Concerns of an economic downturn escalate as the rapid spread of COVID-19 necessitates widespread event cancellations, business and school closures, and quarantines. These actions have undoubtedly caused economic activity to decline, and we’ve already seen some consequences as equity returns have plummeted. Meanwhile, plunging oil prices are leading to lower prices at the pump while U.S. oil companies struggle to make ends meet. The implications of these events and the degree to which they will distress municipalities are yet to be seen, but some municipalities will certainly be impacted more than others.
Municipal credit resilience depends primarily on the main sources of revenue and their volatility, as well as the municipality’s current credit condition; however, bond characteristics such as maturity date, insurance, and pledged repayment sources are also important to consider. For example, revenue sources related to tourism will likely suffer, as well as revenue sources tied to economic activity such as sales taxes and income taxes. If an economic downturn were to extend past the short-term, tax assessed valuations may decline as demand for housing lessens, which would reduce property tax revenue collected by local governments. Also, pension plan funding levels could be impaired by the deterioration in equities and other risky assets, which would lead to higher net pension liabilities and required annual contributions in some cases. Municipalities may also be forced to use some of their reserves if revenues fall materially. While municipal default rates have historically been very low, circumstances like these can trigger dire consequences for certain municipalities. In less extreme cases, there could be numerous rating downgrades.
Bonds Least at Risk
General obligation credits are unlikely to be substantially harmed by the current situation if the issuer is not located in an area highly dependent on the oil industry or tourism. Revenue bonds with strong and stable security structures should also be minimally impacted, regardless of the local economy. For example, essential purpose revenue bonds tend to maintain adequate coverage levels as people prioritize paying their utility bills over non-necessities.
Bonds with Heightened Risk
Municipalities in economically volatile areas could experience declines in revenues, and pension funding issues could worsen depending on investment returns. However, issuers with a strong current credit profile may be well equipped to weather a downturn. Debt service coverage ratios will likely fall if a bond is secured by economically sensitive repayment sources. Examples of economically sensitive securities include sales taxes, income taxes, hotel occupancy taxes, stadium revenues, parking revenues, fuel taxes, toll road revenues, and airport revenues, among others.
Bonds Most at Risk
Revenue bonds with economically sensitive securities and narrow or low debt service coverage ratios, as well as general obligation bonds with currently poor credit quality, don’t have much room for conditions to worsen. In addition to the bond types mentioned above, nursing homes revenue bonds could be particularly negatively affected by COVID-19, given that the effect of the virus seems to be worse for elderly people. Long-term care facilities typically have narrow coverage levels and can have large swings in profitability from year to year under normal conditions. Also, bonds with ratings in the BBB range could fall into junk territory depending on specific circumstances.
In summary, municipal bond investors should be wary of issuers in areas with heavy tourism and/or oil activity, especially if current credit data is poor or questionable. Investors should also cautiously analyze bonds secured by economically sensitive revenue sources or revenues from long-term care facilities, particularly if the debt service coverage is already low. However, risk may be mitigated by insurance or credit enhancements, and bonds with a very short maturity date are unlikely to be materially affected by the current conditions. The Baker Group’s proprietary Credit Criterion Check tool can be used to filter these conditions. Please contact your representative for more information.
The Baker Group is one of the nation’s largest independently owned securities firms specializing in investment portfolio management for community financial institutions.
Since 1979, we’ve helped our clients improve decision-making, manage interest rate risk, and maximize investment portfolio performance. Our proven approach of total resource integration utilizes software and products developed by Baker’s Software Solutions* combined with the firm’s investment experience and advice.
*The Baker Group LP is the sole authorized distributor for the products and services developed and provided by The Baker Group Software Solutions, Inc.
INTENDED FOR USE BY INSTITUTIONAL INVESTORS ONLY. Any data provided herein is for informational purposes only and is intended solely for the private use of the reader. Although information contained herein is believed to be from reliable sources, The Baker Group LP does not guarantee its completeness or accuracy. Opinions constitute our judgment and are subject to change without notice. The instruments and strategies discussed here may fluctuate in price or value and may not be suitable for all investors; any doubt should be discussed with a Baker representative. Past performance is not indicative of future results. Changes in rates may have an adverse effect on the value of investments. This material is not intended as an offer or solicitation for the purchase or sale of any financial instruments.