Tough times are ahead for municipal bond issuers. The recession—sparked by the coronavirus-led shutdown of the US economy—will temporarily reduce most tax and fee revenues pledged to bondholders. Continuing negative headlines will also drive issuer ratings downgrades over the coming months. From airports and public transit to education and healthcare, the spread of COVID-19 affects all municipal issuers.
Yet we expect municipal credit to be more resilient than other markets, and we don’t anticipate widespread municipal defaults. Here’s why.
Strong Issuer Fundamentals
Municipal bond issuers are fully equipped to deal with the challenges of normal credit cycles. But this is not a normal downturn. Understandably, investors wonder whether struggling municipalities have the means and flexibility to deal with the coronavirus crisis.
As we see it, this crisis creates a lot of near-term pain for municipals, but long-term fundamentals remain strong, in part because of healthy reserves. Since the Great Recession of 2008–2009, municipal governments have used the longest economic expansion on record to shore up their balance sheets and rainy-day reserve funds.
In addition, state and local governments use the tools at their disposal to manage through times of crisis. Take budget cuts, for example. During the Great Recession, states cut their spending for three straight years. State and local governments also raise revenues, access the capital markets and defer other payments to prioritize their bondholders. They find a way.
As a result, no state has defaulted on its bonds since the Great Depression. And across all muni sectors, the five-year default rate averaged just 0.09% for rated credits from 1970 to 2018, according to Moody’s Investors Service.
Federal Aid to Municipal Issuers and Markets
The federal government is also providing tools and money to help state and local governments navigate the crisis. In early April, the Federal Reserve instituted the Municipal Liquidity Facility, which will devote around $500 billion to buy muni notes with maturities of 24 months or less. This will help alleviate near-term pressure on issuer cash flow. Details are coming, but the Fed’s announcement alone offered the market much comfort.
The Fed’s liquidity facility came on the heels of three federal stimulus bills to support businesses and workers with lifelines of cash, grants and loans. The latest of the measures, the Coronavirus Aid, Relief, and Economic Security (CARES) Act, injected a record $2.2 trillion into the economy. The money includes significant direct aid to states and municipalities to help ease short-term strains on municipal bond issuers.
Where the Money Is Headed: Fighting Shortfalls in Key Sectors
The CARES Act has earmarked $150 billion in grants to states, territories, local governments and Native American tribal councils, apportioned by population. Larger municipalities can apply for up to 45% of their state’s allocation—with minimal strings attached—to use for COVID-19 incurred expenses.
That money can’t arrive quickly enough. As the economy grinds to a halt, the first point of impact for municipal issuers is sales and income tax revenues. With stay-at-home laws in effect in most states, sales of non-necessities are down sharply, and with millions now out of work, there is less income tax revenue. Lost revenues impinge on every state’s and town’s capacity to pay teachers, cops and city maintenance staff, among other expenses.
In addition to the $150 billion to state and local governments, the CARES Act has focused some of its funding on sectors that have been particularly hard hit—and that are mission critical to battling the virus and keeping society moving.
Hospitals: About $120 billion will go to hospitals, representing around 10% of the average facility’s annual revenues. This is a major boost to hospitals, though we believe more assistance may ultimately be needed.
Education: The crisis has completely disrupted schools, sending students and educators home. Because the outbreak happened near the end of the academic year and academics have moved online, tuition and fees won’t be refunded, and room-and-board refunds are limited in size. We believe most school districts and public colleges are still in good financial shape, but the $31 billion in CARES Act aid will be welcomed.
Transportation: About $25 billion and $10 billion will fund local transit and airport authorities, respectively. With the majority of the country immobile, transportation-related revenues generated by services ranging from public transit to toll roads are dwindling.
Airports: With air travel significantly curtailed, there is concern over the ability of airports to meet debt service payments. The CARES Act’s $10 billion allotted for airports is a major positive, because it’s much more than the actual amount of airport debt outstanding.
More Help Is Available
The CARES Act is a sweeping and positive step, but more will be needed to fight the virus and meet state and local governments’ legal obligations to balance budgets in the face of substantial revenue losses.
Thankfully, more help is at hand from the federal disaster declaration, which will trigger reimbursements for costs to fight the virus from the Federal Emergency Management Agency. The declaration also gets much-needed personnel and resources on the ground faster.
We believe the federal government will act again by passing a fourth stimulus bill to push more aid to state and local governments, which are on the front lines in the fight against the virus. Some Congressional leaders are also discussing target areas such as infrastructure and small businesses and more help for hospitals.
The COVID-19 crisis is unprecedented, but so is the response. Governments will be deeply impacted, but we anticipate that that the economy will begin to rebound during the second half of 2020. And, in our view, municipalities are well-positioned for the long run and will continue to service their debts.
- John Ceffalio
- Municipal Credit Research Analyst—Global Credit Group
- Daryl Clements
- Portfolio Manager