All states reopened by the end of the second quarter, and the pent-up demand for travelling and visiting with one another returned in boatloads – or should I say plane loads! Even the airport sector has a stable outlook from rating agencies and analysts. US airport traffic is up substantially from last year’s June 27 figure of 633,810 passengers, though this year’s figure for the date, 2.17 million passengers, is just 83% of the total for the same day in 2019. (TSA checkpoint travel numbers (current year versus prior year(s)/same weekday) | Transportation Security Administration)
Many municipal negative sector outlooks assigned during the pandemic were revised back to stable during the first and second quarters. Most recently, on June 23rd, S&P revised the outlook on hospitals to stable from negative, based on good revenue recovery, strong balance sheets, and good management providing financial stability. Some sectors and credits dependent on enrollment, occupancy usage, or ridership remain negative, such as higher education, some transportation, and senior living communities.
In this quarter’s commentary we discuss the many moving parts of the recovery and the muni credit scene:
• Municipal credit quality trends and themes we are watching for indications of future credit quality – including the energy transition away from fossil fuels
• Infrastructure and stimulus
• State rating actions – some surprising
• The Affordable Care Act
• Fund flows and extreme demand for munis
The positive municipal credit story is three-pronged:
• Revenue collection higher than budgeted expectations due to higher income, capital gains, and sales taxes
• Substantial federal stimulus funds to individuals, businesses, and municipalities
• Good credit quality and reserves prior to the pandemic
These conditions helped municipalities weather the pandemic. However, changes brought on or accelerated by the pandemic remain as challenges. Consider the following:
• Population movement to suburbs or low-cost states: The pandemic and the shutdown of the economy initially caused a dramatic change, with an observed trend in populations shifting and employers and large taxpayers moving to less dense locations and those with lower taxes. Other factors that induce people and companies to move are climate, affordability, crime level, housing availability, and tax policy. These are systemic issues that a municipality may be able to address.
• Increases in tele-health, tele-education, tele-work, and going paperless. Trends in these areas can challenge management but may also provide opportunities for savings with more online presence. This presence will likely change trends in enrollment at schools and colleges, occupancy at hotels and hospitals, and ridership on mass transit, to name a few; and these are all items that affect revenue collection and credit quality.
Then there are items that were issues to contend with prior to the pandemic. Many of the risks are long-term in nature but need to be addressed now.
• Pensions and other post-employment benefits (OPEB) are a serious ongoing issue.
• Infrastructure repair and rehabilitation remain to be managed. Our US infrastructure has an overall rating of C- from the American Society of Civil Engineers (America's Infrastructure Report Card 2021 | GPA: C-). Stories of failed infrastructure reducing public efficiency are not hard to find. They include the I-40 bridge connecting Tennessee and Arkansas, where a structural crack caused bridge closure and truckers and travelers lose more than an hour of their time, compared with eight minutes to cross when the bridge is in service.
• Severe weather and climate events are becoming more frequent. The West is in a major drought, threatening water levels. Texas experienced a deep freeze that temporarily brought down parts of the state’s electric grid. Many states have dealt wth longer and stronger storms, sea level rise, or more frequent wildfires.
• Cyber risk management is a necessity. Many munis are on top of this, and states, as vendors to municipalities, can also play a role. Munis manage vast amounts of data and operate essential utilities and hospitals. Cyber officers, cyber insurance, and policy statements against paying ransomware are becoming more prevalent.
• There is risk in the energy transition away from coal, oil, and even gas. This trend may affect the credit quality of electric utilities, of municipalities that depend on fossil fuel-based utilities for taxes or employment, and of munis with a dependence on extraction royalties and fees. There are some indications that nuclear utilities may do better during the Biden administration.
These are the trends we will continue to monitor with regard to how they affect the bonds we invest in.
Infrastructure Plan and Stimulus Spending
In our Q1 commentary, “Q1 2021 Credit Commentary: Back to the Past?” we discussed the various approved federal stimulus programs and the potential for infrastructure funding. It appears an infrastructure plan may continue to be elusive, and some market participants think it may be binary: Either we get both plans or none at all.
The infrastructure plans envisioned by the Biden administration are large and encompass so-called social or care infrastructure. A bipartisan version has evolved for roads, bridges, water, electric grid, and broadband; however, it may be conditioned on a partisan social infrastructure plan passed through budget reconciliation.
The pandemic-related stimulus already approved through the CARES Act, the American Rescue Plan, and the American Jobs Plan was massive, and reportedly not all of it has been spent and thus may be reallocated to the infrastructure plan. Although the stimulus funds have been a huge help in maintaining municipal credit quality, a longer-term risk may be unintended consequences of so much aid, such that municipal, business, and individual budget discipline goes out the window!
