The world as we knew it has been left behind. Stability and safety of municipals bonds was a given. Many pundits have considered municipal securities to only be second to Treasury securities in the safety factor. This premise was extremely tested when positive in flows to the mutual funds ceased and the selling pressure crested in a very extreme fashion. Municipal yields climbed by fifty basis points in a day that was very uncharacteristic. In subsequent days over the last couple of weeks, yields and spreads have calmed considerably. The new issue market that was dysfunctional is no operating close to expected once again. In summary of recent activity, the technical aspects are now within the band of expectation.
So far, we have focused on market aspects and not on credit aspects. The tests are ahead for credit. Having some handle on what areas will fare well versus becoming stressed has some value. The classic debate has always been the value of a general obligation bond versus a revenue bond. Many portfolio managers have been favoring revenue bonds for some time. The thought has been that a good revenue stream would perform under most anticipated stressful circumstances. Clearly, the pandemic event has had a very pronounced effect on revenues that had not been anticipated. Quarantine at home safety requirement has had a real impact on transportation revenue of all kinds. One only needs to contemplate briefly about where the interruptions are manifest.
A primary consideration is what will be the duration of this event. If we assume the length is in months, most revenue bonds have some level of reserves that would cover such an interruption if required to make a payment. Drawing on a reserve first to make a debt service payment should not be the first line of defense. However, we are in extraordinary circumstances. I would think that the rating services would have to think very hard before doing so. There would be a rash of downgrades perhaps for an ephemeral reason. I would stay focused on this aspect for clues as to future rating behavior.
On the general obligation side of the credit spectrum there is also a great deal to contemplate going forward. The IMF has recently posited that the American economy will decline by an estimated 5.9% this year. Do you recall when we were fretting about 2% growth? The reduced level of economic activity will have a direct impact on all credits. However, there are nuances to be found in the primary revenue sources of the income tax, sales tax and property tax.
Most local GOs rely on the property tax as the primary source of revenues. Most people will do their best to pay their property taxes in order to maintain control over their primary residences. This premise is even true during harsh recessions assuming that people are not as overleveraged as they were back in the 2008 crisis. Local GOs may be more pressured if they do not have relatively strong balance sheets with adequate reserves. School districts would be expected to fare better overall. In many states, the state has the ultimate obligation to provide for education. In times of crisis, this backstop would be called upon.
Credits that rely on the income tax and the sales tax would be more affected in the near term considering the sharp reductions in both revenue sources. States fit this category. Although states have sovereign powers and are more capable of raising taxes or selling more debt to navigate the downturn. States will also be very pressured by their responsibilities towards Medicaid spending. Most state are highly rated and would be expected to be able to sustain and bolster their operations during this crisis. That does not mean that downgrades cannot occur.
Look for credits that have basic financial wherewithal and avoid the more speculative credits. Leave the later to the municipal professionals. Increased yield may prove to be not enough compensation in this environment.
04/15/20 at 11:39 AM
John Hallacy
John Hallacy LLC
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