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Municipal Bonds

Federal funding boosts credit resilience as recovery continues

Municipal Credit Research Team
Experienced sector specialists represent one of the industry’s largest credit research teams dedicated to municipal investing.
A staircase inside a glass building

MuniNotes highlights

 

Federal government fiscal support for state and local governments, as well as various credit sectors such as airports, senior living facilities and education, is providing a cushion as the economy continues its recovery.

 

Credit report: U.S. airports bolstered by extraordinary support

The coronavirus pandemic has been extremely challenging for the airport sector. However, solid liquidity, extraordinary government support and conducive debt capital markets have provided a constructive framework to navigate the crisis.

The U.S. government has provided the sector with approximately $20 billion in aid: $10 billion in March 2020, followed by an additional $2 billion in December 2020 and $8 billion in March 2021. This helped mitigate the impact of the shelter-in-place mandates resulting from COVID-19, since the airport sector is essential within the global infrastructure and to the overall health of the economy.

This funding bolstered the already strong unrestricted cash balances and debt service reserve funds that the majority of airports held prior to the pandemic. Unrestricted cash has historically been around 500 days cash on hand, on average. These reserves, combined with the additional liquidity support from the federal government, have allowed most airports to successfully manage the significant blow to passenger traffic and revenue.

The airport sector is showing signs of life from a fundamental credit standpoint, and air travel passenger volumes have improved over the first four months of the year. As of April, TSA daily volume was running approximately 40% below the same period in 2019, pre-COVID. This is significantly higher than the decline of approximately 90% year-over-year most airports experienced between March and July 2020.

We expect the recovery in air travel will continue improving as a larger percentage of the population is vaccinated and state and local governments continue to loosen restrictions.

While Nuveen anticipates continued improvement in passenger volume through 2021, we do not envision traffic levels returning to pre-pandemic levels for a few years. Corporations will likely be slow to encourage business travel, as rapid advances in technology will continue to facilitate more cost-effective virtual meetings. Leisure traffic may also be slow to return, as a portion of the consumer base will remain wary of the virus.

That said, we continue to believe the U.S. airport sector will manage through the crisis effectively, albeit with weakened credit metrics that will take two to three years to fully recover. Weaker credit metrics have resulted in a number of downgrades across the sector, but we do not expect monetary defaults to follow.

Figure 1: U.S. airport travel volume is slowly increasing

 

U.S. ports are resilient to unexpected events

Ports around the world have grabbed headlines in recent months: Suez Canal Blocked by Massive Cargo Container Ship. America’s Imports Are Stuck on Ships Floating Just Off Los Angeles. Pain at the Ports as Cruise-Related Businesses Wait Out Pandemic.

Ports have suffered many instances of operational disruption over time — from trade wars and cyberattacks to extreme weather and pandemics. These disruptions generally go unnoticed by consumers, until there’s a glitch in the system. But these glitches rarely sink a port’s financial wherewithal. Ports are major drivers of the U.S. economy, and they have myriad ways to mitigate the risk of operational disruption.

While U.S. ports have not received any direct federal pandemic relief aid, seaports are often part of a public port authority that oversees much of a regional transportation infrastructure, which may include bridges, toll roads, airports and transit systems. Some of these areas, such as airports and mass transit, have received direct federal stimulus money.

President Biden’s proposed American Jobs Plan would provide $2 trillion to modernize the nation’s infrastructure over eight years. Of that $2 trillion, the plan would dedicate $17 billion to invest in inland waterways, coastal ports, land ports of entry and ferries. At this point, the plan remains in the blueprint stage.

Public ports and port authorities often mitigate unanticipated revenue volatility stemming from operational disruptions with their strong liquidity and segregated reserve funds. Heading into the pandemic last spring, the nation’s largest ports had more than a year’s worth of cash on hand to cover operating expenditures.

Operational ports — those in which the port owns the cranes and cargo-handling equipment and hires the labor to work the docks — have flexibility to adjust labor costs when cargo volume is impacted. These types of ports cut staffing and capital budgets early in the pandemic. For those ports managed under a landlord model, the port enters into long-term agreements with private port operators, such as shipping companies, dockworkers or cruise lines, for a fixed fee, making them inherently less susceptible to revenue swings.

Ports are generally faring well in terms of their cargo volume and profitability.

With the notable exception of cruise ports, which continue to be negatively affected by the shutdown of the cruise industry in the U.S., ports are generally faring well in terms of their cargo volume and profitability. Container ports on the East and West Coasts have reported all-time highs of container throughput this year in response to robust U.S. consumer demand for goods. Ports have rebounded quickly from the volume declines seen at the start of the pandemic, when the supply chain was disrupted by the closure of factories overseas and weak consumer demand in the U.S.

In comparison, container volumes were impacted much less by the COVID-19 pandemic than during the global financial crisis. Total TEUs (twenty-foot equivalent units) declined for six straight months in early 2020, but container counts declined monthly for nearly a year-and-a-half for many of the large cargo ports during the financial crisis.

 

Retirement communities face a lingering financial impact

When COVID-19 appeared, the senior living industry’s reason for existing became its biggest liability. How would communities that cater to the social and health care needs of seniors keep their clients safe from a virus that disproportionately affected the elderly in communal settings?

After some weeks of confusion at the outset of the pandemic, senior living communities were forced to lock themselves up from outsiders, even new residents. Marketing stopped and prospective residents reconsidered their plans to move into facilities. The press portrayed senior living facilities as places where people were dying, isolated and abandoned, unable to meet with family.

As a result, occupancy in senior housing across the country has decreased by nearly 7% since the first quarter of 2020. Skilled nursing occupancy declined by more than 13%, falling to 71%, the lowest level on record.

