The trends that we experienced in the second quarter — rising inflation, increasing geopolitical risks, declines in both stock and bond markets, and the risk of recession posed by Fed actions to fight inflation — continued into the third quarter. Mortgage rate increases and a decimation of savings put the brakes on the overheated housing market and will likely contribute to a reduction in spending in other parts of the economy. Hurricane season also produced Ian, which will likely prove to be one of the costliest hurricanes to date. See John Mousseau’s Q3 commentary https://www.cumber.com/market-commentary/q3-storm-bond-market-and-storm-century.
Most municipalities start their fiscal year on July 1. This year, some states announced surplus tax refunds or tax rate cuts because of record tax collections — income, sales, and capital gains — for the fiscal year ended June 30, 2022. The Tax Foundation reported in July that 10 states reduced individual income taxes, and 6 states reduced corporate income taxes, while 11 states provided rebates. Some of the reduction in tax rates is also reported to reflect competition brought on by a more mobile workforce since the pandemic. For these reasons, along with increased prospects for a recession, revenue growth may be lower as of fiscal year end June 30, 2023. We discussed pension and other longer-term challenges, which remain an important facet of credit, in our Q2 credit commentary, found here: https://www.cumber.com/market-commentary/q2-2022-credit-how-world-changes.
The risk of recession will weigh on muni credit; however, we continue to be constructive on munis, given improved budgeting practices and accumulated reserves or rainy-day funds. The still-tight labor market should keep unemployment low, and massive amounts of federal funds for infrastructure and other programs should help projects get off the ground, providing needed infrastructure as well as jobs. The states that are more exposed to income and capital gains, such as New York and California, have already reported revenue well below last year’s level; so mid-year budget adjustments will be watched for clues as to changes in credit quality.
Muni bonds have generally good credit quality and lower risk than corporate bonds do. Moody’s annually conducts a default rate study that shows the extremely low default rate of munis. The 1970 to 2021 cumulative default rate for Moody’s rated munis was 0.15%, while the default rate for investment-grade munis was even lower, at 0.09%. Speculative grade munis have a default rate of 6.94%. Corporate bonds, by comparison, had a 1970–2021 cumulative default rate of 10.36% and 2.17% for investment-grade-only bonds. Many more corporate bonds are rated in the lower investment grade or non-investment grade categories. Moody’s notes that the median rating of municipal issuers is Aa3, compared to Baa3 for global corporates.
Most muni sectors continue to have stable outlooks assigned to them by the rating agencies, though this picture will likely change as recession sets in. Those sectors that are already challenged, such as private higher ed and health care, deserve increased attention. The WFH economy seems here to stay for many; however, there is some indication that some companies may require more in-office time to increase communication and more effectively onboard new employees. It will be interesting to see how this trend evolves and affects transit-related bonds. Massive federal stimulus programs, including the American Rescue Plan, the Infrastructure Investment and Jobs Act, and more recently the Inflation Reduction Act, have yet to fully flow through the system and may help contribute to muni budgets.
Hurricane Ian inflicted major damage and loss of life. Here is my commentary on Hurricane Ian https://www.cumber.com/market-commentary/hurricane-ian. According to NOAA, estimates of wildfire and storm damage in the first nine months was already $23.9 billion excluding Ian, western wildfires, and Hurricane Fiona — NOAA expects that the year’s total damages will exceed $100 billion. With initial estimates of Ian damage estimated at $67 billion, that level is easy to conjure.
Another tragedy, partly climate related, was the loss of water supply to the 150,000 people served by the Jackson, MS, water system. Lingering rain and flooding, as well as lack of system maintenance and poor governance, were all factors that led to the city’s being without potable water for weeks. See David Kotok’s https://www.cumber.com/market-commentary/esg-part-2-jackson-mississippi.
Environmental, Social, and Governance (ESG) investing continues to be a topic of debate and has often been politicized. ESG provides a way for investors to have an impact and offers a framework for analyzing various risks and factors for investment purposes.
To make more information available to investors, both the House and Senate have proposed bills to require municipalities to provide disclosures in a machine-readable format that could take years to develop. While additional transparency is good, the municipal industry remains fragmented, with differing requirements established by states and other overseers. Further, reporting is not consistent in terms of the way financials and other information is provided. The Government Financial Officers Association and others in the industry have made clear that the form of the legislation does not consider the fragmentation, that it would be costly to implement and should not be rushed through as part of a larger legislation package being pushed through Congress. We agree that the legislation needs to consider the varied nature of the requirements municipalities face and that Congress is trying to force something too soon. However, the resistance reminds us of pushback to the Government Accounting Standards Board’s requiring detailed pension information, which is now part of disclosure in financial statements, affording taxpayers and analysts better information to work with.
State Ratings Actions – note the emphasis on long-term liabilities such as pension funding in a number of the rating actions.
Fitch upgraded New Jersey’s GO rating from A- to A, and S&P changed its outlook to positive on the state’s A- rating. Fitch’s upgrade and its positive outlook reflect strong fiscal momentum in recent years and consistent policy actions to confront the state’s long-term fiscal and liability challenges, such as pensions.
Fitch upgraded Ohio to AAA and the school district enhancement program to AA+, reflecting material strengthening of the state's financial resilience and budget management.
Moody’s upgraded Minnesota's issuer rating to Aaa, citing both a track record of prudent governance that has driven growth in financial reserves and strong management of long-term liabilities, such as improved pension contributions, that will keep Minnesota's leverage and fixed-cost burdens among the lowest of all US states.
S&P revised the state’s outlook to stable from negative on Vermont’s AA+ rating. S&P notes the credit profile is stabilized by recently enacted retirement reforms designed to significantly reduce unfunded pension and other liabilities in the long term.
On October 8th, S&P changed its outlook on Massachusetts’ AA rating to positive from stable, reflecting the state's improved reserves. If those improved levels are sustained, those reserves may bode well for a higher rating.
There are many headwinds flowing through the economy that will have implications for municipal bond investing. At Cumberland, we will keep an eye on these headwinds as we continue to use a top-down approach to evaluating investment risk. We also evaluate issuer-level information through various information providers, many of which provide alerts so that we have up-to-the-moment information on credits that we follow.
Patricia Healy, CFA
Senior Vice President of Research & Portfolio Manager
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