Amid the Pandemic, State and Local Governments Appear Resilient
July 10, 2020
By and large, we believe issuers in this key segment of the municipal bond market have the financial resources and flexibility to weather the disruptions caused by COVID-19
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This article is from the Q2 2020 edition of The Muni Quarterly.
There has been concern regarding the credit quality of state backed municipal bonds due to the large-scale social distancing measures imposed during the COVID -19 pandemic which have slowed down U.S. economic activity. These measures have reduced consumer spending and workers’ wages, resulting in falling sales and income tax revenues. While all states will face economic pressure, we don’t think that should not translate into near-term credit issues; in our view, they all have the liquidity, reserve fund balances, and financial flexibility required to perform during this period.
After an 11-year economic recovery, most state and local governments are entering this recession from a position of strength. State and local government revenues increased over 40% from their pre-2008 financial crisis peak, and governments have been managing their budgets more prudently, in our opinion. In prior economic expansions, they were quick to increase spending and keep their “rainy day” funds lean. When the “rainy day” hit in 2007, many governments had to make severe cuts, but they remained resilient. During the Great Recession (GR) of 2008–09, most states cut their spending for three straight years. But they appeared to learn a lesson from that downturn, and in the most recent expansion, many states applied surplus tax revenues to build up reserve funds. In fact, the median state rainy-day fund reached 7.6% of general fund expenditures in fiscal year 2019, as compared to 2.1% in fiscal 2008, according to data from the National Association of State Budget Officers. So, now they have more dry powder to offset the revenue declines that likely will be coming.
Stronger State and Local Balance Sheets
Many investors may assume that states and local governments have too much debt. However, debt service only accounts for between 5-10% of revenues for most issuers. In fact, state and local governments have deleveraged since the GR. Total debt outstanding in the municipal market has been essentially flat for the past 10 years cumulatively, based on data from the U.S. Federal Reserve. A recent Moody’s report highlights the fact that the median amount of debt funded by taxpayers fell, as a percent of a state’s economy, to 1.9% in fiscal 2019, the lowest level since 2006. Approximately half of all municipal debt issued over the last decade has been to refinance other bonds and thereby reduce debt service costs. Many states have become more fiscally austere and have issued less debt than they previously had and are using the revenues built up during the expansion to pay for capital expenditures.
Governments have reacted to this crisis by cutting jobs, as state and local government payrolls declined by 1.5 million since March, according to the Bureau of Labor Statistics. Most of those cuts have come from public education and are at the local level. These declines are larger than those experienced following the GR when state and local governments eliminated 750,000 jobs.
In addition to reducing expenses, states also have the flexibility to raise revenues, and in fact hiked taxes by $100 billion during the GR, according to the Center on Budget and Policy Priorities. If the pandemic crisis lasts longer than they anticipate, and revenues continue to fall short of targets, most states have the ability to make midyear budget adjustments.
Assistance from the Federal Government
During the GR, the federal government provided grants to states and temporarily increased the federal share of Medicaid spending. Amid the pandemic, Washington has once again provided financial help to the states. Congress recently enacted the Coronavirus Aid, Relief, and Economic Security (CARES) Act, a $2 trillion package that provided $150 billion to state and local governments. In addition, a separate program increased the federal share of Medicaid by 6.2%, which would equate to $35 billion if it remains in effect all year. The CARES Act also provided some help to state unemployment insurance programs.
Although these increases are helpful, they are not large enough to prevent states from having to reduce spending. Further, the CARES Act funding is limited to cover costs directly related to COVID-19 that weren’t already provided for in state budgets and they cannot be used to make up revenue shortfalls. Further aid to states is expected, as fourth round stimulus package has been proposed by several senators and congressman, with discussions expected to commence in July.
In addition to federal stimulus, and their own budget cuts and/or revenue increases, some states will borrow to close budget gaps. States can also tap a new U.S. Federal Reserve (Fed) lending programset up in response to the coronavirus crisis. For the first time, the Fed has been authorized to buy debt from, or lend to, states and cities. It is unclear whether the central bank will buy municipal bonds at all, or which ones they might buy, but it is an option. However, the rates that they charge to borrowers in most cases will be above market, so the program is considered a backstop and only a few, more stressed issuers will use it. Municipal bond issuers might try to borrow long-term to pay for immediate, short-term operating costs, but it is generally considered unsound practice, with potentially negative credit rating implications. Some governments constitutionally or statutorily prohibit such borrowing. However, in extreme cases, it does provide states with an ability to manage financial operations.
U.S. states are sovereign entities that have many levers they can pull to help weather economic turmoil. So in the end, we believe the states will manage as they always do in recessions, cutting budgets and raising revenues, but at least this time, they have larger reserves, a possible Federal Reserve backstop, and significant federal stimulus funding. Given the complex, rapidly evolving economic environment fostered by the pandemic, we believe access to rigorous credit research can be a useful tool for investors as they consider potential opportunities in municipal bonds at the state and local level.
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A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.
The CARES (Coronavirus Aid, Relief, and Economic Security) Act is a $2 trillion stimulus passed by the U.S. Congress in March 2020, to blunt the impact of an economic downturn set in motion by the global coronavirus pandemic.
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