The first half of 2020 was dominated by the COVID-19 pandemic, which hit the municipal bond market hard. State and local governments experienced a sharp and sudden drop in revenue, and an increase in expenses, amid stay-at-home orders and business shutdowns.
Looking ahead to the second half, we expect state and municipal budgets to remain under stress, so we favor focusing on higher-rated issuers (AA/Aa) and above for the bulk of an investor’s muni bond holdings. For investors with a higher risk tolerance, a small allocation to lower-rated issuers (A/A) with certain characteristics may be appropriate.
What we expect to see in the second half
Investors likely will be rewarded for staying up in credit quality. A theme that emerged during the first half of the year was volatility due to lack of liquidity. Liquidity is often defined as the ability to sell a security in a reasonable amount of time at a reasonable price. Liquidity in the muni market was strained in March as investors pulled more than $20 billion out of bond mutual funds and exchange-traded funds (ETFs) in a matter of two weeks. To put this in perspective, weekly inflows for mutual funds and ETFs averaged about $1.8 billion in 2019. The substantial outflows caused prices of most municipal bonds to decline and resulted in negative year-to-date total returns, as illustrated in the chart below. The volatility was more severe for lower-rated bonds.
Returns for A-rated-and-above issuers are positive for the year
Source: Bloomberg Barclays Indices, as of 7/6/2020. Past performance is no guarantee of future results.
We think investors will continue to be rewarded by staying up in credit quality during the second half of the year, because higher-rated issuers generally have better resources to manage through the issues caused by the COVID-19 crisis. We don’t expect widespread defaults, but do think that downgrades are likely.
Issuers with already strained finances are most at risk of downgrades. When a bond is downgraded it usually falls in price. If you hold a bond that gets downgraded you should evaluate if it still meets your risk tolerance. We would be more concerned about a bond that is downgraded multiple notches, or to below—or very near below—investment grade.
Federal Reserve actions will continue to help stabilize the market. To counteract the swift decline in muni bond prices, Congress in March passed the CARES Act, which provided direct aid to states and also authorized the Fed to create new facilities to help stabilize markets. The most relevant facility for the muni market is the Municipal Liquidity Facility (MLF). This facility allows the Fed to purchase short-term notes, up to 36 months in maturity, from states, many large cities and counties, and select revenue bond issuers.
To date, only one muni issuer, the state of Illinois, has used the facility, because it’s more advantageous for most issuers to issue into the market.
Although the facility hasn’t frequently been used, it provides a safety net for the muni market. By having the facility in place and having shown a willingness to be flexible, the Fed is signaling to the market that it will provide support if necessary. This has helped stabilize prices and borrowing costs, especially at the short end of the yield curve. Going forward, we do not expect a repeat of the volatility in March, largely because of the Fed’s actions.
The next step is more direct aid from Congress. State and local governments have been especially hard hit by the COVID-19 crisis because two large sources of revenue—sales and income taxes—have substantially declined due to the drop in economic activity. The good news is that states entered into this crisis in a fairly solid financial situation, in aggregate. Most states have benefited from the long and slow economic recovery since 2008, and have taken steps to shore up their finances. For example, the median state rainy-day fund reached 7.6% of general fund expenditures in fiscal year 2019, according to the National Association of State Budget Officers. However, to illustrate how swiftly and severely the crisis has affected state and local finances, the state of California went from projecting a $5.6 billion budget surplus to having a $54.3 billion budget deficit that will require federal aid to help close the gap, according to state officials.
States are facing a substantial shock to revenues due to the coronavirus
Source: Moody’s Analytics, as of 6/24/2020.
Direct aid in the form of grants from Congress would help to alleviate the strain that state and local governments are facing. We expect Congress will pass some form of aid, but the timing and amount is in question.
Without additional aid, we expect state and local governments will cut expenses or take other budgetary measures, because most are required to have a balanced budget. Although the declines in revenues are severe, we don’t expect widespread defaults, because debt service is usually a very high-priority item for state and local governments.
Higher-rated issuers should be able to manage more easily through the financial disruptions. During the second half of the year we expect that higher rated issuers will be able to better manage through the financial strains caused by the COVID-19 crisis. In general, higher-rated issuers benefit from things like stable and diverse revenue sources; flexibility to manage expenses; liquidity sources that can be tapped in times of need; and potentially support from a sponsoring government, like a state.
Although munis face many headwinds in the second half of the year, we don’t suggest avoiding them, especially if you’re in a higher income-tax bracket. Yields are attractive for highly rated munis vs. other highly rated investments like Treasuries and investment-grade corporate bonds, especially for investors in higher tax brackets, as illustrated in the chart below.
