In the depths of the muni market plunge back in March, many feared that the sky had fallen and that municipalities would not be able to manage their services and debt repayment.
The initial fall in prices was due to a collapse of liquidity, when muni money market funds had no one to sell to – until the Fed stepped in. See John Mousseau’s piece “The Long Strange Trip of the Muni Market in 2020,” https://www.cumber.com/cumberland-advisors-market-commentary-the-long-strange-trip-of-the-muni-market-in-2020/. Concern lingered because no one knew what the pandemic would bring. In John’s piece he discusses the Cumberland Despair Index, which combines the COVID-19 infection rate of a municipality with its unemployment rate – and in some cases this is a big number! The index highlights possible stress and helps to direct our analysis.
Those who are familiar with the municipal market know that municipalities are resilient and have tools to manage through a crisis. See our June 8th commentary, “Where Are Munis Getting Their Money?” https://www.cumber.com/cumberland-advisors-market-commentary-where-are-munis-getting-their-money/. Additionally, by means of the CARES Act, the federal government stepped in to support the increased costs of the pandemic and to provide additional relief to businesses and individuals to “get over the hump.” Importantly for credit quality, many municipalities had experienced 10 years of upgrades surpassing downgrades, and many had amassed healthy reserves.
Most of us live in a municipality, and most of us take its services for granted; so it is hard to imagine that our own town might disappear or not make good on promises to repay borrowing. Over the years, though, there have been highly publicized stories of municipalities, such as Deroit, MI, and Jefferson County, AL, that have had severe problems and even filed for bankruptcy. These stories and a large retail buyer base can sometimes combine to cause pricing volatility or instances of throwing the baby out with the bathwater, as happened during the Meredith Whitney scare, the Taper Tantrum, Brexit, and the Trump election. The muni market sold off in these situations and presented buying opportunities, because, while in general the credit quality of municipal bonds is very good, mutual funds have to sell when faced with redemptions. See our discussion of default rates later in this piece. Rated municipal bonds have very low default rates and generally high recovery rates in the event of a default.
The pandemic created many challenges with its drastic decline in economic activity, and it accelerated trends already in place, including remote work and learning, telehealth, online shopping and food delivery, and heightened cyber-risk. The pandemic also highlighted housing affordability, income inequality, and other societal risks.
Another wave of COVID infection has again reduced economic activity, but vaccinations have begun. We will put the pandemic behind us in coming months, and none too soon.
Additional fiscal stimulus was finally passed by Congress at the end of 2020, and there may be more stimulus in the new year. The stimulus once again does not include direct aid to state and local governments, but it will help support spending and other economic activity that indirectly boosts the revenue of state and local governments. The new stimulus program clarifies that recipients do have the ability to write off business expenses covered with PPP money. The CARES Act hadn’t permitted the write-off, and businesses were afraid they were going to have huge tax bills. The change may reduce tax revenues flowing to state and federal government, but it alleviates a burden on many struggling businesses.
The municipal securities most affected by the pandemic were in the sectors of transportation, hospitality and entertainment, higher education, and healthcare; and most of these sectors did receive CARES Act funding. Many bonds secured by hospitality taxes were supported by the issuing municipality because of the importance of the venue to the local economy or because the issuer had a debt-service reserve it could dip into to make up for a shortfall in pledged revenue. Bonds that are secured by property-tax payments are generally expected to be more stable but may still come under pressure to the extent that the local economy is exposed to tourism and entertainment and depending on the timing of the rebound back to pre-pandemic levels. Places that experienced declines in population, job growth, and property values will be challenged to adjust spending and services accordingly.
S&P took a number of negative rating actions through the third quarter, but a large majority (80%) of actions were outlook changes. Downgrades dramatically outpaced upgrades through the first three quarters of 2020, with 3.7 downgrades for every upgrade. S&P notes that downgrades had not outpaced upgrades since 2011. Moody’s states that rating activity was lower in November, with downgrades at 19% of actions and upgrades at 18%, while affirmations and confirmations accounted for the rest. In November, negative actions were 50% lower than in October, and November actions were significantly below the 2020 monthly peak in April, just after the coronavirus’s economic damage began to take hold.
Moody’s notes that although COVID-19 continues to weigh on credit quality in US public finance, the sector demonstrates overall stability. And although negative ratings actions were not as extensive as feared, S&P notes in its December 10, 2020, report U.S. Public Finance 2020 Year in Review: One Like No Other that the extraordinary events of 2020 will likely shape the decade ahead, wryly observing, “This year won’t be over for years to come.” As the pandemic has continued to spread, public finance issuers across the US have had to navigate the social, financial, and economic effects of the disease. And we remind our readers that after the 2008–09 financial crisis, downgrades exceeded upgrades for years.
Both rating agencies have indicated that their ratings do not include the expectation of additional stimulus. How issuers navigate the next few years and any additional stimulus will certainly affect issuer credit quality.
State Downgrades in 2020
Outlooks on all states are negative, as are the outlooks on most municipal sectors.
Hawaii and New York State were downgraded to Aa2 by Moody’s, due to the effects of COVID-19 on their economies and revenues.
S&P downgraded Alaska to AA- and Wyoming to AA as a consequence of the collapse in oil prices and COVID-19. S&P’s downgrade of New Jersey to BBB+ reflected a structural budget deficit, increasing debt, and pension underfunding that would be further exacerbated by the pandemic.
Keep in mind that if a state is downgraded, there are many entities in the state that may also be downgraded because they depend on the state for funding or security. In New York, some of the Dormitory Authority bonds are an example. In New Jersey, the transportation trust fund bonds, though they have their own dedicated taxes and fees, rely on the state to appropriate the dedicated funds; and they were downgraded along with the state. State intercept programs that withhold state aid for bond payments that support many school district issues were also downgraded.
