The election, the election, the election… not so much when it comes to muni credit quality.
Of course, the ideas being bandied about by the presidential candidates – if implemented, and depending on whether we have a divided government – could have ramifications for municipalities. But state and local governments have generally been working toward improving their finances and operations and should be able to adjust to political changes.
Muni supply has increased, with issuers rushing to market before the election. The increase in supply is being met with more demand in the muni space to lock in what may be high rates for a while. See John Mousseau’s muni market update: “3Q 2024 Total Return Municipal Review,” https://www.cumber.com/market-commentary/3q-2024-total-return-municipal-review.
While news outlets, economists, and pundits discuss the election, municipalities are trying to navigate the quagmire of data management, cyber risks, a shortage of accountants, demands for higher wages, worker shortages, the runoff of pandemic funds, demographic changes, and the lack of affordable housing, as they build resiliency and prepare for elections! There is also rising tax revenue from higher property values and sales tax from retail spending. All the while, there is a focus on financial management, with reserves averaging over 25% of expenditures. Reserves help cushion a downturn in revenue or help cover the expense of unexpected events. The build-up of reserves is a product of officials’ willingness to make cuts or raise revenue to meet longer-term plans and sometimes take action during the current year rather than wait for the next budget cycle. Also, fewer municipalities are depending on “one-shots” (for example, pandemic aid) to cover recurring spending.
Past recessions have led to reduced discipline with the pressure of a less-employed taxpayer base while revenue is down. However, municipalities have learned that it can be painful in the long run to abandon good financial management. The increase in financial transparency, with more required reporting on items like pensions and other post-employment benefits, has contributed to better financial discipline.
The improved discipline does not apply to all municipalities, as there have been some downgrades, and many higher education and healthcare munis face challenges. Generally, larger healthcare systems are getting stronger while smaller players and stand-alone hospitals are experiencing declines, and some small private colleges are struggling.
Risky municipal sectors such as senior living, charter schools, local multifamily housing, and special projects have seen an uptick in covenant violations and defaults according to recent data from Moody’s and Municipal Market Advisors. Many of the violations are by issuers that are rated below investment grade or not rated at all. Both Moody’s and MMA note that although violations are increasing, they are not higher than in normal times and not near levels seen in recessionary times.
Upgrades have continued to outpace downgrades in the safe sectors such as general-obligation bonds and dedicated tax bonds issued by states, counties, cities, towns, and school districts as well as enterprise revenue bonds issued by water, sewer, and electric utilities; airports; state housing authorities; and some higher education and healthcare institutions.
The outcome of the election, no matter who wins, will affect municipalities; however, the extent of the impact will depend on the policies that get passed, the timing of those changes, and the flexibility munis have with good budget management and ample reserves on hand.
Hurricane Helene
Helene has brought more awareness to weather events and the damage they can do, as well as to insurance needs and the federal funding of disaster relief. AccuWeather increased its estimate of Hurricane Helene’s damage and economic losses to between $225 billion and $250 billion. Earlier we sited AccuWeather’s estimate of $160 billion; but with additional information and realization of the horrific situations that persist, that figure has increased, as has the death toll, to over 200 (https://www.cumber.com/market-commentary/hurricane-helene). The Insurance Journal cited sources estimating insurance claims between $5 billion and $7 billion, a far cry from the damage and economic loss figures. Many in the areas that suffered damage did not have flood insurance coverage, and this will make rebuilding more difficult and costly.
Meanwhile, Hurricane Milton is expected to make a direct hit on areas of Florida still recovering from Helene.
Milton is a massive storm projected to affect a significant portion of the state with storm surge, hurricane force winds, tornados and rain. Given the density of the area damage could be extensive, and some estimates are already at $200 billion. Enki Research estimates between $60 billion to $75 billion in economic loss while property damage estimates by CoreLogic are between $123 billion and $175 billion depending on where the storm hits. We will address the aftermath of the storm in a future commentary. We hope those in the storm’s path stay safe.