The Biden plan for social or care infrastructure might be better left for another day, once the economy stabilizes and we all have a better picture of potential needs and can evaluate what the stimulus and other policies, state and federal, have provided.
State Rating Actions
A number of the states that have recently had their outlooks or ratings moved to stable or positive are states that have had a history of rating downgrades, mostly because of pension funding issues and gridlocked government. The recent ratings improvements show the resiliency of the states and reflect the substantial federal aid that has been extended. However, pension and OPEB funding continues to be a long-term concern, and it can take a long time or large outlays to turn around an inadequately funded position.
Illinois was upgraded by Moody’s to Baa2 from Baa3 on a material improvement in the state’s finances. Fitch rates Illinois BBB- and on June 23rd assigned a positive outlook, while S&P rates Illinois BBB- stable.
Connecticut was upgraded to A+ from A by S&P (Moody’s upgraded to Aa3 in March). The state has made progress on reducing debt and addressing its pension and OPEB underfunding.
New Jersey’s A3 outlook was changed to stable by Moody’s, reflecting better-than-expected revenue performance in fiscal 2021 and the expectation that large resulting fund balances will support budget flexibility through the coronavirus pandemic recovery. New Jersey is well positioned for the next 12–18 months as the state continues to manage historic budget challenges, including large structural budget gaps and growing pension contributions. S&P rates New Jersey BBB+ stable, and Fitch rates the state A- with a negative outlook.
As mentioned earlier, the states of CT, IL, and NJ have been improving, albeit from low levels. They have put in place plans to increase the funding of their pension systems and have been sticking to them. Pension problems arose, for these states and other municipalities, because of chronic underfunding that resulted from pushing action to future administrations, retired pension beneficiaries outnumbering employed beneficiaries, and little flexibility in reducing benefits promised to earlier generations or in converting to defined contribution plans. Thus the level of unfunded pension liability and plans for funding shortfalls are important items to evaluate.
Investment returns have been significant for many pension plans, adding to funded levels all around. However, with borrowing costs low, many municipalities are considering issuing pension obligation bonds (POBs) and investing the proceeds, with the thought that investment returns will be higher than the POB debt service.
However, should the purchased investments perform poorly within a short time of investment, the municipality will be on the hook for the debt service and will need to make relatively larger annual payments to the pension fund.
Affordable Care Act – States and Healthcare
The US Supreme Court recently ruled in California v. Texas that the plaintive states challenging the ACA did not have standing to bring the suit. Consequently, the ACA remains as it is without the court’s ruling on its validity.
Medicaid spending is the second largest budgetary expense item for states, second only to K–12 education spending. Medicaid has expanded in 38 states and the District of Columbia since the implementation of the ACA in 2010. States were enticed to join with higher federal aid and reimbursement in the early years of adoption; and, recently, pandemic-related stimulus has temporarily increased the federal share of Medicaid spending. There is concern that as the federal portion declines, the states’ Medicaid burden could affect state budget flexibility.
The Supreme Court ruling is neutral for healthcare credits, as there was no change to the status quo. However, Fitch notes that margins at hospitals have improved since the ACA was implemented. Declines in self-pay patients often translate into lower uncollectible accounts, so changes to the ACA are an important consideration for analysts of healthcare credits.
Fund Flows and Demand
Recently, there has been huge demand for tax-exempt municipal bonds. The predominant factor driving demand is the expectation of higher future income tax rates at both the federal and state levels. See John Mousseau’s commentary “Bond Market Reversion to the Mean.” https://www.cumber.com/market-commentary/bond-market-reversion-mean-real-yields-held-hostage.
State and federal entities are looking at other taxes, too. States continue to legalize marijuana and approve gambling venues in an effort to diversify and to collect more taxes. Discussions abound about gas taxes and vehicle mileage tax rates; metro areas are increasing toll road capacity; and cities are instituting congestion pricing to increase revenue and to reduce congestion and pollution. Many municipal bonds have 30-year maturities. Will the taxes and revenues that secure particular bond issues be sufficient over that time period, or will issuers need to find additional revenue sources?
At Cumberland Advisors we continue our top-down approach to investing, looking at rates and other macro trends as well as identifying national and sector trends to guide our analysis of individual credits. Our fixed-income accounts are invested mostly in high-quality munis with an average rating of AA. Bond spreads, or the difference in yield between different-quality bonds and sectors, are very tight currently, since demand is very strong and because rates are low in general. There have been very strong flows into muni ETFs and mutual funds and a “run” into higher-yielding bonds and funds as investors search for a bit of incremental yield. When fund flows reverse, there will likely be an opportunity for separate-account managers.
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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.