Q1 2021 Credit Commentary: Back To The Past?
Summary
- Are we going to go back to the past, as economies around the world open and vaccinations and herd immunity take hold?
- At Cumberland Advisors, we see less near-term municipal credit risk, but we are a little cautious of weaker sectors and regions that may not receive aid or that have had their economies altered by the pandemic.
- Most municipalities learned from the financial crisis to be prepared for outlier events by establishing strong reserves and cutting back spending. We hope that fiscal responsibility continues despite the massive federal support at this time.
By Patricia M. Healy, CFA
Are we going to go back to the past, as economies around the world open and vaccinations and herd immunity take hold? Many activities will return to how they were before the pandemic struck, but others may be changed markedly forever - such as shopping, education, telehealth, cyber risk, and internet access available to all. The return to life nearer normal may be delayed depending on the resurgence of the virus and new strains, which could lead to reimposed shutdowns. John Mousseau refers to a return to normalcy in his recent commentary on the bond markets, "The Bond Market's 'Return to Normalcy.'"
This past quarter marked a reversal from the trajectory of the first quarter a year ago, and in some cases even from last month, considering the recently approved $1.9 trillion American Rescue Plan. Cities, towns, schools, businesses, and other venues that were shuttered at this time last year are opening now, although it may take years for some activities, such as business air travel and convention center attendance, to attain pre-pandemic levels. Many analysts assert that these volumes will not rebound until 2024.
Last year, everyone was afraid for the lives of loved ones or themselves. Now, with many being vaccinated, we see a light at the end of the tunnel and will be able to freely give hugs again! Delivery services flourished last year, and many went on-line for shopping and work or took targeted trips to the supermarket with masks and hand sanitizer. Now folks are heading to restaurants and planning trips.
A year ago, the loss of jobs was sorely felt, and those on the front lines were extremely overworked. The federal, state, and local governments took huge steps to provide needed resources to people and businesses. Various federal aid programs, including the $2.7 trillion CARES Act, totaled about $4 trillion in 2020 but did not include direct aid to municipalities. However, payments made to individuals and businesses to replace lost revenue and to help retain employees kept folks working and spending. The stock market recovered and produced strong returns, and some states' revenues exceeded what had been budgeted. The Wayfair decision, which allowed municipalities to collect sales taxes at the point of sale instead of the physical location of the seller, also helped revenues.
Still, for many municipalities, all this would not have been enough. There was fear, and the reality of a reduction in state aid to schools and colleges, and revenue shared with towns and cities. States reducing aid to local governments and to education is what usually happens during or after a recession. This reduction puts a burden on local governments to balance operations costs, and that adjustment generally includes reducing the largest expense - labor costs (which can sometimes slow an economic recovery since muni employment is about 13% non-farm payrolls) - and to increase property and other taxes and fees. These stresses can lead to credit downgrades if budgetary imbalances are not addressed.
Consequently, at the end of last year, in a note titled "Q4 Quarterly Credit Commentary - Municipal Credit and Beyond," we wrote that credit quality would be challenged going forward. However, with additional substantial stimulus now, including $350 billion in direct aid to state and local governments in the American Rescue Plan, and with the progress of the vaccinations, many market participants have changed their views. Rating agencies have changed many sector outlooks back to stable after revising them to negative in the 1st and 2nd quarters of last year.
At Cumberland Advisors, we see less near-term municipal credit risk, but we are a little cautious of weaker sectors and regions that may not receive aid or that have had their economies altered by the pandemic. Additionally, we are concerned about the unintended consequences which may take time to play out. The need to balance revenue and expenditures may be postponed; and when aid runs out, choices about spending priorities and raising revenues will need to be dealt with. The thought that the federal government will continue to bail out folks, businesses, and municipalities may entice entities, especially political entities, to exercise less budgetary restraint.
Most municipalities learned from the financial crisis to be prepared for outlier events by establishing strong reserves and cutting back spending. We hope that fiscal responsibility continues despite the massive federal support at this time.
Infrastructure Plan
And, speaking of stimulus, the proposed Build Back Better plan is reported to total up to $4 trillion in various phases, to cover more than infrastructure, and to require massive tax increases. Many see an expansive plan as stimulus because of the jobs created and other subsidies provided. And beyond the question of much-needed jobs, an enhanced, more resilient infrastructure will assuredly be safer and will lead to a more efficient economy. The recently released proposal is aptly named the American Jobs Act and totals $2.3 trillion over 8 years, to be funded over 15 years with a rollback of the corporate income tax cut of 2017, which would raise corporate tax rates back up to 28% from 21% and reinstitute the tax on foreign corporate earnings. Only $620 million would go towards traditional transportation such as roads and bridges, while most of the remainder would fund affordable housing and elder care and boost semi-conductor manufacturing capacity at home. Another $100 million would expand broadband.
The next phase of the Build Back America plan, the American Families Plan, would fund childcare, healthcare, and education initiatives through higher personal income and wealth taxes. The expansiveness of the plan and how to fund it will likely continue to be hotly debated in the ensuing months. Infrastructure plans are considered important by both parties, but the two parties have a hard time reaching a consensus.
It is important to arrive at some form of a plan soon, even a less ambitious one, so that states and municipalities can move forward with planning and construction funding. We have been moving in the right direction, but more needs to be done. The American Society of Civil Engineers (ASCE) Infrastructure Report Card now grades our infrastructure at a C-, up from D+. That mark is still not good, as we know from our grade-school report cards ("2021 Report Card for America's Infrastructure grades reveal widening investment gap," by Civil Engineering Source). Aviation, drinking water, energy, inland waterways, and ports improved since the last report in 2017; however, bridge grades declined from a grade of C. Recent events such as the Texas freeze, more frequent and damaging storms and fires, and sea level rise highlight the need for more resilient infrastructure. And an emphasis on environmental, social, and governance (ESG) issues continues to be a priority for some investors and planners.
