Munis can offer attractive investment potential now, given valuations and policy support. But, credit risk assessment is critical.
In March, the municipal market saw volatility explode, as municipal debt was at the epicenter of a liquidity crunch. The Federal Reserve acted quickly to ensure ample liquidity. However, COVID-19 and the government’s response, designed to contain the virus’s spread, thwarted economic activity and challenged municipal budgets. With taxing authority and support from both the Fed and Congress, we continue to see municipals as attractive, tax-advantaged investments, but a careful evaluation of credit risk is paramount.
In this piece, we assess:
- Coronavirus-induced state funding gaps
- Policy support required
- Where we see value and risk
- Actionable investment implications
The challenges imposed by COVID-19
Municipal funding is cyclical. When economic activity is negatively shocked, revenues tend to decline and expenses accelerate. We estimate a coronavirus-induced funding gap this year of $250 billion to $450 billion (given an anticipated $100 billion to $300 billion decline in revenues and a $150 billion increase in expenses).
Here’s how we get there:
In 2020, we expect the U.S. economy to contract by roughly 5%, year-over-year. The historical relationship between U.S. economic activity and municipal revenues suggests that own-source general revenues (think state and local tax collections) are likely to decline by 3% in that scenario (in nominal terms, roughly $100 billion). In the bear scenario, where COVID-19 endures and current economic conditions are unchanged for the rest of the year, we would expect an 8% decline in own-source general revenues (in nominal terms, roughly $300 billion). This is a macroeconomic, top-down approach, but meshes well with Moody’s bottom-up analysis that sees state revenues contracting by $150 billion to $200 billion this year.1
The shock will be felt unevenly across states, depending on funding profiles. Since the 1970s, property taxes and sales taxes have proven to be the most reliable revenue streams, while income tax has been especially volatile.2 Even during the global financial crisis (GFC), property tax collections were positive on a year-over-year basis. While normally sales tax is quite reliable, lockdowns have effectively halted commerce and challenged its durability in this recession.
Own-source general revenue and U.S. economic activity have shown a strong relationship over time
Line graph displays the U.S. economic activity in comparison to the year-over-year change in own-source general revenue from 1977 to May 1, 2020. It indicates that there has been a strong historical relationship between municipal own-source general revenue and economic activity. Given we expect the economy to contract by 5% in 2020, the base case for own-source revenue is a 3% drop, with a bear case of an 8% drop.
On the expense side, inflation-adjusted per capita spending has jumped an average of 3.5% in recession years dating back to the 1980s—in nominal terms that’s roughly $150 billion in aggregate for 2020. The biggest challenge will be the overhead expenses. Medicaid currently consumes 17 cents of every dollar of state-generated revenue and is likely to increase during this health crisis.3 Furthermore, despite the post-GFC bull market, unfunded pension obligations increased from 18% of GDP in 2009 to 21% of GDP in 2017, with acute concentrations in select states. Michael Cembalest, Chairman of Market and Investment Strategy for J.P. Morgan Asset & Wealth Management, has done extensive research on unfunded pension obligations that shines an important light on those states that will need to take action, such as Illinois and New Jersey. Importantly, by adjusting obligations for more reasonable return assumptions and the revenue shock of COVID-19, Cembalest shows that unfunded obligations are likely to increase markedly due to COVID-19.
Policy support is warranted—it’s economics, not politics
States have levers they can pull to plug funding gaps:
- Rainy day funds have grown to $75 billion, but are uneven across states; Texas and California hold approximately 40% of all rainy day funds.4
- States may divert funds away from pension obligations to pay current expenses, and the vicious circle there continues.
- Fed liquidity facilities will ensure access to financing should investors be unwilling to extend credit. The Municipal Lending Facility will ensure reasonably priced borrowing out to three years.
For most states, those levers will be insufficient, and the federal government will need to fill the hole. History suggests the states will get their money. In every recession since the 1980s, the federal government has ramped up its transfers to states by an average of roughly 15%, or about $125 billion in 2020 dollars.5 The CARES Act6 has already earmarked $150 billion for state funding—the bridge is halfway built. Furthermore, the HEROES Act7 opened with a starting offer of roughly $900 billion for state and local governments—a figure that would fill the 2020 funding gap and do a lot of heavy lifting to close 2021 funding gaps, should they exist. That number seems politically out of reach, but showcases how seriously policymakers are taking this COVID-19 shock. We expect they will finish the bridge.
