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Municipal Bonds

Climate change and COVID-19 test the municipal market

Municipal Credit Research Team
Experienced sector specialists represent one of the industry’s largest credit research teams dedicated to municipal investing.
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MuniNotes highlights

 

Wildfires and drought are challenging some U.S. cities and counties, but state and local tax governments overall proved to be very resilient during the pandemic. Higher education continues to navigate the ever-changing COVID-19 situation, boosted by generous federal stimulus money.

Credit report: Do drought and wildfires impact credit quality in California?

Warmer temperatures have triggered drought conditions throughout the western and southwestern United States. Drier conditions make these areas prone to wildfires, putting local economies and the health and safety of residents at risk. As temperatures rise, some cities and counties are projected to experience more severe weather conditions that may result in more frequent drought and wildfires than historical trends. As a result, assessing climate risk is an important component of credit analysis. California is one of several states currently experiencing the impacts of climate change.

After enjoying several drought-free years beginning in 2016, conditions shifted in 2021. As of July 2021, Governor Newsom had declared 50 of California’s 58 counties to be in drought. No statewide emergency has been declared this year, although the state has taken strong measures in the past, mandating that residents cut water usage by 25%. Rather than mandate water restrictions, the governor signed an executive order in July calling on all Californians to voluntarily reduce their water use by 15% compared to 2020 levels.

Water conservation measures can lead to reduced water sales and reduced water revenue, but that alone doesn’t necessarily correlate to a weakening of debt service coverage for water delivery systems.

A number of factors influence the ability of California’s local water systems to manage potential water shortages. Systems that have invested in water storage infrastructure and alternative water sources typically fare better in times of stress. Larger utilities tend to have stronger finances and more liquidity and are typically better equipped to manage revenue disruptions. The ability to increase customer rates, often through drought surcharges or higher base charges, is a strategy often employed to manage through conditions that can otherwise result in lower water sales.

California’s water systems are accustomed to drought conditions. Sufficient water supply is maintained through long-term planning, conservation practices and technological improvements. State law requires large water suppliers to prepare an urban water management plan detailing how they would respond to a multiyear drought and a single-year cutback of up to 50% in their available water supply. These plans are updated every five years. Some systems have turned to emerging technologies such as desalination to offset water shortages.

Generally, water utilities entered current drought conditions on a strong fiscal footing with solid debt service coverage and liquidity. Based on Moody’s 2019 medians, median debt service coverage was 2.2x, and median liquidity stood at 427 days cash on hand. Strong liquidity levels provide financial flexibility to mitigate the impact of unforeseen events and eliminates the need to increase rates for short-term disruptions. Wide-scale defaults are not expected, as water systems provide an essential service to the public. Rating downgrades could occur for systems unprepared to manage the impacts of the drought. The longer drought conditions persist, the greater potential for fiscal stress and credit quality deterioration.

Wildfires present another credit challenge

The California Department of Forestry and Fire Protection estimates the length of the wildfire season has increased by 75 days. Through July 2021, the number of wildfire incidents was up 12.4%, and the number of acres burned is up nearly 30% over the prior year.

Large-scale destruction generates concern over property values, specifically the assessed values of the properties within the affected areas. Local governments with properties that are destroyed could see a dip in assessed values, which are used to calculate the tax levy for repayment of general obligation bonds.

A number of factors offset the fiscal impact of assessed valuation declines from wildfires, including the size of the overall tax base; the presence of strong reserves; and external support from the state, the Federal Emergency Management Agency (FEMA) and even private insurance. Municipalities with strong cash positions have a cushion to deal with the immediate impact from a natural disaster before state and federal aid reimbursements are received.

Historically, the state of California has backfilled lost property tax revenues from wildfires, mudslides and other natural disasters and held harmless state aid from any loss in attendance for which school district funding is based due to wildfire dislocation. Municipalities with larger tax bases have historically tolerated assessed value losses better than smaller cities with more limited or concentrated tax bases.

No payment defaults on rated debt have occurred due to natural disasters. The City of Paradise, which has a modest tax base, experienced a massive property loss in the wildfires of 2018. Paradise was the largest participant in the California Statewide Communities Development Authority’s 2007 Series A-2 pension obligation bonds pooled financing. Despite this loss, the city stayed current on its debt service payments with help from private insurance and state assistance to backfill lost property tax revenue.

We do not anticipate widespread defaults due to the fires, but tax base impairment from wildfire destruction could potentially create sufficient fiscal stress on local governments to result in rating downgrades.

Water utilities entered current drought conditions on a strong fiscal footing with solid debt service coverage and liquidity.

Populations and economies have historically proven to be resilient to natural disasters. Areas of the U.S. have weathered hurricanes, droughts, floods, earthquakes and tornadoes, but none severe enough to cause wholesale investor panic. Rebuilding activity following a disaster can actually be a positive for a local economy, leading to an increase in new property valuations and overall tax collections. Local governments are more likely to see long-term fiscal stress if population declines become more permanent. Long-term population declines have not historically been rooted in natural disasters, but rather in regional deindustrialization and economic shifts, such as those seen in Detroit, Michigan, and Youngstown, Ohio.

