-deferred account. Instead of receiving tax-advantaged income they typically do, their growth and income become a taxable distribution from the account. As we’ve covered before, Municipal Bonds are priced to account for their lower nominal yield by way of a favorable tax-equivalent yield investors consider before purchasing these bonds.

One often-overlooked option that may attract renewed investor attention in the wake of Illinois’ potential downgrade is Closed End Funds. The majority of all Closed End Funds in existence are dedicated to investing in various segments of the Municipal Bond market. These funds often have the broadest of all fund mandates, and typically are tactically active by nature. These often more aggressive funds are managed in a way that allows them to be discerning in their security selection at times. This feature may appeal to the more cautious Municipal Bond investor who still desires high income from their bond portfolio.

ETF’s that track Municipal Bond indexes may end up benefitting from the more market-agnostic attitudes of passive index investors. Those that continue to include substantial Illinois positions in their portfolios may drive some of the more conservative investors away, however, as headlines and news stories sensationalize the burgeoning crisis. Investors may end up reevaluating their Municipal holdings in the wake of the increasingly publicized debt dilemma facing the state. Alternatives do exist for these investors, and that could put passive Municipal ETF’s in a difficult place, perhaps taking uncomfortably proactive measures in a passive industry.