Cumberland Advisors Market Commentary – Cumberland Responds to Barron’s
Three of us have collaborated on this discussion. Our views are pretty much aligned. We think Congress is hobbling an economic recovery by delaying the funding related to COVID-19 and now, additionally, funding related to the wildfires. We think many municipal entities are under extreme stress. And federal help is needed now, or these entities will have to reduce staff, swelling the ranks of the unemployed across the nation and reducing municipal services at the very time that demands for those services are at record levels.
We will identify the author of each part of this collaborative effort.
Barron’s has described the $1 trillion funding gap in US states and local governments. Much of that gap is created by or worsened by COVID-19. See “Cities and States Are Facing a $1 Trillion Budget Mess. There Will Be More Trouble Ahead.” Barron’s, https://www.barrons.com/articles/cities-and-states-are-facing-horrific-budget-holes-there-will-be-more-trouble-ahead-51598638702.
So what can be done and how to do it are now key policy questions.
Here are the general outlines of a proposal. The federal government can use its guarantee to back up to a $1 trillion municipal issuance. That would enable worldwide purchases, just as the US federal guarantee enables mortgage lenders like Fannie Mae to issue debt for global market purchases. The federal guarantee also allows the Federal Reserve to purchase such debt and to maintain orderly markets in it.
The debt can be issued by states and their agencies with the guarantee. The debt can be of the self-liquidating type; thus, it is eventually paid back by the states and doesn’t permanently increase the federal deficit. The US Treasury can set rules and the use of funds purposes description. That purpose of issuance can be well-defined (infrastructure, public health, water-sewer, etc.) or left to states’ discretion. Debt type can be inflation-indexed or conventional or zero-coupon or sinking-fund or floating-rate or a mix. The self-liquidating structure is typical in municipal bond issuance and there is no reason to change it. Maturity length can be out to 30 years or even longer. There already is a mature market for long-term Munis.
With the issue, credit pressure on states and their regional and local subdivisions will be buffered, and they will be able to advance and finance the many services that COVID-19 and post-COVID-19 economic recovery will require. We believe the Barron’s estimate of $1 trillion is sufficient to close the funding gap and carry the recovery process for as long as the next two to three years and until the vaccine/treatment issue is resolved with some trust and clarity for the whole population.
We believe that if we want US business to recover and our nation to flourish again, we must get the 90,000 state and local political jurisdictions onto a stable funding platform. The longer we wait, the more difficult a business and economic recovery will be. Now is the time for action. Let me pass this discussion to my colleagues.
Here’s John R. Mousseau on muni markets.
The Barron’s cover story for August 31, 2020, “The Trillion Dollar Hole,” made some good points – the most important being the long-term track record of municipal credit. The article correctly noted that Arkansas was the only state to default on its debt in the Great Depression. What was missing was the fact that Arkansas went that route in order to aid local towns and cities that would have had a harder time recovering on their own, and the decision was made that the state could more easily recover its financial balance than these juridictions could on their own. By the way, Arkansas subsequently cured the default and paid everything it owed to bondholders.
This is not to say that challenges aren’t there for states. We know those – underfunded pension plans, insufficient rainy day funds in many states, and a number of states on the wrong side of “the Laffer curve,” where further tax increases (think combined state income taxes, state sales taxes, and local property taxes) result in a DROP in total revenue to the state, not an increase. For example, New Jersey has been experiencing this phenomenon for several years.
The key for a number of these municipalities and states, and for some troubled issuers is to cut spending to tread water through the remainder of the pandemic and to access the capital markets where available. As we saw with the State of Illinois, as well as with New York MTA in May, issuers may not like the rate that the market affords them, but access has still been robust. Both deals were multiple times oversubscribed; and today, four months later, these bonds still trade well more than 100 basis points lower in yield than they did when they came to market. For example, in May of this year, the State of Illinois (BBB-) had a deal where bonds in 2045 came to market at a 5.85% yield. Those bonds have recently traded at a 3.60% yield to a 10-year call. This happened when the general market had shifted down only about 45 basis points in yield. This is not to say that the market does not back off for more challenged credits. But the market has clearly embraced the federalism we have seen in the wake of the pandemic, whether that takes the form of the Treasury’s special vehicle or the Federal Reserve’s direct purchasing of notes (Illinois and MTA) or the yet-to-be-passed infrastructure program.
The course and tenor of municipal finance changes markedly with the broad distribution of an effective vaccine, though not right away; the changes will be a step function. High-grade credits are already back to pre-pandemic levels, and in the case of shorter-term yields they are well below pre-pandemic levels, because the Fed has cut short-term interest rates. We would expect a general narrowing of credit spreads as a vaccine begins to be accepted and administered nationwide. More-troubled credits such as convention centers, smaller colleges, student housing, airports, transit systems, and sales tax bonds in general should all start to move up on a relative basis.
