Cumberland Advisors Market Commentary – COVID-19 and Municipal Credit Quality

Author: Patricia Healy, CFA, Post Date: March 2, 2020
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Until recently it was unclear if the new coronavirus would reach the United states. Now we have 88 reported cases in the US, at least two without a clear connection to travel to China, and as of Sunday night two deaths; so we feel it is time to comment on the ability of US municipalities to withstand financial dislocations resulting from the virus. Please see https://cumber.com/category/market-commentary/ for numerous commentaries by David Kotok on COVID-19 and other virus-related discussions.

Market Commentary - Cumberland Advisors - COVID-19 and Municipal Credit Quality

Municipal credit quality continued to improve through the third quarter of 2019, per Moody’s and S&P, with upgrades still more prevalent than downgrades; and from our observations it seems that trend is persisting. One of the reasons for continued upgrades is the growth of rainy-day funds, or set-aside reserves. These balances can counter an unexpected decline in revenues from a reduction in employment or economic activity (think faltering income tax and sales tax revenue) or shocks to expenses (a bad snowstorm or other natural disaster). At the same time, corporate bond credit quality has drifted lower; and, as many economic pundits have opined, a shock from the virus could reduce employment in the US as supply chains are disrupted, consumers pull back on spending, and corporations reduce hiring. To the extent that these impacts materialize, they will affect the level of income and sales taxes that help fund municipal operations.

If the virus follows a SARS or MERS or flu trajectory, the economic dislocation should not last long, and economic conditions would likely rebound, with pent-up demand for certain products and services reversing the slowdown to some extent. An extended dislocation and decline in economic growth could cause reductions in financial flexibility, though we have a long way to go on that front, with the national unemployment rate at a low 3.5%. (See John Mousseau discuss current market conditions with Suncoast News here: https://www.cumber.com/cumberland-advisors-president-ceo-discusses-worst-week-on-wall-street-since-2008-financial-crisis/.)

As the virus takes hold in the US, federal and state aid to municipal health providers would also be expected to improve preparedness around the country and could help soften the blow to rainy day funds.

The healthy reserves of many states and cities are why we think municipalities are well positioned to weather some economic dislocation. We have mentioned numerous times that this build-up of reserves is a function of the memory of dislocations from the financial crisis. The drawdown of reserves to counter lower revenue growth would likely be met with expense reductions as well. The drawdown of reserves, in and of itself, should not result in a ratings downgrade, because a municipality should not be penalized for using a rainy day fund for its intended purpose. However, a municipality that continues to draw down reserves without a stated plan to replenish them may be subject to a downgrade if corrective action is not taken.

Other sectors of the municipal market, such as state housing agencies, utilities, airports, and toll roads, have also improved as a result of good growth and improved financial operations. Granted, there are municipalities that have been downgraded due to increases in debt, reductions in state aid, population declines, and poor pension funding, among other reasons. Consequently, it is important to differentiate among credits when investing.

What about our US healthcare system? How well are our municipal or not-for-profit healthcare systems and standalone hospitals financially prepared to cope with the virus? Municipal healthcare-related bonds are issued mostly by not-for-profit healthcare systems that have been growing and diversifying by acquisition and new construction projects. They are generally large and have been diversifying both geographically and with respect to product delivery (by providing insurance or acquiring doctor groups, for instance), all while trying to keep ahead of ever-mounting patient-information regulatory and technological requirements. Many of these systems have national or regional service areas, adding to diversification.

The rating or credit quality of the healthcare sector has been mixed, with some systems experiencing upgrades as acquisitions add to diversification and a better competitive position, and some systems experiencing downgrades because of increasing leverage and/or having become too large and thus more difficult to manage. There are also standalone hospitals in urban settings and rural areas, and the bonds issued for these institutions are sometimes secured by a general-obligation pledge of a municipality as well as by net hospital revenues.

We expect the effects of the pandemic to be uneven. Urban settings may have more resources to fight a pandemic; however, since more travelers pass through densely populated urban areas, the virus could be brought in and spread more rapidly. Conversely, a rural hospital may have little transmission in its service area, but does it have the resources to confront a viral breakout if one occurs? In a pandemic there would likely be a surge in virus treatment at the expense of higher-paying surgical procedures. An important metric to consider when evaluating healthcare credit is number of days of cash on hand. Many higher-rated credits have in excess of a year’s worth of cash to cover expenses, as well as investments whose value exceeds outstanding debt.

It is comforting, to some extent, to be hearing more news about preparedness efforts at states and cities, hospitals, and businesses. The Wall Street Journal had a comprehensive article today on US hospital preparedness: https://www.wsj.com/articles/widespread-coronavirus-cases-could-tax-u-s-hospitals-11582920055. At Cumberland Advisors, our business continuity plan has gone into place as we assess the ability of our employees to work remotely, and we have encouraged folks to stock up on nonperishables. Our location in coastal Sarasota, FL, has many of us conditioned to being prepared for disasters such as hurricanes.

The spread of the virus worldwide, travel bans, and self-imposed reductions in travel will likely affect airports. Airports in the US have various types of contracts with airlines, some that insulate the airport from declines in traffic, some that are are based on traffic, and others that have elements of both. Airports with contacts based on traffic generally have strong debt service coverage and liquidity. Ports have contracts with shippers, which generally include minimum obligatory payments. Enplanements at airports and tonnage through ports are leading indicators for the health of these systems regardless of the contracts and should be monitored for changes and for management’s response to changes in traffic.

At Cumberland Advisors, we are attuned to current developments and keenly aware of past history regarding epidemics and pandemics and the effects they can have on various sectors of the economy and on municipal credits. We will continue to take developments with regard to COVID-19 into careful consideration in our investment decision-making.

Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
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Upcoming event with Cumberland Advisors that features a panel with Patricia Healy…

Join Cumberland Advisors on Friday, March 20, 2020 for a program called “An Outlook on Energy Policy“. The event is held in partnership with the Global Interdependence Center, the University of South Florida Sarasota-Manatee, and with support from the Alliance for Market Solutions and First Trust. This half-day conference will explore investing in energy, policy approaches to climate change, and energy’s effect on Fed policy. “An Outlook on Energy Policy” will feature Danielle DiMartino Booth, CEO & Chief Strategist for Quill Intelligence LLC, Samuel Rines, Chief Economist, Avalon Advisors, Jim Lucier, Capital Alpha Partners, Former Congresswoman Gwen Graham, Former Congressman Carlos Curbelo, Jim Slutz, Director of Study Operations at the National Petroleum Council, along with other speakers and moderators.

More information and speaker bios can be found at the Global Interdependence Center website: https://www.interdependence.org/events/an-outlook-on-energy-policy/

We look forward to sharing with you an event filled with conversation, thought leadership, and valuable information.


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