The pandemic, the war in Ukraine, and pressures and challenges arising from response to those shocks include shutdowns, substantial stimulus, an accommodative Fed, an uptick in virtual work and shopping, supply chain disruptions, relocations, social concerns such as rent affordability, hiring difficulties, rising wages, and fear of going (or lack of desire to go) back to the office or back to work at all! The lurking worries seemed to come to a head in Q2. Increasing prices, inflation fears, and the ability of the economy to grow with those pressures saw the Fed hike rates to put the brakes on the economy to combat inflation. Meanwhile, markets declined worldwide, and there were few if any investments to hide in. At the end of Q1, the S&P was down less than 200 points from year-end 2021, but by the end of Q2 it was down an additional 800 points and back to where it was in Q1 of 2021! A year of investment gains had been lost. Faring no better, the bond market experienced its worst performance in 50 years, and munis performed worse than Treasuries did. See John Mousseau’s recent commentary for a discussion of rates, fund flows, and bond performance: “Round Up the Usual Suspects.”
This quarter we discuss implications for munis from investment-market declines, inflation, and a potential recession. We touch on the dangerously low water levels of Lake Mead, Supreme Court decisions, rating agency activity and state rating changes, credit spreads, and bond insurance.
Many of the challenges facing muni credit quality are long-term in nature, like demographic changes, pension funding, and climate adaptation. Sometimes, addressing these items is kicked down the road to other administrations – or not – providing clues to governance risk.
What Do the Market Rout, Inflation, and Recession Mean for Munis?
Pension funding levels are a big focus for muni credit. Those states that have the lowest pension funding levels have lower ratings. They include Illinois, rated BBB+/Baa1/BBB+ by S&P, Moody’s, and Fitch, respectively, and New Jersey, rated A-/A2/A-/A by S&P, Moody’s, Fitch, and Kroll respectively. Most states have AA and AAA ratings.
Pension fortunes have reversed because of the market rout, and inflation will cause pension benefits paid to rise through cost-of-living adjustments. This trend could put pressure on future payments assumptions, lower funded levels, and increase required annual deposits to keep funded levels rising. Moody’s notes that increasing interest rates are pushing down the present value of total liabilities, but this will likely be offset after by investment losses this fiscal year.
Municipal pension fund management has been improving because of increased awareness by stakeholders. Many details are required by the Governmental Accounting Standards Board to be reported in annual financial statements. This increased transparency has helped lead to more rational assumptions for long-term asset and liability levels. Thus, states have been making progress in pension funded levels by making more than the required minimum annual contributions. Some states used 2021 revenue windfalls to make additional deposits.
A recession that necessitates cost cutting could see muni managers choosing between social programs or annual payments into a pension fund and raising taxes and other fees.
Munis have been experiencing increased costs for a while. For example, it was costly to hire nurses and to pay bonuses during the height of Covid-related hospitalizations, as well as to replace employees that are retiring and or just leaving the workforce. Many governments have already seen cost increases because of labor shortages and supply chain disruptions – and those increases are expected to continue. The markets fear higher inflation and consider a recession a strong possibility. Robert Eisenbeis, Cumberland’s Chief Monetary Economist, discusses recessions, the Fed, and inflation here: https://www.cumber.com/market-commentary/feds-next- meeting. Recessions are generally marked by two quarters of negative GDP growth; but if that does happen, the recession may be short-lived, since GDP has gone down from very high levels.
State and municipal revenue growth has been strong and from numerous sources, including income tax, capital gains tax, sales tax, and federal stimulus. Pandemic aid did help many people and many businesses stay afloat, while others had a bit of a windfall.
Higher municipal revenue may be eyed by employees demanding higher pay and benefits, citizens looking for a return of the pandemic windfall, or municipalities starting new programs that lock them into higher spending levels. In a recession, programs often need to be cut or funded from tax and fee increases to maintain budget balance and credit quality, which can be easier said than done, recession or not.
Most municipalities have been increasing reserves and generally engaging in better budgeting, having learned from challenges in the wake of the financial crisis, so we expect munis to continue these practices and to retain flexibility.
Lake Mead Water Levels Dangerously Low
Drought risk came to the surface in a macabre way as bodies from the 1970s were discovered in barrels in Lake Mead, near Las Vegas, as the water level fell. This event brought further attention to the fact that the water level was down to less than 30% of capacity and is in danger of going lower if precipitation remains low and/or actions are not taken by users of the water flowing in and out of Lake Mead. It is unfortunate that this was the first time some folks had heard of reduced water levels — though that was not the case for those of us who keep up on water topics or who live in areas that are challenged directly by water supply issues. Las Vegas Water saw the need for an intake pipe at a greater depth in Lake Mead over ten years ago; and luckily it did build it, because the upper intake pipe is now visible.
Municipalities do such a good job of providing water and at such a low cost that it is often taken for granted. This can be good for citizens and for economic development, but the incentive to conserve is held down. Many in the water-awareness space advocate higher water rates to discourage consumption, though that strategy runs counter to affordability and economic development.
Changing climate and weather, from droughts to storms, are challenging utilities and the cities and towns that depend on them. High water rates and supply concerns could make a muni less desirable to people and businesses. Most large water utilities do long-term supply planning in concert with state and regional entities. Water supply is just one of the environmental risks to be evaluated when considering bond credit quality. Other ESG factors with regard to water include social risks such as rate affordability and governance risks such as the implementation or encouragement of conservation efforts. These risks need to be identified, but it is also important to evaluate actions the municipality is taking to manage those risks.
