March 2020 –“Munis and the COVID-19 Depression”
We are planning to do this month’s review with double spacing to try and emphasize social distancing, even amongst words. Ok, no more virus jokes…
What a month! We will highlight the wild ride in muniland, and take a look ahead. If you were not watching the market every day, you may have missed the violent muni market liquidity crisis and pending credit crisis, hence the suggestion of munis and depression in our monthly title. As of month’s end, yields were up 45 bps -but did not settle there by taking the easy road!
While MainLine has been keeping its investors up to date on the muni market, one of the concerns we have heard from you is: what will happen to muni credit if the lock down extends for a long period of time and the economy remains frozen? In this month’s review, we discuss what happened to munis’ ability to repay debt during the Great Depression, and how we think this may play out if we have a prolonged COVID-19 Depression.
Muni Market Review
I am not sure what to say about the March we just witnessed:
- Do I say rates are up 45 bps over the month?
- Do I say rates are down 140 bps from last Friday?
- Do I say rates went up 180 bps, then went down 140 bps, and are now 45 bps higher than the beginning of the month?
- All are true! It almost felt like munis had become stocks.
The drastic movement in rates, lack of liquidity, and disjointed market participants limited the ability of many investors to take advantage of the rate swings, as things moved fast and fierce. The market started with a strong sell-off, due to muni high yield credit concerns and the need to meet investor outflows; it then rallied back less than 2 weeks later, with the news that the Fed would be buying munis. The funny thing is: the Fed has not started buying yet, and we are not certain how they will be doing it. The news of the Fed buying did slow the outflows from the funds and, we feel, does set a floor for how low prices can go. However, the impact of the virus on the muni market has not disappeared over the last couple of weeks. MainLine feels the worst may be over (price declines), but we think the volatility will continue. We have called in capital for our various Funds and are investing strategically.
Market News and Highlights/Lowlights
For the two weeks ending March 18, outflows from muni funds were at $24 billion (as reported by ICI), the largest 2 week total since 1992 when we started keeping stats.
- The biggest concern and the one market indicator MainLine has been focused on is the 7-day variable rate note index. This reflects the amount of cash in the muni market and serves as a good indicator in this recent crisis. The level was at 1.10% to 1.20% in early March as the market was reaching record low yields. In the heart of the crisis from March 18 to 23, the rate was up to 5.5% to 6.0%. As the market has been healing lately, they are now resetting near 1.80%. Follow the cash and, at this moment, the rest of the muni market will follow. This is why we feel the muni market suffered a liquidity crisis caused by the virus and not credit.
- Want to hear a good credit news story about the virus and the city of Chicago? It exists in the success of the unique tax strategy established in 2015. The “Amusement Tax”,collects a 9% tax on the Chicago users of Netflix, Hulu, and Spotify. Considering the circumstances, we have to believe that pool of tax revenues is up, and there will be a lot more cities/states to looking to do the same in the future.
- At their worst (for a very short while) long-term munis were at roughly 400% of USD taxable swap rates. Good, clean high-rated issuers were yielding close to 4%, while the 30-year swap rates were below 1%. This sets a new record of cheapness since collecting data from 1994. The last record cheap ratio was around 200% in the 2008-2010 banking crisis. Now, there is some math involved when comparing these ratios and the level of rates at the time, but I think it is safe to say, munis were a mess.
Munis and Economic Depressions:
Introduction:
We are not certain how long the national lock-down will exist, but if it extends through the summer, the lack of economic activity will affect the municipal market. In this monthly, MainLine reviews the potential impact to the repayment of principal on muni bonds during a COVID-19 depression. We will first review how munis did during the Great Depression and then extrapolate to the current muni market to see what we think could happen in a COVID-19 induced economic depression.
Munis and the Great Depression:
The municipal market, still very young, slowly grew during the Great Depression of the 1930s. This was during a tough time for the municipal market, as a sudden rise in relief expenditures, coupled with a drastic drop in tax collections, led to widespread municipal bond defaults. From 1929 to 1937, there were over 4,700 municipal defaults, roughly 7% of the average outstanding debt. Chaos followed, and numerous types of legislation were introduced to address state sovereignty and federal government concerns. As a result, Chapter 9 (United States Bankruptcy Code available exclusively to municipalities) was born in 1946 and, ultimately, most municipal defaults were worked out in less than 18 months with payments being made in full. The final amount of debt defaulting was 0.5% of the average outstanding debt. Arkansas was the only state to default in 1933, but in the end, they made investors whole.
