Foresight

Munis and Covid-19: Let’s give ‘em something to TALF about


Municipals are often viewed as a safe-haven corner of the market during turbulent times, insulated from bouts of volatility typically experienced in other asset classes like corporate credit. But this is currently not the case. The shutdown across the country is creating sizable holes in municipal issuer budgets, as billions of dollars in tax and public use revenues vanish.  According to the National Conference of State Legislatures, the impact of Covid-19 is “like nothing we’ve ever seen before”.  Localities reliant on tourism and oil prices will be especially hard hit; additionally, the effect will be particularly severe on entities that rely heavily on sales taxes, which raised more than $400 billion in revenue in 2018. 

Adding insult to injury, filings for unemployment benefits are surging across the country, leading to a potential decline in income tax collections.  Over the two week period ending April 2, jobless claims totaled 10 million, the largest number since the government began collecting this data in 1967, and this is just the beginning.

Millions of Americans are likely to lose jobs as the pandemic has halted travel and social events, while small businesses and restaurants continue to feel the brunt of it. In fact, one estimate expects the US restaurant industry will lose 7.4 million jobs alone. 

The philosophy of “cash is king” as pandemic fears rise has driven decisions by everyone from large corporate treasurers to retail investors, as evidenced by substantial outflows from municipal mutual funds.  For the week ending, March 18th, municipal mutual funds reported outflows of -$12.2 billion, the highest amount on record dating back to 1992 – and nearly twice as large as the previous record.   For the last week of the month, the trend grew with reported outflows of $13.7 billion (through March 27).   

Price discovery is as poor as it was during the Global Financial Crisis.  The new issue market is almost at a standstill as issuers and investors wait on the sidelines as opposed to selling or buying in an irrational market.  Billions of dollars of new issue supply in recent weeks has been postponed, cancelled or changed to “day-to-day” status.  Even with the Federal Reserve cutting interest rates to zero, municipalities continue to postpone sales.  As an example, supply ending the week of March 27th reported supply of $2.2 billion, which is only 27% of the typical supply. 

I’m from the Government, and I’m here to help[1]

In the past few weeks, the massive response to the pandemic here in the US has been unprecedented. The Fed dropped short-term rates to near zero and has essentially become the ‘buyer of last resort’ by reinstituting unlimited QE, reinstating the Term Asset-Backed Securities Loan Facility (TALF) and expanding the Money Market Mutual Fund Liquidity Facility program to include short-term municipal debt with maturities of less than 12 months. Last week, the Fed announced a second round of massive initiatives to support the economy, including buying an unlimited amount of bonds to keep borrowing costs low and setting up programs to enable credit flows to both corporations and state and local municipalities. 

Most recently, the trillion-dollar Coronavirus Aid, Relief, and Economic Security (or “CARES”) Act was passed and signed into law at the end of March. Besides the popular parts of the bill which include individual cash payments to US citizens and up to four months of pay to laid-off workers, among other proposals, billions of dollars have also been earmarked for essential service emergency relief funds for airports, public transportation, hospitals as well as support for small businesses.

Municipals in 2020: Harnessing disruption will be key

We are closely monitoring several sectors, including airports, health care, higher education, and sales tax revenue bonds, among others, as the situation continues to evolve. Historically, the government has supported municipal issuers, including airports after the September 11 attacks as well as FEMA funding after natural disasters, because of the services municipal issuers provide.  In addition, debt relief in the form of debt to grant conversions through special-purpose financing or through the Small Business Administration is expected.

The map below is from the Rockefeller Institute, and it illustrates just how important this might be, as over a quarter of all cases in the US are concentrated in the NY-metro areas. With mass-transit, hospitals, and generally every municipality anticipating sharp revenue drop-offs, from a balance-of-payment perspective this could also have a tremendous impact on the Federal Government’s revenue, since New York is one of a few states that contributes more dollars to the Federal Government than it receives.

Rockefeller Institute Balance-of-Capital values, 2018

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Source: Rockefeller Institute, 2018. Based on most currently available balance-of-capital values, which is the amount that a state receives in from the Federal government versus the amount it pays to the Federal Government. Red indicated a negative balance, blue reflects a positive balance.

While fundamental research is vital now more than ever, we are encountering unchartered territory.

One of the tools in our research arsenal, Schroders Municipal US Sustainability Explorer (MUSE), is a proprietary investment tool that allows analysts to access dozens of data points across environmental, social and governance factors and assign an Overall Sustainability score to over 3,000 counties in the US. What makes this tool unique is that it affords us a forward-looking lens into the population that supports the municipalities that comprise each county.

At a high level, MUSE enhances our longer-term perspective compared to traditional municipal fundamental analysis. For example, there are thousands of issuers around the State of New York, each with a unique profile from a fundamental perspective, but also a social and governance factor standpoint. While the Covid-19 outbreak will indeed stress the limits of issuers’ ability to balance budgets and/or maintain services while revenues are stressed, there are a variety of positive factors that lead us to believe that, once the pandemic abates, most issuers will remain in a strong position.

New York rates fairly high in terms of ESG and Sustainability across municipality issuers

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Source: Schroders. for illustration only. Blue shading reflects high sustainability ratings, orange reflects low sustainability ratings, For more information, visit www.schroders.com/US for complete methodology.

Credit selection has always been important in the investment process, and MUSE is key to our municipal credit process.  This proprietary model gives us a longer-term perspective into municipal vulnerability or sustainability which is critical during times of abrupt stress that has yet to be reflected in the fundamental data.  MUSE provides us with the confidence to hold or buy, based on long term non-traditional ESG data when others are panic selling, or possibly sell if any one factor warrants concerns.

Conclusion and outlook

These are unprecedent times in municipal credit − thoughtful analysis combining traditional fundamental research and more detailed ESG analytics focused on the long term is critical. We are anticipating some state and local budgets to become unbalanced as we head into the summer.  Reserves can be used for short-term support, but a prolonged crisis will force municipalities to make cuts. Longer-term headwinds such as poor demographics and challenging environmental factors, or tailwinds such as access to medical care, healthy lifestyle trends, and water treatment, will help us to make high confidence longer-term investment decisions, which may lead to attractive returns. 

While the municipal market is dealing with significant volatility, we firmly believe in the essentiality of the municipal market for long-term investment opportunities.  Credit selection has always been important in the investment process; we are closely monitoring all sectors for short term (airports, health care, higher education, and sales tax revenue bonds) and long term (state and local governments) ramifications. 

Finally, from a cross-over perspective, municipals are offering yield opportunities that may make them attractive for “taxable” buyers. For those looking for a different type of income source, TALF-influenced assets like municipals may make this the time to explore the asset class.

 

[1] Ronald Reagan, August 12, 1986.

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.