COVID-19 and its Impact on Municipal Credit (Part I)
We would be remiss to not wish each of our readers and clients safety and peace of mind during these most trying times. Following Governor Pritzker’s “stay-at-home” order, we want to let you know our firm will remain open via remote access operations and lightly staffed crews in our Peru, O’Fallon, and our Chicago headquarters offices.
We provide these essential services:
- Access to municipal bond investment capital
- Market liquidity for investors and issuers across the country
- Bond portfolio management expertise
The tumult of last week’s market tested all of us. For the most part our clients’ Separately Managed Account (SMA) bond portfolios held up well: forced selling by others does not create realized losses in SMA portfolios. Conversely, most investors in complex derivative type bond products: bond funds and bond ETFs realized significant losses last week.
Importantly, our team reacted as I expected they would and weathered the chaos helping a multitude of our clients deal with these volatile markets.
The entire Bernardi team remains unaltered, in place and ready to help you navigate the uncertainty we are all experiencing. So please call or email us with your questions, concerns and requests.
Thank you for your confidence in us. I hope all of you are safe and healthy.
Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
March 23, 2020
*****
“A plague o’ both your houses!”
Last week’s market events left very few investors unscathed.
Historical precedents that compare to today’s crisis and its impact on municipal credit is a mixture of a nationwide natural disaster and financial crisis rolled into one. That said, should efforts to “flatten the curve” prove successful as they have been in South Korea and China, the impact on our economy and municipal balance sheets will be short-lived and much more mild than what some currently fear. Additionally, the economic snap-back could be robust. This, of course, is mere conjecture at this point in time.
Our Approach to Municipal Credit and Protecting Your Portfolio
In this environment liquidity (rainy-day balances), revenue source prominence (lien priority and/or purpose), and income source flexibility are important aspects of a bond’s underlying credit quality. Our focus on public purpose general obligation and essential revenue source bonds largely provide such levels of security and is frankly why we build “mattress-money” portfolios around these types of municipal bonds. In fact, in our Tactical Ladder composite, 95% of sector holdings were invested in these two forms of bonds: GO & essential revenue source backed.
| In fact, in our Tactical Ladder composite, 95% of sector holdings were invested in these two forms of bonds: GO & essential revenue source backed.
These two sectors are generally well-positioned at the outset of this outbreak after a sustained period of economic expansion and have built up rainy-day funds accordingly. Prior to this crisis reserve fund balances were at their highest levels ever in the last twenty years (higher than before the Dot-com bubble recession and Great Financial Crisis.)
Secondly, revenues that back general obligation bonds and essential service utilities are prioritized by constituents/users during tough economic times. Property taxes are paid as people aim to retain their mortgage title and water bills are upheld to keep the faucets flowing. Even during the 2008-09 crisis – which was underpinned by a housing crash – there were no defaults in high-grade general obligations bonds, which are primarily secured by property tax revenue.
Detroit is not a high-grade credit and has not been on our list of suitable credits for decades. But it serves as a good example of the above point: the city – plagued by mismanagement and population outflows for 60 years – did not declare bankruptcy until 2013 – 4 years after the crisis took hold. Furthermore, the city’s water & sewer revenue bondholders did not take a haircut in the bankruptcy process (although Detroit initially tried to force the issue) demonstrating the importance of water/sewer bill payment priority in a normal order. The Puerto Rico bankruptcy process is challenging this precedent and perhaps the unprecedented nature of Covid-19 effects will too – but this is a topic for another commentary at a later date.
Historically, municipal credits mostly change slowly. The general obligation pledge enables a broad suite of levers for issuer to pull in order to meet debt commitments. And we expect many state and local governments will use these in the coming months. The most vulnerable credits are troubled entities that have been “kicking-the-can” underscoring the importance of adhering to the first Pillar of Bernardi municipal credit analysis: solid underlying credit quality.
There are many options available for solid quality government entities to help them navigate unexpected financial situations, especially compared to corporate issuers. For example, a municipality can increase revenue by raising taxes or user fees. Arguably this an unwise action, but if undertaken it likely would increase revenue streams in many places. Contrarily, if General Motors attempted to increase revenue by trying to sell cars at higher prices, it likely would fail.