Another back-to-the-past item that has been proposed and that could help with infrastructure funding by lowering costs for municipalities is eliminating a ban on tax-exempt advanced refunding bonds, which was instituted with the Tax Cuts and Jobs Act. Just as you can refinance your mortgage, municipalities can refinance their debt. The Local Community Act would also include increasing the private activity cap and the size of issues that are considered bank qualified and would maybe bring back a direct subsidy program like Build America Bonds (BABs). The bipartisan Local Community Act has been proposed to bring these tools back and is endorsed by municipal issuers and investors alike. Regarding a BAB-like program, if there is a chance that the direct subsidy paid to the issuer could be subject to sequestration, as it was after the BAB program began, issuers would likely not use the tool.
During the ban of tax-exempt advanced refunding bonds and with interest rates being low, many municipalities issued taxable municipal bonds. The increased supply of taxable municipal bonds, especially those issued by larger cities, not-for-profit healthcare, and higher education institutions attracted overseas investors because of higher US interest rates and better credit quality, and as a natural ESG investment. Also, banks and insurance companies increased their holdings of taxable and tax-exempt municipal bonds.
Impact or ESG measurement is well developed in equity and corporate bond markets, while the muni impact measurements are still evolving. Companies are generally assessed for their total impact; however, municipalities' impact generally starts with the use of proceeds for an individual bond issue. For example, the proceeds may be used to finance a water treatment plant, and then the governance of the issuing government is evaluated - for example, are the rates charged for water usage fair? The National Federation of Municipal Analysts recently established a working group to help in the development of municipal industry ESG standards. The process is underway, but many municipal issuers and the projects they finance have always had an ESG bent.
State Rating Actions
In addition to revising the state sector outlook to positive, Moody's and S&P both revised their outlooks on the State of Illinois to stable from negative. Illinois is the lowest-rated state, at BBB-, just above what is considered junk. It has one of the lowest-funded pensions, a huge bill backlog, and a history of political gridlock, making it difficult to get things done. The outlook changes were a result of improved financial performance during the pandemic and the recently passed stimulus, which provided direct aid to states and locals.
The State of Connecticut's rating was upgraded by Moody's to Aa3 from A1. The rating agency noted the state's progress on controlling spending and the expectation that reserves will grow to 19% of expenditures by the end of the fiscal year (June 30). The fact that high-income earners did not lose their jobs and a rising stock market helped improve state revenue. The Tax Foundation estimates that the state will receive $2.6 billion from the American Rescue Plan and local governments will receive 1.6 billion.
The American Rescue Plan contains restrictions on the use of funds: The direct aid cannot be used to prop up pensions or to reduce taxes. There are lawsuits pending by many states positing that the restrictions are a violation of states' rights, and it is important for the aid to get quickly to needed areas. Funds are fungible, and we expect the states to prevail and have flexibility.
Pensions
We think pension and other post-employment benefits such as health insurance are a big concern for many municipalities, and the need to fund them has reduced spending in other areas. Brookings recently released a study showing that some contend pensions don't need to be fully funded. Maybe 100% funding is not necessary, however not paying annual required payments to at least keep funded levels up is a risky option, as the liability can grow exponentially. The study does mention that many adjustments that municipalities have already made to plans can help funded levels grow over time.
Credit Factors
Credit factors that were important prior to the pandemic continue to be so. The reopening of the economy, fiscal stimulus, and the revision of most municipal sector outlooks to stable bode well for municipal credit quality going forward. As we have mentioned over the past year, many municipalities had built up rainy-day funds and reduced debt since the financial crisis. However, we are keeping an eye on muni credit quality. Muni rating downgrades tend to lag other sectors after a recession. The experience after the financial crisis showed this. While we have seen transportation-, tourist-, and convention-related credits downgraded because of the extreme drop in activity and revenues, other munis have not been downgraded, although they have been on the forefront of battling the pandemic - think of schools, publicly owned hospitals, increased social service spending, and PPE procurement.
During the pandemic, some municipalities dipped into reserve funds, and/or refinanced and restructured debt so that annual debt service payments will be lower in early years (sometimes referred to as scoop and toss). Even given stimulus funds, it will be important for those munis that used these tactics to take actions to regain structural balance - in other words, to align revenues and expenses so that deficits are not pushed into future years, compromising flexibility. Some municipalities supported debt-financed projects they were not on the hook for, but those projects were important to future economic development of the municipality. Convention centers are an example of such projects, reflecting another aspect of muni credit analysis - a project's importance to a community.
While municipal credit ratings have benefited from the American Rescue Plan, corporate credit quality continues to decline. Corporations rushed to market as interest rates started to rise, and they used bond proceeds to buy back shares and to make acquisitions. Increased leverage was the main culprit cited in downgrades. Prospects for corporations are better, too, however, because of stimulus and a return to normalcy; however, the average credit quality of a corporate bond is BB, or below investment grade.
Although we buy high-quality corporate debt in our taxable fixed-income strategy, we are also currently interested in taxable municipal bonds because of their higher credit quality.
So, back to the past. Many of the credit considerations we have mentioned, such as maintaining structural balance, existed prior to the pandemic. Stimulus may help forestall immediate consequences. The traditional factors of muni credit analysis will continue to be important: the strength of the service-area economy, the security pledge and reserves, financial and capital management, as well as the analysis of specific sector developments like regulation and state and federal mandates. We will continue to keep an eye on credit quality developments in sectors and on individual credits. It has been an interesting and cautious ride and will continue to be so.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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