Municipal Credit and the Pandemic
The negative economic and fundamental credit consequences from COVID-19 are raising concerns among municipal investors. As the unfortunate effects of the pandemic endure, municipal entities are faced with growing revenue shortfalls as sales and income tax revenues decline and social service costs spike in sympathy with demand. Some of the largest municipal issuers and state governors have made public appeals for additional federal aid with the growing size of losses, which has caught the attention of the market, prompting questions surrounding whether the current level of federal aid is enough.
We do not expect the pandemic to result in wide-scale defaults among municipal credits. The vast majority of credits have underlying strengths, such as extensive taxing power and independent rate setting authority that support flexibility to continue making debt service payments. That said, the potential for rating agencies to downgrade certain credits is high as changes in revenue and cost profiles will likely persist across all sectors and worsen in the coming weeks and months. With this level of economic disruption, weaker municipal credits have a propensity to be stressed and even default. However, we are confident that the overall credit picture for investment grade municipal bonds remains solid. We believe an active security selection approach, coupled with a high-quality bias, will help investors face the challenges ahead.
State and Local Governments
Certain credits will come under more stress than others amongst both general obligation and revenue sectors. From a state and local government perspective, the biggest hit to state budgets is due to the dramatic reduction in tax revenues including personal income, sales, corporate, capital gains taxes, among others. The Center on Budget and Policy Priorities released a report that estimates collective state budget shortfalls of $185 billion, $370 billion and $210 billion for fiscal years 2020, 2021 and 2022, respectively.1 Increased spending due to unemployment benefits and healthcare as well as for direct COVID-19 response expenditures like personal protective equipment (PPE) and testing acquisitions is causing additional strain.
Severe market losses have eroded pension plans, many of which were already well below full funding levels prior to the pandemic (albeit showing improvement in recent years due to increased contributions and rising market valuations). According to Milliman, the average public pension funding ratio declined from 75% to 66% in the first quarter of 2020.2
Fiscal stress caused by the pandemic will also undoubtedly negatively impact states’ ability to continue to fund infrastructure projects, which are vital to both address needed replacement and repair and mitigate the impact of climate change. However, there could be a federal effort to stimulate these projects and create jobs. President Trump frequently emphasizes the need for infrastructure spending and has suggested its inclusion in future stimulus plans. There has also been consistent bi-partisan support for infrastructure investment, albeit through different approaches. Furthermore, interest rates remain low, which provides an opportunity for long-term financing at a relatively low rate.
Improved fiscal discipline is also supportive of states and localities. Most have enjoyed robust post-recession revenue growth and improved cash reserves. We believe states and local governments will likely want to maintain some level of reserves for future emergencies and are incented to manage a portion of their budget deficits via expenditure reductions. Also, the level of potential federal aid could temper the magnitude of draws from reserve funds. Regardless, we do not expect the possibility of depleted reserves to have any impact on the ability of states to meet their debt obligations. States are required to have balanced budgets and have many tools at their disposal to achieve this obligation, including the ability to cut expenditures and/or raise taxes. On a relative basis, we believe state and local governments with diversified revenues streams and solid pension systems should prove resilient in this environment.
Generally, performance across the revenue sector has been further penalized compared to general obligation debt on the back of the recent disruption to municipal credit. Importantly, our internal analysis of revenue debt found many sectors have additional stable financial results than comparably-rated state and local general obligations. During times of economic volatility, the revenues backing debt service payments on revenue bonds can be more stable than the taxes that back general obligations.
Revenue sector performance will continue to show a distinction between “good” and “bad” credits as the full economic and financial impact of the pandemic unfolds. In our opinion, revenue sectors most at risk are those associated with travel (e.g. airports, toll roads and mass transit), healthcare (e.g. hospitals and continuing care retirement centers (CCRCs)), and leisure/entertainment (e.g. hotels, convention centers and stadiums). Essential service sectors such as utilities/water/power should alternatively hold in relatively well.
Declining enplanements fueled by the coronavirus pandemic adds fiscal pressure to airlines as well as airports. Airports in general have robust liquidity, and shutdowns will allow expenditure reductions. Federal support for both airlines and airports is a positive and mitigating factor.
Mandated telecommuting, school closures and limitations on public gatherings collectively represent an event risk that will lower traffic and revenue. The majority of toll roads have significant scale and entrenched market positions with notable liquidity that enables them to better absorb both short and prolonged traffic and revenue shocks.
Hospitals are seeing supply costs rise and revenues decline. Many have built up solid cash reserves and both state and local governments are stepping in to make sure hospitals stay open and stable. Federal support is also a mitigating factor.
Refunds offered to students being forced to vacate early are expected to be minimal for the spring semester. Expect limited refunds from tuition since classes are moving online and should fulfill credit requirements. Unused dining will probably be refunded but are not a large source of revenue. There is a mixed approach to schools offering refunds on housing but the impact is expected to be limited since it is near the end of the semester. Weaker schools, mainly small privates, that had had been struggling before will be most impacted, along with those heavily reliant on endowments draws and international students.
Sales Tax Bonds
Reduced economic activity driven by less travel, cancelled events, tourism, recreation, etc. has negative tax and fee revenue impacts. Many issuers have set aside funds to provide cushion from the stress of lower revenues.
Essential services should fare well in this environment as customers will continue to need electricity, water/sewer, etc., especially as they are required to stay in place. A government bailout that includes sick pay, enhanced unemployment benefits, and potentially direct stimulus payments to individuals, should provide funding to continue paying bills. Worth noting are utilities with service areas that are heavily reliant on industrial/commercial customers could be at risk.
When considering revenue sector exposure, we believe it is important to fully examine a borrower’s balance sheet to gauge financial flexibility and the financial abilities of management. An active approach to individual sector and security selection, backed by robust fundamental analysis, will support relative performance as some revenue sectors will take longer to recover than others.
Going forward, there undeniably remains a level of uncertainty surrounding the full economic impact of the COVID-19 pandemic and the ultimate scale of federal assistance. We believe a prudent focus on sectors and securities with stable, investment grade credit characteristics will lead to relative outperformance as markets ultimately benefit from better liquidity and higher confidence. Importantly, we believe that the COVID-19 pandemic is not the root cause for systemic risk in municipal fixed income. As such, outflow instances tend to generate significant investment opportunity. Effective security selection and an emphasis on credit quality are essential to mitigate a performance impact of any deterioration in municipal fundamentals.
1 Leachman, Michael. New CBO Projections Suggest Even Bigger State Shortfalls. Accessed at: https://www.cbpp.org/blog/projected-state-shortfalls-grow-as-economic-forecasts-worsen on March 20, 2020.
2 Comtois, James. Milliman: Largest public plans see record drop in funding ratio for Q1. Accessed at: https://www.pionline.com/pension-funds/milliman-largest-public-plans-see-record-drop-funding-ratio-q1 on March 20, 2020.
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