Municipalities derive their revenues from many sources. At the state level, sales taxes, personal income taxes, and corporate taxes are the largest sources of revenue; and there are other taxes and fees that states can raise. We’ve all seen them, from gas taxes and fees to gambling and lottery revenue. Local governments and school districts levy property taxes as their major source of revenue, and essential-service utility systems derive revenue from the fees charged for services. Mass transit bonds are secured partly by fares but mostly by sales taxes and government subsidies.
The coronavirus-induced recession comes on the heels of a period of strong growth in revenues enabled by improved economic activity and better fiscal and budgetary balance by municipal governments. Fund balances have been built up and debt levels reduced, so that upgrades exceeded downgrades for years leading up to this recession. Municipalities are thus partially positioned to weather the storm, at least for a time, by drawing down reserves and conducting interfund borrowing. They can also cut expenses, raise taxes and fees, and issue debt to manage their way through a crisis. In addition, given the severe effects of the shutdown on revenues and the increased expenses municipalities face to combat the virus and increase social service spending, the federal government has sought to provide some relief.
The CARES Act and other programs
The CARES Act, enacted very quickly after the shutdown of the economy to combat the coronavirus spread and reduce stress on our healthcare system, directed funds to those entities expected to be the hardest hit, including healthcare systems, states, airlines, and transit systems. The HEROES Act is being considered in Congress and could provide another $1 trillion for state and local governments to help stem the tide of lost revenue since initial aid was designated for the cost of fighting the pandemic. Philosophical discussions about additional aid linger over the unintended consequences of providing it, while governments and market participants estimate that another trillion in stimulus is needed, providing pressure for Congress to enact this additional round of aid.
Bob Eisenbeis’s April 28th commentary succinctly describes fiscal stimulus and the Federal Reserve programs enacted to help mitigate loss of revenue and to support liquidity in the financial markets. The Municipal Liquidity Facility (MLF) is one such new Fed program. See https://www.cumber.com/cumberland-advisors-market-commentary-the-fed-and-markets/.
The Municipal Liquidity Facility
The MLF is a special-purpose vehicle that will purchase up to $500 billion of securities from states and large cities and counties, and on June 3rd the Fed expanded the potential borrowers to include multi-state entities or designated revenue bond issuers. States, counties, and cities must have had an investment-grade rating prior to April 8, 2020; and the others must have had at least a low A rating to access the MLF. The maturity of the notes purchased by the MLF cannot exceed 36 months, and the interest rate will be a fixed rate over a standard index for the respective maturity plus a spread determined based on the issuer’s rating. The spread for AAA issuers is 150 basis points, while the spread for BBB- issuers is 380 basis points. If the issuer is non-investment-grade, the spread is 590 basis points. These spreads are wider than general market spreads are, and they indicate that the Fed prefers to be a lender of last resort. See https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200603a1.pdf.
Illinois, first to access the MLF
Illinois, the lowest-rated state at BBB-/Baa3 - which is the lowest rung of investment-grade ratings, was the first municipality to access the MLF. The state borrowed $1.2 billion of one-year, general-obligation-backed notes late last week, paying the Federal Reserve a 3.82% rate (the comparable index was just 0.02%). The state did access the long-term bond market recently with an $800 million deal, but for shorter maturities there is little demand. This borrowing is to offset cashflow disruptions but could lead to more deficit financing if there is not additional stimulus and if revenues fall farther than budgeted. Illinois may be the first state to access the facility, because in contrast to most states and municipalities that have bolstered their financial and budgetary positions, Illinois has been mired in political gridlock and has amassed a $7.2 billion bill backlog. (See https://www.cumber.com/illinois-unpaid-bill-backlog/ )The state is authorized to borrow up to $5 billion from the MLF and may need to do so in order to meet budgeted expenditures. It is incumbent on the state to manage its budget and to continue working toward a balanced budget to keep its investment-grade rating intact.
In addition to the higher-than-general-market rates charged for borrowing from the MLF, another reason the MLF has not been accessed is that municipalities need to have the authority to enter into transactions. In the case of Illinois, the state was authorized to sell bonds only on a competitive basis. The Illinois legislature needed to pass a statute allowing the state to issue general-obligation bonds on a negotiated basis to an individual buyer – in this case the Fed.
In a competitive process, numerous broker dealers bid for the bonds, resulting in what is hoped to be the lowest price. This type of pricing mechanism is good for straightforward, easy-to-understand credits. Negotiated bond sales can be beneficial in the case of an issuer that has higher risks and lots of moving parts.
The State of New Jersey, at A-/A3 negative, is the second-lowest-rated state. The State is trying to pass legislation to let it borrow from the MLF and expand allowed reasons for borrowing. New Jersey had already extended its fiscal year to July from June to accommodate the delay in receipt of federal and state income taxes to July 15th.
The New York City Metropolitan Transportation Authority, which has seen a ridership decline of 90% and has received money from the CARES Act is also considering accessing the MLF.
The MLF and other federal stimulus and programs have already lent some stability to the market and will allow market access to those states and issuers needing additional borrowing, though, as we noted earlier, many municipalities have financial cushions, reduced debt, and other revenue-raising capabilities, as well as prospects for additional federal funds.
Why, then, we might ask, are corporate bonds yielding less than some taxable munis are, when corporations have been on a debt-issuance binge for years to buy back stock and to finance M&A, increasing their leverage and experiencing downgrades, with further downgrades expected?
At Cumberland Advisors, we think the relative strength of muni credit quality provides an opportunity to invest in the municipal market, although we do expect downgrades depending on the severity and length of the recession. Some downgrades have already occurred for transit- and tourist-related tax-backed bonds. Other rating actions may depend on budget cuts, revenue raising, and federal support, as well as vaccines and treatments that mitigate COVID-19’s impact. Negative headlines such as the comments made by Mitch McConnell (See John Mousseau’s commentary https://www.cumber.com/cumberland-advisors-market-commentary-mcconnell-as-meredith-whitney/) may cause investors to pull money from the municipal market, as we saw in early March, thus providing an opportunity. Over the longer term the prospect of higher future taxes bodes well for tax-exempt municipal bonds.
Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
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