MARKET COMMENTARY

Munis Working to Make Ends Meet: Staying the Course in Radiator Springs and a Town Near You

06.17.2020 - Jeffrey S. MacDonald, CFA

Key Takeaways
  • While the creditworthiness of municipalities has come under stress due to COVID-19, we do not see a growing wave of defaults in the municipal bond market in the wake of the shutdown.
  • We believe higher-quality municipal bonds are still a more attractive after-tax value for many investors than other parts of the fixed income markets.
  • Muni bonds continue to provide safety of principal and risk mitigation—qualities that they always have—and we consider them to be an ongoing, important component of a multi-asset class portfolio.

My son was a huge fan of the Pixar movie “Cars” back in 2006 when he was four. “Radiator Springs” is a stereotypical town down on its luck, as you know if you’ve ever seen it.  Once a tourist hot-spot on the once-popular Route 66, Radiator Springs was bypassed by a new and faster highway, causing its economy to slow to a halt.  This unfortunate development crippled the economic vitality of the town in response to an exogenous shock, largely out of its own control. 

The COVID-19 outbreak in many ways represents a comparable shock, albeit more abrupt and severe, to states and towns across the country as economic activity—and the revenues that it represents to these communities—serve as collateral damage in the battle to contain the spread of the virus.  Bringing back robust economic activity across the US economy is ultimately the solution, but how soon and how much near-term damage can these localities and issuers sustain on the road back to an open economy?

State and Local Governments Are Being Hit from Both Sides

Governments have always required funding to run. This funding, for centuries, has largely come in the form of taxes.  At the Federal level, revenue generally comes from taxes on earnings from individuals, small- and medium-sized businesses or corporations. Federal tax receipts for fiscal 2020 (ending June 30, 2020) will be about $3.75 trillion. 

At the state and local level, in addition to the taxing of income, funds also come from spending-related revenue streams like sales tax, gasoline tax, toll roads and utility fees. Many issuers rely on these sources of income to service their existing debt and to continue to provide services to the public. The current shutdown has drawn this creditworthiness into question.

Herein lies the challenge: the state and local governments on the frontlines of the COVID-19 battle are being hit on both the income and spending sides during the shutdown. And, unlike the federal government, they need to pass a balanced budget annually. 

The creditworthiness of municipal bond issuers is being challenged across most sources of revenue that support the servicing of state and local government debt.

General Obligation Issuers: Challenged by Lower Tax Revenue and Pension Obligations

General obligation debt (GO) is debt at the state or local level that is backed by the “full faith and credit” of the issuer. These bonds are generally not backed by any income stream from a specific public service.  Revenues that typically support debt service to issuers in the GO space include sales, income, and property taxes, most of which have been significantly compromised during the shutdown. 

Unfunded pension liabilities that many GO issuers are responsible for have also been a challenge, even before the COVID 19 related shutdown. While markets appear to be recovering to some degree in recent weeks, the ability for GO issuers to make contributions to these pension plans to keep them adequately funded has become more difficult. 

The good news for investors is that we do not see a growing wave of defaults in the municipal market in the wake of this shutdown. States are not legally allowed to file for bankruptcy, and while cities and local governments are, we believe that the current environment offers enough fiscal flexibility to avoid those types of extreme measures for state and local governments.

A new round of stimulus from the federal government could provide some relief at the state and local level. And, the ability for issuers to access the market for credit has improved recently. The bad news is that, unlike the federal government, these issuers need to pass balanced budgets each year. The most effective way to do this in the short term is to slash budgets (currently underway), which can compromise the services these municipalities are able to offer to the public. Longer term this brings negative social welfare issues to the table which is certainly not an attractive outcome.

For some time, we have recommended our investors stay up in quality in this sector of the market and in the current environment we continue to support that view. 

Revenue-Based Issuers: Significant Revenue Shortfalls

Revenue-based debt typically finances income-producing services secured by a specified revenue source. Heading into the COVID-19 shutdown, we favored debt in this sector. At that time, the consumer and broader economy were performing well, and the increased spending and use of many of these services improved the ability for revenue-based issuers to service their debt. These issuers were also exempt from the unfunded pension obligation headwind that the GO sector continues to face. 

However, today the impact to revenue at the local and state level from the shutdown is considerable.  Several subsectors in this area illustrate this recent weakness:

Hospitals/Healthcare

  • While any business servicing customers at full capacity would generally be a good thing, the recent stress on the healthcare system fighting COVID-19 has led to significant revenue shortfalls in the sector.
  • Healthcare facilities have used loans and lines of credit to bridge the gap, but a deterioration in credit metrics followed by potential ratings downgrades is likely to result. The ban on elective surgeries, which carry higher margins and revenues, has been a drag as well.

Water and Sewer

  • While generally viewed as a safe “essential service” sector, commercial and industrial revenues have slowed in the current environment. Political pressure around rate freezes and relief also represent challenges to this sector in coming months and quarters.
  • Businesses who fail could reduce the customer base for many of these issuers and foregone capital projects could pressure needed capital outlays in the future.

Transportation

  • We expect some serious revenue shortfalls in this sector in the short term. From airports, toll roads and public transportation like the MTA in the tri-state area, usage is down almost 90% by some measures.
  • The transportation system in the US at both the national and local level is likely to be viewed as essential and necessary to maintain operations. In truly stressed situations, like the MTA for example, support at the Federal level is likely to provide what is necessary to ensure that these services continue to be provided.

Higher Education

  • Fall 2020 enrollment continues to be the main concern in this sector. Many smaller private colleges were already facing enrollment and financial challenges heading into this slowdown.
  • Limited visibility into the ultimate resolution of returning to college campuses next year is still a risk, but the strongest credits in this sector should weather the storm effectively.
Market Conditions Are Improving

The federal fiscal response and, more importantly, the programs introduced by the Federal Reserve have improved market conditions meaningfully since the stress experienced in the latter part of March.  We also need to remain focused on the notion that liquidity does not equal solvency, and that this debt is still an obligation of these issuers that ultimately needs to be repaid. 

The recent re-opening of much of the US economy has been an encouraging sign and markets have embraced the hope that this shutdown may be shorter-lived than initially feared. For state and local governments and the debt that they need to service, possibly the best outcome in the coming months and quarters is that governments and citizens safely and responsibly return to the types of activity that allow life to start the journey back to normal. 

Like Radiator Springs, we believe our towns will come back to life over the long term: Luigi’s vacant tire shop will again service Ferraris, the “Wagon Wheel” plaza’s restaurants will be filled by tourists and the annual Radiator Springs Grand Prix will again attract international race cars from around the world.

Unlike Radiator Springs, Lightening McQueen’s racing operations are not coming to a town near you to provide an economic boost to make up for the shock that the COVID 19 shutdown has engineered. That will need to come from a more balanced, responsible re-opening of the US and Global economy whereby businesses and consumers both begin to “Start Your Engines!”. 

The worst is likely behind us, but with improved risk appetite the compensation for aggressive positioning becomes less compelling by the week. Yields in the market would not be considered attractive in a historical context, but higher-quality municipal bonds are still a more attractive after-tax value than many other parts of the fixed income markets. They continue to provide safety of principal and risk mitigation--qualities that they always have--and we consider them to be an ongoing, important component of a multi-asset class portfolio.

The information provided is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy, or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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