Still shaking off 2022’s dismal returns, municipal bond investors now worry about the impact of a potential economic downturn. Gloomy news reports of projected budget gaps for state and local governments only add to their anxieties. But the muni market is more resilient than headlines suggest, and a closer look across sectors can help discern areas of opportunity from those that require a bit more caution.
Muni Market Resilience Starts at the State Level
Many state and local governments will face fiscal challenges next year, but they inherently have the flexibility to work through them. For example, foreseeing a $22.5 billion deficit due to a slowing economy, California is already strategically delaying funding and shifting spending to close the gap without having to tap into its $36 billion in reserves.
More broadly, the outlook is favorable for most state and local governments, thanks to the record budget revenues and reserves in hand. In fact, the median state reserves-expenditures ratio is currently 25%—well above its roughly 10% over the long run. By contrast, the ratio was just under 12% heading into the global financial crisis of 2008.
Strong fiscal report cards are the linchpin of the muni market’s overall appeal. They also explain why muni bonds have weathered economic malaise much better than corporate bonds. In fact, muni bonds have had fewer downgrades, more stable ratings and significantly fewer defaults—near-zero—compared to corporate issues since 1981, which includes five official US recessions (Display).
Other Muni Sectors Can Benefit from Healthy State and Local Finances
Among the largest beneficiaries of strong state and local government finances are school districts and charter schools—essential services where funding generally takes priority. As a result, they represent muni sectors we think are particularly well positioned for a potential slowdown. Charter schools, for example, receive over 80% of their funding from states with strict constitutional mandates to protect education as a basic right.
Select high-yield muni sectors are well-positioned for a downcycle too. And given their wide spreads, they can also add defensive characteristics and income potential to a portfolio. Current standouts include charter schools, affordable housing and toll roads.
Affordable housing should benefit from rising demand in a downturn. California’s Workforce Housing Program bonds, for instance, play a vital role in the state’s economic growth goals, which are challenged by the lack of affordable housing for middle-income earners. Toll roads have rich cash reserves—enough to carry them through 500 to 1,000 days of disruption—and low labor costs, given the popularity of “easy pass” transponders.
Not All Munis Are Recession Proof
Just as important as choosing opportunities is determining what to avoid. We’re especially wary of the high-yield sectors most vulnerable to economic headwinds, such as senior living facilities, tobacco bonds and land deals.
The senior living sector is suffering through long-lasting effects of the pandemic, including severely weakened demand. A softening housing market is another headwind, since most senior communities rely on entrance fees, which are highly dependent on seniors’ ability to first sell their homes at healthy prices. Combined with staffing shortages and high turnover, we expect senior living credit quality to waver, along with an increase in defaults.
Land deals involve parcels reserved for tract home communities and commercial buildings. Paying back the bonds hinges on selling the completed structures, so we think this sector will weaken if the real estate market softens further.
Tobacco settlement muni bonds are backed by expected payments from tobacco companies to municipalities to reimburse them for healthcare costs related to smoking ailments. Revenues are based on national annual cigarette sales, which will likely decline more than average in a downturn as disposable income shrinks.
Some Muni Setbacks Aren’t Related to a Downturn
Not all muni sector challenges spill from the same well. One very important sector to watch is hospitals, which are under considerable pressure, but not because of a pending slowdown. Rather, healthcare facilities face lingering qualified nurse shortages, which has driven up wage expenses to retain the ones they have. Many facilities are also cash strapped as they push to repay Medicare advances received at the onset of the pandemic.
Balance sheet deterioration across the healthcare sector, which especially struck high-quality issuers in 2022, should subside this year. We also think margins will improve as payor reimbursement rates modestly increase to offset heightened labor costs while patient volume and demand for profitable elective services rise to pre-pandemic norms.
The Fed’s aggressive rate-hike cycle has taken longer than expected to stave off inflation, but eventually the economic engine will slow, and inflation along with it. In the meantime, we’re optimistic about muni market opportunities for the rest of 2023, regardless of where the economy lands. Today’s muni entry point is one of the best we’ve seen in some time, with compelling value across sectors after February’s sell-off and wide spreads among select credit. Yields remain high too, which offers buffering from further increases, not to mention the strongest income potential in years.
While opportunity is knocking, investors should still be selective and stay flexible, as not all munis will weather the storm, when—or if—one starts to build.
- Bryan Laing, CFA
- Credit Analyst—Municipal Bonds
- Natalie Laven, CFA
- High Yield Research Analyst—Municipal Credit
- Richard Schwam
- Research Analyst—Municipal Credit