The Global Pandemic’s Impact on U.S. Municipal Bonds | Lord Abbett
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Fixed-Income Insights

We highlight the challenges as well as the potential resilience of the U.S. municipal bond market and its credit quality in a period of extraordinary volatility and economic shock.

The impact of the coronavirus (COVID-19) on U.S. financial markets has not been a subtle one. Municipal bonds, like their counterparts in equity and taxable bond markets, have been tossed about in the sudden uncertainty that quickly took hold of investor sentiment.

The following highlights the challenges as well as the potential resilience of the U.S. muni bond market and its credit quality in a period of extraordinary volatility and economic shock.

Credit Research Process
Lord Abbett’s municipal bond team is spending a significant amount of time on calls with issuers, industry experts, rating agency analysts, and dealers to gather information. We continue our deep granular research on all holdings and sectors. But with the new issue market quiet, we are focused more on surveillance of our holdings and closely following developments in all muni sectors. Our analysts are considering the effects of the coronavirus pandemic on credit quality and are identifying those holdings that may be at most risk or may be less affected. This includes running stress tests for sectors to determine how credit quality would beaffected under multiple downside-revenue and increased-expendi- ture scenarios. Each type of stress test needs to be unique to the sector that we are looking at.

Our research has resulted in the following assessment:

State and Local Governments
In our opinion, there is no question that state and local govern- ments will face reduced revenues as sales and income taxes decline for an unknown period following business shutdowns and rising unemployment. Revenues will be further squeezed as states face higher expenditures for healthcare and social services. And, unfortunately, volatile financial markets are likely  to dampen pension returns for 2020, forcing states to bear the burden of higher annual pension fund contributions in the future. We believe that states with the weakest public pension funds, such as Illinois and New Jersey, will be pressured the most. We will be looking to see if they are able to continue their recent  trend of making their annual pension payments.

On the positive side, heading into this economic storm, state and local governments were in a historically strong position in terms of revenues. State and local tax receipts have grown more than 3% annually since the 2008-09 financial crisis, allowing most state governments and municipalities to build up a financial cushion over the past several years.

Moreover, all states have sources for short term cash needs including the new Coronavirus Aid, Relief and Economic Security Act (CARES Act), signed into law on March 27, which adds up to $280 billion of direct stimulus to municipal bond issuers. In addition, on April 9, the U.S. Federal Reserve established the Municipal Liquidity Facility that, through a special purpose vehicle, will purchase up to $500 billion of short-term municipal notes to help state and local governments manage cash flow stresses.

Local Governments
As with the states, local governments have amassed a significant amount of liquidity over the past five years, which we expect will cushion the impact of negative economic growth.

Moreover, most local governments draw a significant amount of revenue from property taxes, and as such are less exposed to temporary economic activity swings. Historically, property tax revenue generally provides a buffer during an economic slowdown because:

  • In most cases, assessed values are only reassessed every few years.
  • The annual increase in assessed value is capped each year, so in many cases, the assessed value is well below market values.
  • This means that even if market values go down, the assessed value would not be impacted.

In short, it would take a couple of years for property taxes to be meaningfully affected by an economic shock such as the current pandemic.

For the most part, we expect that higher credit-rated counties and cities with positive demographics and wealth levels and robust reserve funds should perform best. New York City, for example, is a high grade credit because they have reserve funds, financial controls and diverse sources of revenues, including income and real estate taxes.

Those local governments that are highly reliant on state funding or sales tax revenues, have less liquidity, and have sizable unfunded pension liabilities will face the most credit pressure.

On the positive side, we believe the CARES Act will provide relief to many local governments; the states may also provide some level of support.

The economic shock resulting from COVID-19 has also had significant impact on specific sectors of the muni market:

Transportation
Although downgrades are likely, mass transit systems are natural monopolies and essential service providers. Nonetheless, transit systems are experiencing significant declines in ridership as more and more employees are working from home. After the virus slowdown, we may see a shift toward commuting by car rather than mass transit, at least in the short term. The recently passed CARES Act provides $25 billion as a buffer to a short-term decline in ridership.

Toll roads will be affected as the volume of car traffic has fallen with state and county stay-at-home orders. Mitigating risk is that many have good debt service coverage and capital spending flexibility. The strongest credits are roadways in and out of major cities while weaker ones are roads with cheaper or free viable alternatives. Overall, the toll road sector tends to have strong liquidity, which we believe will help absorb short term disruption. Some systems have the additional security of sales tax or motor fuel/rental tax pledges.