Also, many municipalities have seen their property tax base increase in value, with COVID-led demand for single-family homes continuing to push housing prices northward along with the pace of sales. So there is room for many local general-obligation bonds to soldier on or perhaps to have a higher tax base. In addition, municipalities are innovative in deriving new revenue sources. Think of a financial transaction tax going to New York City, or of states or counties extracting a “toll” on drones that traverse the airspace above their roads (which the municipalities control). The idea is that lower sales taxes in some areas can be replaced by usage taxes in other areas
We expect to see some creative financing, especially from larger issuers. We know that New Jersey advanced $7–$9 billion in financing. What if you were to sell an inflation-indexed 100-year bond, non-callable, such that the supplemental inflation payment was in the form of tax-exempt coupons. Then have the federal government back the principal of the bonds but the state or city be responsible for the coupon payments and supplemental inflation payments. With thirty-year US Treasury TIPS at a yield of -0.3%, even a troubled issuer like the State of NJ could get away with a real yield of 1–1.5%. For longer-view investors we think that would be attractive as an inflation hedge. It might appeal to pension funds that don’t need the tax exemption.
We know that many of the troubled credits out there (Illinois and New Jersey, even before the pandemic) have a LIQUIDITY issue (a need for cash to pay bills as normal collections are less from sales taxes, ridership revenue for transportation credits, etc.) but not an INSOLVENCY issue. That is an important distinction and one that contributes to the overall extremely good track record of municipal debt. Continued access to the capital markets, combined with realistic choices and belt tightening, should pave the way for better days for municipal issuers and for the market as the economy comes back.
Here’s Patty Healy on how a federal backing that raised $1 trillion would help the existing $4 trillion municipal finance sector to stabilize and would lower borrowing costs for most jurisdictions in the United States.
State and local municipalities received $150 billion in CARES Act funds, and the action was swift, delivering aid to the hardest-hit sectors and to states and large municipalities. Presumably, the state funds could be downstreamed to localities. The funds, however, were not without strings and could be used only for COVID-related expenses, not for revenue replacement, though revenues had plummeted dramatically. Other programs were designed to help businesses retain employees, and unemployment benefits were increased so that bills could be paid and some level of consumption could continue as the economy shut down to battle the pandemic.
Municipalities, which are on the forefront of addressing the pandemic, having seen a substantial drop in revenues, have had to cut budgets and personnel and in some cases reduce planned capital expenditures. Some may not even make the annual payments required to keep their pension funding levels from decreasing. If they don’t, pension funding becomes more expensive in the longer run – a vicious cycle that has caused the loss of financial flexibility for some and credit downgrades for others. Higher leverage and credit downgrades do increase borrowing costs.
According to the Bureau of Labor Statistics, state and local public employees make up approximately 13% of the American workforce, with municipalities alone employing nearly three million people nationwide. The Center on Budget and Policy Priorities noted that total nonfarm payroll employment (private plus government) fell by 22 million jobs in March and April, wiping out a decade of job growth. Despite job growth since then, including 1.0 million jobs added in August, private payroll employment remains 10.7 million jobs below its February level while state and local government payrolls remain 1.1 million jobs below their February level. The history of the financial crisis showed that the loss of municipal employment was a drag on the economy and lengthened time to recovery.
Congress has been dragging its feet in providing additional aid to municipalities, and many hope some aid will arrive shortly; otherwise, budget cuts will continue, services will be reduced, and the recovery will be slowed. The Center estimates that states, excluding local governments, need $555 billion, with the shortfall expected through fiscal 2022. If municipalities could plan on some aid, even phased-in aid; and if funds are not immediately available, at least budgets could take into consideration additional future aid and minimize the number of layoffs and service reductions.
Any mechanism to get needed funds to state and local governments – and soon – would help retain state and local public employees. A guarantee fund could be useful, lowering funding costs for municipalities close to the cost of Treasury bonds. The September 16, 30-year Treasury bond yielded 1.45% at the end of the day (Sept 16), while AAA-rated municipal bonds yielded 1.72%; the 10-year was at 0.67% compared with AAA yields of 1.16%. Shorter-term yields recognize the short-term risks that the market perceives in the municipal market. Debt repayment could be stretched out so that the additional debt-servicing burden would be minimal. Already a number of issuers are refinancing higher-cost debt and in the process reducing the amount of near-term maturities. They are also extending the final maturity of the bond, a move called “scoop and toss” in Muniland. While in good economic times scoop and toss is a signal of stress at a municipality that opts to do it, during an extreme situation it becomes a tool for the municipality to manage through the crisis.
Bottom line from our three authors: We are not in business-as-usual financial times. State and local governments need help, and the federal government has the ability to help them. The time for that action is now.
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