More frequent and more destructive disasters from storms, floods, and wildfires, combined with less insurance availability, could be a long-term risk for munis unless residents, builders, and municipalities work on improving resiliency. The Climate Adaptation Center in Sarasota has highlighted on its website that Hunters Point Pearl Homes Development in Cortez, FL, has already survived three major hurricanes since inception in 2022: Ian, Idalia, and now Helene (“A beacon of resilience in the face of Hurricane Helene and climate warming,” https://www.theclimateadaptationcenter.org/2024/10/01/a-beacon-of-resilience-in-the-face-of-hurricane-helene-and-climate-warming/). The homes are built for strength and sustainability, utilizing cutting-edge materials, with reinforced walls, steel structures, elevated foundations, solar panels, and battery backup systems. This development and others like it demonstrate that communities can be more resilient; however, the cost of creating that resilience brings the question of affordability to mind. Still, there are actions individuals and municipalities can take to limit building in surge-, flood-, and wildfire-prone areas or to bolster building codes, as California has done to better survive earthquakes.
FEMA funding
In July, to further our country’s resilience, FEMA announced that public infrastructure built with federal emergency funds must conform to stricter flood-risk standards to better protect against rising climate risk. The standard, which was years in the making, requires buildings and other infrastructure built with FEMA funds to be elevated higher above local flood levels or relocated to safer areas.
Although Congress passed a continuing resolution to keep the government open, many members affected by Hurricane Helene have urged Congress to reconvene and approve more FEMA disaster aid in the face of Helene’s increasing damage estimates. Hurricane Milton will likely further increase that call.
Commercial Real Estate and Muni Credit
Moody’s released the results of its stress test on municipal governments. It was initiated because the decline in commercial real estate (CRE) property values is expected to be the largest in years. The results are a function of how dependent a particular city is on CRE property taxes and related revenue, the strength of the local market, and the legal and practical flexibility to adjust tax rates to avoid a decline in revenue.
Thankfully, the stress test results indicate that most US cities’ credit quality can withstand a significant decline in CRE values, because the associated tax revenue is a relatively low proportion of total city revenue. Some cities, such as Boston and San Francisco, which have some of the greatest exposure to CRE issues, are rated Aaa by Moody’s, although San Francisco has a negative outlook.
State Ratings
Kentucky and Oklahoma experienced upgrades, and positive outlooks were assigned to Arizona and New Jersey. Again this quarter there were no negative actions. We highlight state rating actions each quarter because of the importance of the overall economy, financial operations, and funding commitments to local governments.
Kentucky was upgraded by Moody’s to Aa2 stable from Aa3 positive. The upgrade is driven by a sustained commitment to healthy reserves and structural balance, including continued adherence to high annual pension funding to pay down unfunded liabilities, and by expected growth in a diversifying economy. The action follows upgrades by Fitch in May 2023 and S&P in June 2023.
Oklahoma’s rating was raised by Moody’s in September to Aa1 with a stable outlook. The upgrade reflects a very strong fund balance, very low leverage, and a long trend of conservative budget management. S&P and Fitch both rate the state’s credit quality AA with a positive outlook.
In September, S&P assigned a positive outlook to the AA issuer default rating (IDR) for Arizona. The state mostly issues bonds that are subject to appropriation – so not quite as solid as a general-obligation rating because of the need to budget and appropriate for debt service – and those bonds were upgraded to an AA- rating with a positive outlook. Moody’s issuer rating on Arizona is Aa1 stable, and the state’s appropriation debt receives an Aa2 rating.
Moody’s assigned a positive outlook to the A1 State of New Jersey rating in August, recognizing solid economic and revenue performance that supports prospects that the state will maintain strong fund balances while continuing full actuarial pension contributions. S&P rates NJ A stable, and Fitch’s rating is A+ stable.
New Jersey continues to have one of the worst-funded pension systems, along with Illinois and Kentucky; however, like these states, NJ has put a plan in place and is following the plan to achieve better levels of funding. Attention to addressing the large pension liability has resulted in numerous upgrades.
At Cumberland Advisors we think the high-quality munis like those we invest in with an average rating of AA will be able to weather upcoming challenges. The challenges include less revenue from CRE, changing tax schemes, regulations that a new administration may institute, and possible disaster damage. The rebuilding that occurs after a devastating storm generally brings much economic activity, and eventually the affected municipalities recover. We also consider whether municipalities are addressing longer-term risks such as demographic changes due to an aging population or population movement due to climate considerations, as well as pension funding changes.
Patricia Healy, CFA
Senior Vice President of Research & Portfolio Manager
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