Covid-19 containment efforts are chipping away at state and local tax revenue, while spending on public services is rising. Because (unlike the federal government) states cannot borrow on an unconstrained basis, there is concern state and local entities across the US will be squeezed financially and have difficulty making payments on municipal bonds. These worries, and a market environment marked by scant liquidity, have driven muni bond yields to historically high levels relative to Treasuries. At one point, 10-year munis yields hit 3% vs. just 0.8% for Treasuries. Although the yield spread has since narrowed, it is still substantial :
10-year, AAA-rated General Obligation municipal bonds: 1.14%
10-Year US Treasury bonds: 0.64%
While the muni bond market faces major challenges, I don’t think it is in dire straits. There are multiple levels of support being provided to municipalities by the Federal Reserve as well as the federal government.
Last week, the Federal Reserve said it would provide $500 billion in short-term lending to state and local governments to help fund budget gaps caused by Covid-19. While all states can access the program, some concerns have been voiced. That’s because of restrictions on the size of counties that can qualify for support — only 10 cities and 16 counties are technically eligible. This may not seem like broad-based support, but it actually is.
The level of municipal bond issuance is generally correlated to population. California and New York, for example, have issued about 33% of all the US municipal bonds on the market. Those 16 counties that are eligible for Fed support? My math says they account for about 30% of reported Covid-19 cases. So, the Fed has focused on the areas likely to have the greatest need for these loans. And of course, states can participate and pass that support down to local municipalities at the city and county level, as needed.
I think the role of the Fed here isn’t to provide a bailout and choose winners/losers, but to provide liquidity to keep the muni bond market functioning. Providing added liquidity the way the Fed has is clever on a couple of fronts. In scope, $500 billion is roughly 15% of muni bond new issuance, which has averaged about $400 billion a year in gross issuance. Interestingly, net new issuance has been negative for years – if you subtract bonds maturing or paid off early. In fact, the size of the muni bond market has been shrinking over the past decade.
The Fed is also using a second mechanism to support the muni market: it is allowing existing short-term muni debt and VRDNs (Variable Rate Demand Notes) to be used as collateral for muni money market new issuance, creating another backstop. I think new muni issuance will be able to be rolled over with the support of this Fed program. I also expect that the Fed will begin to buy longer-dated muni bonds if market liquidity starts to dry up again, most likely starting with purchases of muni bond ETFs.
Still, at the end of the day, Fed liquidity facilities can only do so much, and I don’t think that’s what really will solve the problem. Direct federal government aid or grants have a clear role to play, and fortunately we have this type of fiscal support coming from Congress.
State and local governments are receiving $150 billion of the $2 trillion in new fiscal spending via the CARES Act. This is direct funding to combat the impact of Covid-19 (excluding additional hospital support), which is what really moves the needle. States and municipalities are also receiving an additional $200 billion in emergency appropriations to support ongoing operations.
Do municipalities have enough overall support via the CARES Act? Consensus seems to be no, even if muni markets have been recovering. I’ve seen numbers that say anywhere from $100 billion to $600 billion in additional aid is needed. The willingness seems to be there in Congress to provide this level of extra aid. Reports are that CARES Act II is planned to include another $250 billion for state and local governments.
I think the Federal Reserve is looking for states to handle their operations with support from the federal government. Again, the Fed is providing liquidity to the muni bond markets via loans to some of the most important issuers, while allowing states to diagnose local problems and appeal for more direct aid from the legislature.
My view is that the federal government will do whatever it takes to prevent the chaos of widespread municipal bond defaults. Municipal tax collections are actually historically quite stable, with personal income taxes being the most volatile component (that’s a problem for states, not local governments). The chart below shows historical municipal tax collection from state and local sources to give context to how well municipalities have made it through prior crises.
My sense is that some municipal bond issuers will face near-term problems with funding, budgeting, and liquidity constraints – but not long-term problems (pension funding shortfalls can be addressed post-crisis). There will certainly be pain points on a case-by-case-basis, such as for hospitals and airports. And some municipalities will have liquidity issues because of deferred tax collection. I anticipate we will see some state and local government employees furloughed if not now, then post-crisis.
However, based on history and federal government actions to date, I don’t expect many municipal bond defaults, despite the unique challenges that Covid-19 presents. For context, the historical rate of default on municipal bonds initially A-rated or higher has been less than 1/10th of 1 percent. The greater risk is of credit downgrades from rating agencies, which will likely affect lower-rated muni bonds the most and cause renewed liquidity concerns.
As far as LNWM portfolios go, we are comfortable with our muni bond positions, even if we may yet face additional volatility. As we move past Covid-19, the yield advantage of muni bonds relative to Treasuries will likely prove transitory and reward patient investors.
We are invested in high-quality munis, rated AA on average, issued by larger entities with reliable financial statements. We’ve never invested heavily in the high-yield muni bond arena, a fragile, small corner of the market that is the most likely to see defaults. Nevertheless, the municipal bond fund managers we invest with have been stress-testing the bonds they own under various scenarios of falling municipal revenue over the next 12 months; so far, they are confident that the muni bonds they hold will continue to make payments during that timeframe.