Seaports will face volume pressure as worldwide output will decline. Some ports charge rents and have minimum payment guarantees which allow them to withstand a short term downturn. Cruise terminals will be negatively impacted as bookings are likely to remain soft.

Health Care
The pandemic is triggering challenges for the health care sector, spurring operating issues and balance sheet pressure. We anticipate that higher patient volume and revenue related to COVID-19 will probably be offset by higher expenses especially for labor and the loss of more profitable elective procedures.

Highly rated systems may experience near term challenges but, in our opinion, should recover considering balance sheet strength and purchasing power. Small stand alone and rural hospitals are more exposed to volatility in performance but many have adequate liquidity levels to make it through. The federal government has shown its strong support through the CARES Act, dedicating $100 billion of funds to this sector.

Airports
The reduction in air travel levels will increase financial pressure on all U.S. airports, at varying levels. Airport revenue bonds are secured primarily by payments made by airlines through terminal rentals and landing fees, not directly by passengers traveling through the airport. We believe it is unlikely that an airline would make a decision to pull out of an airport that serves a vibrant economic base.

Stimulus relief, robust liquidity, and reserve funds are expected to support the credit quality of airports. Federal support for airlines will also lessen the stress, allowing airlines to free up more resources to pay increased airport costs.

The funding relief in the CARES Act provides $10 billion to U.S. airports. The money will be dispersed to most airports with the amount determined by flight volume. Large airports will receive stimulus grants in amounts ranging between 15-38% of 2018 revenues.

Higher Education
We also think most universities are well positioned financially to withstand the Covid-19 crisis in the short term. Nonetheless, the prospect of lower enrollment exists for this fall due to recruiting challenges and lower international enrollments.

Schools with already negative enrollment trends and higher dependence on student tuition will be most at risk. Schools with sizable endowments and lesser dependence on student tuition revenue will be able to withstand possible enrollment declines best. Supportive to the sector, the CARES Act will provide $14 billion to universities.

Public Power and Water/Sewer Utilities
Public power and water/sewer utilities are not expected to face immediate credit pressures, as they are monopolies and are an essential service. Those few utilities with a higher concentration of industrial customers are most at risk as businesses remain closed. On the other hand, increases in residential electric demand could offset the decline in commercial and industrial sales. There also could be systemic “limited credit pressures” such as customer late payments or non-payments.

However, most of the systems have high debt service coverage and reserve funds. And most public power issuers maintain robust cash balances that we believe should further buffer any near-term disruption in cash flow.

Opportunity through Active Management
There is still much uncertainty regarding markets. And we do not know precisely how the COVID-19 crisis will affect municipal credit because it will depend upon the length of time that the economy needs to be partially shut down. However, we are confident that our team of municipal credit analysts has the experience and the proficiency to identify those factors that will determine how individual credits will perform during this time period. Although there will be some pockets facing distress, we believe that most sectors and credits will hold up well during the crisis. With our disciplined fundamental credit analysis process, in our view, we are positioned well to identify those issuers who face the most risk and those that have the best potential to perform well. It’s our belief that there will continue to be good investment opportunities in the municipal market, but to find them in this environment, we think there will likely be a big advantage in having active management supported by strong credit research.

 

IMPORTANT INFORMATION

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. High-yield, lower-rated securities involve greater risk than

higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Lower-rated investments may be subject to greater price volatility than higher-rated investments. A portion of the income derived from a municipal bond may be subject to the alternative minimum tax. Any capital gains realized may  be subject to taxation. Federal, state, and local taxes may apply. There is a risk that a bond issued as tax-exempt may be reclassified by the IRS as taxable, creating taxable rather than tax-exempt income. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Investments in Puerto Rico and other  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 information provided is for general informational purposes only. References to any specific securities, sectors or investment themes are for illustrative purposes only and should not be considered an individualized recommendation or personalized investment advice, and should  not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that  markets will perform in a similar manner under similar conditions in the future. Past performance is not a reliable indicator of future results.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The credit quality of the securities in a portfolio is assigned by a nationally recognized  statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise  provide general investment education. None of the information provided should be regarded as  a suggestion to engage in or refrain from any investment-related course of action as neither  Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and subject to change  based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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