04.14.22

The Impact of COVID-19 on Municipal Debt and What This Means for Investors in the Months Ahead

Municipal bonds offer important tax benefits and can be an effective way to diversify investment portfolios while generating steady income. However, knowing which issues and sectors to invest in can get complicated during the best of times. Over the past 18-months, the market has required investors to be even more nimble, fluid and risk-averse. That’s because almost all projects and sectors supported by municipal bond revenues have been impacted in different ways during the COVID-19 pandemic and economic recovery. Below, fixed income research analysts from TIAA, FSB’s Investment Management Group (IMG) share their insights on how the municipal bond market has fared, the importance of a rigorous credit process to help protect portfolio value, and what investors can expect in the months ahead.

How COVID-19 impacted municipal debt

Municipal bonds, or “munis,” are debt securities that may be issued by government entities, such as states, cities, and counties seeking to raise money for regular operations or special projects. They can also be issued by private-sector corporations to help build or improve hospitals, conference centers, sports stadiums, and more. Munis have an interesting distinction that most investments, including stocks, do not. They impact your everyday life from the roads and bridges you drive on, to the schools your children or grandchildren attend, and airports, hotels and conference centers you visit. Because you likely interact with many of the projects and venues supported by moneys raised through investments in municipal bonds, you also have a direct impact on their success or failure.

This became increasingly evident in March 2020, at the start of the COVID-19 health and economic crisis, when many investors pulled money out of the municipal bond market, leading to large fund outflows that soaked up liquidity. At the same time, tax-exempt yields spiked because sellers far exceeded buyers and the market became extremely volatile and illiquid.

Bond rating agencies assigned negative outlooks to almost all municipal sectors and correspondingly handed out several high-profile downgrades. In fact, ratings downgrades in 2020 outpaced upgrades for the first time since the Great Recession. Credit concerns were further exacerbated by the plummeting use of public transportation, due to a combination of health and safety concerns, more people working from home, diminished tax revenues for state and local government, and reduced student enrollment and housing demand at colleges and universities, among others.

Stimulus funding was key to supporting the municipal market
Congress and the Federal Reserve (the Fed) responded to the crisis in an unprecedented manner, passing three major pandemic support bills, beginning with the Coronavirus Aid, Relief, and Economic Security (CARES) Act in March 2020. The CARES Act included almost $400 billion in municipal relief and authorized the Municipal Liquidity Facility, which allowed the Fed to purchase up to $500 billion in notes from states, providing liquidity and stability to the municipal market. The monies in the relief package provided significant support to state and local governments along with other sectors including:

  • $100 billion in grants for healthcare providers
  • $27 billion for education
  • $25 billion for transit providers
  • $10 billion to maintain operations at airports

A second relief package, the Coronavirus Response and Relief Supplemental Appropriations (CRRSA) Act passed in December 2020, included additional aid for some of the most impacted municipal sectors.

The American Rescue Plan Act (ARPA) was the largest of the three major COVID-19 relief bills in terms of direct relief for the municipal market, totaling over $570 billion to municipal issuers. It helped accelerate the recovery outlook for the broader economy by stimulating consumer spending through income support, and reducing the risk of non-payments for mortgages, rents and utilities.

While long-term risks for certain sectors and issuers will remain and could become magnified in the coming years as the fiscal high fades, the municipal market and credit has certainly benefited from this level of aid and relief.

Some sectors were hit harder than others
According to Mairaj Elahi, IMG Fixed Income Credit Analyst, while the draconian outlooks for municipal bonds that were forecast at the onset of the pandemic failed to fully materialize, pandemic-induced lockdowns did create significant revenue challenges for municipals.

