Defaults could increase post-COVID-19
While munis are holding up better than most asset classes amid the COVID-19 crisis, don't be surprised to see a few defaults along the way, says Dan White, head of fiscal policy research at Moody’s Analytics.
“Aside from the immediate increase in demand for many government services during this national emergency, the most visible impact to most municipal issuers will come via lower revenues,” White said in a report released Friday. “If the downturn increases in magnitude or duration, expect the impact on the muni market to be much more severe.”
He said that when the COVID-19 crisis is finally over, municipal defaults and bankruptcies among at-risk issuers will likely rise.
“The flurry of financial market activity this week has done some interesting things in the municipal bond market, and not everyone is coming out a winner,” White said. “What started as a boon for most munis as investors sought safe spaces and higher yields has become a bit more Darwinian as cash becomes king and some corners of the market look ahead to potential liquidity problems”
White pointed to the New York Metropolitan Transit Agency, which is asking for a $4 billion bailout, as one example.
“From an economic perspective municipal issuers have been riding high. Real tax revenues have more than fully recovered in virtually every state, and as a result state and local government employment just recently surpassed prerecession peak levels,” he said. “As a result, governments in the U.S. are generally in a good position to withstand a COVID-19 recession.”
He said that while state governments are in better shape than ever before to handle a recession, they will have to work in tandem with the federal government to ensure sufficient liquidity for issuers facing operational disruptions.
The most visible impact to most municipal issuers will be lower revenues, White said.
“The demand shock resulting from what is likely to be at least several weeks of social distancing and travel limitations will pull overall economic activity materially lower in the second quarter of 2020,” he said.
White said that even though the majority of the economic disruption will occur in fiscal 2020, the revenue impacts will extend into the first half of fiscal 2021.
“The length of the downturn will matter a great deal, but our preliminary analyses estimate that the amount of fiscal shock to state governments alone in the next few quarters could be as much as 10% of overall general fund revenues,” he said. “This would be roughly in line with the types of moderate recession scenarios that states have been stressing their budgets with as part of their annual budgeting processes.”
He said that the good news is that most states, in large part because of their newfound use of stress-testing in the budget process, are well prepared for an economic downturn of that magnitude.
“In our most recent 50-state stress-testing exercise, we found that 28 states had sufficient money set aside to handle the impacts of a moderate recession without having to raise taxes or cut spending. An additional 12 states were relatively close to having sufficient funds set aside, while only 10 were substantially unprepared,” he said.
Those states that have set aside sufficient reserves will be able to continue on without having to make any contractionary policy decisions that could lower aggregate demand even further.
Those not prepared will likely have to impose spending cuts or tax increases at a time when their economies can least afford them.
“As a result, look for those economies with state budgets best situated for the current crisis to outperform those whose governments are least prepared through at least 2021,” White said.