Muni yields are attractive relative to alternatives for high-income earners
Source: Bloomberg Barclays Indices, as of 7/1/2020. Note that corporate bonds assume an additional 5% state income tax and 3.8% Net Investment Income tax for the 32%-and-above tax brackets. Yield-to-worst (YTW) is the lowest potential yield an investor may receive from a bond, assuming the issuer does not default. The chart uses the Bloomberg Barclays US Municipal Index for municipal bonds, the Bloomberg Barclays US Corporate Index for corporate bonds and the Bloomberg Barclays US Treasury Index for Treasuries. Past performance is no guarantee of future results.
Absolute yields for highly rated munis are low, but yield spreads have increased to levels that make them attractive for investors, in our view. A spread is the additional yield above a AAA-rated muni an investor receives for taking on the added credit risk. For investors with a greater risk tolerance, we suggest adding some A/A rated issuers.
Higher spreads make yields for lower-rated munis more attractive
Bloomberg Barclays US Municipal Bond Index, as of 7/6/2020.
What to expect for various sectors
Below, we will take a look at some of the major muni sectors, and our view on what to expect in the second half of the year.
State governments: Defaults are unlikely, but the sector may experience credit downgrades. Exercise caution on states with already low credit ratings, strained finances, or high unfunded pensions. A downside of low interest rates is that it will likely increase pension expenses. The sector as a whole should be moderately stable due to the many levers that states have at their disposal to help balance their budgets.
Local governments: Most local governments rely on property taxes as their main source of revenue. So far, real estate has been holding up well in part due to the Fed keeping interest rates low. This has helped keep mortgage rates low and has been supportive of home values. Moreover, property tax revenues are based on the assessed value of a home, which tends to lag the market value of a home. Even if home prices decline, local governments that rely on property taxes likely wouldn’t feel the impact immediately.
We’re more cautious on local governments that rely on sales tax revenues as their primary source of revenue and already have strained finances. The economic shutdowns and stay at home orders have had a negative impact on economic activity which in turn has translated to lower sales tax revenues.
Health care: We suggest caution on the health-care sector overall. Health-care and hospital facilities were especially hit hard by the COVID-19 crisis as it resulted in higher labor and equipment expenses and declines in revenues, partly due to suspending elective surgeries. Elective surgeries tend to be profitable for health-care providers. However, direct federal aid is helping to offset some of the negative financial impacts of the COVID-19 crisis. This sector could be further negatively affected if an additional round of federal aid doesn’t materialize, or a surge in COVID-19 cases results in postponing elective surgeries.
Transportation (airports, toll roads, and mass transit systems): Social distancing and stay at home orders have resulted in substantial declines in travel. We are most cautious on issuers that are heavily dependent on revenues tied to tolls, fares, or other usage fees. For example, most mass transit systems rely on federal, state, or local taxes or aid for over 50% of their operating revenues. This can help serve as a mitigating factor to the substantial drops in ridership, but may not be enough to fully offset revenue declines.
Liquidity will be a very important factor in this sector in determining an issuer’s ability to manage through the crisis. This will vary by issuer. For example, airports generally have between one year and three years of days cash on hand1 to cover operating expenses as well as debt service reserves, according to Moody’s. We suggest caution on transportation issuers that are small and regional, newly established, have low liquidity sources, or a combination of those factors.
Higher education: The higher-education sector essentially can be split into private and public colleges and universities. Private colleges tend to be heavily dependent on tuition revenue whereas public schools are less so because they receive state aid. We think there are opportunities in this sector, but there are many questions. We suggest caution on small private schools that are heavily dependent on tuition and don’t have a national draw.
Essential services (water and sewer and electric power): We expect little to no impact on essential services issuers. We think these types of bonds should continue to exhibit stable credit characteristics.
Special tax: Special-tax bonds are often backed by a specific tax, such as a sales tax or a tax on hotel occupancy. They can range from being a very narrow to broad pledge. We would suggest caution on bonds backed by tourism-related taxes in this sector. Bonds backed by broad-based pledges should generally fare better. Moreover, many of these bonds benefit from a reserve fund or a relatively high coverage ratios.
What to do now
We don’t think that now is the opportune time to begin taking risks in the muni market, but that doesn’t mean that munis should be avoided in the second half of the year. Again, we suggest focusing on issuers that are highly rated (AA/Aa and above). If your risk tolerance allows for it, add lower rated (A/A) issuers in more stable sectors or that have revenue sources that lag the general economy.
1 “Days cash on hand” represents the number of days a company can continue to pay its operating expenses with the current cash it has available.
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