Dissecting recent rhetoric regarding municipals
Some recent articles have served their purpose and have raised the awareness of municipals across a wider audience than is typical for the space. Many commentators outside the tradition space feel that it is just a focus of high-net worth individuals. But I have to say that I genuinely believe the vibrancy of the municipal market affects all citizens and not just municipal professionals.
Some pundits have maintained that state and local revenue losses are uncertain as to the decline and as to the duration. Despite unemployment that is remaining relatively high, there has been some improvement, as retail sales have accelerated from the depths. One may argue that a fair amount of spending was due to the extra $600 unemployment check that has now been discontinued.
It is not clear if the additional payment will be reinstated, although, the sides are talking again about doing something. The Executive Order that has provided an extra $300 payment has been unevenly adopted and is viewed as running its course relatively quickly. The difficult news is that these $300 additional payments are not being distributed all that rapidly.
The revenue losses have been in many categories but especially personal income taxes, retail sales, and corporate income taxes. The latter will not be fully known for some time. But we know that the losses are in the 10% to 30% range for a least a quarter or more. The loss estimates for states at $555 billion through June 30, 2022 and for cities at $360 billion could very well prove to be on the low side.
Governments fully appreciate they must balance their budgets. Since most of the expense is concentrated in employee salaries, there will be a lagging effect of when the reductions will take place. Hiring freezes, furloughs, and early retirements may all be enacted before any waves of cuts take place. It is just that the former actions are never quite as effective. It is hard to see a scenario where service delivery will not be affected in the near term.
Bankruptcy filings to date this year are up only marginally. Most governments work hard to find a solution that does not include filing for bankruptcy. Refunding debt and reshaping the repayment schedule within existing parameters was often one of the ways out. With no ability to do advance refunding at this time, this option would be expected to be less frequent than during stressful times of the past. Current refunding remains in place.
According to the MSRB, the default rate for municipals last year was 0.18% and was 1.74% for corporates. One would expect an uptick in both measures. I could envision an increase in the municipal rate to 0.50% as it has been close to in other stressful times in the past. There is this notion that only small issuers are affected. We know that it has more to do with whether the credit is in a higher-risk category.
The deferring of critical projects is often a common practice in a financial crisis. This happens when the revenue stream is not sufficient or available for some reason. In this cycle when the rates are so low, it would make more sense to capitalize as much interest as is permissible to forge ahead. We know that these rates may last for some time but not forever. Another factor is that many projects that were already underway have finished ahead of schedule due to fewer interruptions.
Pictures of trash waiting to be picked up in select cities also raised the ire. I would say that more of this condition has to do with sick days and schedules than other factors. This is not the same environment as the legendary sanitation strike in New York City in the ‘70s.
Another factor cited is that states will often cut back on important local aid at stressful times. This is quite true. All local governments should be finding ways to protect their budgets. There is a chance that if the virus persists, the cuts could become permanent to a degree.
Downgrade risk is cited as most probable for states and localities. State adjustments are typically modest even in stressful times because of the sovereign powers that states possess. We have not experienced a state being placed below the Baa/BBB category in modern times. There is good reason to think this possibility will still be avoided in this environment. One reason for this optimism is the Fed is prepared to lend if necessary. Local downgrades are more likely since localities have less financial flexibility. The evidence to date is that rating actions have been relatively light in scope. There is a reasonable concern that this will change over time especially as more audited financial results become available. We know that there is a built-in lag on the actual reporting. Rating agencies need justification to make their adjustments and may not move just on broader macro concerns.
Then we revert to the age old “kitchen” debate of general obligation security versus revenue bond security. In the case of the revenue bond, the pledge is usually clear and direct. The revenue bondholder is secured by the revenue stream. Revenue bonds often have excess coverage over requirements that provides a buffer on the downside. But we know that many revenue bonds have also been affected by this pandemic. Pick the sector, it has been affected.
The general obligation pledge is being denigrated by comments that politicians will not take the necessary actions. I do not hew to this opinion. In many cases, when the crisis is on it is easier to obtain cooperation to avoid Armageddon. The one caveat is that if the revenues dry up appreciably, the changes required are more gut wrenching and will require more wrangling. Most desire to avoid a filing. The negative outcome is that it becomes the end of the career path for those in the key positions. There is clear incentive not to seek out that path if avoidable. Some would say the stigma of a filing is gone. I do not concur.