With much of the U.S. still in the grips of the COVID-19 pandemic, the country’s economic woes continue to mount. In the months since shutdown orders began, nearly 40 million Americans have filed jobless claims, and the Federal Reserve Bank of St. Louis estimates the pandemic could put 47 million people out of work.
Not surprisingly, the economic downdraft has raised questions about the financial health of municipal issuers. But while credit downgrade risks remain and default rates may tick up from historical averages, PIMCO does not expect a large wave of investment grade or high yield municipal defaults.
Coming into the crisis, the municipal credit backdrop was sound but bifurcated. While most municipal credits took advantage of the growing economy to rebuild their balance sheets, some struggled to get their fiscal house in order.
COVID-19 put a swift end to what was largely a sanguine credit backdrop. With economic weakness depressing tax collections, we expect most states and local governments to implement sizable austerity measures to close budget gaps. Several states have suggested shortfalls ranging from 10%-20% of their annual budgets, while one third party has provided an estimate of $765 billion through fiscal 2022.
Because spending and gross investment by state and local governments account for more than 10% of U.S. GDP and 13% of total employment, austerity could have an adverse effect on the nation’s economic output.
But the news may not be as dire as it appears.
Accumulated reserves, additional policy levers should help close gaps
U.S. states are sovereign entities that have many levers they can pull to help weather economic stresses. These are just some of the options at their disposal:
- Cutting expenditures
- Drawing from existing general fund reserves, which entered the pandemic at historic highs
- Borrowing from other internal accounts that have built cash intended for other purposes, such as transportation projects – this type of “interfund” borrowing was common during the global financial crisis
- Levying and increasing taxes and fees
Tax increases may be unpopular, but they were common following the global financial crisis. This time around, we expect some states to use the pandemic to push through tax hikes they favored before COVID-19, while others seek temporary tax measures to stabilize budgets.
There are a couple additional points to consider as well:
- Only 28 states allow municipalities access to municipal bankruptcy proceedings and, as we noted in a recent blog, states are not eligible.
- Municipal debt balances remain relatively low (see Figure 1), as external borrowing has remained flat since 2008, while corporate and Treasury markets have increased by $16 trillion over the same period.
Where does that leave local governments?
Because local governments are so diverse, the pandemic’s impact is likely to be idiosyncratic. Local governments that are reliant upon tourism and cyclical revenue streams are likely to see more challenging budget outlooks. Additionally, those that are heavily reliant on state aid will likely be forced to reduce spending in the coming months to offset looming state cuts.
Fortunately, as Figure 2 depicts, most local governments rely primarily on property tax revenues, which are unlikely to see near-term stress given the lag between property tax assessments and actual collections.
Should the economic decline result in deteriorating property values, local governments have considerable lead time to adjust their budgets accordingly.
Federal support: unprecedented, but more is needed
One of the most important paths to fiscal stabilization is federal aid. Already, state and local governments are benefiting from an unprecedented amount of federal aid, as well as financing from the Federal Reserve:
- The CARES Act provided $150 billion of grants to state and local governments for COVID-19-related expenditures and billions of dollars in direct aid to not-for-profit healthcare facilities, transit districts, and airports.
- The $500 billion Municipal Liquidity Facility provides states and some local governments access to short-term loans to support their cash flow needs and has now been expanded to include smaller borrowers.
- Recent legislation provides for a more than 6% increase in federal Medicaid matching funds.
But even this may not be enough. Governors are lobbying the feds for $500 billion in additional funding. Without it, austerity measures – and their impact on economic growth – are sure to be deeper.
Where do various segments of the municipal market stand?
Much like states and governments, certain segments of the municipal market are better positioned than others, in our view.
- Airports, tolls – Airports as a whole are receiving $10 billion in funding from the CARES Act, and we expect the sector to remain resilient. Many strong toll assets can withstand extraordinary stresses in traffic volume and still produce sound debt service coverage.
- Water, waste, utilities – Essential-service revenue bonds are generally defensive and should hold up well, but capital expenditures can be cut to preserve cash in the event of reduced demand from customers.
- Healthcare – Smaller, single-site hospitals with weak balance sheets may struggle, while larger, higher-rated healthcare systems could emerge relatively unscathed – even under stress scenarios.
- Pensions – We view pension underfunding not as an immediate crisis, but as a longer-term secular issue for most municipal credits. Though the pandemic is likely to result in further declines in funding ratios, we do not expect to see immediate insolvency in investment grade credits.
Some high yield issuers may struggle
Some of the biggest risks lie in lower-rated credits, which may face an uphill battle as a result of the pandemic. We expect an uptick in the number of borrowers in distress across several sectors of the high yield market, including long-term care facilities and retail-focused development projects, as well as travel-dependent hotels and convention centers. More recent-vintage deals that were ramping up with lower reserve levels may also struggle to satisfy debt service obligations.
Municipals have historically exhibited low default rates
While we do not expect to see a large wave of bankruptcies even in the high yield space, the rate of high yield defaults could climb from historical norms over the coming year. But here it’s important to note that municipal default rates have historically lagged those of other spread-product issuers. In fact, according to J.P. Morgan and Moody’s Investors Service, from 1970-2018, the average annual municipal default rate was 0.015%, which is quite low relative to other asset classes. Moreover, as Figure 3 depicts, high quality municipals have fared much better than their high yield counterparts.
These are challenging days for investors, and it can be difficult to make sense of it all. During times like these it pays to have investment professionals doing the hard work of credit analysis: digging through financial statements, stress testing positions against various recovery scenarios, and selectively seeking yield opportunities.
While state and local governments face a unique set of challenges, many municipal issuers are uniquely positioned to weather economic stresses particularly higher-rated issues with strong balance sheets. In spite of myriad economic disruptions, we expect high quality municipals to remain resilient.
Visit Municipal Bonds at PIMCO for more on how we help investors unlock the potential of munis.