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 A handful of the Nov. 4 races such as the dead heat in Illinois,
possibly the most fiscally dysfunctional state, shape up as de facto
referendums on reform and their results could make municipal bond
investors alter their bets.
"People are not so much voting for governor in some of these states
but how they want the pensions addressed," said Craig Brandon,
Co-Director of Municipal Investments at Eaton Vance in Boston.
Investors want to see the states tackling chronic underfunding of
pension plans that over-promised and failed to deliver in the wake
of the 2008-2009 global financial crisis.
Out of 36 races scheduled alongside mid-term congressional elections
investors will focus on those that involved big issuers and could
change the state's budget fortunes.
Over the past two decades, California, New York, Texas, Florida,
Illinois, Pennsylvania, New Jersey, Massachusetts, Ohio and Michigan
- and public entities in those states - have been the top issuers in
the $3.7 trillion municipal debt market, according to Thomson
Reuters data. All but New Jersey are holding governor elections next
week.
The estimated funding shortfall for current and future payouts of
top 25 U.S. public defined benefit pension plans has tripled to at
least $2 trillion in less than a decade, Moody's ratings agency said
last month.
 "If you've got pension fund costs going up at an astronomical rate
and revenues going up at a much more reduced rate - you can't get
blood from a stone," said John Mousseau, director of fixed income at
Florida-based Cumberland Advisors. "Everyone's got to share in the
solution."
TAX DILEMMAS
Raising taxes is one such solution and whether the states follow
that route could be a deciding factor in some races.
In Illinois, which has the most underfunded retirement system among
U.S. states with a $100 billion uncovered pension liability,
incumbent Democratic governor Pat Quinn wants to turn a temporary
income tax rise enacted in 2011 into a permanent one.
His Republican opponent Bruce Rauner wants to phase it out and
suggests savings instead, such as ending the practice of ramping up
state employees' pay before they retire to boost their pensions.
"The permanence of that tax increase would make it a better credit,"
said Peter Hayes, Head of BlackRock’s Municipal Bonds Group, which
holds a variety of Illinois-based debt. Hays said that could
potentially make the group notch up its exposure to the state's
debt.
Some investors also see merits in Rauner's proposals.
"I would think that Rauner offers some long term hope for altering
the business-as-usual approach," said Chicago-based John Miller,
co-head of fixed income at Nuveen, which has around $530 million in
Illinois State general obligation bonds.
The election looks set to come down to the wire with a Chicago
Tribune Oct. 23 poll showing Rauner with 45 percent support and
Quinn had 43 percent.
While tax hikes are inherently unpopular, cutting costs is also
difficult with several such efforts challenged in courts.
In Kansas, governor Sam Brownback chose to do the polar opposite and
slash taxes hoping to spur the economy.
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The state is a minor player in the municipal debt market, but the
race there is interesting because it shows how doing what is
seemingly popular is not a sure winner either.
The tax cuts triggered a Standard & Poor's credit downgrade in
August and polls in local media show Brownback trailing rival
Democrat Paul Davis who promises to end the incumbent's
"experiment." Bond investors will also watch races Pennsylvania
and Rhode Island.
Rhode Island candidate Gina Raimondo, the Democrat state Treasurer
and a former venture capitalist, led some of the nation's most
far-reaching pension reforms in 2011 that drew lawsuits from public
sector unions over benefit cuts.
Cumberland's Mousseau said extending retirement ages and raising
workers' contributions were hardly "anything magical" - but showed
leadership and he would view the state's bonds more favorably if
Raimondo were to get elected.
Eaton Vance's Brandon also said he would be watching Rhode Island
race.
"Labor does not like her, but I think the average person on the
street who doesn't have a state pension likes what she says."
In Pennsylvania, where Governor Tom Corbett is trailing Democratic
opponent Tom Wolf, the hot-button issues are the governor's cuts in
education funding and escalating pension liabilities which
contributed to a recent credit ratings cut.
Corbett's pension reform proposals failed to gain traction during
his term while Wolf says he favors maintaining the status quo for
public employees' pension plans and BlackRock's Hayes sees the
election as one of the most fiscally important.
Some ballot initiatives are also catching investors' attention,
including one in California, where voters will decide whether to
require that surplus revenues are saved for its Rainy Day Fund and
used for emergencies, debts or budget deficits.
 Democratic Governor Jerry Brown, who has turned around the state's
finances after years of deficits, is ahead in the polls against
Republican Neel Kashkari, according to local media.
Hayes said in a research note that California's Rainy Day ballot
proposal has the potential to significantly improve the state’s
future financial flexibility and credit rating.
"We always want the outcome that gives a better credit profile for
any city or municipality," said Hayes.
(Additional reporting by Hilary Russ; Editing by Tomasz Janowski)
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