The pandemic quickly affected credit quality in the sector. Expenses promptly rose as providers scrambled for supplies. The CARES Act initially offered modest assistance that helped make up some of the difference through 2020, but overall funding has been insufficient. Most providers successfully procured PPP loans, which have been since been forgiven and have been treated like grants. Ultimately, government assistance has not fully covered pandemic-related losses, and it does not look like new money will be forthcoming.

Unsurprisingly, the sector is now seeing a wave of covenant violations. For many communities, cash flows have dropped below required levels, triggering technical defaults and forcing communities to seek forbearance from bondholders. Communities with sufficient cash are likely to recover, but those that let cash get too low are at increased risk of payment default.

The future is looking better. Most residents have gotten vaccinated, although staff have been more reticent. Communities are reopening their public spaces, and we expect to see a recovery in occupancy, though not completely in the first year.

How the pandemic will affect ongoing marketing and public opinion remains an open question. Negative press covering hot spots in senior living has inflicted reputational damage that is unlikely to dissipate quickly. We expect memories to eventually fade, but fears will likely remain in certain markets.

Local school districts as a credit sector have been stable throughout the pandemic.

We also expect to see a lingering financial impact. Continuing care retirement communities (CCRCs) take on insurance risk and rely on reserves and cash flows to fund their actuarial liability. Actuarially speaking, nearly all communities have lost some ground. Depending upon entrance fee agreements, we can expect the actuarial hit to remain an issue for some borrowers over the next decade.

Some providers are expressing fear about potential legal liability for COVID-related issues. If Congress does not act to indemnify providers, we can expect to see lawsuits from both employees and residents. It is impossible at this stage to say if the threat is material.

To date, low interest rates have helped to bolster M&A in the industry. Facility valuations have been holding up, but entrance fee CCRCs pose legal, financial and reputational risks to buyers of troubled long-term care facilities, so recoveries could be low in certain instances.

   

Aid for schools is meaningful 

The American Rescue Plan Act (ARPA) provides $123 billion in new direct funding for K-12 school districts to be deployed over the next two years, representing the largest one-time federal allocation of direct aid to local districts. It will have a meaningful impact on communities across the country, as most schools will transition back to in-person learning this year.

Across the U.S., school funding is shared by states and local districts, with the federal government normally providing a small fraction of revenues. Local school districts, as a credit sector, have been stable throughout the pandemic, despite the difficulties of moving to distance learning and staying connected to students.

Credit stability is not surprising, as the sector relies on stable property taxes and formula-based state aid. Though funding formulas vary widely by state, states provide about half of local school funding and local governments provide the balance. School districts are often vulnerable in periods of economic downturn, as states facing their own budgetary strain cut school funding, leaving districts to adjust their budgets in response.

For the current fiscal year, most districts adopted their budgets at a time when state revenues were expected to fall much more precipitously than they did. Districts assumed state aid would be cut and adjusted accordingly. In many cases, remote learning positively impacted budgets by lowering staffing costs. But distance learning also resulted in lower enrollment for many districts, as parents opted out of online learning for younger children. Lower enrollment frequently means cuts in perpupil-based state funding.

Favorably, ARPA funding requires states to maintain education funding at the pre-pandemic level. This ensures the new federal funding cannot become a justification for state cuts.

Individual districts will have wide latitude on how to spend ARPA funds to safely reopen and manage the impacts of the pandemic, but 20% of the funds must address learning loss and make up for lost instructional time. Most schools are expected to reopen for in-person learning by this fall, which will come with its own set of new costs. In order to reopen safely, districts will require further investment in technology, safety equipment, modernizing HVAC systems and additional custodial staff.

Many of the nation’s larger and lower-rated school districts are expected to receive enough ARPA funding to more than bridge near-term budget gaps. For example, Chicago Board of Education will receive an estimated $1.8 billion in ARPA funding, following $800 million in federal pandemic aid allocated in December 2020 and $200 million under last year’s CARES Act. For context, the district’s $6.9 billion budget for FY21 only assumed about $340 million in federal aid. Moody’s upgraded the district to Ba3/Stable in March, and S&P upgraded the district to BB/Stable in April.

Los Angeles Unified School District is set to receive an estimated $2.6 billion in ARPA funding, following about $2 billion already received in 2020, and the district is now projecting surplus operations for FY21 and FY22. Likewise, Philadelphia School District expects to receive $1.1 billion in ARPA funding, which would preclude the need for budget cuts in the upcoming year.

 

 

Market statistics

Municipal-to-Treasury ratios tighten (%)
High yield municipals are performing best in 2021
Municipal yields (%)
Total returns by sector (%)
Characteristics and returns
Credit spreads are tightening
Municipal-to-Treasury ratios are lower than normal
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Endnotes
Sources
American Rescue Plan Act Includes Much-Needed-K-12 Funding, Center for Budget and Policy Priorities, March 15, 2021

Nation’s Largest School Districts Aim to Reopen Fully in the Fall, Wall Street Journal, April 9, 2021

Moody’s Investors Service

Standard & Poor’s

USA Today

The Wall St. Journal

Los Angeles Business Journal


The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. For term definitions and index descriptions, please access the glossary on nuveen.com. Please note, it is not possible to invest directly in an index. 

 

A word on risk
Investing involves risk; principal loss is possible. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Bond insurance guarantees only the payment of principal and interest on the bond when due, and not the value of the bonds themselves, which will fluctuate with the bond market and the financial success of the issuer and the insurer. No representation is made as to an insurer’s ability to meet their commitments. This information should not replace an investor’s consultation with a financial professional regarding their tax situation. Nuveen is not a tax advisor. Investors should contact a tax professional regarding the appropriateness of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.

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