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Q1 2024 Credit Commentary – Will this be the year credit trends reverse?

Patricia Healy, CFA
Wed Apr 17, 2024

Interest rates and inflation are still up, but the Fed has paused and indicated that easing will be the next step. However, given better-than-expected economic data, the estimates of rate cuts are fewer and farther in the future. The stock market performed well in Q1, with expectations of lower future rates and perceptions of increased productivity due to AI. The strong market performance has improved the wealth of households, pensions, endowments, insurance companies and others. While Treasury rates rose more recently with the stronger-than-expected economic data, positive demand helped munis have an excellent first quarter. See John Mousseau’s quarterly, Recently, muni yields have followed Treasury yields up, with liquidation of assets to cover tax payments coming due and higher expected supply. Muni demand is expected to increase, as it usually does during the summer, with reinvestment of June 1 and July 1 coupon and maturity payments. Adding to demand may be the expectation of higher tax rates in the future, with the TCJA expiring at the end 2025, though some may benefit through higher SALT deductions.



The first quarter also had the unfortunate, but by now usual, replay of a budget showdown in Congress that at the last moment avoided a government shutdown but through a plan that also avoids big decisions on contentious border and geopolitical issues. The Senate and House now have until Sept. 30, 2024, to negotiate and propose a budget that will pass, which could prove to be disruptive (and informative), given the proximity to the elections in November.

The collapse of the Francis Scott Key Bridge, blocking the Port of Baltimore, is expected to have wide-ranging effects, on the auto and coal industries in particular, but also on broader economic activity and supply chain disruptions. It also shines a spotlight on infrastructure weaknesses in the US and the supply and pricing of insurance for such events. We briefly commented on this and expect to have follow-up commentaries as events unfold: Similarly, the 4.8 earthquake in the tri-state area Friday morning stopped many in their tracks. It also focused awareness on our infrastructure as construction sites, buildings, roads, railways and dams were assessed to see if any damage was sustained.

On April 9, 2024, Moody’s maintained the Maryland Transportation Authority’s Aa2 rating but changed the outlook from stable to negative due to uncertainty around the Francis Scott Key Bridge replacement costs, including funding and timing, on top of financial metrics that were expected to narrow from prior capital investments. The MDTA owns and operates eight facilities, seven of which produce toll revenue to support bonds issued by the MDTA. The collapsed bridge contributed about 7% of Authority revenues; however traffic will be diverted to two other Authority facilities. The minimal rating action at this time attests to the importance of the MDTA facilities and the strong management and historical financial operations.

Commercial Real Estate

Concern continues over the future of older office buildings with the work from home (WFH) trend, and by extension there is concern about regional banks that have lent to such properties and municipalities that have large budgetary exposure to them. However, other areas of commercial real estate such as retail, industrial, warehouse, and healthcare are in better shape. Tempering concerns for banks are diversification and staggered maturities of loans, while diversification of large taxpayers - not just office buildings, and flexibility to phase in changes in assessed values and tax rates temper concern for municipalities.

Delays in financial statements – shortage of accountants

The healthy March jobs report showed increases in employment including higher than average increases in local government employment, which had been lagging, as municipalities have had trouble attracting talent. There remains a shortage of accountants, with both municipalities and companies having challenges completing financial statements in a timely fashion. These challenges have led to issuers being placed on credit watch for a downgrade and/or withdrawal of credit ratings because the rating agencies do not have sufficient information to maintain opinions. In early March, S&P placed almost 200 muni ratings on CreditWatch negative and indicated that if financials were not received then ratings would be withdrawn. The Wall Street Journal reported that Tupperware and Advance Auto Parts have had delays and that companies are having trouble attracting auditors and accountants. The WSJ reported last fall that “Companies over the past year have cited a lack of skilled accounting personnel for material weaknesses in their financial-reporting controls, typically a predictor of restatements. More accountants are retiring without an adequate pipeline of entrants in the profession to fill the void.” We note that this shortage of accountants comes at a time when the SEC and investors are requiring more detailed disclosure, including climate-related information.

Consumer, global corporates, and munis

The backdrop of strong equity returns and higher fixed-income yields is juxtaposed with higher prices, the expiration of pandemic funds, rising insurance premiums, and higher consumer delinquencies and defaults. Moody’s expects consumer credit to shrug off last year’s increases in delinquencies and notes that surveys of consumer confidence, while mixed, are stronger than last year. Moody’s also saw an increase in global corporate downgrades and defaults, though expectations in the future are for stabilization.

Muni upgrades continue to surpass downgrades. Moody’s notes that 2023 was the third such year in a row, with 716 upgrades to 199 downgrades. S&P upgraded 1,157 ratings and downgraded 225 in 2023. S&P calculates a downgrades-to-upgrades ratio (excluding housing), and in 2023 it was relatively low at 0.23. This compares with the highest recorded ratio since 1981 of 5.36 in 2020 at the height of the pandemic. The lowest ratio was 0.06 in 2008; and while the economy was poor following the global financial crisis, the ratio has not exceeded 1.00 except in 2020. The second highest ratio was 3.68 in 1991, and the early 1980s also had more downgrades than upgrades. After the financial crisis, which brought increased regulation of the rating agencies, there was a movement to better align muni ratings with corporate ratings on a default-rate statistical basis, that is, to effect a recalibration because rated munis have a much lower default rate than rated corporate bonds. In 2010, Moody’s recalibration resulted in upgrades to over $2 billion in munis.

