Municipal bond investors need to closely consider downside credit risks amid coronavirus
There is extreme concern about state and local government credit and marketability specifically, as pressures on state and local governments and related enterprises remain severe.
There is no doubt the aggregate news surrounding the path of the pandemic is getting increasingly grim. Evidence of further worsening of pandemic incidence and pressures in a substantial number of states, including especially Florida, Texas, Arizona, Mississippi, Nevada and South Carolina — in terms of the slope of the recent increase, and the level relative to earlier peaks.
New aggregate cases in the U.S. averaged about 35,000 at the first peak in early April, but are averaging over 40,000 currently, and appear to be heading higher.
Of course, none of this takes into account the threat of a Phase 2 during the late fall/winter months — nearly all of the recent bounce appears to be related to states opening up too rapidly, or too carelessly.
Indeed, a number of states are seeing sufficient new outbreaks to suggest that reopenings may be deterred or even reversed, particularly in light of sharply reduced adherence to social distancing, wearing of masks and related practices.
The importance of the potential for deterring or reversing reopenings is important for credit trends: the recent decline in GDP could easily become worse, and state-by-state pressure on economic patterns and budgets could accelerate in ways that make budgetary pressures even worse.
The New York Times daily data shows the 124-day moving average of the trend in new cases is upward in 40 states, and downward in only two states as of Sunday, July 5.
The reduction in the “risk premium” for investors in muni debt has been impressive. One-year yields are down from 0.48% to 0.21% over the past three weeks. Yields on five-year high-grades are down from 0.75% to 0.43%. On 10-year paper, the decline is from 1.11% to 0.88%. On the long end, the drop is from 1.94% to 1.64%.
Clearly, investors are currently being compensated rather poorly for any impending declines in aggregate muni credit quality and/or marketability, which seem to be very likely outcomes.
A key factor keeping relative muni yields as low as they have been is a supply/demand imbalance. On the supply side, tax-exempt issuance in June was down by a substantial 9.3%, even as taxable issuance was up a whopping 697%, even as calls and maturities of tax-exempts reached their June 1-August 1 semi-annual peak. With yields this low, muni investors need to be extremely cautious about putting new cash or bond call/maturity proceeds back to work.
Investments in municipals for most investors are intended to be low-risk, in terms of principal value and total return, and the economic and credit risks that investors are facing have increased, even as yields have declined.
There is a substantial risk of downward pressure on state and local credit quality that is not currently incorporated in municipal bond market ratings or valuations.
Indeed, even absent certainty of a downward trend in credit quality, there is concern that it appears nearly all of the potential for changing valuations falls to the downside.
Although total issuance in the muni market was strong in June, tax-exempt issuance was actually down modestly, just as tax-exempt bond calls and maturities were reaching their June 1-August 1 peaks.
Meanwhile, the reticence on the U.S. Senate side to providing much-needed fiscal support to state and local governments, despite clear evidence of the need.
Recent proposals to support state and local governments currently take two primary forms. On the House side, The $3 trillion Heroes Act has already been approved. That bill would provide $1 trillion in support for state and local governments. On the Senate side, the most generous form of support would be the so-called “SMART” bill, sponsored by Sens. Robert Menendez and Bill Cassidy, which would include $500 billion in support for state and local governments. In recent months, we have heard a number of related rationales for the Senate to avoid providing the needed fiscal support, even at the reduced level in the SMART legislation.
Budgetary pressures on state and local governments appear to go well beyond the state-level revenue shortfalls being estimated by a number of key sources. There is concern regarding the need for sharply increased expenditures to deal with issues such as the threat of severe numbers of evictions from rental properties, impending potential reductions in Federal unemployment payments, and pressures on families and individuals that may well require state intervention to avoid a sharp spike in pandemic-related personal bankruptcies.
Considerable risks to a number of enterprise revenue bond sectors that issue large amounts of municipal bonds, particularly related to transportation, healthcare, elderly care and higher education.
The healthcare sector specifically is facing a substantial financial crisis that never quite ended after the Great Recession.
In terms of the impact of the pandemic on state employment — and resultant quality of governmental service — job losses so far have already been sharp. According to BLS data, in May, employment continued to decline in government (-585,000), following a drop of 963,000 in April. Employment in local government was down by 487,000 in May. Local government education accounted for almost two-thirds of the decrease (-310,000), reflecting school closures. Employment also continued to decline in state government (-84,000), particularly in state education (-63,000).
And this of course, still doesn’t get us through the potential Phase 2, which is not expected to show up — if it does — before late fall, potentially simultaneous with the new flu season.
Our bottom lines don’t change with all of this: The risks to the economy, to state and local budgets, to municipal enterprises and to municipal credits, can potentially get a lot worse as these patterns occur. Municipal investors are not yet prepared for the combination of very low yields and asymmetrical credit risk that they currently confront.
Budget gaps appear to be sharply understated.
A number of important organizations have estimated the magnitude of aggregate state-level budgetary shortfalls as a consequence of the pandemic.
For example, a study from the Center for Budgetary Priorities dated June 15 estimated that the state-level budgetary gaps in FY 2020-22 would total $615 billion. Other estimates seem to be similar. These estimates sharply underestimate the magnitude of total state and local government shortfalls over that period for several reasons:
Of course they do not include local-level shortfalls at cities, counties and other local governments.
These types of estimates tend to focus almost exclusively on reduced tax revenues — income taxes, sales taxes, etc. However, what has not yet been effectively estimated is the magnitude of needed spending increases at the state and local level, including moneys needed to limit evictions, foreclosures and personal bankruptcies as millions of individuals and families face unemployment and/or sharply reduced income levels.
There will be ongoing sharp healthcare spending requirements related to the pandemic itself, as Covid-19 patients face long periods of extremely costly in-hospital treatment.
Many components of our state and local government complex are going to rapidly come under increasing budgetary pressure as pandemic pressures likely expand, and that pressure will be magnified if the Senate does not cooperate with at least half a trillion in fiscal support for state and local governments — as well as extensions in support for unemployed individuals beyond current provisions.
First, there finally appears to be ongoing concern regarding the magnitude of the Federal deficit, which even without further much-needed support in a number of forms.
Second, any high level of support for state and local governments has been described as a “Blue State Bailout,” which would go more heavily to high-spending “blue” states governed by Democrats.
Third, it has been strongly suggested by a number of Republican legislators that moneys included in a large state/local benefit package would go heavily to states with massive unfunded pension liabilities, and utilized to support these pensions rather than to provide badly needed budgetary and humanitarian support, as we would suggest.
And, frankly, the half trillion level is unlikely to be nearly enough. That level of support would have only only kept cuts in public sector jobs at a precarious level of 2.6 million jobs, or 1.7% of nonfarm employment below the recent peak, if the full half a trillion in the SMART bill is available.
Growing expenditure requirements would appear to be sharply underestimated — and potential job losses appear likely to increase as the magnitude of the pandemic broadens and deepens.
Even with that level of subsidy, the budget holes could be greater than in the EPI forecast.
The negative implications for state and local credit quality could grow sharply, to an extent that is not at all considered in current market valuations.
Considerably greater muni bond investor caution than that shown in current yield levels is strongly warranted.