We have received inquiries about the impact Covid-19 is having on municipal fixed income securities. These inquiries are a natural extension of the number of headlines and news articles predicting fiscal problems for communities across the United States.
Various levels of economic lockdowns have not only reduced revenue from taxes and usage fees but also increased expenses. These increased expenses can stem both directly from necessary responses to the public health emergency and indirectly from such second-order effects as unemployment benefits, payroll support programs, small business grants, technological costs for distance learning and distribution costs for food programs that took place in now-closed schools.
On the revenue side through July, tax receipts year to date are down an average of 2.9% across the 47 states which report this data. However, the degree of variability across states is very high as shown below in the chart from JP Morgan.
Tax receipts, the largest contributor to revenue, come in different forms with two major categories being sales and property taxes followed by less common tax structures such as those based on tourism or oil revenues. The following chart from Barclays below shows the revenue sources of state and local governments over the last two years. It is apparent that while revenue was down in the second quarter, it has not reached a crises level for most locales.
Many state and local governments lean more on property taxes than other sources of revenue. A city like Anchorage and a state like New Hampshire are two that rely heavily on property taxes (see the following chart from JPMorgan which shows the geographical dependence on property taxes). These entities are unlikely to be as acutely affected by economic shutdowns as those that are dependent on sales or tourism taxes.
States with tourism based taxes (e.g. Nevada, Hawaii, Florida) are down significantly more than average. Examples of tourism taxes include a bed tax (Anchorage has a 12% room tax), restaurant taxes and arrival/departure taxes, either by aircraft or cruise ship. It appears that the second quarter of 2020 will mark the low point in economic activity. Municipal revenue bonds backed by this type of tax have seen some weakness in terms of pricing. We would expect that as the economy picks up and consumer mobility increases, tax receipts should follow. We do not expect a complete rebound as areas with tourism based taxes will not get back the lost 2020 tourist season. But we do expect tourism taxes to reverse their declines as we head into 2021.
Two large factors impacting state and local governments moving forward are: 1) the expected quantity of stimulus coming through the next fiscal package and 2) whether a new wave of Covid will derail the existing rebound in activity.
There continues to be a lot of uncertainty and moving parts in the current environment. State and local governments must balance their budgets over time unlike the federal government which can continue to issue debt to fund deficits. Government officials are trying to decide what to do next to address Covid driven budget shortfalls from lower revenue and rising expenses. There appear to be two primary options on the board: cut expenses (Mayor of New York) or increase revenue through taxes (New Jersey). In Alaska, we will probably see a combination across the board.
When APCM purchases municipal securities, we are careful to think through what factors affect a bond’s source of repayment and will those factors persist.
One of the distinguishing features of the investment grade muni bond market is that it has over 50,000 issuers compared to the investment grade corporate market with a ‘mere’ 4,000. Each one of these issuers has unique characteristics which makes it important to review how revenues are being impacted. In general, we have avoided bonds that are backed by revenue streams such as bed or rental car taxes, hospital bonds or transportation bonds (e.g. road/toll and bridge) as these could face headwinds. We have maintained a preference for bonds with higher ratings backed by more stable sources such as General Obligations, School Districts and Water/Sewer/Sanitation receipts.
We continue to think investment grade municipals have attractive value over corporate bonds even at the current low rates. Corporate balance sheets continue to show increasing leverage and we stay cautious on their credit quality. JP Morgan points out that over the last 12 months there have been $2.3bn of defaulted munis and $76bn in corporate bond defaults.
Looking back over the last 20 years, covering three different recessionary periods, investment grade defaults have been few and far between. While APCM only invests in investment grade securities, it can be informative to look at the High Yield space to assess the default risk over time and from the JPMorgan graph below, it is apparent that the corporate default rate has been much higher than the muni default rate through recessionary periods.
While we understand that reasonable concerns exist due to headlines about municipal bonds, we believe that risks in muni bonds lie more with potential downgrades (rating agencies lowering a bond’s rating) and not with default risk, especially for general obligation bonds. That said, we do expect to see pockets of muni defaults within weaker revenue-based bonds if the economy continues to drag. We continue to maintain our exposure to the muni asset class and view it as an important part of many of our client accounts.
Paul Hanson, CFA®