The state of most concern currently is Illinois, which is rated BBB-/Baa3 by S&P and Moody’s, with a negative outlook. The state attempted to raises taxes on wealthier residents through a hotly debated ballot initiative in November; however, voters turned down the increase, and the state needs to come up with an alternative plan. Illinois has the second-worst-funded pension system – better only than New Jersey – as ranked by Pew Charitable Trust.
Recently a number of smaller, riskier continuing-care communities and land-secured deals dependent on growth have become impaired. This news makes investors skittish; however, many of the defaults are by issuers that were not rated or in corporate-like business lines.
Moody’s default study, published in July, showed the 10-year cumulative municipal default rate for investment-grade credits at just 0.10% and for all rated municipal bonds at 0.16%. These figures compare with corporate bond default rates of 2.25% for investment-grade and 10.18% for all rated. Recovery rates are higher for municipal bonds, too, at 68%, compared with 47% for corporate bonds. However municipal recovery rates are variable, ranging from 100% to 0%.
The ravages of COVID-19, the specter of downgrades, and the possibility of some defaults have increased the value of bond insurance to investors, and the rate of its usage has increased. The two active bond insurers are Assured Guaranty Municipal (AGM) and Build America Mutual (BAM).
AGM is a legacy bond insurance company with tremendous resources and is rated AA and AA+ by S&P and Kroll Bond Rating Agency, respectively. It has exposure to some defaulted Puerto Rico bonds; however, healthy capital levels and strong management reduce the risk to the company of Puerto Rico losses. BAM is a relatively young bond insurer with a mutual company structure. It is not as large as AGM, but it has no Puerto Rico exposure. It is rated AA stable by S&P.
The Year Ahead
The prospects for municipal credits in the coming year depend on the shape and speed of the recovery. The acceleration of certain trends may increase productivity, and the pent-up demand for personal interactions may combine to make the next few years boom – or many people may continue to be restrained or just not find as much interest in travel and group gatherings as they previously did. In either case, here are some credit-related issues we will be looking at in 2021 and beyond. Some are very long-tailed risks, such as pensions or population declines, which will challenge management to reinvent the raising of revenues and the provision of services to municipalities. The lingering risk of short-term shocks such as COVID-19 or, for smaller municipalities, the loss of a major employer will fully challenge management.
Pension funding remains one of the biggest risks to municipal credit. COVID-19 has had shocking effects on revenues and expenses, and municipalities may be tempted to reduce payments to pension plans, but that choice could lead to bigger problems down the road. Market participants will be watching how municipalities manage this. Although the stock market has performed well the past couple of years, assumed rates of return in projecting pension funding remain above actualized levels.
Of concern is the news of very underfunded pensions or growing unfunded pension liabilities, which could crowd out services and in the longer run could take priority over bondholders. These are trends to watch.
Shifting demographics are another issue for pensions. The recently completed census shows what we have all observed: The Northeast and other regions are losing population to southern states and states with lower tax rates. In many places there is a shrinking workforce that must support a growing number of retirees, further exacerbating the pension problem. Some pension underfunding stems from population moves, some from technological advances, and some from longer lifespans. This issue has been highlighted for years by numerous entities such as Pew Research Center, other think tanks, and the rating agencies. This is an early warning system, and sponsors of public pension funds should be warned that this is the biggest long-term problem. If it is not addressed, it will reduce budgetary flexibility. This is an area of analysis that Cumberland has been focused on for many years; and it is why we have avoided the debt of entities such as New Jersey and Illinois, which have little budgetary flexibility and have experienced numerous downgrades.
Pension obligation bonds are sometimes issued to add funds to a plan. This strategy can reduce the annually required contribution, though debt service on the POBs still has to be repaid. A decline in pension fund market value shortly after investing the proceeds of the POBs could result in the need for higher annual contributions than hoped for.
Cybersecurity and internet access issues
COVID-19 accelerated many trends that were in place, such as remote learning and working. A few months back, a survey of mayors indicated that expanding broadband was one of the most important ongoing capital investments. At the same time, with so many folks online, the demands on our systems have made them vulnerable to cybercrime. Individuals, businesses, and governments cannot afford not to invest in cybersecurity. This issue has and will continue to be an area of focus for municipalities. Some have put in place a chief cybersecurity officer (CCSO) or other layers of management dedicated to cybersecurity issues.
COVID -19 and the economic shutdown wreaked havoc on revenues, so additional taxes and fees are anticipated over the next few years. This consequence will likely make tax-exempt municipal bonds more desirable.
ESG (environmental, social and governance-related investing)
COVID-19 and the economic shutdown cast greater light on many social differences, such as income inequality, home affordability, and access to healthcare. The year also saw record-setting hurricanes and wildfires – environmental risks. At the same time, the desire of many investors to have their investments have an “impact” has been growing.
The increase in the use of taxable municipal bonds has attracted “crossover buyers” such as sovereign wealth fund pension plans, which have for years been concerned about impact. Thus ESG-related credits could see more demand and possibly better performance because of these buyers. ESG may be something for account managers to keep in mind, although it has been hard to prove in the past that impact investing makes a difference in returns. Better AI and other tools are being developed to measure impact and returns, so ESG is an area to watch.
At Cumberland Advisors we assess macro and micro trends to evaluate the credit quality of our portfolio holdings. We consider shorter-term shocks like COVID-19 and longer-term trends such as population shifts and their effects on resources and spending needs. No doubt 2021 should shape up to be a most interesting year for life and for investment. All of us here at Cumberland Advisors wish you a happy and healthy 2021!