Muni market keeps wary eye on likely government shutdown

As the government slouches toward a shutdown this weekend, municipal market participants expect short-term fallout to be relatively minor but are keeping a cautious eye on unexpected pitfalls.

A shutdown could disrupt federal infrastructure projects, halt rulemaking on new financing tools, freeze federal subsidies to direct-pay debt and generally cause uncertainty for borrowers and investors alike.

Relatively flush cash positions will help protect cities and states from immediate damage. And although Moody's Investors Service on Monday warned that a shutdown would be a negative event for what is the last triple-A rating on the nation's credit, most muni credits enjoy a healthy distance from the sovereign.

Still, the potential havoc caused by a full shutdown of the U.S. government could agitate markets and unnerve borrowers, muni market participants said.

"We in Washington have become jaded about these things, but the reality is for many folks in this country and even abroad this is a disconcerting and even dangerous event," said Charles Samuels of Mintz Levin, counsel to the National Association of Health & Educational Facilities Finance Authorities.

"If there is a shutdown many borrowers are going to consider how temporary delays in federal spending specifically affect their obligations and services. At the human level, there are plenty of federal employees  who finance groups deal with, who may miss a paycheck causing real hardship. It is a political football but not a joke."

Brian Sigritz

The U.S. has seen 20 government shutdowns since 1976, most of which have been brief and carried relatively limited economic impact, according to Morgan Stanley. The most recent, in late 2018 under the Trump administration, lasted 35 days – the longest to date – but only partially closed agencies, as Congress had passed five of the 12 appropriations bills. The 17-day full shutdown in 2013 would be a more apt comparison to the latest standoff, said Brian Sigritz, director of State Fiscal Studies at the National Association of State Budget Officers.

"Anytime there's a federal shutdown it presents a challenge to states, but a longer shutdown is more problematic from a fiscal management point of view than a shorter one," Sigritz said.

Most states have built up their rainy-day funds in the post-pandemic years, but those can plug holes only so long, Sigritz said.

"If the shutdown were to persist, rainy-day funds wouldn't be enough to make up for the lack of federal funds," he said.

Mandatory programs funded outside of the fiscal-year appropriations, like Medicaid, would continue while discretionary funding would freeze. Of the $6.3 trillion 2022 federal budget, roughly $1.7 trillion was discretionary, according to the Congressional Budget Office.

"Right now, states are in the process of figuring out what programs are affected and talking to their state agencies to see what the impact would be on individual programs," Sigritz said.

Investors so far seem sanguine about fallout on the muni market.

"The major question is whether a shutdown is going to result in a ratings impact in the municipal market, and the answer here is no," said Jennifer Johnston, director of research for Franklin Templeton's fixed income-municipal bond team. Only credits that are closely linked to the U.S. credit rating, like military housing or federal lease-backed debt, have direct exposure.

"There's just not a significant portion of the municipal market that's directly linked to the federal ratings," Johnston said.

Municipal Market Analytics said in a Sept. 25 report that the impact would be "modestly negative" — though an extended shutdown would "raise the risk of a near-term economic recession." Given the constant partisan standoffs in Washington, a closure "should finally end all questions about Fitch's recent downgrade of the U.S. bond rating," MMA added.

Unlike previous shutdowns, this one follows a few years of Washington raining a record amount of money on cities and states. The American Rescue Plan Act, the Coronavirus Aid, Relief, and Economic Security Act, the Infrastructure Investment and Jobs Act and the Inflation Reduction Act collectively have allocated billions to local governments and states since 2020.

"There are such tight federal fiscal relationships now," said Emily Brock, federal liaison for the Government Finance Officers Association.

Potential disruptions are not linked to the funding itself — most of which remains outside the appropriation process and so won't be affected by the shutdown — but by the administration of the funds, Brock said.

The potential closure of the Treasury Department's pandemic aid office, for example, comes just as issuers are in the middle of a compliance reporting period.

Rulemaking and guidance tied to new programs like new tax credits in the Inflation Reduction Act , which are moving on a tight federal timeline, would also likely be halted, Brock said.

And it's unclear how a shutdown would impact major federal loan programs like WIFIA, TIFIA and RIFF, Brock said.

 "The administration of all these funds is hanging in the balance of these discussions, and there are a lot of issuers out there who are watching it much more closely this time," she said.

On the infrastructure side, a government shutdown or a series of continuing resolutions "will impede the ability of state DOTs to translate Congressional mandates and funding in the IIJA into tangible surface transportation programs and projects," the American Association of State Highway and Transportation Officials warned in a recent letter to Congress.

The U.S. Department of Transportation would furlough at least a portion of its workers, which could suspend some discretionary grant programs and permitting processes. The Environmental Protection Agency and the Department of the Interior would also furlough employees, which the White House last week warned could delay environmental reviews and permitting of infrastructure projects.

The Federal Aviation Administration may also be forced to close on Sept. 30 as its five-year funding authority expires at midnight Saturday. On Wednesday, House Transportation and Infrastructure Chair Sam Graves, R-Mo., introduced a bill to extend FAA authority through Dec. 31.

Transportation Secretary Pete Buttigieg said at a press conference Wednesday that if the FAA authority lapses, the agency would not be able to collect revenue or would have to spend money from the Highway Trust Fund, which might never come back in. "Effectively it's kind of like a tax holiday for airline charges," Buttigieg said.

The Federal Highway Administration and Federal Transit Administration would remain in operation. The FTA would be able to reimburse transit agencies for previously approved projects, but it's not clear the agency would be able to approve new grants, according to the American Public Transportation Association.

If the government shuts down Sunday, Treasury would likely at some point suspend the sale of State and Local Government Series securities as one of a series of so-called extraordinary measures to conserve cash.

Congress has waived the pay-as-you go, or PAYGO rule, allowing federal subsidies to continue to flow to direct-pay securities like Build America Bonds, through Sept. 30 and the waiver remains until budget discussions take it up.

The muni market is closely watching those two measures, said Brett Bolton, vice president of the Bond Dealers of America. But as threats of a shutdown have become somewhat normalized over the years, generally "folks continue to move forward as normal," he said.