  • Transportation - The transportation sector faced perhaps the greatest challenges with subway ridership declining by almost 80% at one point, and airport passenger traffic reduced by over 60%. For example, the New York Metropolitan Transportation Authority (MTA) faced severe subway ridership declines, reaching an all-time low in March 2020, after a nearly 90% decline, followed by a slow recovery. However, bridges and tunnels saw a rapid recovery following the nationwide lockdown, since more people preferred driving than travelling on planes and subways. As a result, toll road activity has recovered to almost 90% of its pre-pandemic level. Fare-dependent transit systems still remain the most vulnerable, while tax-supported systems will be less impacted.
  • Hospitals - The health care system was disrupted in an unprecedented manner, as shortages of hospital beds, labor and personal protective equipment wreaked havoc. Rising COVID cases led to halting of elective surgeries, which typically generate more revenue. Labor shortages and increased demand for protective equipment resulted in higher operating costs and lower margins. With so much uncertainty and risk, investors were struggling to assess the sector at the onset of the pandemic. Large multi-hospital systems servicing stronger demographics were the least impacted, while small single hospital systems, rural systems, and senior and assisted living facilities were impacted to a higher degree.
  • Colleges and universities - Revenue pressures from enrollment declines, restrictions on student housing and state funding cuts created fiscal challenges for many in the higher-education sector. Large university systems and research universities with strong demand and greater financial flexibility have seen less impact than small private colleges.​
  • Hotels and tourism - Hotel and convention center bonds remain the most vulnerable due to ongoing health and safety concerns. Bonds secured by tourism-backed taxes faced revenue shortfalls as tourism came to a halt early during the pandemic. Hotel occupancy declined by almost 90% in March of 2020, and revenues are still below pre-pandemic levels. Convention center revenues also plummeted as most events got cancelled due to travel and capacity restrictions. The sector may continue to face challenges as the global pandemic continues and travel restrictions evolve.

How the Investment Management Group’s investment process prepares clients to navigate through volatility

Responding to this shifting landscape requires a rigorous process for assessing and evaluating risk on an ongoing basis. According Jill Richman, Sr. Director, IMG Fixed Income Credit Analysis, having a tested process in place is critical during periods of volatility or uncertainty. IMG’s municipal fixed income process includes the following actions:

  • Disciplined fundamental research process – IMG conducts proprietary research at the time bonds are purchased, with a focus on project essentiality, industry fundamentals, historical performance and security and other bondholder protections. The team’s investment process includes rigorous fundamental analysis designed to protect portfolios from downside risks.
  • Prudent risk management through ongoing surveillance of portfolio holdings – Bond holdings are reviewed at regular intervals to detect any early credit weakness. The analysis includes financial statements and disclosures, forward projections, dialogue with management officials and rating agencies, as well as monitoring of daily news feeds. The process helps identify credit problems early on to proactively manage risk.
  • Proactive portfolio adjustment and diversification – IMG focuses on diversifying risk by avoiding concentration in any single municipal issuer when constructing portfolios. The team also performs a broad-based evaluation of issuers, states, sectors and macroeconomic trends to proactively manage any emerging risks and adjust portfolios accordingly.

What should investors expect in the months ahead?

Despite the risks, munis remain resilient
IMG’s fixed income team expects investment grade municipal defaults to be rare due to better-than-expected revenue recovery for many states and local governments. In addition, stimulus checks and enhanced unemployment benefits circumvented large drops in retail spending, thus mitigating what would otherwise have been sharp declines in sales tax collections. Income tax collections have also fared better than expected despite considerably high unemployment rates.

A surging stock market and rising home prices also served to blunt declines in overall tax receipts. Property taxes represent about 30% of total local revenue, on average, and stable property values should benefit most local governments and school districts.

Finally, the long economic expansion has enabled most states to build reserves at an all-time high, mitigating some of the impact from the pandemic. Median rainy-day fund reserves for states are at an all-time high and median reserves for most local governments also remain above where they were following the last recession.

Professional investment management can help navigate the muni market
The steps required to effectively sort through and evaluate tens of thousands of individual issues or hundreds of municipal bond funds can be onerous. Applying complex selection criteria is just the beginning. Monitoring holdings, initiating proactive portfolio adjustments aligned with individual risk parameters, and performing ongoing surveillance of the creditworthiness and diversification of bond holdings are all critical steps in the management process. Having a disciplined process implemented by a team trained to make investment decisions under even the most challenging circumstances can really make a difference.

“Professional portfolio management is about expanding your access to resources and providing the coordination and synergy you need across the different aspects of your investment planning,” Richman said. “It establishes a foundation for helping you accomplish all of your goals, whether that includes generating income, managing your tax exposure or other priorities.”

Want to know about how municipal bonds may fit in your overall portfolio?
To learn more about how a professionally managed portfolio, including municipal bonds, may help you pursue your goals now or in retirement, schedule time to talk to a TIAA advisor today.

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