As it turns out, 2024 was not the year credit trends reversed, as we wondered in our Q1 credit commentary (https://www.cumber.com/market-commentary/q1-2024-credit-commentary-will-be-year-credit-trends-reverse. Both the muni and the corporate bond markets seemed to experience more upgrades than downgrades, though final stats aren’t released till after the quarter ends. Corporate credit spreads remained tight in the quarter – a signal that market participants expect few credit problems. The Bloomberg US Aggregate Bond Index spread was +81bps over the comparable Treasury at year end, while at the beginning of the year spread was +99. The high spread was +111 on August 5, 2024.
Q4 saw another disruptive hurricane. Milton, hard on the heels of Helene in the third quarter, was one of the most destructive storms in the US since Sandy. There was also of course the re-election of Donald Trump and the market’s intense focus on the Fed reducing rates, although intermediate and long rates rose. John Mousseau noted in his quarterly market commentary how bond yields corresponded to events in the quarter (https://www.cumber.com/market-commentary/trump-yield-rally). The Fed cut the fed funds rate in September, November and December 2024. The next rate cut is not expected until mid-year, as the economy continues to do well and there is some concern that there will be rising inflation.
Municipalities rushed to market in Q4 as funding needs increased with the runoff of pandemic aid and postponed projects needed financing, as well as the anticipation of higher future interest rates. The final volume estimates for 2024 are approaching $500 billion, while the past few years’ average has been closer to $400 billion. Estimates for muni volume in 2025 range from $400 billion to over $700 billion for the case that the elimination of the tax exemption of municipal bond interest proceeds. A larger supply than historically seen may improve yield prospects for buyers of muni bonds, relatively speaking.
Muni Sector Credit Trends
Healthcare and higher education continue to be under pressure, given the demographics of an aging population and wage pressures.
The water and sewer sector saw more S&P downgrades than upgrades, and S&P has continued its negative outlook on the sector. The agency notes that accelerating capital spending could further pressure margins as utilities address aging infrastructure, asset hardening, investing in new sources of supply, and complying with increasingly stringent regulations.
The public K-12 school district outlook was changed to negative by Moody’s in early December, noting declining enrollment because of demographics and increased competition from charter schools as well as rising costs of wages and benefits, changing state funding, and the runoff of federal pandemic aid. These challenges could result in lower reserve levels.
Moody’s also noted similar challenges for local governments and states; however, they maintained a stable outlook for those sectors.
There have been downgrades. San Francisco lost its Aaa Moody’s rating in October and is now rated Aa1 with a stable outlook. Oakland CA was downgraded in December by Moody’s to Aa2 with a negative outlook, as the city is projecting deficits, although reserves are expected to remain strong.
Muni Default Rate Study
Moody’s municipal default study, released a little later than usual in October last year, showed that municipal default rates in 2023 remained low historically and compared with corporates. The 5- and 10-year cumulative default rates for Moody’s investment-grade-rated munis over the period of 1970 to 2023 were 0.04% and 0.09% respectively. The investment-grade global corporates default rates were much higher, at 0.87% and 2.21% respectively. Moody’s also found that munis have more stable ratings with fewer ratings transitions from category to category.
Munis generally have higher credit quality than corporates. In the chart below you can see that the average rating for a municipality is Aa3, while corporate bonds average around a Baa3 rating.
Natural Disasters and Insurance
NOAA reports there were 27 billion-dollar weather and climate disasters in 2024, trailing only the record-setting 28 events analyzed in 2023. These disasters caused at least 568 direct or indirect fatalities, which is the eighth highest for these billion-dollar disasters over the last 45 years (1980-2024). The cost was approximately $182.7 billion.
The LA fires that began on January 7, 2025 are still burning, and death and damage continue to grow. See my recent commentary at https://www.cumber.com/market-commentary/los-angeles-wildfires-2025-0.
Often when there is a big disaster, the discussion of insurance has two sides.
Folks complain that natural-disaster (hurricane, tornado, earthquake, flood and fire) insurance is too expensive for residents to afford. On the other hand, many argue the cost of insurance isn’t high enough to dissuade residents from living in disaster-prone areas. California and Florida both have entities to help spur insurance activity in their states, because that helps with economic development. It seems states may become more selective about encouraging development and types of development. At the same time, more frequent disruptive weather events, especially flooding but also extreme heat and cold, are happening in areas that rarely experienced those types of events in the past. It’s a challenge for municipalities and for insurance companies.
In November Moody’s upgraded three Florida insurance-related entities to Aa2, reflecting the strong parental linkage between the State of Florida, which is rated Aaa, and its state-sponsored insurance entities. The two-notch difference reflects the unpredictability of weather events that could drive up claims on current resources and results in bonding and increasing assessments. Currently, Florida Insurance Guaranty Association (FIGA) is the only entity collecting assessments.
The Florida Hurricane Catastrophe Fund, previously rated Aa3, provides reinsurance to encourage insurers to conduct business in the state. Citizens Property and Casualty Insurance Corp., previously rated A1, provides insurance to residents that cannot obtain it at a reasonable price from private insurers. FIGA, previously rated A2, pays claims to residents in cases where the private insurer is insolvent.
All state-sponsored entities derive credit strength from strong state oversight and management, large reserves from pre-event bonds, and the ability to collect assessments on all property and casualty insurance policies in the state – giving them powers similar to the broad taxing power of the state. Moody’s notes that these entities are highly essential to the economy of the state. We have mentioned in previous commentaries the strong operations and that the state has passed legislation to reduce fraud and encourage rebuilding with resilience, not just replacement.
Regarding California, on Jan. 13, 2025 Governor Newsom signed an executive order to suspend and/or streamline the building permitting process to allow victims of the recent fires to restore their homes and businesses faster. The order addresses price gouging and commits agencies to work with the legislature to identify statutory changes that can help expedite rebuilding while enhancing wildfire resilience and safety.
State Ratings
Pennsylvania was upgraded by Moody’s to Aa2 in October, and a stable outlook was assigned. Moody’s noted significant increases in its budget stabilization reserves and moderated pressure from long-term liabilities that reduce historic credit weaknesses and that will provide important flexibility in the event of future budget stress. Fitch rates the state AA and S&P rates it A+ with a positive outlook.
The outlook on California’s Aa2 rating was revised by Moody’s to stable from negative in December. The action recognizes the implemented spending cuts combined with stronger than expected revenue as the state’s economy remained strong. S&P rates California AA- and Fitch rates its bonds AA. The fires are still burning in LA and the damage and economic loss estimates continue to grow, so there will be some impact on the state’s budget. However, California has such a large and diverse economy – it would be the 5th largest in the world if it were a country – that the ratings will likely remain in the AA category.
At Cumberland Advisors we invest in high-quality municipal bonds, such that the average client portfolio credit rating is AA. We take a top-down approach to analysis and will be watching global developments, changing tax schemes and regulations that a new administration may institute, economic growth and interest-rate movements, as well as how municipalities are addressing budgeting and longer-term risks.
Patricia Healy, CFA
Senior Vice President of Research & Portfolio Manager
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