Once upon a time, US municipal bonds were generally considered less risky than corporate bonds. Backed by the full faith and credit of state governments, investors had confidence they would receive their principal plus interest without fail. Times have changed. For some states and local governments, decades of financial mismanagement and massive pension liabilities are threatening to upend the full faith and credit pledge. In this article, Franklin Templeton Fixed Income takes a look at the situation, with Illinois being an example of a particularly dire case.

As municipal bond analysts, assessing pension risks hinges partly on the willingness of elected officials to implement tangible pension reforms. Absent that, large pension obligations can significantly degrade budgets, credit quality and eventually impair bondholders.

Here’s the good news: after excluding some local bond exposures, like Chicago’s, that still leaves well over 85% of the general municipal market available for investment. In some instances, we think essential-service revenue bonds offer more stability than general obligation bonds.

A Global Challenge that Feels Very Local

If there’s one issue where frictions between budget reforms and politics burn brightest, it’s pensions. With the proportion of retired pensioners and lifespans increasing across the globe, many governments face a challenging dilemma: how to raise enough tax revenues from the young to pay for the pensions promised to the retired? It’s a vexing issue that impacts our firm’s sovereign bond research as much as it does our municipal bond analysis.

Consider Brazil, for example. Pension liabilities currently absorb a third of Brazil’s federal tax receipts and fuels chronic deficits. Transitioning to a sustainable glidepath means Brazil’s new president, Jair Bolsonaro, must pass sweeping reforms that require changing Brazil’s constitution. Even if the reforms make it through congress this year, there’s nothing stopping a future president from reversing them.

Case in point: Italy. After passing reforms in 2011—increasing the retirement age to 67, shifting more workers to defined contribution schemes, and stopping inflation indexing of pensions above a certain income level— Italians elected a new government in 2018 that promised to overturn them.

In the United States, unfunded pension liabilities loom particularly large at the state and local level, making them a key focus for our municipal analysis. The scale of the liabilities is unnerving.

In August of last year, Moody’s reported that adjusted net pension liabilities across US states spiked to $1.6 trillion in fiscal 2017—increasing 25.5% from the prior year and representing 147.4% of state revenues.1 When Moody’s and the US Federal Reserve add up unfunded pension liabilities across state and local US governments they total around $4 trillion.2