Municipal Credit Update: Revisiting the Pandemic’s Effect on Municipal Credit Risk

“The potential impact of the COVID-19 pandemic on the City cannot be quantified at this time, but the continued outbreak of COVID-19 could have an adverse effect on the City’s operations and financial condition.” This disclosure, or something like it, is now regularly included in documentation by municipal issuers. While we would love to have more details than that, the exact magnitude of the pandemic’s repercussions on state and local finances still cannot be accurately determined.

However, we do have some clarity on the results of the 2020 fiscal year, given that most local government fiscal years close in June. The U.S. Census Bureau reports that total state tax revenue declined 29% in the second quarter of 2020 compared to the same quarter in 2019. The chart below exposes the states with the largest declines in total tax revenue when comparing Q2 2019 to Q2 2020. Most states did not cut funding to school districts in the 2020 fiscal year, but instead used one-time budgetary maneuvers to make ends meet. If state revenues continue to be depressed, they may be forced to make cuts across the board, including education. Vulnerability to state funding changes can be measured by analyzing the district’s dependence on state funds relative to total revenues. Of course, further federal aid would mitigate this risk. Congress is working on ideas for more aid, but none have fully passed at this time. The HEROES Act, passed by the House on October 1, 2020 but not yet by the Senate, contains $676 billion in funds for state and local governments with $208 billion specifically allocated for education spending. The HEROES Act comes with an important restriction: states may not cut their budgets for education spending, which will help to further protect school districts from state funding cuts if enacted.

Municipal Credit Update: Revisiting the Pandemic’s Effect on Municipal Credit Risk
Source: U.S. Census Bureau

Also, the National League of Cities reveals that all major local tax revenue sources slowed with severe declines in sales and income tax receipts. Sales tax revenue dropped by 11% on average in the 2020 fiscal year. Property tax revenue continued to grow, but the growth rate slowed compared to 2019 and may continue to slow and even decline in 2021 and 2022 depending on economic conditions. Property tax trends are slow to follow economic fluctuations because assessed valuations are typically set well in advance of the actual bills being due, and changes in assessed valuations are often more muted than changes in market value due to caps on assessed valuation increases and other calculation considerations. However, the longer the economy remains depressed, the more likely it is that home prices will deteriorate and cause declines in property tax revenue absent rate increases.

Certain downtown areas and other once busy areas that are now much emptier because of people working from home may be particularly susceptible to property tax revenue declines as demand for those expensive commercial spaces lessens, especially if the work-from-home trend remains after the pandemic ends. Some large cities may even experience de-urbanization if people choose to relocate to smaller cities in favor of more space and, in some cases, less taxes. According to LinkedIn, New York City and the San Francisco Bay Area both recently experienced steep declines in their inflow-to-outflow ratios with both cities losing more people than they gained while smaller cities like Jacksonville and Salt Lake City experienced net gains in new residents.

Looking forward to the 2021 fiscal year, many questions linger. Cities and states are anticipating an even larger decline in general fund revenues than they experienced during 2020, reserve levels have lessened from pre-pandemic levels, and it is not clear when or if events and gatherings may resume regular schedules. Investors must continue to diligently monitor their holdings for potential credit deterioration as outlined in our earlier Municipal Credit Update concerning the COVID-19 pandemic.

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For More Information
Dana Sparkman

Dana Sparkman, CFA

Senior Vice President/Municipal Analyst
The Baker Group LP

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