At Cumberland Advisors we invest mostly in AA and AAA rated munis that have the wherewithal to manage risks, whether through good economic diversity, strong financials, or forward-looking management.
Flurry of Supreme Court Decisions
The Supreme Court recently issued rulings with varying implications for states and municipalities. Some of the issues covered, including abortion and limits on administrative agencies, such as the ability of the EPA to regulate, have been pushed to Congress or down to the state level for rules and regulations to be developed, while some states are looking to revise the laws on numerous issues or refusing to do business with companies whose values don’t align with the state’s. These political and regulatory stances may affect the desirability of living in a particular state, causing an increase or a reduction of population. These factors, along with demographic changes, tax treatment, climate and weather, and employment opportunities are long-term issues that evaluators of municipal credit need to monitor for effects on credit quality or the ability to pay debt.
Rating Activity Continues to Be Positive
The rating agencies have noted record revenue, stimulus, and improved muni management as factors contributing to the trend of positive rating actions exceeding negative rating actions. Some of the positive action entails the reversal of downgrades that occurred during the early months of the pandemic.
Moody’s reported that upgrades outpaced downgrades for five quarters in a row through Q1. Local governments accounted for most of the upgrades, while a large Texas muni utility was downgraded because of expected increases in debt to pay for increased costs from winter storm Uri. S&P also had more positive rating actions over the year, and in June 2022 there were 44 upgrades and 29 downgrades.
Sometimes the rating agencies wait for risks to be embodied in the reported financials, but a risk to financial operations may already be evident. The budgetary and management steps taken to mediate the risks must also be taken into account in accessing rating actions, because management may be able to address a problem. Bond managers can generally sell bonds on early detection of risk or opportunity and ahead of rating actions.
Credit spread is the difference in yield between a muni bond and the average yield for a AAA muni of the same maturity. Spreads are often monitored to gauge credit risk. As the perception of credit risk increases, the spread widens. Spreads also rise with increases in interest rates. When rates were low, the difference in credit spreads was small, and there seemed to be little differentiation in sectors and ratings. Now that rates are rising and a recession may be upon us, spreads are widening. Conversely, narrowing spreads indicate expectations of credit improvement. Individual credit spreads that are out of whack with the average spread of other bonds in the same sector and maturity can indicate that there is a unique risk affecting that bond issuer. At Cumberland we monitor credit spreads in many sectors and ratings regularly as an indicator of the health of the economy overall. See David Kotok’s recent commentary “Credit Spreads & Oil Price,” https://www.cumber.com/market-commentary/credit-spreads-oil-price.
State Rating Changes
Louisiana’s general-obligation rating was upgraded by Moody’s to Aa2 (stable) from Aa3 (positive). The upgrade reflects the significant progress the state has made in restoring its financial reserves and liquidity in recent years by structurally aligning revenue and spending, despite a generally declining trend, volatility in gas and oil production, and unfavorable demographic trends. A stable outlook reflects the state’s ability to balance its budget in response to economic shocks and to exercise cautious financial management that mitigates the state's exposure to financial volatility and weak economic fundamentals. S&P rates the state AA- stable.
Louisiana is subject to storms and major flooding. Hurricane Katrina in 2005 caused major damage, and the state suffered rating downgrades that year. S&P downgraded the state to A- and Moody’s to A2. Since then, the state has improved its financial performance, as attested by the Moody’s upgrade.
Credit Spreads and Bond Insurance
The two bond insurers/financial guarantors that we utilize are Assured Guaranty Municipal (AGM) and Build America Mutual (BAM). AGM is rated AA by S&P, A2 by Moody’s, and AA+ by Kroll. BAM is rated AA by A&P.
Just as credit spreads expand with uncertainty, bond insurance demand increases. Wider spreads may give the bond insurers better pricing power. The benefit of bond insurance to a municipality is the interest-rate savings on bonds issued with insurance. Investors benefit from a higher rating assigned to the bonds and because there are two sources of repayment. In contrast to property and casualty insurance, financial guaranty insurance is paid in all cases — there are no outs for the insurer. Note, though, that a bond insurer could be downgraded. Bond insurers derive their strength from strong capital levels, adept risk management, detailed underwriting, and high-quality investment portfolios. Additionally, insurers are regulated on the state level and by rating agencies, which are de facto regulators because the rating agencies are transparent on capital levels and insured portfolio risk measures that are used to rate the bond insurers.
At Cumberland we use a top-down approach to drill down to a sector or geographic area that may be negatively or positively affected by what we are seeing. We employ a credit scoring model that uses what we think are leading indicators; and if these metrics for a muni are moving in a negative direction or are lower than median levels, that credit is tagged for review. Some indicators are enrollment, occupancy, trend in margins, debt service coverage, and cash measures. These indicators are, of course, balanced with the ability of the muni to address long-term challenges, taking into account the strength of the service-area economy and its direction as well as financial strength measurements. Most of our investments are AA or otherwise of very good quality, such that they have a high probability of being able to withstand their upcoming challenges.
Patricia Healy, CFA
Senior Vice President of Research & Portfolio Manager
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