The not-for-profit healthcare and higher education sectors, however, saw more downgrades than upgrades during 2023 as both sectors were impacted by demographic changes, higher labor costs, and capital expenses, coupled with limited revenue growth. Moody’s revised its outlooks on the two sectors to stable from negative, while S&P continues to maintain negative outlooks on healthcare and mass transit and has a mixed outlook on higher education, with smaller private schools having more challenges.

S&P revised the outlooks on public power and electric cooperatives to negative in January, while keeping the retail electric sector outlook stable. The negative outlook reflects inflation, reduced wherewithal for ratepayers to pay utility bills, the sensitivity of rate-setting bodies to economic conditions, and generally weakening financial metrics. This negative outlook also considers regulatory and legislative mandates that would trigger substantial utility spending on clean generation resources. This is often referred to as energy transition risk.

Municipal water systems continue to have stable rating agency outlooks because of independent rate-setting authority and good financial cushions; however, headwinds prevail, given increased regulation of “forever” chemicals and other contaminants as well as supply concerns and affordability issues. Recent settlements with chemical companies will help reduce costs for the systems most affected. Challenges also include water-supply issues due to drought or overdevelopment, which could constrain economic growth, affecting not just water system credit quality but also general government credit quality if not managed properly.

Overall, future upgrades may be limited because there have been so many upgrades in the past three years. Anecdotally, we see that the trend of upgrades surpassing downgrades continued in Q1.

To sum up, it does not appear that this is the year credit trends reverse, but they may plateau. There are numerous global and local events that could affect this outlook; but overall, municipal fundamentals of good budgeting and healthy reserves remain.

State ratings

Pension funding has always been an important issue for state ratings, because it is a large and generally growing expense that if not managed properly could overwhelm the financial strength of a state or any municipality. We saw this particularly with Illinois and New Jersey, whose credit ratings fell but more recently have risen again with higher pension funding levels in conjunction with and because of better financial management and budgeting.

There are other issues on the horizon that municipalities need to manage that are slow-moving but need to be addressed. They include an aging population, a smaller workforce, and other demographic movements; water scarcity and energy transition impacts and costs; preparations for a changing climate, with rising sea levels, more frequent flooding, and bigger, deadlier wildfires; as well as aging infrastructure in general. These items are being observed by analysts, think tanks, rating agencies, and municipalities themselves. To the extent the issues are not addressed, they could result in rating changes in the future. In the discussion of state rating and outlook changes that follows, pension funding is mentioned, as are demographic trends.

Louisiana was upgraded by S&P to AA (March 20th), reflecting the state’s demonstrated commitment to improving and maintaining reserves above levels that S&P considers very strong, as well as the state's ongoing effort to reduce unfunded pension liabilities through strong pension funding discipline. The state's buildup of reserves should help mitigate the effects of possible revenue disruptions or unanticipated cost escalations, while its improved pension funding should help reduce the potential for significant long-term fixed-cost pressures. The state’s debt is rated Aa2 by Moody’s, AA- by Fitch, and AA by Kroll. Louisiana has recovered substantially from poor financial operations and the destruction by Hurricane Katrina in 2005 when its S&P rating was A.

New Hampshire’s rating was upgraded to AA+ from AA by S&P (March 25, 2024). The upgrade incorporates the state’s improved economic and demographic growth trends that continue to perform near or above those of US and regional peers. S&P further notes that the state's demonstrated commitment to controlling expenditure growth, preserving revenue stability, and building higher reserve balances across recent economic cycles position it to sustain financial stability. Moody’s and Fitch rate the state’s debt Aa1 and AA+, respectively.

Washington State’s outlook was changed to positive by S&P on its AA+ rating (January 11), reflecting the state's positive economic momentum that will help support revenue collections over the current biennium. The commitment to maintaining and replenishing its reserves and robust forecasting practices will benefit the state in identifying potential pressures, and the state will continue to balance expenditure growth with available resources in future budgets. The state is rated Aaa by Moody’s and AA+ by Fitch.

Mississippi’s outlook was changed to negative from stable by S&P on its AA rating (March 1, 2024), reflecting elevated credit risks stemming partly from persistently weak economic and demographic trends, which could result in an increasingly challenging budget environment as the state manages through its phased-in income tax reductions. Budgetary pressure is further elevated due to pension contributions falling short of their actuarially determined contribution amounts in each of the past three years, along with a relatively high level of unfunded pension liabilities. S&P noted that the long-term rating reflects Mississippi's strong government framework and responsive financial and budget management practices that have historically aided structurally balanced budget performance and maintenance of strong reserve balances. Debt is rated Aa2 by Moody’s and AA by Fitch.

At Cumberland we take a top-down approach to analysis, so we will be watching global developments, the economy, and interest rate movements, as well as how municipalities are addressing longer-term risks. The majority of our muni bond holdings are rated in the double A category, characterized by a wealthy and diverse economic base, strong financial operations, reasonable debt levels, a manageable pension liability, and proactive management.


Patricia Healy, CFA
Senior Vice President of Research & Portfolio Manager
Email | Bio


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