Bottom line: the general obligation pledge enables income source flexibility and helps to better protect the underlying credit within client portfolios.
Credits Directly Impacted by COVID-19 Crisis
With implications of the COVID-19 pandemic on municipal operations and credit still evolving, the most immediate impact appears to be on areas such as health care, airports, public transit, sales tax bonds, and credits that have unique exposure to tourism or oil production.
Health care sectors will be impacted as hospitals scramble to adjust their operations to cope with a large influx of infectious, often very ill, patients. While the operational impact is daunting and upfront costs will almost certainly rise, the ultimate financial impact remains somewhat uncertain as this depends on how heavily a particular system’s service area is hit. Moreover, direct federal financial assistance to the health care sector to ensure operations continue is likely given its critical position in containing the spread of the virus. If this occurs it will mute some of the negative financial impact of this crisis. 
Airports have a daunting financial challenge as operations in the near term will be reduced substantially. Additional declines depend too on the possibility of any domestic travel bans imposed by the federal government. Internal liquidity will be a key challenge for major airports to weather given the significant slowdown in traffic; but much depends on how long travel remains substantially depressed. A few months may be manageable for many airport systems; beyond that, prospects become less clear. Again what, if any, federal assistance is forthcoming is unclear. Airline credits themselves are under review as of March 17th, Moody’s downgraded its corporate rating on Southwest Airlines Co and placed its rating, along with the corporate ratings of American Airlines Group Inc., Delta Air Lines, Inc. and United Airlines Holdings, Inc, on review for downgrade.
Public transit systems have also experienced an immediate impact as individuals are either staying home or utilizing more isolated means of transport. Similar to airports, a decline lasting a relatively short period of time will be manageable, while longer sustained declines will be more challenging. The Metropolitan Transportation Authority of New York, NY (MTA) issued a recent material event notice detailing significant declines in ridership in mid-March of this year compared to the same period last year and its severe financial impact.
Municipal bonds whose sole security is sales tax revenue will likely be impacted by the decline in economic activity–and therefore sales–as a result of social distancing and sheltering at home due to the pandemic. Likewise, the narrower the sales tax, the more acute the impact could be. For instance, if the sales tax only applied to tourism or entertainment related sales instead of all taxable sales. That said a recent Supreme Coutry ruling allowing states to collect online sales tax revenues will offset these pressures.
Bonds impacted by a hit on tourism. A prime example of such an area is Hawaii, which has a high concentration to tourism-related industries.
Moreover, the oil price decline sparked by disagreements between OPEC members Saudi Arabia and Russia at the beginning of March may have by itself led to a downturn in oil producing regions. Those areas may now have to contend with a prolonged slump in oil prices in addition to the economic contraction from the COVID-19 pandemic. Municipalities within the states of Pennsylvania, North Dakota, Oklahoma, Texas, Kansas and the state of Alaska, itself, are some prime examples.
Near Term Outlook and Approach
In the broadest sense, the impact on municipal issuers will depend on the severity of economic contraction related to the pandemic. The more prolonged the extreme measures taken to combat the spread of COVID-19 are, the greater the impact on virtually all issuers will be.
Although the pandemic is an idiosyncratic challenge and differs from virtually any other that government officials have faced, local governments and essential service providers are generally on solid financial footing. Additionally, the general obligation and essential service revenue bonds of these issuers provide notable security provisions. Constructing healthy portfolios is as much about as what you buy and what you don’t buy and we will continue to be wary of bonds backed by volatile, economically sensitive, or low priority revenues.
If you have any questions about the underlying credit within your portfolio or the market in general please contact your Investment Specialist. As we have communicated to various clients over the previous week, we find the current market as a tremendous buying opportunity given current, liquidity-driven, price dislocations (higher yields).
Thank you, be safe and healthy,
Sincerely,
Bernardi Securities, Inc.
March 23, 2020
Matthew P. Bernardi
Vice President
Brian Shea
Director of Municipal Credit