The world was a different place only a few weeks ago. Municipal bond funds had experienced 60 straight weeks of inflows – a record streak totaling around $75 billion.1 But fast forward to the week ending March 18, 2020, and fears of COVID-19 caused municipal funds to experience $12 billion in outflows, another record.2 Outflows began mostly in high yield funds, forcing fund managers to sell bonds to meet redemptions. Because most high yield municipal funds hold 30%-60% of their positions in investment grade bonds, selling pressure rippled through the entire municipal market, leading to further outflows across municipal funds. As markets tumbled, investors shifted from a “flight to quality” stance to “flight to cash,” putting pressure on short-term municipal securities and resulting in larger than expected price declines in short and ultra-short municipal funds.
Liquidity, liquidity, liquidity
Market participants in all markets, not just municipals, have been seeking liquidity. Sellers have been willing to accept large discounts, further driving down prices. However, on March 20, the Federal Reserve (Fed) stepped in to provide liquidity to the municipal market. The Fed announced it will allow short-term municipal bonds to be used as collateral in its emergency lending program. The Fed further expanded its support to municipals by including variable-rate demand notes (VRDNs), which are widely held by money market funds. Making short-term municipal bonds eligible as collateral in emergency Fed lending has increased the demand for these securities, improved liquidity and allowed the municipal market to find more stable footing as of March 24.
Below we highlight the impact of the coronavirus pandemic on some key municipal sectors that we follow:
Prior to the coronavirus outbreak, Moody’s upgraded its 2020 outlook for the higher education sector to stable from negative, citing steady revenue growth and solid reserves. Because of the coronavirus, higher education institutions have announced their transition to online learning, closed dorms and sent students home. We believe higher education institutions generally have resources to help cushion the impact of temporary reductions in revenue and increases in expenses related to the coronavirus. These resources may include cash, investments, endowments, government funding and ongoing contributions from alumni and other donors. But the overall impact on the sector depends on the severity and duration of the virus. The impact on individual institutions will likely vary according to their overall financial strength prior to the virus outbreak. Smaller, poorly capitalized institutions that rely heavily on tuition revenue, and those already challenged by declining enrollment and financial resources, will likely be more significantly affected if the impact of the virus is prolonged.
Public power, water and sewer
These utilities are viewed as essential services, vital to America. We expect these services to continue to be provided and used. In the unlikely event of large revenue declines in these sectors, it is our belief that state and federal governments would step in to provide the necessary support.
Hospitals may face higher expenditures (staffing, overtime, supplies) if inpatient volumes increase and patient stays become lengthy due to COVID-19. The proportion of low-margin business (urgent care and outpatient visits) may rise, as patients seek to determine their illness, and higher-margin business declines as elective surgeries are delayed. Fortunately, a large majority of hospitals have planned for seasonal flu and other outbreaks, and many have liquidity and plans in place to handle a crisis. Because the population most at risk are the elderly, who are covered by Medicare, we do not foresee a huge surge in uninsured patients due to the pandemic.
Although airports are experiencing decreased activity, they generally maintain strong liquidity and debt service coverage, and we do not expect defaults in this sector. According to Moody’s, the median days of cash on hand for the sector was 659 in fiscal year 2018, the highest since Moody’s began tracking this metric in 1999.3 It is worth noting that airports have weathered difficult market conditions before, including the sharp drop-off in travel post 9/11, without default.
Additionally, many of the large airports have either “residual” or “hybrid” use and lease agreements with signatory airlines, in which airlines are obligated to cover the net costs and debt service of the entire airport in the event that revenue from airport operations is insufficient. Failure to do so could result in the termination of airlines’ landing slots and/or terminal gates. Some airports have a “compensatory” rate-making framework, in which airlines are only charged for the costs of the facilities they use. These airports could be at risk of a credit downgrade if there is a prolonged downturn in airline activity. However, airports operating under this framework tend to have slightly higher levels of liquidity and debt service coverage. Notably, the credit profile of an airport is largely insulated from the financial profile of its parent government because of Federal Aviation Administration limitations on the distribution of excess revenues to the parent government.
Like the airport sector, toll roads will likely see a decrease in activity but, because of strong liquidity and debt service coverage, we do not expect a material increase in downgrades or defaults. The use of toll roads was healthy prior to the coronavirus outbreak, and we expect it to recover when the crisis abates. Toll roads are also supported by fully funded debt service reserve funds that are typically sized at the lesser of a) the maximum annual debt service, b) 10% of outstanding debt and c) 1.25 times average annual debt service, further providing a financial cushion.4
State general obligation bonds
Invesco Fixed Income expects the credit quality of most states to remain stable because of historically high rainy-day funds and the ability to manage revenues and withhold payments to local governments, such as cities and school districts. In fiscal 2019, the median rainy day fund equaled 7.5% of general fund spending, which is an all-time high and compares to roughly 5% before the 2009 recession.5 States most likely to be hurt by the economic fallout of the coronavirus are those heavily reliant on tourism and the oil and gas sectors. Also, states with high underfunded pension liabilities may need to increase pension contributions because of low market returns, but we believe these states will face increased credit downgrade risk and not increased default risk.
Continuing care retirement communities (CCRC)
CCRCs are at risk, but we believe a repeat of the tragic situation in Washington State becomes less likely as more is understood about controlling the spread of the virus. CCRCs serve the population most vulnerable to the virus but they offer all levels of care with health staff onsite that can detect and treat residents as soon as the virus is detected. Seniors living in a CCRC would likely receive treatment sooner than seniors living at home. However, any CCRC, even one with no contagion, faces the idiosyncratic risk that it could be perceived as a health risk, and that could impact its ability to attract future residents.
We cannot predict when the coronavirus pandemic will abate or how acute market volatility will be going forward. But we believe there will be a bottom at some point. Municipal credits have a long history of low default rates, and while we might receive a temporary tax break or a government check, none of these will permanently lower our taxes. Municipal bonds are one of the few sources of income that is not subject to federal taxes — and that income is now more attractive than it was at the beginning of the month.
Professional management is fundamental
Invesco Fixed Income’s team of dedicated municipal credit analysts is among the most seasoned in the industry with over 21 years of research experience.6 Our team continuously analyzes the municipal universe to identify investment opportunities or deterioration in credit quality. Site visits are an important part of our bottom-up fundamental research process. Credit analysts perform 150-200 site visits and management conference calls per year. This specialization means that every bond is thoroughly vetted before being selected for portfolios.
1 Source: Lipper, data as of February 26, 2020
2 Source: Lipper, data as of March 18, 2020
3 Source: Moody’s, “Fiscal 2018 Medians Economic growth, lower fares continue to under financial performance (Airports – US),” November 20, 2019
4 Source: Invesco
5 Source: Moody’s, “2020 outlook stable with continued revenue growth and record reserve levels (State government – US),” December 3, 2019
6 Source: Invesco, data as of December 31, 2019
A bond issuer may cease to be rated or its ratings may be downgraded. Such action may adversely affect the value of the bonds.
Municipal securities are subject to the risk that legislative or economic conditions could affect an issuer’s ability to make payments of principal and/or interest.
The value of the bonds will generally fall if interest rates, in general, rise. In a low interest rate environment risks associated with rising rates are heightened. The negative impact on fixed income securities from any interest rate increases could be swift and significant. No one can predict whether interest rates will rise or fall in the future.
Invesco and its representatives do not provide tax advice. Individuals should consult their personal tax advisors before making any tax-related investment decisions.
The opinions referenced above are those of the authors as of March 25, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.