Recent political rhetoric suggests this time may be different, and politicians may favor bankruptcy over further federal aid. But we find that path unlikely for two reasons:
- States are not currently allowed to file for bankruptcy. The U.S. Constitution prohibits state governments from “impairing the obligation of contracts.” Changing that clause would call into question the viability of all contracts written previously. Furthermore, even if they had the option, which state leaders would want to declare bankruptcy—especially in a health crisis? It’s more likely, even with a bankruptcy option, that the status quo will endure.
- State bankruptcy seems like a bad deal for the federal government. The states leading the charge for more aid are the same states that produce the highest return on investment (ROI) for the federal government. For instance, Connecticut collects seven times more federal tax dollars for the Internal Revenue Service than it receives in federal assistance.
The federal government could sacrifice attractive sources of ROI should it permit state bankruptcy
The bar chart displays the return on investment (ROI) for the federal government of each U.S. state. It highlights that states vary in their ROI: Minnesota, New Jersey and Virginia have some of the highest ROI, whereas Wyoming, Alaska and Mississippi are on the lower end.
Credit analysis is critical
There’s value in municipals, particularly for investors willing to look at bonds with maturities of five years or longer. Relative to Treasuries, municipal bonds with maturities of five years or longer are trading wide to their five-year averages, suggesting further municipal price appreciation is likely. If you think federal deficit spending will result in higher individual tax rates ahead, municipal relative value is even more compelling. However, challenges created by the COVID-19 crisis make credit analysis paramount.
Here is our sector-based assessment of the risks posed by the coronavirus:
This graphic breaks down the risk assessment across key sectors, including: Local GOs, School Districts, Public Power, Water & Sewer, States, Toll Roads, Airports, Healthcare and Higher Education. The graphic organizes these sectors from less or more risk.
For decades, municipal debt has offered attractive, tax-adjusted returns for investors. COVID-19 certainly presents a challenge, but with taxable authority and monetary and fiscal support, we expect municipals to continue to offer value for investors.
- Look for durable income streams. States that rely on sales and income taxes are likely to be most challenged by the COVID-19 crisis, and the resulting lockdown and social distancing. Local general obligation bonds (GOs) typically rely on property taxes, which we expect to be the most durable revenue stream. Essential services are just that—essential—and unlikely to be adversely impacted. Given federal aid, state GOs with expense flexibility should be able to absorb revenue shocks.
- Consider diversifying. This is particularly important for those with investments concentrated in states with challenged expense profiles. In many instances, national substitutes are available that still offer yield pickup relative to Treasuries, on a tax-equivalent basis. With heavy issuance and stable funding profiles, Texas and Florida look like attractive means for diversification. Northeast investors are likely to give up yield, but in return, get a step-up in credit quality and continue to outyield Treasuries on an after-tax basis.
- Consider extending duration. Relative to Treasuries, municipal bonds with five-year or longer maturities offer the most value. Municipals tend to have call dates, so their durations may be lower than their final maturities would suggest. Inflation is the enemy of long duration, and we don’t fear that risk currently.
1 Moody’s Stress Testing the States, April 2020.
2 U.S. Census Bureau Annual Survey of State and Local Government Finances, as of 2017. J.P. Morgan Private Bank calculations show between 1977 and 2017 annual standard deviation for property tax of 2.7%, sales tax of 3% and individual income tax of 5.8%.
3 Pew Trusts. Barb Rosewicz, Justin Theal and Katy Ascanio. As of January 2020.
4 NASBO Fiscal Survey of the State, Fall 2019.
5 U.S. Census Bureau. 2000, updated annually. Annual Survey of State and Local Government Finances, 1977–2017. Compiled by the Urban-Brookings Tax Policy Center, Washington, DC: Urban-Brookings Tax Policy Centers (1977–2017). Date of Access: December 11, 2020. J.P. Morgan Private Bank calculations.
6 The Coronavirus Aid, Relief, and Economic Security Act.
7 Health and Economic Recovery Omnibus Emergency Solutions Act.