Increasing drought conditions and growing frequency of wildfires mean investors must incorporate climate risk analysis into credit selection and evaluate how prepared individual issuers are to manage through fiscal stress these disasters may cause.

Municipal credit proves resilient

State and local tax governments proved to be very resilient during the pandemic. This was quite unexpected last spring when lockdown measures went into place, many businesses closed their doors and commercial offices saw a mass exodus. Most governments projected steep revenue losses and crafted budgets in an environment of significant uncertainty.

A year and half into the pandemic, the U.S. still faces some unknowns about how new virus variants and vaccine hesitancy may negatively impact the economy. But investors are now confident that a wave of municipal defaults is unlikely and the vast majority of municipal issuers will be able to weather the next few years bolstered by unprecedented allocations of federal COVID-relief aid.

Substantial federal monetary and fiscal support from multiple stimulus bills helped stabilize the fiscal health of state and local governments over the past year and half. Enhanced unemployment benefits and direct payments also promoted stability. For the first quarter of 2021, total state and local tax revenues were up 10.4%, compared to the first quarter of 2020. Sales tax collections have steadily improved over the past three quarters after modest declines in early 2020.

MuniNotes updated chart

As of mid-July, total consumer spending is up 11.8% over January 2020. As expected, property taxes, which account for about half of local government revenues, have remained remarkably stable. States did not see huge losses in income taxes, as most jobs lost in the pandemic were concentrated in lower-wage sectors. The U.S. labor market lost an estimated 22.4 million jobs due to COVID-19, primarily in the hospitality and entertainment sectors. Most projections do not expect total employment to recover to pre-pandemic levels until sometime next year.

In March 2021, Moody’s revised its outlook for local governments to stable from negative and recently upgraded its lowest-rated state, Illinois, from Baa3 to Baa2. Three other states have garnered positive outlooks – New York, New Jersey and Louisiana. S&P expects credit stability to hold through the end of the year and notes that they maintain negative outlooks on only 6% of rated credits, down from 8% a year ago. Overall credit conditions have improved, but the specifics are a bit more nuanced for many credits that still have structurally imbalanced budgets. Monitoring how stimulus funding is deployed over the next two years will be a focus to ensure that spending doesn’t create future budgetary cliffs.

Higher education is tested by COVID-19 and adapts

The higher education sector faced numerous challenges at the outset of the pandemic, as the virus caused campuses to close, students to move out of their on-campus housing and professors to quickly adapt to online teaching.

At the height of the crisis last spring, there was no shortage of headlines touting the end of higher education as we know it, with closures predicted for large swaths of institutions. Now it is clear that the higher ed sector, while challenged, did not buckle under the pressure. However, new strains of the virus may create more difficulties for colleges and universities as they look to fully reopen in the fall.

Enrollment declines last fall were less than many anticipated, for both public and private institutions. Brand name institutions are still in high demand from students across the country. Looking ahead to fall 2021, expectations for enrollment are still in flux, with many institutions reporting higher freshman deposits to date as compared to this time last year.

In general, more institutions reduced expenses and rationalized programs more than in the past, which helped financials in FY20 and is expected to help in 2021 as well. These changes will also set up these colleges and universities for more financial success going forward.

Additionally, federal stimulus funds certainly helped colleges and universities manage through this difficult time. Higher education institutions received $40 billion from the American Rescue Plan, in addition to a combined $37 billion from previous stimulus packages. These funds are very significant and will help bolster finances in the sector over the next one to three years.

Regarding public higher education, state aid for public universities was on the chopping block last spring and summer. Better-than-projected state revenues and additional federal support allowed most public universities to experience smaller cuts than originally expected or to be spared completely. As was the case prior to the pandemic, public universities in states with challenged financials are more at risk of revenue disruptions.

While smaller, lower-rated private institutions with weaker market positions are more at risk for severe ratings pressure and credit concerns, higher investment grade credits, with robust balance sheets and good student demand, will generally maintain credit quality or face only modest rating pressure resulting from fallout from the pandemic.

Higher education institutions received $40 billion from the American Rescue Plan, in addition to a combined $37 billion from previous stimulus packages.

 

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
www.calmatters.org, “Drought emergency declared in Central Valley, Klamath region.”

“Medians-Rate increases support stable financial metrics in 2019”, Water and Sewer Utilities-U.S., May 11, 2021, Moody’s Investors Service

Officer of Governor Gavin Newsom, “As Drought Conditions Intensify, Governor Newsom Calls on Californians to Take Simple Actions to Conserve Water”, July 8, 2021.

www.fire.ca.gov/incidents, 2021 Fire Season Outlook

“U.S. municipal bond defaults and recoveries, 1970-2020”, Moody’s Investors Service, July 9, 2021.

https://www.census.gov/data/tables/2021/econ/qtax/historical.html

Moody’s

Tracktherecovery.org

S&P Global Ratings, U.S. Public Finance Mid-Year Outlook: Beyond COVID?, July 22, 2021

This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy, sell or hold a security or an investment strategy, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her financial professionals.

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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