The creation of chapter 9, especially for revenue bonds, should help protect and keep most of the defaults from the 1930’s from occurring again. We already know, based on the month of March, that there will be stress in the system leading to downgrades. However, we also now know the US Government is willing to provide help. Yes, we do not think a muni investor should own bonds simply because the US Government is going to bail it out. We think more research and security is needed. The details of the US Government plan are still being developed, and the muni market knows from history, things can change.
Below, we discuss the sectors of concern and how we analyze them under a COVID-19 induced depression:
Healthcare & Hospital backed bonds are a sector with a wide range of opinions. MainLine feels strong systems and facilities are going to be solid credits, going forward, but could have a short-term liquidity problem. The importance of the sector has never been more evident, and the US Government has this sector as a top priority for obvious reasons. The demographics and financial strength of the issuer needs to be reviewed and those that are important should be a safe investment. Monies have been set aside in the relief plan to help with any short-term liquidity issues, as systems will be busy.
Higher Education bonds backed by student dorm revenue or highly dependent on it could be a concern. Most of the high-rated college/universities are not dependent on student dorm revenue and have healthy foundations to help support debt service. We suggest staying clear of the smaller schools with tight operating margins and a dependence on annual admissions revenues.
Industrial Development Bonds(IDB) providing finances to private businesses and projects could be adversely impacted depending on the location and the type of business. These bonds will not be subject to aid, in most cases, are small or new companies.
Airport and Airline backed bonds are another sector of high focus. The relief plan includes a lot of support for these issuers, especially the major airports. We think the major airports, and some of the smaller ones that provide the sole service to solid demographic regions are going to be safe. We prefer being invested in these types of airports than being involved in airline-backed bonds. Airline-backed bonds are more corporate in nature and run outside our range of expertise.
Limited & Unlimited General Obligation (GO) bonds will feel the credit strain and suffer numerous downgrades and the bonds in areas with weaker demographics may face debt repayment concerns. Tax revenues will be down significantly and issuers will be looking for ways to pay their bills. The US Government will most likely help these issuers out, but we feel the investor needs to look further to determine the “safer” ones.
Unlimited GOs are backed by the full faith and credit of the issuer. As you know from our work, there are certain GOs that are better than others. A review of the issuer’s demographics, lien priority of payments, politics and use of proceeds helps further guarantee the safety of GO bonds. MainLine prefers voter-approved bonds backing schools and essential services.
Limited GO are bonds backed by annual budget appropriations. Projects that are not considered essential could be cut out of the issuers’ budgets in times of great economic strain. Projects such as: schools, prisons, water facilities are safe bets for repayment and full annual appropriations. In some cases, limited GOs exist due to the way a local government has set up its issuing parties, and they are just as important as unlimited GOs. Once again, use of proceeds and demographics is vitally important.
Tax-backed bonds are bonds whose repayment is based on the revenues from a designated tax or taxes. In the case of a prolonged recession, tax revenues will be down, leaving less revenue available to repay debt. Depending on the tax, the issuer and the lien on revenues, these bonds could be safer than GOs and/or could be further protected by other sources of revenue from the issuer. It is also important to know what the use of proceeds were used to build or maintain. If it was personal income tax dedicated to build new schools, concern of repayment is much less than if it is a tourist tax being used to build a destination resort.
Conclusion:
MainLine feels, if the US flag comes up in the morning, an investor in the “core” municipal market will have principal protection, as they provide essential services for the public good. We feel essential service issuers meeting certain credit criteria: water & sewer, hospitals, electric utilities, housing, schools and general obligation pledges are “credit good” in a prolonged recession/depression. These are all services that the government is required to provide, in the great, “we will prevail” USA!
Our “sleep well at night” muni investment philosophy has always led us to buying essential service revenue bonds and bonds backed by unlimited taxing power in areas with solid income demographics. These types of bonds tend to hold up quite well in recessionary periods, when high-yield credits are taking a beating. Therefore, while many uncertainties remain surrounding COVID-19, we feel the types of credits we buy will weather the storm.
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